For tax professionals, recent developments in the international tax landscape have made current times exceptionally exciting. For businesses operating internationally, it may be the right time to pick up the phone and call those tax professionals.
In early June 2021, the G7 countries (US, UK, Canada, France, Germany, Italy and Japan) reached a historic agreement consisting of two main aspects or pillars: the first involves businesses being required to pay taxes in countries where they have significant operations and not just where they have their headquarters [Pillar 1], and the second being a commitment to levy a minimum tax on businesses operating in their countries [Pillar 2], primarily to discourage shifting of profits to low-tax jurisdictions.
What exactly are pillars 1 and 2, and how will they impact international businesses?
Pillar 1 is set on the basis that governments whose citizens spend money to effectively fuel the operations of a business, should have a right to tax the profits of that business. Traditional tax laws generally trigger tax incidence with a physical presence, however, since the advent of e-commerce and the paradigm shift from physical to online marketplaces, e-commerce giants can operate in countries without creating a taxable presence (and consequently not paying any taxes). Governments who adopt Pillar 1 would have the right to tax profits that have been earned by a business within its borders, even if such a business does not have any physical presence in that country.
The Global Minimum Corporate Tax Rate (or GMCTR) under Pillar 2 has currently been agreed between the G7 countries at 15%. However, this is the minimum corporate tax rate agreed. Participating countries may impose a higher tax rate. The rationale behind countries adopting a minimum corporate tax rate is to curtail the possibility of corporations shifting their tax residency or profits to a low or no tax jurisdiction. In situations where corporations established in a participating country pay tax at lower rates in other jurisdictions, the participating country’s government would impose the differential tax rate, up to the agreed GMCTR. This would effectively eliminate any tax benefit exploited by a corporation by shifting profits from its own country to a tax haven.
As an example, consider a case where the ultimate parent company of a company is established in the US which has a corporate tax rate of 21%, with a technology and financial services subsidiary set up in Jersey where the corporate tax rate of such a company is 10%. Currently, the Jersey subsidiary’s profits would attract tax at 10% only. However, under the GMCTR Regime, the US would have the authority to tax the Jersey subsidiary’s profits at a differential rate of 5%.
What is the monetary benefit for participating countries?
The OECD has estimated that the pillars could bring in aggregate tax collections to participating countries of more than $81b each year. If participating countries adopt corporate tax rates higher than the minimum 15%, collections would only increase. Considering the significant unanticipated cost burden brought on governments due to the COVID-19 pandemic, along with a dire need to raise revenue to boost economies, the additional tax collections would be welcomed by participating countries.
British finance minister Rishi Sunak has described the agreement as “fit for the global digital age”, and rightfully so. Many politicians and economic think-tanks have highlighted that e-commerce giants such as Amazon do not pay taxes in all countries in which they operate. Tech companies such as Facebook have moved their headquarters to low-tax jurisdictions to manage (read: lower) their tax bill. Where countries adopt the initiatives proposed, corporations will have no incentive to incorporate or shift profits in supposed tax havens.
Sounds good. Any impediments in implementation?
While the agreement can certainly be considered as a step in the right direction to curtail profit shifting and to ensure that governments are able to tax businesses operating within their borders, it comes with its own limitations. For instance, it would be interesting to see how Pillars 1 and 2 will be adopted by participating countries, as each country has its own complex set of tax laws. Furthermore, many countries such as the UK, France, Italy, and India have already unilaterally implemented taxes on digital services. Ideally, such taxes should be repealed prior to adoption of Pillars 1 and 2 to avoid double-taxation on tech companies.
Since the initiatives are aimed to address international tax issues, they need to be adopted exactly as such, i.e., internationally. The G7 countries may have reached an amicable agreement in concept, but the real test would be when the proposal is put up for discussion in the G20 meeting scheduled for July 2021. Where the G20 countries can come to agreeable terms, the proposal would be analyzed by members of the OECD Inclusive Framework, which include more than 135 countries, each having their own agenda on how to increase their tax collections and boost the investment climate for their country.
While introduction of Pillars 1 and 2 will increase tax collections of countries with higher corporate tax rates, countries such as Ireland and Hungary, where corporate tax rates are 12.5% and 9% respectively, may find it difficult to justify a higher minimum corporate tax rate for their economy, as it could remove its attraction as a base to multinationals such as Google and Facebook. These countries are a part of the European Union, which is a member of the G20.
Nevertheless, with another tangible step taken to mitigate profit shifting at the cost of government treasuries, the Pillars 1 and 2 initiatives could go a long way in ending corporations’ efforts in what is described as a “race to the bottom on corporate tax rates”. That is ofcourse, until those corporations pick up the phone.
Stay tuned for our next discussion on this topic after the G20 meeting in July 2021.
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- What is the impact on the companies functioning internationally? – captured in paragraphs 3 and 4 (pillars elaboration)
- What can the companies do right now – harvest tax losses etc? – I think since the topic is macro and uncertain at this stage, we can cover this in a subsequent article
- How does GMCTR function with an example? Like all US revenues earned will be taxed at blanket 15% tax rates, will this be allowed as a rebate for taxes? – example included
- There is a lot of uncertainty right now, mention questions whose answers should the people wait for? Impediments in implementation paragraph modified to capture this
- Are there any unseen effects of this taxation? Like will it increase supply chain cost, or increase in use of intangible cost inherently leading to higher cost of running a business – same as point 2. We can come out with an article later to analyze from a business POV