By Suranjali Tandon, National Institute of Public Finance and Policy, New Delhi, India
For developing countries like India, the agreement reached by the G7 Finance Ministers on June 5 on proposed changes to international tax rules under “pillar one” and “pillar two” may bring little in terms of new tax revenue while imposing new restrictions on tax sovereignty.
The G7 countries committed to imposing a minimum tax of 15 percent on a country-by-country basis and to reaching an equitable solution on the allocation of taxing rights. It is considered a landmark deal, marking an end to the race to the bottom in corporate tax rates. While the agreement on rate is a political victory for the G7, it is important to consider what developing countries like India stand to gain from such an agreement.
The G7 communique makes it clear that the pillar one and two proposals are to be considered a package deal.
Under the pillar one agreement, for large multinational companies in scope, a fifth of the companies’ profits over a 10 percent margin would be reallocated to market jurisdictions. To put this in perspective, based on review of the SEC filings of some of the big tech companies, it is seen that a tiny fraction of profits would accrue to the Asia-Pacific region, of which a smaller portion would accrue to India.
For example, Alphabet’s (i.e., Google’s parent company’s) global rate of profit in 2019 was 22.5 percent. By rough estimate, 2.5 percent would be available for distribution to source countries. With 34 percent of Alphabet’s sales in Asian Pacific countries, there would be about 0.8 percent of Alphabet’s profits to be divided between countries in the region. However, it could be even less if certain rules regarding the pillar one approach are adopted; the exact way in which the profits would be distributed remains to be seen.
Given the limited gains in allocations under pillar one, and the fact that it is proposed as a package deal with pillar two, the impact of pillar two must be stacked against the gains from pillar one.
India’s domestic tax policy is already generally in line with the intent of the minimum tax. Other than the recent reduction in corporate tax rates for new domestic manufacturing companies to 15 percent, the effective corporate tax rate in India has increased over the years to 27 percent. There is also a minimum alternate tax applicable to domestic companies. Therefore, pillar two would not affect the general corporate tax rate in India.
On the other hand, India offers a host of incentives for operations within its recently created financial special economic zone. It is possible then that investments in such zone, largely from foreign investors, may dry up if the taxes will be clawed back. Thus, such an agreement could restrict India’s flexibility to alter its tax system to achieve its economic objectives.
The road up to the G7 deal
Global average corporate tax rates declined from 40.11 percent in 1980 to 23.85 percent in 2020. This was in part the result of a significant reduction in average rates across Europe and in the statutory tax rates in the US in 2017.
However, the reductions in statutory rates are just one part of the story. Over the years, preferential tax regimes allowing countries to gain unfair access to incentives stoked unhealthy tax competition.
One way to deal with the proliferation of tax havens was to review practices of these jurisdictions with a credible threat of sanctions. The OECD’s own work dating back to 1998 on harmful tax practices identified non-compliant jurisdictions with minimal tax. EU too drew its own list in 2017, that in the end thinned to just five jurisdictions. Nevertheless, the use of strategies such as the Double Dutch Irish Sandwich by large multinational enterprises such as Alphabet, Facebook and Apple continued.
To remedy such abject subversion of tax systems, the 15-point OECD base erosion and profit shifting (BEPS) action plan was designed to systematically address all prevailing loopholes in detail. Four of these came to be minimum standards: measures tackling treaty abuse, adopting country-by-country reporting, addressing harmful tax practices, and improving dispute resolution.
Through a process of peer review, discriminatory patent box schemes were to be closed down. Per the country positions submitted during the adoption of Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI), most countries adopted a principal purpose test, a broad anti-avoidance measure, as a means to curb treaty abuse.
However, the call for a minimum tax indicates that all these measures did not meet the desired objective. In fact, a 2019 policy note released by the OECD committed to strengthen the ability of jurisdictions to tax where the other jurisdiction with taxing rights applies a low effective rate of tax to those profits.
The action point was bifurcated into pillar one and two. The blueprints of the proposal released in 2020 demonstrated that the second pillar had in fact moved far beyond the tax challenges arising from digitalisation. It now seeks to apply a minimum rate of tax to country-by-country profits of large enterprises with a global consolidated revenue of more than Euro 750 million.
With the change in administration in the US, there was a sharp change in the tax narrative as well. The US Treasury proposed a hike in the domestic corporate tax rate and a minimum rate set at 21 percent.
Countries such as France and Ireland expressed their reservations with this rate, although France and Germany were early proponents of a minimum tax in the EU.
The G7 ministers have now agreed among themselves on 15 percent. By the read of the headlines, one is misled that tax havens shall now cease to exist. This presumes that the will of these seven nations carries more weight and will be followed through by other countries. However, many issues remain to be ironed out before this may be pronounced as a death knell for tax havens.
Minimum tax in practice
The pillar two proposal would apply to only large companies, of which, from a glance at Forbes list of top 2000 companies, a third are headquartered in the US. Further, there are carve-outs for payroll and tangible assets.
Since the minimum effective rate is to be computed, this will be done by carefully calibrating covered taxes, which includes Amount A in pillar one or Zakat in Saudi Arabia, and the covered income. This would then be calculated by the ultimate parent entity for each jurisdiction.
If the tax rate applicable in a jurisdiction is below the agreed rate, the right to tax the income of entities would belong with the jurisdiction of the ultimate parent entity through an income inclusion rule. As a backstop to the failure to tax through the income inclusion rule, the undertaxed payments rule would allow the jurisdiction of the ultimate parent entity to collect taxes that could not be applied using the income inclusion rule on payments made to group entities in low tax jurisdictions.
The switch over rule would allow for the switch from exemption to credit method where the current treaty exempts such incomes.
Finally, a subject to tax rule would apply where covered intra-group payments such as royalties, interest and payments for mobile factors are made at a lower than agreed rate. In such cases, the source country will withhold the difference between the minimum rate and the rate charged.
Note where royalty is paid with a service, the withholding will apply to constituent parts within scope. The tax applicable would take into consideration the specificities of the local tax system. This would require the residence country to adjust through credit or exemption the charge of top up tax. Therefore, a great deal of complexity needs to be worked through to arrive at the tax base which will finally be available for taxation.
It is suggested that the income inclusion rule and undertaxed payments rule would not require treaty changes whereas the subject to tax rule and switch over rule would require treaty changes.
The G24 group of leading developing economies, which includes India, has expressed that the subject to tax rule is important for source countries. In addition, while the G24 favours its application to services and capital gains that pose BEPS risk, the materiality threshold is not useful.
If the plan to implement the minimum tax goes through, with no bilateral agreement or reservations, the application of these rules by many countries will result in limited source-based taxation.
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