The hidden depth of the Organisation for Economic Co-operation and Development (OECD)’s work to update the tax system for digital businesses is now becoming apparent. The proposals set out in “Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy” (the work programme) will radically rewrite long-established international tax rules and will affect every business with international operations and cross-border income flows, not just highly digitalized businesses.
Commentary on the work programme is typically on its application to large tech businesses, which ignores the breadth of coverage. In this article we explain the potential wider implications, with a particular focus on investment managers.
The work programme sets out two pillars to address the structural challenges that the international tax system is facing.
The first pillar is the one that is most attuned to the digital economy; it focuses on reallocating profit to market jurisdictions and redefining the nexus of tax for non-physical presence. While this is likely to have implications for investment managers who have portfolio businesses with digital business models and operations with a significant user/customer base, for the purposes of this article, we leave this pillar to one side.
The second pillar is the one that goes far beyond the digital economy: it deserves more attention as it marks the advent of a global minimum taxation, and offers a radical shake-up for how all businesses will be taxed, with acute implications for asset managers.
In some respects this pillar is seen to address unresolved base erosion and profit shifting (BEPS) risk and has been dubbed “BEPS v2.0.” However, in our view, the proposals are much more ambitious and strike a different note to the BEPS agenda. In developing these proposals the OECD has moved on from the work achieved during the BEPS project based on the belief that even a modest level of substance in a territory is not enough to justify the risks allocated to an entity that pays no or very little tax. It is this perspective that provides the backdrop for these developments.
GLoBE: Tackling Low or No Taxation
The Pillar Two work stream contains the global anti-base erosion (GloBE) proposal, which is split into two building blocks:
1. the income inclusion rule; and
2. the tax on base eroding payments rule.
The key goal of this pillar is to tackle instances of low or no taxation.
Income Inclusion Rule
This rule is designed to operate like a controlled foreign corporation (CFC) regime, by requiring shareholders to top up their tax by bringing a certain amount of foreign income within the charge to tax if it is not already subject to tax at the globally agreed effective rate of tax. Whilst it is recognized that many countries already have CFC regimes (especially EU member states in light of the anti-tax avoidance directive, ATAD) it is expected this rule will operate as an additional safety net and bring other territories in line.
As the proposal currently stands it will operate as a top-up tax, with the balance of underpaid tax calculated and payable by the parent company. The bulk of the discussions at the OECD are being taken up with determining what reference system is used to calculate the top-up tax, with many jurisdictions not only having very different tax bases but also pre-existing CFC rules.
With limited information presented, there is a question mark around the income inclusion rule and whether it will distinguish between passive and active income streams, as is the case in some domestic CFC regimes. Some jurisdictions are likely to take very different views on whether they should be taxed equivalently. However, what is clear is that if this is agreed it marks a significant convergence of international tax rules, even if it is not as explicit as the harmonization planned under the EU’s Common Consolidated Corporate Tax Base proposal.
Tax on Base Eroding Payments Rule
The tax on base eroding payments rule will allow source jurisdictions to protect themselves from the risk of base eroding payments by introducing two further rules.
First, the “undertaxed payment rule” proposes to deny deductions or impose a withholding tax on certain base-eroding payments.
Second, the “subject to tax rule” will revise tax treaties such that treaty benefits will be limited to situations where the relevant income is subject to tax at a prescribed global minimum rate.
This would see treaty benefits denied by:
- reducing the current limitations that exist on taxing the business profits of nonresidents. This would work by reversing the existing Article 7 restriction except where those profits are subject to tax at a minimum rate;
- making corresponding transfer pricing adjustments under Article 9 dependent on the effective tax rate of the jurisdiction making the primary adjustment;
- limiting benefits for dividends, interest, and royalties, and capital gains payment under Articles 10–13 if the residence state does not tax the payment at the prescribed minimum tax rate; and
- reallocating exclusive taxing rights from the residence territory to the source territory for other income under Article 21.
The second part of this article will look at the most commonly asked questions that arise out of the provisions of the work programme, with a focus on the impact for investment managers.
Ceinwen Rees is a Partner and Rhiannon Kinghall Were is Head of Tax Policy at Macfarlanes.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.