Cross-Border Taxation—Reset for Global Companies

Cross-border tax is now drawing global attention from governments, policy makers, strategists, trade bodies, multinational enterprises, shareholders, and boardrooms.

Dramatic geopolitical shifts, technological innovation, globalization, new consumer demands, have all changed the landscape of international taxation. Increased sharing of information between tax authorities, evolving tax revenue mix, increased focus on market economies, and the need to collect additional tax revenues, are culminating in extensive changes to cross-border tax laws and treaties.

Multinational enterprises (MNEs) with cross-border business with or without physical presence globally are significantly impacted by tax reforms triggered by the efforts of the Organization for Economic Cooperation and Development (OECD) and Group of 20 countries, and changes in taxation of key economies to overhaul their tax laws.

This has all ushered in a complete tax reset for businesses with global operations.

Concerns for Global Companies

Reputational Risk for Large Corporations Versus Shareholders’ Return

Corporate boards are responsible for making financial decisions in their stakeholders’ best interests. The rapidly evolving and ground breaking changes in cross-border tax policies are increasingly going to be an agenda topic in board meetings and discussions. The board will be interested to know the corporation’s:

• global competitiveness;
• choice of geographical location for business versus tax reasons;
• global tax status;
• international/business restructuring plans;
• supply chain;
• international tax strategy;
• certainty of tax positions adopted and mechanism to update/evaluate them on a continuing basis;
• mechanism/plan to resolve international tax controversy in future; and
• overall plan to deal with and stay attuned to the changing landscape of cross-border taxes.

Global tax compliance will be a top priority. Companies will need to be compliant either on their own initiative or on the initiation of action/query by local authorities. In any event, the board will look to companies’ readiness in terms of resources allocation, revenue, etc.

Reputational risk around tax has reached new levels. Governments and the general public are taking unprecedented interest in large corporations and the percentage of their revenue/profits’ attribution to taxes. With the majority of these corporations having their head offices in low-tax jurisdictions, international tax initiatives have put them on the radar of tax authorities.

As stakeholder capitalism develops deeper roots and goes mainstream, there is a reputational correlation for businesses using tax-friendly jurisdictions: Even if technically and legally correct, companies need to consider if it is worth the reputational risk in these changing times.

The time is not far off when global companies will be under pressure ethically towards their country of residence/operation: They will be expected to be aware of moral and civic responsibilities towards paying fair taxes in each jurisdiction.

The introduction of international tax measures such as digital services taxes and a global minimum tax (BEPS 2.0 Pillar One and Pillar Two), and the ongoing tax reforms following the global pandemic, will force companies to retire to their boardrooms to tweak their “strategic” business nexus structures and devise solutions for adapting to the new regime by lifting their prime focus from “country shopping” to risk mitigation and compliance.

Evolving Tax Revenue Mix

Tax revenue mix is evolving at a rapid rate with the focus shifting from direct to indirect taxation. Corporate tax rates are on a declining path. Newer indirect taxes are growing steadily, raising revenue in a more progressive, efficient and equitable manner. Countries may consider realigning their internal tax organization and strategy on taxation of immobile factors of production such as land, structures, etc. versus mobile factors.

In 2019, OECD countries raised 32.3% of their tax revenue through consumption taxes such as value-added tax (VAT), making it the prime revenue source. This is unsurprising given that all OECD countries (except the U.S.) levy VAT at relatively high rates. Social insurance taxes and individual income taxes are the next important sources of tax revenue, at 25% each. (By contrast, in 1990 individual income taxes accounted for more revenue than social insurance taxes.) Countries collected relatively little revenue from corporate income tax (9.6%) and property tax (5.6%) (figures sourced from OECD estimates).

Taking India as an example, a plethora of indirect taxes, such as goods and services tax and the Equalization Levy, have been implemented to augment the total tax collection. In 2020, India’s tax pie showed a sharp fall of 26–27% in direct tax collections but a rise in revenue raised from indirect taxes to about 56% of overall tax collections (the highest in about a decade).

Increasing Focus on Market Economies

Digital presence is increasing relentlessly and so is the speed of introduction of digital services tax (DST) regulations by market economies across the globe. The surge in the digital economy, and the Covid-19 pandemic, led some EU member states and other countries to jump on the digital tax bandwagon and enact their own DSTs to tax digital MNEs.

The OECD has been working unceasingly. The current proposal is to work on an apportionment formula with a threshold, etc., basically to allocate taxing rights in respect of a portion of an MNE’s profit from production to market countries. Most countries and trade bodies support the OECD’s unified approach around consensus building, which includes a commitment by members to implement the proposal simultaneously and to withdraw any unilateral measures. Until that is done, MNEs need to be cognizant of and in compliance with the DST laws of the countries in which they operate.

Evolving Tax Authorities and Increasing Information Exchange Across Countries

Calls for increased transparency have led to advances in technology being deployed by tax authorities. Increased use of technology in international tax audits, to better assess business risk, boost tax collection, and enhance automation, means more detailed and extensive tax data is at the disposal of the authorities.

The presence of several developing countries in the G-20 has bolstered the determination of the OECD-initiated and G-20-embraced Global Forum on Transparency and the Exchange of Information for Tax Purposes. Nearly three-quarters (74%) of the Global Forum members are now committed to start automatic exchange of information (AEOI). Rwanda is the 120th Global Forum member to commit to start AEOI by a specific date.

Growing numbers of tax information exchange agreements and mutual legal assistance treaties are being signed to avoid double non-taxation and facilitate effective exchange of information. Rigorous transparency, disclosure and accountability in domestic laws is also becoming the norm.

Ever Increasing Pressure to Collect Revenue

The world economy was already facing turbulence owing to Brexit, trade wars, hyper-inflation and decarbonization, before Covid-19 added fuel to that fire. Increasing the tax base of economies to help replenish government coffers was the key driving factor for a paradigm shift in the international tax framework.

Moving Forward

International cooperation and a unified approach are undeniably the way forward. Coordinated implementation of international tax reforms is critical in establishing a consistent global tax system that facilitates cross-border trade and economic growth.

Through the Looking Glass: Reforms Needed in the International Tax Space

The international tax framework has undergone a massive transformation over the last five years, courtesy of the OECD base erosion and profit shifting (BEPS) Action Plans, fundamental changes in the transfer pricing domain, the digital tax question, and introduction of a global minimum corporation tax! With the pandemic accelerating the changes, and the Biden administration’s push for improvement in the international tax sphere, the global tax reform fire was rekindled, leading to “BEPS 2.0.”

However, there are a number of issues in the implementation of the proposed international tax amendments.

BEPS 2.0 and Future of Transfer Pricing

In 2015 the OECD published 13 final reports and an explanatory statement outlining the BEPS project and, as a result, the global TP landscape underwent a major shift. However, the proposed reforms were not conclusive enough to accommodate the changing dynamics of global businesses; a series of fraught negotiations and discussions followed. As a result, BEPS 2.0 was released with the purpose of tackling the TP complexities coming to the fore for MNEs and tax authorities.

BEPS 2.0, an outgrowth of the BEPS initiative, has evolved to cover in its scope not only the digital economies but also dynamically changing business models. With a view to reaching a “multilateral, consensus-based solution” which would revolutionize corporate taxation of MNEs and raise/reallocate tax revenue around the globe (approximately $100 billion under Pillar One and $150 billion under Pillar Two), the OECD released its two-pronged strategy.

To be precise, Pillar One seeks to broaden the taxing rights of market jurisdictions by going beyond physical boundaries and allocating global profits to the countries in which the MNEs’ customer base lies. It seeks to avoid the nuances of double taxation through a “netting-off” mechanism. The formulary approach to allocation is based on a calculation according to the published OECD guidelines. This may require a significant degree of coordination among tax authorities and possibly result in multilateral tax controversies.

Further focusing on global tax base erosion, Pillar Two intends to mitigate instances of profit shifting and tax avoidance by MNEs by introducing a global minimum tax (GMT) that every company would be required to pay, regardless of where it is physically headquartered.

With Pillar One, vast changes are expected in the TP arena as it could significantly impact MNEs not just in terms of their global tax liabilities but also their governing business and operating models.

Pillar One’s approach of abandoning the arm’s-length principle for the calculation of Amount A (part of the formulary calculation), but continuing to use it in allocating profits between related parties, is problematic. The existing TP rules have been put under a microscope, and their effectiveness is being tested. Inconsistency between the Pillar One principles and existing TP conventions raises questions to which the authorities do not, at present, have answers. Whether the adoption of Pillar One means the end of the conventional TP system, or we will circle back to arm’s-length pricing, is an issue requiring much consideration!

Transition to the new system may open up a whole new area of TP controversies, which will need to be addressed immediately. Companies covered under the scope of the new rules need to be on top of all ongoing developments, undertake an assessment of the rules and how these impact their business and financial matrix, and also plan well in advance all the measures needed for seamless transition to the new rules.

Alternatives to the existing rules may be sought at some time in the future, which may offer easier, simpler and more easily administered principles.

Global Minimum Tax—Major Change to the Global Tax Landscape

A GMT of 15% is finally a reality!

Years of negotiations and discussions finally yielded a result on Oct. 8 this year, when 136 nations consented to a proposed GMT. With the holdouts Ireland, Hungary and Estonia later joining the group, the agreement represents the consensus of all G-20, EU, and OECD nations, which together account for over 90% of global GDP. Agreement from Kenya, Nigeria, Pakistan and Sri Lanka is not there yet.

The road to a global tax agreement is still long, involving several technical and policy complexities. Each of the 136 countries now need to change their respective local laws for effective implementation of a GMT by 2023. It was also agreed that no newly enacted DST or other similar measure will be imposed from Oct. 8, 2021 and until the earlier of Dec. 31, 2023 or the coming into force of the Multilateral Convention (the proposed global mechanism for implementing the GMT). So, the fate of such taxes recently introduced by various nations, including India, needs to be assessed. India has recently confirmed it will withdraw the Equalization Levy once the global tax reform is implemented.

The concept of a GMT is expected to challenge the tax incentives, deductions, exemptions and allowances offered by countries. Going forward, it will be necessary to address how national tax systems and the existing network of double tax treaties will need to be adapted/modified to fit into this multilateral agreement. Issues related to the complexities of enforcement and tax collection also need to be addressed. These clarifications are necessary to prevent an increase in international tax disputes.

The Digital Tax Conundrum

As described above, the growth of the digital economy and the onslaught of Covid-19 led EU member states and several other countries to join the digital tax bandwagon and enact their own DSTs. While the globally accepted approach to taxing the digital economy is still underway, digital companies will be required to comply with these unilateral levies, and need to have suitable tax expertise to continuously track global developments and determine their obligations considering VAT, treaties etc., to ensure correct compliance.

Companies need to closely monitor local tax changes, as countries have different coverage scope, methodology, thresholds, etc. Passing on the DST burden to end customers defeats the purpose and intention of the legislation and many countries are trying to ringfence that. DST involves a time-consuming process of overhaul of the digital system to keep track of IP addresses, invoicing systems, double taxation issues in various jurisdictions, impact on national incentives for research/innovation, priority of the Subject to Tax Rule over the Income Inclusion Rule, and other issues.

Further, ambiguity surrounding the valuation/taxation of intangibles, which are inextricably a byproduct of the digital economy, and also the taxability of commission/income derived from digital transactions, are open issues raised by the imposition of DST requiring clarification.

Way Forward for Global Companies

The past two decades witnessed seismic shifts in all aspects of international businesses: investments, returns, distribution of profits, and deployment of capital. These changes have impelled companies to continually change their tax strategies. Teams responsible for cross-border taxation need a new skills mix and a reporting matrix of various internal stakeholders, board, local and international tax authorities.

In light of the BEPS project and global tax overhaul, companies should make adjustments around financing and TP in order to comply with the new requirements or thresholds. With historical change like GMT, it is the perfect time for MNEs to review their business models and structures and assume tax responsibility globally. In sync with swiftly enacted laws, MNEs will need to track the location and duration of employees across countries, as this could affect previously agreed income tax calculations and existing agreements with global tax authorities.

On the TP front, MNEs should establish new operating models to reflect the new reality of a group’s performance in light of the functions, assets and risks of the relevant entities. Closer introspection is needed on the TP aspects, since previously only the transaction level perspective was being considered. Now, with the global tax reset, the entire global supply chain needs thorough analysis and scrutiny. Taxing profits on location of value addition seems to be the new norm!

Risk mitigation should not be underestimated. The G-20/OECD’s recommendations are contingent upon countries enacting legislative amendments to their tax laws and revising their tax treaties with other jurisdictions. Two key areas, compliance and documentation, must be considered.

Companies need to be tax compliant globally. Business models are bound to adapt, respond to fast-paced changes in international tax and evaluate how to mitigate future risks. Documentation is critical in this process. As long as businesses are documenting their rationale very clearly, when the time comes for audit, this will help them in explaining their reasoning. And how much documentation is enough? This is one of those rare cases where I will say: “more is better.” Document, document and document!!

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

Anshu Khanna is a Partner with Nangia Andersen LLP, a member firm of Andersen Global.

The author may be contacted at: anshu.khanna@nangia-andersen.com