Update on the ongoing global international tax reform

January 2022 | EXPERT BRIEFING | CORPORATE TAX

financierworldwide.com

As has been well documented, international corporate tax reform under the base erosion and profit shifting (BEPS) project 2.0 is currently underway at the G20 level, to address the challenges of the digital economy. The project comprises ‘Pillar 1’ and ‘Pillar 2’.

Existing international tax rules no longer provide a fair system for taxing businesses where value is created. Increased globalisation and digitalisation of the economy means that many businesses can operate successfully in a jurisdiction without any (taxable) physical presence there, and intangibles can be held in low tax jurisdictions to minimise the tax burden further. The two pillars of this reform aim to address these concerns by ensuring that profits are taxed where they are generated, and at a minimum rate of tax.

The Organisation for Economic Co-operation and Development (OECD) and G20 proposals for global tax reform, providing for a new taxing right for market jurisdictions over certain profits of the largest multinationals (Pillar 1) and a global minimum tax rate (Pillar 2), are close to being finalised following agreements reached in October 2021, which have clarified issues remaining to be determined.

Agreements reached recently on issues pending to be determined

A political agreement has been reached on some of the key thresholds and tax rates to be applied in the OECD’s Pillar 1 and Pillar 2 proposals, with further information on timing also published.

It should be noted that Ireland, Hungary, Estonia and Mauritania have newly joined the agreement, having received assurances in respect of the minimum tax rate and implementation periods.

In addition, the US and some European countries have announced a compromise agreement in relation to the elimination of domestic digital services taxes (DSTs) and trade tariffs which the US had threatened to impose in retaliation to DSTs. Under this compromise agreement, transitional arrangements have also been agreed.

Determination of the precise percentage of residual profit to be allocated to market jurisdictions under Pillar 1, within the agreed 20 percent to 30 percent range. It has been agreed, under Pillar 1, that the very largest multinationals (those with a global turnover over €20bn, reduced to €10bn contingent on successful implementation, with the relevant review beginning seven years after the agreement comes into force, and the review being completed in no more than one year) will have 25 percent of their profits above a 10 percent profit margin reallocated and then subjected to tax in the countries in which they operate and earn revenue of at least €1m per year, or €250,000 for smaller jurisdictions (known as ‘Amount A’) rather than all taxing rights sitting where the business has physical presence.

Amount A of Pillar 1 will be implemented via a multilateral convention, due to be finalised and available for signing in 2022 and coming into effect in 2023, together with changes to domestic laws where necessary. Work on Amount B, the fixed return for baseline marketing and distribution physically taking place in a market jurisdiction, will be finalised by the end of 2022. Amount B will be determined according to the arm’s length principle, unlike Amount A.

Dispute prevention and resolution mechanisms designed to avoid double taxation for Amount A and provide certainty to multinational enterprises will be mandatory and binding. Certain developing economies with no or low levels of mutual agreement procedure (MAP) disputes may be eligible for an elective mechanism.

Determination of the exact global minimum tax rate and other thresholds under Pillar 2. Under the abovementioned political agreement, it has also been confirmed that the Pillar 2 minimum tax rate will be 15 percent.

Substance based carve-outs, which consist of a reduction in the taxable base on which the minimum tax rate will be applied, will be determined on the basis of two factors: tangible assets and payroll, which may encourage multinationals to locate their employees and assets – i.e., their real economic activity in jurisdictions with advantageous taxation. These provide for an initial mark-up on the carrying value of tangible assets of 8 percent and of 10 percent on payroll, with each reducing to 5 percent after the transition period of 10 years.

The subject to tax rule (STTR), which allows jurisdictions to impose withholding taxes on certain related party payments, has been limited to those payments which are subject to a corporate statutory tax rate below 9 percent, the top end of the previously announced 7.5-9 percent range.

The model treaty provision in respect of the STTR, along with the model rules for the scope and mechanics of the income inclusion rule (IIR) which imposes a top-up tax on a parent entity where a subsidiary is taxed below the minimum rate, and the undertaxed payments rule (UTPR) which denies deductions or otherwise adjusts the tax position to the extent that the low tax income of a subsidiary is not caught by an IIR were expected to be published in November but at the time of writing this article they have not yet been published.

There will be an exclusion from the UTPR for businesses in the initial phase of their international activity (those businesses with a maximum of €50m of tangible assets abroad and that operate in no more than five other jurisdictions will be considered to be in such initial phase). This exclusion is limited to a period of 5 years after the business comes into the scope of these rules for the first time.

A multilateral instrument will follow by mid-2022 to facilitate the implementation of the STTR into relevant bilateral treaties, with the aim of Pillar 2 becoming effective in 2023.

In addition, the European Commission announced a draft directive on Pillar 2 for February 2022.

Determination of the process for the withdrawal of unilateral DSTs and transitional arrangements. The political agreement reached also commits countries to remove unilateral DSTs when Pillar 1 comes into effect. In the meantime, it requires that no newly enacted DSTs or equivalent may be imposed on any company from 8 October 2021 until the earlier of 31 December 2023 or the coming into force of the multilateral convention.

In this context, the US, UK, France, Spain, Italy, Austria and Turkey have announced a compromise agreement under which their domestic DSTs will be repealed when the OECD’s Pillar 1 proposals come into effect in 2023. In return, the US has agreed to terminate its proposed retaliatory trade tariffs.

In addition, the compromise allows that transitional rules will provide for carry-forward tax credits to be available to companies to the extent that liability to these DSTs during a transitional period is more than the amount payable by them under Pillar 1 in the first year of its application. In other words, domestic DSTs will stay in place until Pillar 1 is in force, but with a tax credit for excess DST which ensures that affected companies do not pay more tax under DSTs than they would have done under Pillar 1, had that been implemented earlier.

The excess DST will be calculated as being the amount by which the DST accruing in the transitional period (between 1 January 2022 and the earlier of the date the Pillar 1 multilateral convention comes into force or 31 December 2023) exceeds the amount equivalent to the tax due under Pillar 1 in its first year of application to that company (pro-rated to ensure the amounts are proportional to the length of the transitional period). This amount will be creditable against future taxes due in respect of Amount A of Pillar 1 in that jurisdiction.

This compromise agreement has been welcomed as not only does it avoid punitive trade tariffs which the US had threatened to impose in retaliation to DSTs, but it enables jurisdictions to retain the revenue from these DSTs until Pillar 1 is in place.

However, it should be noted that as the DST credit can only be set off against future Pillar 1 liabilities, this credit system is only of value to the relatively small number of multinational enterprises which meet the €20bn turnover and 10 percent profitability thresholds to fall within the scope of Pillar 1 within the first four years from its implementation in each country.

Remaining issues still pending to be determined

Notwithstanding the agreements reached during October, a number of issues are still to be determined, such as the precise methodology for calculating the tax due or to be reallocated under the new rules, the methodology for calculating the effective rate of tax paid by in-scope businesses in each country, what the remuneration for baseline marketing and distribution functions on the ground (Amount B) will be, how the global tax reform will affect the EU proposal for a digital levy, and whether a directive will be required for implementing Pillar 1. These and other issues should be defined within the coming months.

Eduardo Gracia is head of the tax practice group at Ashurst. He can be contacted on +34 91 364 9854 or by email: eduardo.gracia@ashurst.com.

Eduardo Gracia

Ashurst