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The Corporate Tax Revolution is Coming—Are We Ready?

Feb. 18, 2021, 8:00 AM

Creating a global solution for the taxation of the digital economy is right up there with finding an instant cure for climate change—seemingly impossible. Nonetheless, this has been a primary focus of the Organization for Economic Cooperation and Development (OECD) for a number of years and, with a mid-2021 deadline looming, negotiations are getting down to the wire.

The brainchild of the OECD’s efforts is a global-taxation overhaul, known as Pillar 1 and Pillar 2. These controversial proposals defy a system born in the 1920s, when determining a final destination for corporate profits was as easy as reading a business’s brick-and-mortar address. Businesses, of course, are no longer that simple—and neither is the global tax landscape, where the “digital economy” has quickly morphed into the economy itself.

Corporate profits are still taxed in the jurisdiction where a company is headquartered, however for most companies, the Internet has provided a gateway to earnings far beyond physical reach. Tech giants like Google, Facebook, and Apple know this all too well, of course, as current tax laws have enabled them to book billions in profits in low-tax jurisdictions, leaving neither footprints nor a single tax dollar in the higher-tax countries, where they were earned. Eliminating these kinds of digital-tax loopholes is what the OECD has been wrestling with since the Final Report on Base Erosion and Profit Shifting (BEPS) Action 1, “Addressing the Tax Challenges of the Digital Economy” emerged in 2015. But like any policy requiring global consensus, politics are a big part of the equation.

From a transfer pricing perspective, digital tax challenges are building for multinational companies, as well. Taxpayers already have to navigate a transparent environment with nuanced regulations changing at every border, giving way to only faint, if any, signs of tax certainty. Add to that Pillar 1 and Pillar 2, a tangled web of proposals that stand to overthrow our current tax system, unilateral digital services taxes, all of which are uniquely structured to suit the gains of individual countries; and yet another wildcard: A new administration—and treasury secretary—in Washington. The digital tax struggle has become a political tug-of-war and if things continue on this path, multinational companies could find themselves layered between old and new compliance burdens, feeling their way through a maze of unique, complicated regulations that adhere to formulas as opposed to principle.

Sharing Profits

The OECD’s overall goal is to create a unified global corporate tax system whereby multinational businesses are taxed where profits are earned, regardless of physical presence. Combined, Pillar 1 and Pillar 2 are expected to raise an additional 4%, about $100 billion, in corporate tax dollars globally.

Pillar 1 is by far the more complicated of the two, which is ironic given that it’s not designed to raise much additional revenue, but instead, redistribute about $100 billion in corporate tax revenues in jurisdictions around world. After more than a year of public consultation and negotiations about the proposal, in October 2020, the OECD released the Pillar 1 Blueprint, which the Inclusive Framework refers to as a “solid basis for future agreement” (as opposed to an agreement itself). The Pillar 1 Blueprint leaves many political and technical issues unresolved, which the OECD acknowledged in late January 2021, at the 11th Meeting of the OECD/G20 Inclusive Framework on BEPS. Chair of OECD’s Committee on Fiscal Affairs (CFA) Martin Kreienbaum said one of the OECD’s key priorities in the coming months would be to simplify Pillar 1 features—a daunting task as there is still so much to streamline.

Pillar 1 contains two key amounts: Amount A allocates a share of a multinational group’s residual profits to certain market jurisdictions. Meanwhile, Amount B is a fixed return for marketing and distribution activities that physically occur in a given market jurisdiction. The OECD, as well as stakeholders, agree that the determination of these amounts—and to whom they apply—still needs clarification. While global leaders claim that tax certainty is an area of vital importance, the proposal’s complex formulas, corporate inclusions, and carve-outs suggest high compliance costs for multinational companies and additional burdens for under-resourced tax administrations, inevitably leading to more tax disputes.

The Blueprint includes chapters on Amount A’s scope, nexus, revenue sourcing, tax-base determination, profit allocation, and elimination of double-taxation and Amount B’s scope and quantum. Other chapters address dispute prevention and implementation and administration. Political interests have been particular stumbling blocks to the proposal’s scope, meaning which MNEs will be subject to the taxing rights under Amount A. As it stands, digital companies have been broken into two types—automated digital services (transactions with little or no human involvement) and consumer-facing businesses. Some member countries prefer a phased-in approach, which would entail paving the way for Amount A with companies benefitting from automated digital services and consumer-facing businesses trickling in later. Meanwhile, the U.S., which has been a holdout on digital tax talks, wants to see Pillar 1 launched on a safe-harbor basis, whereby businesses would elect to be subject to Pillar 1. Needless to say, other countries are dubious.

Pillar 1 requires new nexus rules, as the proposal hits multinational companies with tax liabilities in jurisdictions where they don’t have a physical presence. Given that Amount A is essentially a residual profit split between jurisdictions, world leaders will have to agree on new nexus rules that determine which jurisdictions have rights to Amount A. For transfer pricing purposes, Pillar 1’s biggest disruption is that digital profits are distributed based on a formula—not the founding principle of transfer pricing, the arm’s-length standard. For now, however, the Blueprint doesn’t define profitability thresholds determining the allocable tax base or the reallocation percentage threshold. For multinational companies, a huge issue will be protection from double taxation in regard to the relationship between regular transfer pricing rules and Pillar 1. For example, if transfer pricing rules allocate residual profits to market jurisdictions, profits can be taxed through those allocations—and then again via Amount A.

The Pillar 1 Blueprint addresses this by offering up the option of a “marketing and distribution profits safe harbor.” But it seems the more questions the Blueprint tries to answer, the more it creates. The marketing and distribution safe harbor is a fixed return for routine marketing and distribution physically taking place inside a country. It’s added to the Amount A calculation. But that fixed return is essentially the same as Amount B—maybe. The Inclusive Framework has yet to clarify exactly how they’re related.

Amount B’s fixed return is more reminiscent of transfer pricing as we know it. To implement, countries would have to adopt it into domestic law. The OECD recommends using the transactional net margin method to determine Amount B unless another method proves more appropriate. In the coming months, the OECD will focus on the preferred profit level indicator, determining the regions and industries that should get returns, and even a potential pilot program.

The implementation of Pillar 2 is estimated to raise an additional $40 to $70 billion in global corporate income tax (CIT) revenue. This proposal, a minimum tax compared to Pillar 1’s reallocation of profits, is mired in its own web of intricacy—a document published for public consultation in 2019 solicited more than 3,000 pages of feedback. The Global Anti-Base Erosion proposal, or GLoBE, as Pillar 2 is known, proposes a minimum level of tax, where individual jurisdictions would agree to tax at least 12.5% of the profits generated by companies headquartered inside their borders. One of the biggest hurdles here is figuring out how the U.S.’s GILTI regime—a 10.5% minimum tax on U.S.-based multinational companies’ foreign profits—will work in conjunction with Pillar 2. As it stands now, U.S. companies would be subject to GILTI, not Pillar 2, but it could potentially force the U.S. to up GILTI’s minimum rate.

GLoBE is a global minimum tax that encompasses four types of payments:

  1. an income inclusion rule, basically a supplemental tax if a foreign branch or a controlled foreign corporation is taxed below a global minimum level;
  2. an undertaxed payment rule, which denies related parties’ deductions or imposes withholding taxes if they are taxed below a minimum rate;
  3. a switch-over rule, which supports the switch from exemption to a credit method if a permanent establishment is taxed locally below a minimum rate; and
  4. a subject to tax rule, whereby a taxpayer taxed below a minimum rate is subject to withholding taxes and/or denied treaty benefits.

A loophole that GLoBE has yet to close is that its effective tax rate targets multinational companies who pay taxes on cross-border transactions below a certain threshold—but taxes paid in one jurisdiction can be applied to the effective tax rate of another, creating complexity which incentivizes base erosion. GLoBE will require its own anti-abuse rules, and the Inclusive Framework is still considering exclusions on Pillar 2’s calculation of the effective tax rate and top-up taxes on the GLoBE rules, as well as which types of payments (interest and royalties, franchise fee, insurance premiums) present the most significant BEPS risk.

A New Treasury Secretary

If global leaders can agree on anything about efforts regarding the taxation of the digital economy, it might be that the Trump administration proved uncooperative. Former Treasury Secretary Steven Mnuchin withdrew from OECD talks last summer claiming the U.S. wouldn’t concede on even an interim basis to changes that would affect American digital companies. The U.S. went even further, threatening retaliatory tariffs for European countries launching unilateral digital services taxes (DST), which would have been especially devastating given the Covid-19 pandemic. U.S. Trade Representative Robert Lighthizer took it so far as to announce an investigation into whether the U.K., Spain, Italy, and other countries were involved in unfair trade practices due to digital tax initiatives.

Now, however, things could be looking up. President Biden’s new treasury secretary, Janet Yellen, told the Senate Finance Committee that she would enter into OECD international tax negotiations “immediately and vigorously.” She also said that retaliatory tariffs trickle down to American households, which seems to imply she has little interest in launching them. Even Pascal Saint-Amans, director of the OECD’s Center for Tax Policy Administration, has been quoted saying that Yellen has a more “constructive approach” to reach a solution this year.

Despite Yellen’s team-player attitude, the treasury secretary is unlikely to agree to global tax revamps that bruise only American tech companies. If the OECD wants Yellen’s buy-in on Pillar 1 and Pillar 2, European luxury companies will likely have to be subject to them as well, a plan frowned upon by European leaders.

While the U.S. may have ambivalence about Pillar 1 and Pillar 2, European countries are ready for a digital taxation overhaul. Many have already launched interim unilateral digital services taxes, constructed so member states get a cut of revenue derived from digital transactions in their jurisdictions. Austria, France, Hungary, Italy, Poland, Spain, Turkey, and the U.K. have all launched taxes on certain gross revenue streams—not profits—generated by large digital companies. It’s already on the horizon for others like Norway and Slovenia. The fact that the U.S. once saw these taxes as discriminatory maybe the most vocal issue, but it’s certainly not the only one. Each of these digital services taxes are uniquely structured. For instance, Austria’s DST is a 5% charge applied to online advertising. Meanwhile, Belgium’s DST is 3%, aimed only at user-data sales. While these are seen as temporary measures until the OECD can reach a multilateral agreement, no one knows for sure whether each country will repeal the taxes or when. Add country-specific digital rules to a list of proposals that are not streamlining the global tax landscape.

While world leaders may not agree on how to enhance the architecture of Pillar 1 and Pillar 2, there does seem to be consensus that a simpler tax system is required. Yet the more we try to level the playing field, the more political interests stand to further blur the tax landscape, leading taxpayers away from what everyone agrees is definitively needed: more tax certainty. Maybe we’d have better luck trying to uncover a quick fix for climate change, after all.

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

Author Information

As Chief Economist of CrossBorder Solutions, Mimi Song is responsible for managing client relationships and ensuring the successful completion of all work. At the original iteration, she served as Vice President of Professional Services. Following the sale to Thomson Reuters, Song was a Vice President at Duff & Phelps and served as the Head of Transfer Pricing at the Bank of Tokyo-Mitsubishi UFJ. Mimi Song can be reached at mimi.song@xbs.ai.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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