Seismic shift: harmonising global taxation

October 2021 | FEATURE | CORPORATE TAX

Financier Worldwide Magazine

October 2021 Issue

Taxation is a hot button issue in many jurisdictions. There is a perception that some multinational companies shift their profits abroad to avoid paying their fair share of tax. Efforts have been underway to tackle the problems associated with global taxation, particularly in light of widespread economic digitalisation in recent years.

In large part, existing tax rules are deemed no longer appropriate for modern business. Taxing companies based on their physical presence in a jurisdiction has become outdated, since globalisation and digitalisation means companies can now profit from activities in places where they do not have a footprint, which in turn frustrates government efforts to collect tax revenue. There are also persistent concerns about multinationals’ ability to shift their profits into low-tax jurisdictions and thereby reduce their tax liabilities.

Corporation tax is a complex, controversial and emotive subject. It remains in a constant state of review and reform around the globe. But, given the diversity of interests, achieving consensus across borders is no easy task. A truly harmonised, international approach to taxation in the digital age has been lacking, with some fundamental differences in preferred approaches evident between countries.

Tax in the digital age

The growth of the digital economy has been momentous and has certainly impacted traditional tax systems by allowing companies to compete in markets without a physical presence and to engage in cross-border trade with greater ease. However, the underlying problems this creates are not necessarily novel. “Digital businesses, or the digital initiatives of traditional businesses, are not that different from what we have seen before,” suggests Michael Dolson, a barrister and solicitor at Felesky Flynn LLP. “The problems are not entirely new.

“The key difference is that the digital economy is much less dependent on physical presence in a particular jurisdiction than the traditional economy,” he continues. “Although international tax rules were largely designed to tax economic activity based on physical presence in a particular jurisdiction, those rules are now starting to change in response to the massive growth of the digital economy.”

Action 1 of the Organization for Economic Co-operation and Development’s (OECD’s) G-20 base erosion and profit shifting (BEPS) project in 2015 aimed at addressing the tax challenges of a digital economy. “The OECD’s BEPS project, although notionally targeted at the digital economy, has been impactful in much broader ways,” he continues. “For example, changes to the OECD’s transfer pricing guidance under the aegis of the BEPS project has made it materially more difficult to justify returns for entities that own, but do not develop, intellectual property.

“It is too early to tell how courts will deal with the principal purpose test in the Multilateral Instrument, but that has the potential to upend treaty-based financing and investment structures,” he adds.

“A global minimum tax would limit a government’s ability to exercise tax policy as it sees fit. This raises the question of how to balance a nation’s right to sovereignty with a policy objective of updating the global tax framework.”

Various jurisdictions have taken steps to reform tax legislation. In January 2019, the European Union Anti-Tax Avoidance Directive ATAD (EU-ATAD) took effect in response to the relevant Action Plans of the BEPS project. The introduction of the EU-ATAD helped create some degree of uniformity across EU member states, introducing three BEPS-related rules, plus two rules which did not derive from BEPS, for a total of five substantive anti-tax avoidance rules.

Other jurisdictions have revised national legislation. The UK, for instance, brought in a digital services tax (DST). Since April 2020, the DST provides a 2 percent tax on the revenues of search engines, social media platforms and online marketplaces to the extent that their revenues are linked to the participation of UK users, regardless of where the corporate owner of those revenues is located and irrespective of the physical presence that the corporate has in the UK.

The DST is not a tax on online sales of goods and only applies to revenues earned from intermediating such sales, not from making the online sale, however. The DST also only catches the revenues from online advertising or the collection of data where the business is providing a search engine, social media platform or online marketplace.

Elsewhere, Italy introduced a 3 percent tax on revenues from digital advertising, digital platforms enabling users to interact, and the transmission of data collected from users and generated by the use of a digital interface.

Across the Atlantic, the Biden administration’s outlook diverges from the preceding Trump administration, which refused to sign up for the Multilateral Convention on BEPS in 2016 and reacted negatively to the OECD’s March 2018 report ‘Tax Challenges Arising from Digitalisation’. Change in policy will likely be key to creating any global consensus around taxation.

“We have been closely watching the progress of the Biden administration’s tax proposals,” says Mr Dolson. “Multinationals were starting to adjust to the 2017 US tax reform and final regulations were being issued, and now it appears that the landscape may be changing again.”

Global minimum tax

A recent meeting of the G-20 nations may be the turning point. In July, finance ministers of the G-20 group of economies endorsed a landmark move to stop multinationals shifting profits to low-tax havens. This consensus will be particularly important as the global economy recovers from the dramatic impact of the coronavirus (COVID-19) pandemic.

The G-7 countries have also agreed to back proposals put forth by the US which would require corporations around the world to pay at least a 15 percent tax on earnings. Ultimately, a new system that creates a more equitable distribution of tax between countries and better reflects the changing nature of economic activity may now be within sight. The OECD has estimated that a global minimum tax would allow governments to recover more than US$100bn annually by eliminating the ‘race to the bottom’.

There are drawbacks, however. A global minimum tax would limit a government’s ability to exercise tax policy as it sees fit. This raises the question of how to balance a nation’s right to sovereignty with a policy objective of updating the global tax framework.

In addition, a global minimum tax may result in tax revenues effectively being exported to other jurisdictions, potentially detrimental in a post-COVID-19 environment when countries are looking to rejuvenate their economies. Concern has been raised that a global minimum tax could cause recovery to stutter, particularly in countries heavily reliant on inward investment encouraged by tax incentives.

Two pillars

According to Mr Dolson, the biggest change to global taxation in recent years has been the progress made by the OECD/G20 Inclusive Framework on the Two-Pillar Solution. “The project is ambitious and, should a final implementation plan be agreed to, the impact would be significant,” he says.

Pillar One will ensure a fairer distribution of profits and taxing rights among countries with respect to the largest multinational entities (MNEs), including digital companies. It would reallocate some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether firms have a physical presence there. “Pillar One would require multinationals to allocate 20-30 percent of profits in excess of a 10 percent gross margin to market jurisdictions, even if they do not have enough presence in those jurisdictions to be subject to tax under ordinary rules,” says Mr Dolson.

Pillar Two seeks to put a floor on competition over corporate income tax, through the introduction of a global minimum corporation tax rate that countries can use to protect their tax bases. “Pillar Two would effectively require a multinational parent to include amounts in its income and pay tax when its subsidiaries in another jurisdiction are subject to tax at an effective rate below 15 percent,” explains Mr Dolson. “Alternative measures that are intended to achieve a similar result are also contemplated under Pillar Two.”

According to the OECD, 130 member jurisdictions have agreed to a detailed implementation plan, together with remaining issues due to be finalised by October 2021. The agreement indicates members of the inclusive framework will aim for ‘a robust global minimum tax’ with a limited impact on MNEs carrying out real economic activities with substance. There is an acknowledgement that there is a direct link between the global minimum effective tax rate and the carve-outs. Excluding MNEs in the initial phase of their international activity from the application of the global minimum tax will also be explored. The tax reform is intended to be implemented from 2023.

But there are differences in how jurisdictions are reacting to the OECD’s plan. The US, for instance, has been more enthusiastic about Pillar Two, which introduces a global minimum tax, because it wants to increase taxes on US companies and avoid being undermined by low tax regimes elsewhere. The UK, in contrast, would prefer to make the biggest digital companies, largely US-based, pay their share of tax in the UK.

“The Two-Pillar Solution will likely be successful only if most or all countries adopt equally stringent rules that give effect to the spirit of the proposals and if the OECD/G20 can create a mechanism to prevent adoption in name only,” warns Mr Dolson. “It will be very tempting for countries to defect by creating laws that enact the Two-Pillar Solution that are replete with loopholes, and in so doing compete for multinational head offices.”

For Mr Dolson, the path to reaching the Two-Pillar Solution was certainly not a foregone conclusion. “If you had asked us 12 months ago, we would have been sceptical that any agreement would ever be reached given the scope of the Two-Pillar Solution,” says Mr Dolson. “While the progress in arriving at an agreement has been remarkable, a detailed implementation plan has not been agreed to yet. That detailed plan is the hard work, not an abstract agreement on a 15 percent minimum rate.”

The COVID-19 pandemic has also added weight to the global tax issue. For a start, it has fuelled the digital economy, creating a paradigm shift toward remote working, virtual interactivity and digitalisation, among other developments. Furthermore, fiscal pressures in the wake of pandemic spending have accelerated the quest to appropriately tax companies for profits made in the online environment.

At the same time, the pandemic has materially contributed to rising support for tax reform. “Changes to government and citizen attitudes toward taxation stemming from the pandemic are surely contributing to the progress made on items like the Two-Pillar Solution, which appeared very unlikely to turn into something real when the OECD/G20 embarked on that project,” notes Mr Dolson.

Winds of change

The proposed changes and potential for increased harmonisation are coming at a time of great upheaval. In addition to the practical challenges created by COVID-19, the increased importance of the digital economy has been a game changer in recent years. With all eyes focused on the nexus between tax and trade, policymakers are at last tackling digital services tax with some urgency.

Along the route to harmonisation, international agreements will need to be modified or struck, and laws will need to be enacted and enforced. For companies, tax departments will need to react and adapt to change, bear the burden and implement new processes. The implications for certain organisations could be significant.

“If an implementation plan for the Two-Pillar Solution is agreed to, the tax directors of multinational enterprises will need to take a much closer look at their existing structures and consider whether profit shifting or similar arrangements are still effective or cost-effective,” says Mr Dolson. “There will be a material burden placed on multinationals’ tax compliance teams, so they will need to get to work creating compliance processes right away once legislation starts getting passed.”

As evidenced by the long and arduous road to this point, there is no easy way to ‘fix’ global taxation, but efforts are underway to level the playing field. Though questions remain, the path of travel seems to be drawing closer to consensus on harmonisation.

Richard Summerfield