G20 and OECD: The future of the global tax system

The OECD announced on 8 October that international agreement had been reached on its “Two Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy”. The OECD/G20 Inclusive Framework, agreed to by 136 countries is the OCED’s and G20’s vision for the international tax future, and reinforces the conclusions reached in August 2021. There are two aspects (referred to as “Pillars”):

  • Pillar One - A fairer distribution of profits and taxing rights via reallocation to markets where certain large multinational enterprises (“MNE’s”) have business activities and earn profits, and
  • Pillar Two – A global minimum tax rate

The latest announcement is the next step in the process and will now be followed by:

  • Detailed rules – November/December 2021
  • Multi-lateral conventions and model legislation – late 2021 and early 2022
  • Enacted into law by countries in 2022 for a 2023 start

What are the reasons that change is required?
It has been widely recognised that the existing global tax system (designed when physical presence was the key to economic activity) requires updating to meet the needs of the digital economy. This has been compounded by:

  • The requirement to fund the Covid-19 recovery,
  • Recognition that single country solutions to digital taxation bring inconsistency, double taxation, and continued uncertainty,
  • All businesses are increasingly digital in nature so taxation of “digital companies” is not the answer.

What is the likely tax revenue that will be raised?
The OECD estimate that $125 billion of profits could potentially be reallocated between countries because of Pillar One, with the global minimum tax rate expected to generate approximately $150 billion in additional global tax revenues.

How will it work and who will it apply to?

Pillar One

Pillar One will introduce a new nexus rule that will replace the old permanent establishment rules and provide taxing rights where products are sold, or services provided (referred to as “market jurisdictions”). This seeks to align the market value of goods and services with where they are consumed rather than produced. 

It will apply where:

  • Global turnover of a MNE exceeds 20 billion euro, and its profitability exceeds 10%,
  • 25% of the profit in excess of 10% will be allocated to market jurisdictions, and
  • The MNE would need to derive at least 1 million euros from that country (for smaller economies, with GDP less than 40 billion euros, the nexus will be 250,000 euros)

The OECD also announced that agreement had been reached for the removal of all existing Digital Services Taxes and similar unilateral measures.

Pillar Two

Pillar Two will introduce a global minimum tax rate set at 15% (i.e., the minimum floor beneath which the global tax rate cannot fall), so that if countries have a tax rate below this threshold, other countries will have the right to impose a top up tax.

It will apply to:

  • MNEs that have a global turnover that exceeds 750 million euro.

What are the technical challenges?
The technical challenges with introducing changes of this size are clearly considerable, particularly given laws will eventually need to be passed in all participating countries to give effect to the global policies, for example:

  • Detailed sourcing rules will need to be developed to allocate where goods or services are used or consumed,
  • Agreement over how accounting profits will be measured (and if applicable adjusted) for the determination of profit,
  • The extent to which “safe harbours” will be available to reduce the compliance burden for taxpayers (e.g., in relation to marketing and distribution activities),
  • The planned global dispute resolution procedure will need to be effective to deal with disputes promptly and equitably between countries over taxing rights, and 
  • The exemption and/or credit mechanisms will need to remove double taxation.

What are the other potential roadblocks?

  • The October statement is a good start, however the timetable remains challenging and “temporary” measures will remain in place until the new rules are passed into law,
  • The US faces domestic political challenges to the introduction of a global solution and, as the “home country” of many of the large digital MNE’s its participation will be critical to success of the OECD plan,
  • Ireland, Hungary, and Estonia in Europe had previously held out against the OECD Inclusive Framework, but have now signed, with Kenya, Nigeria, Pakistan and Sri Lanka the only countries that have not yet signed.

What should business be doing now?
The broad principles of the October Statement have not changed from August. The key issues have now been stated and there is a clear direction of travel for the global tax system, , so we recommend the following preliminary analysis:

  • Review your international tax structure (and related party transactions) to ensure you have up to date and reliable information regarding the MNE’s global activities. The MNE’s most recent transfer pricing report will be a good starting point,
  • Test your information management systems – digital exchange of information is already well advanced between countries’ Revenue Authorities and this will accelerate,
  • Corporate social responsibility and governance. Many countries already have disclosure rules on tax policy and information, and more should be expected, so develop and/or test your policies,
  • Communication with stakeholders (employees, suppliers, customers etc.,) is essential to maintain their support and understanding.

Conclusion
The global tax system that is in place in 2023 will be very different from 2021. This is a recognition of the global nature of the digital economy and the financial needs of Governments to raise revenues to fund the Covid-19 recovery. More negotiations are ahead, both technical and political, but the direction has now been clearly established and a new global tax framework is on the way.   

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