OECD Pillar Two Implementation Is a Classic Prisoner’s Dilemma

In one of the most significant international tax reform initiatives, the OECD and G20 united to come up with an action plan under the base erosion and profit shifting project to combat multinational enterprises’ tax avoidance strategies.

To address the challenges arising from a rapidly digitalizing economy, the Organization for Economic Cooperation and Development introduced Pillar One and Pillar Two in 2020. While the two pillars are distinct in their focus, they intertwine in reshaping the landscape of international taxation.

Pillar One is aimed at fair tax distribution. Pillar Two significantly influences MNEs’ location choices and impacting countries reliant on tax incentives to attract foreign investments.

The OECD-led Inclusive Framework jurisdictions can voluntarily choose to adopt or reject Pillar Two under “common approach.” This establishes a strategic dynamic akin to the prisoner’s dilemma.

If adopted, Pillar Two would eventually end harmful tax competition, mandating MNEs to pay a minimum effective tax rate of 15% in all operational jurisdictions and potentially generating an estimated annual tax revenue of $220 billion (9% of global corporate income tax revenue). But individual countries face the temptation to delay implementation of Pillar Two in pursuit of short-term gains.

Components of Pillar Two

Enforcing Pillar Two depends on two essential components working in tandem: the income inclusion rule and the undertaxed profits rule. The third and fourth components, qualified domestic minimum top-up tax and subject to tax rule, were more of an afterthought.

The IIR takes precedence and is paid in the jurisdiction of the MNE’s ultimate parent entity, or UPE. When subsidiaries in various operational regions have an effective tax rate below 15%, an additional top-up tax may be imposed by the UPE’s tax authority to ensure a minimum 15% tax on profits in each operating country.

If the effective tax rate remains below 15% in a particular country even after IIR implementation, the UTPR acts as a secondary measure or backstop. However, its application depends on prior implementation of the IIR.

Given that most UPEs of major multinationals are situated in developed nations, the IIR grants these developed countries the first right to tax the difference. This right is granted before the UTPR can be used, as the UTPR is contingent on prior IIR application.

The QDMTT was introduced to address this. It empowers countries to include a minimum tax through amendment of their local regulations.

A jurisdiction with a QDMTT holds priority, allowing it to levy top-up taxes if an entity within Pillar Two falls below the 15% global minimum rate. Without a QDMTT, revenue would flow to another country based on the order specified by the Pillar Two rules.

Disparate Payoffs

The imbalance in payoffs between developed and developing nations complicates the situation further. The International Monetary Fund categorizes approximately 100 of the Inclusive Framework countries as “developing.” While $220 billion of additional taxes is a considerable payoff for tax authorities, it is anticipated to be mostly in favor of a handful of developed nations that host many MNEs’ UPE.

Many of the developing nations have historically signed bilateral tax agreements to attract foreign investments. These agreements often contain prohibitive clauses that would deny the imposition of additional taxes or a tax floor.

This signals a lose-lose situation for the developing nations. In the short term, they lose both the benefit of providing the tax incentive and the first right to tax under Pillar Two.

The participating jurisdictions find themselves immersed in a complex, multiplayer version of the prisoner’s dilemma. The choice is whether to cooperate or compete in the implementation of Pillar Two—specifically where the payoffs are long-term and depend on coordinated cooperation of all players, while the losses are immediate.

Prisoner’s Dilemma

In game theory, the prisoner’s dilemma serves as a classic scenario where rational players, driven by self-interest, may inadvertently yield to a less favorable outcome despite the potential for greater overall benefits through cooperation.

Consider this example: One day, Andres and Matej find themselves detained in separate rooms following their arrest for a crime. They’re presented with the following choices:

• If both stay silent, they will each serve a one-year prison sentence.
• If both confess, each serves three years in prison.
• If one confesses while the other remains silent, the confessor will be set free while the silent one serves five years in prison.

On the surface, the optimal solution is cooperation—both prisoners staying silent would lead to the least combined jail time. But the players have no way of knowing each other’s move, so each inevitably chooses to confess to pursue short-term gains, resulting in suboptimal outcomes in the long run (recognized in game theory as the Nash equilibrium).

Viewed from the angle of tax authorities, the shorter prison sentence lies in cooperation among all countries to adopt a tax floor that reduces tax arbitrage and leaves more money on the table. Conversely, the longer prison sentence entails certain jurisdictions prioritizing locational advantages that would derail the core purpose of Pillar Two.

Nash Equilibrium in Sight?

Cooperation among all stakeholders would lead to long-term benefits, but immediate losses manifesting through reduced business attractiveness feel more tangible. The verdict at present looks more like the suboptimal long-term prison sentence.

How have the developed nations fared so far? Switzerland, a frontrunner of the Inclusive Framework, has postponed the decisions on IIR and UTPR while adopting the QDMTT. Switzerland is home to behemoth conglomerates such as Glencore Plc, Novartis AG, and Roche Holding AG in cantons with effective tax rates below 15%, so it has remained committed to its locational advantages.

Other major economies have pressed the wait and watch button. While Australia, Japan, South Korea, Canada, and the EU plan to implement Pillar Two this year, key business hubs such as Singapore, Hong Kong, and the UAE intend to delay implementation.

If a substantial number of the high-income countries stall Pillar Two, there are no compelling reasons for developing countries to adopt, particularly considering their imminent short-term losses. China, India, Brazil, and many of the fastest-growing African economies appear to be guarding their self-interests, as we see no Pillar Two buzz in their political discourses right now.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tulika Lall is a transfer pricing specialist with BDO Switzerland, specializing in transfer pricing planning, compliance, documentation, and audit defense strategies.

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