Consensus and Pillar One—An Indian Perspective

The Finance Ministers of the Group of Seven (G-7) countries have recently agreed on a deal for the Organization for Economic Co-operation and Development (OECD) Pillar One and Pillar Two proposals (G-7 Agreement). The G-7 Agreement reiterates their commitment to reach an equitable solution on the allocation of taxing rights, with market countries awarded taxing rights on at least 20% of profit exceeding a 10% margin for the largest and most profitable multinational enterprises (MNEs). The G-7 Agreement comes post the announcement of the “Made in America Tax Plan” (Tax Plan) and the leaked U.S. presentations to the Steering Group of the Inclusive Framework (U.S. IF proposals).

This has brought back hope regarding countries arriving at a consensus-based solution for digital taxation. However, the G-7 Agreement and the U.S. proposals have drawn mixed reactions and concern from different quarters. After years of negotiations, we are closer to a consensus today than ever before: however, certain recent actions by countries also seem to be increasing the divide instead of bridging the gap, thereby threatening the fragile hope for a consensus-based solution.

To recap briefly, the OECD and the Inclusive Framework have proposed Pillar One as the basis for a multilateral consensus-based solution for digital taxation. These efforts, while commendable, required the support of the U.S. in order to bear fruit. While the Trump administration favored a safe harbor approach for Pillar One and pushed for grandfathering for Pillar Two, the Biden administration has decided to re-engage with the OECD with a view to reaching a global solution.

In the meantime, source countries such as India have taken an opposing approach, which includes enacting unilateral digital service taxes such as the Equalization Levy (EL), further expansion of the scope of the EL, proposing and pushing for a simpler (but less comprehensive) bilateral solution through the United Nations (UN) tax committee, issuing reports on attribution of profits based on user contribution, and recently notifying thresholds for significant economic presence (SEP).

While some of these measures, like the notification of thresholds for SEP, or the proposal regarding profit attribution in 2019, may not significantly impact companies from a revenue perspective, the companies would not be wrong in worrying about the timing of certain notifications or proposals. Even if a new notification or measure does not result in additional tax outflow from a company’s perspective, it is the overall signaling by the government and resultant uncertainty that is worrisome. The perceived politics behind these proposals also skews perceptions and creates a more uncertain atmosphere for companies to operate in.

Before breaking down and addressing some of the myths or concerns regarding the U.S. proposals and the Indian government’s reaction to them, it is important to note that the Tax Plan only lays down the proposals by the U.S. Treasury. Similarly, the G-7 Agreement is between only the G-7 members (comprising large developed economies, being the U.S., Japan, Germany, U.K., France, Italy and Canada) and would need to be agreeable to the OECD/G-20 Inclusive Framework, which comprises 137 countries. Consensus on the G-7 Agreement will also require consensus on details, such as criteria for determining “largest and most profitable business” and defining digital services taxes, among others. Therefore, it may be too early to comment authoritatively on its ultimate impact.

Simplification

The complexity associated with the Pillar One proposals was identified by the OECD as one of the key technical issues for Pillar One. Therefore, to this extent, the U.S. IF proposal supports simplification through a neutral scope definition based on objective factors without regard to the business model being digital or otherwise.

With increasing digitalization of all business models, this is more likely to create a stable international tax framework which can survive for the long term even as business models undergo greater digital change. This is also in line with the principles agreed in the Ottawa Electronic Commerce: Taxation Framework, being neutrality, efficiency, certainty and simplicity.

The U.S. IF proposal is likely to ensure neutrality by ensuring that both digital and non-digital companies are treated similarly, especially since conducting centralized businesses without a local presence is possible by non-digital companies as well. By reducing the complexity, it makes it more administrable, easier to understand and comply with, in addition to reducing compliance costs.

The G-7 Agreement also does not specifically refer to automated digital services (ADS) or consumer facing business (CFB) but provides for allocation of taxing right to market jurisdictions for the largest and most profitable MNEs having a profit margin in excess of 10%.

Scope

Including all kinds of profitable companies in the mix, irrespective of whether they are highly digitalized today or otherwise, increases the scope and coverage of the proposal, which should be welcomed by all parties including developing countries. In fact, the recently notified SEP provisions in India deal with all kinds of activities and income derived from a nexus with India without limiting it only to digital activities. Therefore, any other position on this point would be contrary to current positions taken up by the Indian government.

While there has not been much of a concern regarding the expansion of scope by the US IF proposals, considering that digital companies would be covered within its ambit, concern has been expressed by developing countries regarding limiting the scope to the top 100 profitable companies. This is further perceived as being a U.S.-friendly proposal.

This perception may not be fully warranted. The bulk of the companies that will be affected are U.S. companies even under the U.S. proposal, even after excluding certain industries such as financial services, since the largest companies in the technology, pharmaceutical or consumer goods areas are U.S.-based companies. Further, U.S. companies have pushed back, stating that doing away with segmentation would expose large amounts of local revenues from the U.S. to Amount A distributions. Nevertheless, the advantages of doing away with segmentation in terms of simplicity and administrability may outweigh the loss of some accuracy in allocation.

Given that the details of the proposals are yet to be confirmed, it may be too early to conclude whether the proposal would be harmful to developing countries like India. The OECD and Pascal Saint-Amans, Director of the Center for Tax Policy and Administration, has said that the U.S. IF proposal “would simplify the approach tremendously and . . . also meet the request from developing countries” demonstrating support for the same.

We are inclined to agree with that assessment. While concerns have been raised regarding whether the U.S. tax proposals may result in a reduction of taxes towards developing countries, it appears such fears are based on assumptions at this point, given the fine print may not be available. Open points such as profit allocation ratios and negotiations around nexus thresholds would have a significant impact on the final tax position of developing countries under Pillar One.

Having said that, the policy rationale for limiting scope to the top 100 most profitable companies is not apparent from the limited information that is publicly available, and appears to be rather arbitrary. Perhaps a revenue threshold would work better in this regard while achieving the same policy objective.

Nevertheless, from the impact assessments by the OECD in the past in relation to Pillar One, increasing the revenue threshold may reduce the number of companies covered within the scope without a drastic fall in the revenue pool available for distribution.

Therefore, the trade-off between a reduced pool available for distribution, compared to other benefits from a simplified proposal, should be assessed while arriving at a decision. While the G-7 Agreement is silent on its scope, some guidance can be taken from the Pillar One Blueprint. The Pillar One Blueprint indicated that at a 10% profitability threshold, approximately 780 MNEs are in-scope with estimated global residual profit allocable to market jurisdictions being $98 billion at 20% allocation percentage.

There are obvious benefits to reducing the total number of companies that are covered from an administrability and simplification perspective as stated above. Further, the U.S. IF proposal to cover all profitable companies irrespective of the level of digitalization in their current business models would also be aligned with tax policy principles with respect to neutrality. This effect is achieved while also ensuring that the profitable tech companies fall within its coverage.

Therefore, any negative assessment of the proposal at this stage based on publicly available information may be premature and based on assumptions. The focus should indeed be on the long term and building a stable, comprehensive international tax framework for the next few decades.

Considering the Context

It is also important to understand the different proposals in the context in which they are made. It is possible that some of the aspects of the proposals are posturing and not intended to create any significant revenue impact. For instance, the proposal by the U.S. to limit it to 100 companies or set a minimum global tax rate of 21% may indicate a stronger starting point which parties typically adopt at the beginning of a negotiation. The U.S. have since agreed to a 15% floor, which demonstrates the seriousness to negotiate and close a multilateral global solution.

Considering that global discussions seemed to be progressing, the timing of the notification of SEP thresholds by the Indian government is suspect. The Indian government’s support for the UN proposal, announcement of measures such as the SEP thresholds or expansion of the EL, may be posturing in preparation for a hard negotiation in the global discussions.

Ultimately, there are several flaws with the UN proposal, such as its not being comprehensive in scope and that a bilateral approach is not practicable. Further, issues with unilateral levies are also well-documented in terms of costs incurred by Indian start-ups and consumers.

Therefore, as the OECD has indicated, the U.S. proposal attempts to solve some of the criticism of the Pillar One proposal, such as complexity, while ensuring that that ability to raise taxes is not significantly impacted in any such trade-off. It represents the best chance for a successful resolution of the current standoff and has broad support from several EU countries.

Negotiating off the U.S. proposal would maximize the chances of success of Pillar One. Negotiations around profit allocation ratios and nexus thresholds should be the focus for developing countries in addition to the revenue thresholds that will determine the number of companies covered within the scope.

Recent actions show that the U.S. is keen on attaining a global agreement on minimum taxation and is willing to concede on requests by developing countries with respect to Pillar One. The imposition and suspension of tariffs till the end of 180 days by the U.S. against the Indian EL is perhaps intended to incentivize closing of this discussion in a timely manner.

For developing countries that have been raising issues for years now, the time is ripe to take advantage of the keenness shown by countries to close the deal. Despite differing interests even among the G-7, where the U.K. and France were keen on Pillar One and Ireland desired a lower global minimum tax rate, they have managed to find common ground.

Striving towards consensus is therefore the best path forward in the next three months for India, and the G-7 Agreement lays a strong path for the G-20 Finance Ministers’ meeting in July 2021. Pursuing any other path is likely to lead to tax-related trade wars, as the OECD has predicted, which will further slow down post-Covid economic recoveries. While taxes are important, trade and economic growth should not be sacrificed in that trade-off.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Ipsita Agarwalla is a Member, International Tax practice, and Meyyappan Nagappan is Leader, Digital Tax practice, with Nishith Desai Associates.

The authors may be contacted at: ipsita.agarwalla@nishithdesai.com;meyyappan.n@nishithdesai.com