Global tax reform: the OECD’s two-pillar approach

November 2021  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2021 Issue

2021 has already been a big year for international tax, with discussions about tax matters top of the agenda at both the G7 and G20. In July, a pivotal moment was reached with over 130 jurisdictions reaching agreement on the Organisation for Economic Co-operation and Development’s (OECD’s) two-pillar proposal for global tax reform. But what are the two pillars and why are they so significant?

The OECD proposals stem from ongoing efforts to reform the international tax system to make it ‘fairer’. There are already various measures intended to discourage multinational groups from exploiting perceived weaknesses in the international tax system, so this is by no means a new idea. The OECD’s latest initiative seeks to tackle a growing concern that the traditional tax framework was not equipped for an increasingly digitalised and globalised economy, although it is important to note that the two pillars are trying to address two different problems.

Pillar 1 is designed to deal with the fact that increasing digitalisation of business means that traditional taxing rights that turn on whether a group has a physical presence in a jurisdiction no longer seem fit for purpose. This was leading to a growing public perception that large multinationals (and in particular ‘big tech’) were not paying their ‘fair share’ of tax, leading to a number of jurisdictions introducing their own digital taxes (in various shapes and forms), each seeking to claim a share of the big tech tax pie.

These uncoordinated and overlapping unilateral measures left certain multinationals facing multiple layers of taxation on the same amounts, not to mention the accompanying compliance nightmare. US-headed tech groups were particularly hard hit, leading to threats from the US of trade repercussions. An international coordinated response was therefore required to stop such trade wars escalating and to bring an end to the ever-expanding patchwork of national digital tax measures.

Getting the US on board was key to unlocking a global compromise. For obvious reasons, the US was unhappy with the focus on big tech, and, without US support, the OECD proposals stalled. The compromise reached in July is therefore not limited to digital companies, but targets “the largest and most profitable multinationals” (those with global turnover above €20bn and profitability above 10 percent of revenue, although the threshold may come down in time). Regulated financial services and extractives are out of scope, and there is already considerable interest in where exactly these lines will be drawn.

Pillar 1 introduces a new taxing right, not based on physical presence, but instead looking at where revenue is generated. This, in itself, is groundbreaking in tax terms, but Pillar 1 also involves a portion of residual profit being reallocated to market jurisdictions using formulary apportionment concepts, which were rejected by OECD members only a few years ago. While it is thought that the number of multinational groups in scope, at least initially, will be relatively small (around 80-100), the amounts subject to reallocation for those groups could be in the billions.

By way of contrast, Pillar 2 is tackling a different issue, namely groups shifting profits to low or zero tax jurisdictions to reduce their tax bill. The compromise reached is for a global minimum effective rate of tax of “at least 15 percent” (although the US would ideally like this to be higher). This will work by means of a primary rule that operates by way of a top-up tax levied in the jurisdiction where the multinational is headquartered, similar to existing CFC rules. In addition, there are back-up measures, such as applying the top-up tax lower down the group or taxation at source on certain intragroup payments.

The revenue threshold for Pillar 2 is much lower (€750m) and so is likely to impact a large number of multinational groups. Despite the seemingly straightforward concept of a minimum rate of tax, applying Pillar 2 will be incredibly complicated, not least because it is layered over already complex existing rules that try to tackle similar issues.

The July agreement provides that even jurisdictions that have agreed to participate in the OECD two-pillar approach are not required to adopt the Pillar 2 top-up taxes. However, if enough countries choose to do so, it will become harder for jurisdictions to compete for investment using low tax rates and tax exemptions, as the Pillar 2 rules will potentially deny multinationals the benefit of such measures. The idea is to end the race to the bottom in terms of tax rates and to encourage investment decisions to be made on other (non-tax) factors instead.

There is a long way to go before the two pillars take effect and several hurdles still to overcome, not least getting the measures through the US legislative process, which is by no means a foregone conclusion. In addition, international consensus still needs to be reached on a number of technical points, with detailed proposals set to be published in October 2021.

The next challenge will then be national implementation, and it is expected that changes to both domestic law and bilateral tax treaties will be required. The expectation is that there will be a multilateral instrument to try to achieve consistent application and implementation, but the new rules will inevitably give rise to international tax disputes. The OECD’s July framework does anticipate this and provides that there will be dispute prevention and resolution mechanisms to assist those in scope.

These are wide-reaching changes and, for groups operating internationally, there is a lot to digest. It has taken unprecedented levels of international cooperation to develop a solution to these global issues. If you were starting from a blank sheet of paper in designing an international tax system, you would undoubtedly end up with a more straightforward approach. However, this is not the reality, and the result is a compromise that is complicated and may prove difficult to navigate. That said, it must be recognised that reaching a global agreement, balancing all the conflicting needs and desires of over 130 jurisdictions, is an incredible achievement. But with so much still to be decided and the rules due to take effect from 2023, global tax reform is set to stay high on the agenda.

 

Brin Rajathurai is a senior knowledge lawyer and David Haworth is global tax practice group leader at Freshfields Bruckhaus Deringer LLP. Ms Rajathurai can be contacted on +44 (0)20 7785 2161 or by email: brin.rajathurai@freshfields.com. Mr Haworth can be contacted on +44 (0)20 7832 7755 or by email: david.haworth@freshfields.com.

© Financier Worldwide

BY

Brin Rajathurai and David Haworth

Freshfields Bruckhaus Deringer LLP

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