In 2017, the global community, recognizing that taxing rights in the digital era could no longer be confined to physical presence, set out to formulate a solution for taxing the digital economy that was universally acceptable. On Oct. 8, 2021, an important juncture was reached: 136 members* of the Organization for Economic Cooperation and Development (OECD)/G-20 Inclusive Framework (IF), representing more than 90% of global GDP, finally achieved a consensus on several key aspects of the proposed two-pillar solution.
Broadly speaking, Pillar One will formulaically reallocate the profits of around 100 of the world’s largest and most profitable multinational enterprises (MNEs) to market jurisdictions, regardless of the entities’ physical presence. Pillar Two, on the other hand, seeks to restrain competition over corporate income tax among countries through the introduction of a global minimum tax.
The OECD estimates that, under Pillar One, taxing rights over more than $125 billion of profit will be reallocated to market countries each year. The global minimum tax under Pillar Two is expected to generate around $150 billion additional global tax revenues annually. Additional benefits in the form of stabilization of the international tax system and increased tax certainty for taxpayers and tax administrations are also expected to be achieved.
In July 2021, the IF reached a milestone with the adoption of a broad framework for the two-pillar solution. Certain key decisions were left for further deliberation and finalization in October of that year. True to its word, the OECD, in its recent statement of Oct 8., 2021, has tied up several loose ends and enumerated many previously unresolved quantitative parameters.
Pillar One provides that MNEs with global turnover in excess of 20 billion euros ($23 billion) and pre-tax profitability of at least 10% of turnover,would be subject to the new virtual nexus rules. Extractives and regulated financial services have been specifically excluded from the scope of these rules. It has been agreed that 25% of residual profits of an in-scope MNE, in excess of routine profits comprising 10% of revenue, shall be allocated, using a revenue-based allocation key, to the market jurisdictions where the MNE’s goods or services are used. Mandatory arbitration for effective and speedy dispute resolution in respect of “Amount A” has also been agreed.
Separately, under Pillar Two, the global minimum tax rate has been pegged at 15%. The rate would apply as a standard tax rate to a defined corporate income base worldwide. Governments would still be able to set their own corporate tax rates, but if companies shifted their profits to low- or no-tax jurisdictions, then their country of residence would have the right to “top-up” their taxes to the agreed global minimum tax rate, thereby eliminating any advantage accruing to companies as a result of profit shifting.
A new multilateral convention (MLC) would be rolled out to facilitate the required treaty changes and implement the two-pillar approach. The unilateral measures taken by various countries thus far to levy tax on digital transactions would be repealed in a phased manner and no new digital taxes would be imposed by the signatories until the enforcement of the MLC.
Plenty to Do
With the October statement and implementation plan in place, the process is expected to now move towards the operational phase, involving negotiation, signature, ratification and adoption of the MLC.
Consensus is eagerly awaited on several open issues that remain unaddressed. For instance, it is not clear as to how transfer pricing provisions and dispute resolution mechanisms such as advance pricing agreements (APAs) will coexist with the proposals.
The statement reveals that segmentation for determining the Pillar One scope will occur only in “exceptional circumstances.” However, the meaning of “exceptional circumstances” is yet to be defined. The proposal for dispute resolution in respect of Amount A is also interesting, since many countries, including India, may not be open to an international dispute resolution.
Further, it has been provided that where the residual profits of an in-scope MNE are already taxed in a market jurisdiction, a marketing and distribution profits safe harbor will cap the residual profits allocated to the market jurisdiction through Amount A. A marketing and distribution profits safe harbor design still needs to be decided.
Imposition of tax involves two essential elements: a tax base on which tax is levied, and a tax rate. While agreement on a tax rate has now been achieved, a definite standard base/taxable income still needs to be defined. Profit determination is the starting point for both Pillar One and Two (i.e. for determination of in-scope entity, profit attribution, effective tax rate, etc.). However, the accounting rules/standards to be followed while computing “profits” remain in the pipeline.
Discussion is also still required regarding the possible interplay of three treaties simultaneously: (i) any bilateral treaties between nations; (ii) the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), if in force; and (iii) the MLC.
Additionally, clarity is needed regarding the definition of “extractives” and “regulated financial services” that have been excluded from the new MLC framework. The work with respect to Amount B which involves the application of the arm’s-length principle to the in-country baseline marketing and distribution activities, with particular focus on the needs of low capacity countries, is expected to be wound up by 2022.
Although the motive of the two-pillar approach was to address the tax challenges arising from digitalization, the solution does not restrict itself only to digital businesses. Thus, businesses engaged in sale of goods and services through digital modes also fall within the virtual nexus rule, subject to prescribed thresholds. Interestingly, the recently updated UN Model Convention has kept its scope curtailed to only “digitally driven businesses” and does not apply to physical goods or customized services provided digitally.
Arguably, the UN model would have been easier to adopt and administer. However, all countries seem to have compromised for the overall interest of the international community and to achieve a global consensus on the best way forward.
What’s in Store for India?
The world was already rapidly embracing digitalization and the emergence of the Covid-19 pandemic accelerated this process. Digital businesses, including online advertising, digital content services, online gaming, search engines, online teaching, and cloud computing, have grown exponentially. In India, this led to the introduction of unilateral measures such as the equalization levy (EL) and significant economic presence (SEP) rules to tax digital businesses.
However, these measures did not garner support from other countries. The Office of the United States Trade Representative (USTR) initiated an investigation into the taxation of digital services adopted by many countries, including India, on the grounds that it “burdens or restricts commerce by subjecting US companies to additional tax burdens.”
In such a scenario, a consensus-based solution seems to be the best way forward to attain the twin objectives of attaining tax certainty and ensuring a level playing field.
Importantly, the two-pillar approach seeks to tax only the “largest and most profitable MNEs,” while the EL captures more corporates in its tax net on account of its lower threshold. However, in view of the ambiguity around the EL provisions (despite three phases of amendments) a universal law appears to be a better option.
Overall, achieving a global consensus in itself is a significant and historic development. All countries seem to be willing to help each other rather than prosper at the cost of others.
The next few years will be crucial for digital businesses as the world awaits the result of this ambitious project.
*Mauritania has subsequently joined the Inclusive Framework, and the agreement. Inclusive Framework members Kenya, Nigeria, Pakistan, and Sri Lanka did not sign the deal on Oct. 8.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Rakesh Nangia is chairman and Neha Malhotra is a director at Nangia Andersen LLP.