The world’s tax system under construction

November 2022  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2022 Issue

When the Organisation for Economic Co-operation and Development (OECD) embarked on its Base Erosion and Profit Shifting (BEPS) project in 2013, backed by a unanimous G20 mandate, few people could have imagined that this would trigger a truly groundbreaking development in international taxation to the level it has reached today.

This historic achievement, comparable to the first-time establishment of the arm’s length principle in transfer pricing (TP) about 100 years ago, is now supported by more than 140 countries, i.e., the current members of the Inclusive Framework on BEPS.

Major driving forces behind the project were, firstly, the desire to reduce the much-lamented information asymmetry between multinational taxpayers and fiscal authorities in the countries these multinationals operate in. Secondly, the intention to substantially increase the level of transparency in identifying and disclosing harmful tax planning practices and tax avoidance structures by multinationals. And thirdly, the vision to create a level playing field in the international taxation of multinationals, including coherent implementation and application of tax regulations, and fairer tax competition and distribution of taxable income among countries, especially with a view to taxing profits earned in the context of the digital economy.

Pillars 1 and 2

To that end, the OECD came to realise – most likely at the latest upon publishing the 15 BEPS action reports in October 2015, and Action 1 in particular – that its initial goal, to tax well-known US digital giants and essentially ‘ring-fence the internet economy’, was not achievable from a technical, legal or political perspective.

It is not an understatement to say that the considerate, patient negotiation approach of the US administration over the last 10 years has delivered excellent progress in diverting and diluting the initial, biased goal of singling out a few of its tech-companies as targets for collecting more tax in countries around the world. Instead, this goal has been transformed into the Pillar 1 and Pillar 2 models.

These highly technical and extremely complex tax models now target a much more diverse range of industries – sectors like fast moving consumer goods, for example, which might not have considered itself a forerunner of the digital economy in the early stages of the BEPS project.

However, including a broader range of sectors as sources or financiers of additional taxable income worldwide is a conditio sine qua non from an OECD perspective. Otherwise, it seems hard to imagine how the OECD could possibly deliver on its promise to generate billions of fresh tax income in countries participating in the Inclusive Framework.  

Pillar 1, devoted to taxable income reallocation, is currently under development to enable a reallocation of large multinationals’ (i.e., those with €20bn-plus annual global turnover) excess profits (i.e., 25 percent of their consolidated group profit over and above a 10 percent profit margin) to market jurisdictions (the ‘demand side’), even if these multinationals do not have a physical presence in those market jurisdictions. The measures could potentially go live in 2024, but this will largely depend on whether the substantial technical tax complexities encountered in their development can be resolved by the OECD in time and in view of the ongoing parallel development of Pillar 2.

Pillar 2, aimed at delivering global minimum taxation, is being developed ahead of Pillar 1. It is close to being implemented globally in 2023. Pillar 2 has been designed to ensure that large multinationals with annual global turnover exceeding €750m pay a minimum level of corporate income tax (i.e., 15 percent on income) effectively earned in each jurisdiction where they operate.

It has been argued that implementing the two-pillar overhaul of the global tax system is imperative to avoid the ‘tax war’ conceived by Pascal Saint-Amans, comprised of competing, divergent digital service taxes around the world. However, the technical tax difficulties associated with any practical implementation of Pillars 1 or 2 are manifold.

Major challenges lie in unambiguously determining the taxable profit of multinationals, attributing potential additional tax liabilities to countries (market states), the unprecedented practical execution of tax collection and distribution on a global scale, and last but not least, establishing a binding dispute resolution process to resolve double taxation issues for multinationals affected – a feature from which many countries shy away as it interferes with their tax sovereignty. In any case, implementing one or both of the pillars requires multinationals to develop a new, extended approach to tax accounting and reporting.

The OECD approach to developing these models tends to be based on an initial concept followed by iterative public consultations toward finalising that concept. Unfortunately, draft and final guidance documents are rarely shorter than 50 pages, leaving ample room for differing interpretations due to the intended scope for compromise. OECD guidance is soft law. Nonetheless, it is used as a blueprint, or at least an instructive framework, for domestic tax lawmakers in most countries around the word.

Features of behavioural TP

The joint initiatives of the OECD, G20 and countries participating in the Inclusive Framework – despite their self-interest in setting national tax policy to create attractive conditions for inward investment – have a clear goal. Fiscal authorities around the world continue to focus on enhancing and enforcing arm’s length pricing in multinationals’ TP structures, with a view to establishing a more robust culture of compliance.

Compliance culture in this context is not only about abiding by tax laws in different countries, but also about honesty from multinational taxpayers – in essence, behavioural TP.

So, what instruments are being employed in behavioural TP? Multinational taxpayers may be required to undertake tax and TP self-assessments in certain countries. These may be enhanced by documentation requirements and sanctions that provide positive or negative incentives to guide corporate taxpayers’ behaviour.

Positive incentives include voluntary cooperative compliance initiatives, penalty protection, or audit relief for evidence-based compliance. Negative incentives, on the other hand, may sanction taxpayers’ failure to comply or to submit correct and sufficient information to fiscal authorities, by issuing penalties, shifting the burden of proof on to taxpayers, imposing an additional level of scrutiny, or pursuing legal action such as criminal prosecution of non-compliant taxpayers.

Based on the recent EU Directive 2021/2101, public country-by country reporting will apply to European-based multinationals as an additional feature of behavioural TP, starting as early as 2025. Up to now, the strict confidentiality of taxpayer information has been a feature of tax law, and the OECD has upheld this premise in its 2022 ‘Transfer Pricing Guidelines’.

It seems too tempting, however, to miss the opportunity to put reputational pressure on multinationals by forcing them to defend themselves to vocal interest groups and other watchdogs.

The road ahead

Clearly, the regulatory framework for tax and TP is tightening in almost every country. Consequently, financial, time and reputational pressures will be levers to help drain additional taxable income from multinational taxpayers going forward.

Therefore, the need to obtain robust tax advice and employ qualified in-house specialists for tax and TP matters is unlikely to decline in view of the growing complexity of the world’s tax system.

 

Dr Martin Lagarden is head of global transfer pricing in Finance/tax & trade at Henkel. He can be contacted on +49 151 6800 8927 or by email: martin.lagarden@henkel.com.

© Financier Worldwide

BY

Martin Lagarden

Henkel

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