The GloBE puzzle: a debate way beyond use of financial accounts

By Dr. Leopoldo Parada, University of Leeds School of Law

A few days before closing the public consultation on the OECD Secretariat’s pillar 1 unified approach, the OECD released a second public consultation document, this time referred to as pillar 2 or the so-called global anti-base erosion (GloBE) proposal.

However, and unlike pillar 1, the GloBE document appears to be more a specific questionnaire regarding the feasibility of using financial accounts for tax purposes rather than a structured and well-developed proposal to achieve minimum global taxation.

Please do not get me wrong, a discussion regarding the use of financial accounts for calculating tax bases is important, but it should not be the core of the debate regarding GloBE, especially when plenty of other more important questions remain open.

This approach just prevents us from seeing the forest for the trees, which, to be completely fair, appears to be a rather big forest, even when compared to pillar 1.

What we know about GloBE

From the programme of work released in May 2019, the only clarity we have regarding pillar 2 is that this proposal calls for the development of co-ordinated rules that may avoid the shifting of profits by multinationals with the result of no or low taxation, and which include two specific domestic rules and two tax treaty amendments, which are presented as the “four components” of the GloBE formula aiming to ensure minimum global taxation.

These rules include:

1. an income inclusion rule, which would allow countries to tax income from branches or controlled entities abroad if that income was not subject to minimum effective taxation reinforcing, therefore, the idea of residence taxation;
2. an undertaxed payment rule that denies a deduction or grants source-based taxation (including withholding taxes) for payments made to related parties if those payments were not subject to minimum taxation reinforcing, therefore, the idea of source taxation;
3. a tax treaty switch-over rule, which would allow a country to switch from exemption to credit method when profits attributed to a permanent establishment (PE) or derived from immovable property (not part of a PE) are not subject to minimum effective taxation, and
4. a subject to tax rule, which would grant or deny tax treaty benefits if an item of income was not subject to tax at a minimum rate.

While the rules 1 and 2 would require domestic implementation, rules 3 and 4 would require modification of the existing tax treaty network for those cases where neither a switch-over nor a subject to tax clause has been introduced.

Accordingly, the interaction among the rules appears to be simple: while the switch-over rule complements the application of the income inclusion, the subject to tax does an equal task regarding the undertaxed payment rule.

Yet, and in spite of this simplistic presentation, the proposed GloBE rules raise important practical and policy questions, which should be addressed at equal footing with other issues, such as the use of financial accounts for tax purposes.

Things may indeed get very complex…

If we start from some basics, legal homogenous definitions among countries are not the general rule at all. Therefore, it is expected that concepts such as deduction, inclusion, payment and even income do not match – and perhaps even contradict – raising interpretation issues and complexity.

The OECD may solve this issue by offering clear and consistent definitions concepts used in the GloBE proposal. True! However, experience tells us that theoretically consistent definitions may still leave open important queries. We just need to look back to the OECD/G20 base erosion profit shifting (BEPS) final report to Action 2.

For example, what will be the treatment of income included in the country of the controlling entity for purposes of the income inclusion rule when losses are incurred in that country? Will the income inclusion requirement still suffice?

The logic would say that a payment that is offset against deductible expenditure or losses that have been carried-forward should be treated as having been included. This is at least the position adopted regarding hybrids and linking rules in OECD BEPS Action 2 with respect to the defensive rule, which resembles the income inclusion rule. However, we have no certainty if that approach will prevail under the GloBE rule.

Accordingly, one may fairly raise some questions regarding the role of withholding taxes. Will the OECD maintain its approach that withholding taxes do not amount to “income inclusion” as it does regarding anti-hybrid rules in the OECD BEPS Action 2?

If one agrees that the economic burden of withholding taxes relies on the payee rather than on the payor, the OECD approach lacks consistency, especially if withholding taxes are applied at a rate that satisfies the minimum tax rate.

GloBE rules and other specific anti-avoidance provisions

In addition to questions regarding legal definitions, withholding taxes, and the tax treatment of losses, questions also arise regarding the interaction between the GloBE rules and other specific anti-avoidance rules, such as interest limitation rules and controlled foreign company (CFC) rules.

Take the example of the undertaxed payment rule which denies a deduction. Will that rule apply before or after interest limitation rules? Will the income inclusion rule be a sort of lex specialis applying therefore before interest limitation rules?  If that is the case, should the income inclusion rule include a carry-forward option to avoid permanent economic double taxation?

Similarly, domestic CFC regimes will need to be amended to consider the new income inclusion rule, particularly to avoid double taxation. That will certainly increase the complexity of already existing and complex CFC regimes around the world.

It appears that after all imposing a GILTI and BEAT regime as a worldwide standard may not necessarily fit well the interest of all countries, especially those with small and less technically prepared tax administrations.

GloBE rules and tax treaties

The interaction between domestic and tax treaty GloBE rules may be another big headache, at least within the field of speculations that we still live in.

For example, even though it is clear that the income inclusion rule and the tax treaty switch-over rule may complement to each other when it comes to the case of the effective minimum taxation of profits of a branch (PE) subject to a branch exemption in the residence jurisdiction, that might not be the case of a subsidiary that is not a PE.

In such a case, even though the domestic income inclusion rule may still apply –a subsidiary is a controlled entity unless the concept of control changes in 180 degrees– it is true that a domestic switch-over might be required to ensure the success of the income inclusion (the treaty will not apply here because the subsidiary is not a PE). The foregoing might nonetheless implicitly legitimize the already existing practice of overriding tax treaties, constituting a risk for the general stability of tax treaties.

Similarly, a subject to tax provision may have a major impact on the reallocation of taxing rights. For example, if royalties are paid from a company to another and they are not subject to minimum taxation in the recipient country, the exclusive taxing rights of the residence state disappears, reallocating the taxing rights to the source state, as well.

That is, the source state may not only be entitled to deny the deduction for the royalties under the undertaxed payment rule, but also tax the royalties at a full withholding tax rate because of the treaty. Still, no one can ensure that this withholding tax will be fully creditable in the recipient state.

Circularity and international coordination

One of the features of the GloBE rules also appears to be their excessive reliance upon the tax outcomes between countries, risking becoming circularly linked in the short-term and to simply fail their purpose in the long-term.

For example, if two countries decide to introduce an income inclusion and an undertaxed payment rule, this might create an absurd result where the country of the payer denies a deduction for a payment to the extent that a payment is not taxed at a minimum rate in the payee country (undertaxed payment rule), and the payee country considers the same payment taxable to the extent that no minimum taxation occurred in the payer country (income inclusion rule), leaving both countries unclear about who should get in first.

If one follows the logic of taxation, that is, receiving revenue to finance domestic public expenditure, it should be expected that a country that wants to safeguard those revenues gets in first. Could a tie-breaker rule solve this issue? Perhaps, but only to the extent the tie-breaker rule does not become in itself circularly linked.

Moreover, one should not forget also that even if countries wish to act in the interest of other countries, they normally do so only for countries with which they have a deep affinity based on cultural, economic, or geographical reasons.

Therefore, the success of GloBE will not only depend on introducing a rule order (which rule applies first) or tie-breaker rules but, more importantly, on whether the traditional behavior of countries toward others regarding international taxation is capable of change.

Final remarks

The lack of details regarding the GloBE leaves us only able to speculate on the outcome of this proposal and the risks entailed with adopting it. However, riskier still is to make the world to believe that the only important issue to debate regarding minimum taxation and “global linking rules” is the feasibility of using financial accounts for tax purposes. There is certainly much more on the horizon, but for that, it is necessary to know the details.