BEPS 2.0: Re-writing the Rules of International Corporate Tax?

The current framework for international taxation goes back to 1920s when the League of Nations submitted a report on international taxation. From these, resulted Vienna convention, the model tax convention by Organization for Economic Cooperation and Development (OECD) and the United Nations (UN). The UN model tax convention is similar to the OECD’s but for more emphasis on the right of source state to levy tax.

At a very simplistic level, according to the current international corporate tax rules, a multinational enterprise (MNE) operating across borders is liable to tax in the market/ source jurisdiction only where such MNE has a physical presence in the country. This physical presence is known as ‘Permanent Establishment’ or PE. With the growing advancements in technology, it has become easy for MNEs to participate in the economic life of market/ source country without a physical presence therein. Accordingly, the current rules for taxation of cross order activities seem outdated. The dissatisfaction with these rules begin to gain momentum in the aftermath of global financial crisis of 2008 when governments, particularly of emerging economies, found themselves struggling to mop up tax revenues in an era of tepid global growth.

In 2013, following a mandate from the G20 Finance Ministers, OECD and G20 countries, working together on an equal footing, adopted a 15-point Action Plan to address Base Erosion and Profit Shifting (BEPS). One of the biggest aims of the BEPS project was to secure revenues by realigning taxation with economic activities and value creation.

In 2015, the OECD released final reports on all 15 action plans. Amongst other things, the BEPS project will amend around 3,000 tax treaties with the help of a multilateral agreement or MLI¹. Action Plan 1 of the BEPS project dealt with ‘Tax Challenges Arising from Digitalisation’. In the absence of any consensus in the report, multiple interim solutions were suggested like ‘Significant Economic Presence’ or a withholding tax in the form of ‘equalization levy’. It was agreed that further work was required to be undertaken to reach a consensus based solution by 2020.

Unilateral Action by jurisdictions including India

Pending a consensus based solution and in an effort to ramp up tax revenues, countries across the globe started implementing unilateral uncoordinated measures, mostly outside the tax treaty framework, to tax digital companies. India introduced ‘equalization levy’ in Finance Act, 2016 – a 6% final withholding tax on payment to non-residents for online advertisement or any provision for digital advertising space or facilities/ service for the purpose of online advertisement. This levy is supposedly outside the tax treaty framework and therefore credit of tax paid is not creditable in the home jurisdiction. Finance Act, 2018 amendment section 9(1)(i) of the Act to provide that ‘Significant Economic Presence’ of non-resident taxpayers would also constitute taxable presence in the form of ‘business connection’ in India. The latter is within the tax treaty framework and is relevant for non-resident taxpayers coming from non-tax treaty covered jurisdictions.

Similarly, other jurisdictions introduced unilateral measures.

Post BEPS work

Following up and pursuant to Action Plan 1 report, the OECD released in March 2018 – an interim report on ‘Tax Challenges Arising from Digitalisation’.

In May 2019, the OECD came out with a Programme of Work (“PoW”) to develop a consensus solution to tax challenges arising from Digitalisation of the Economy. This PoW was approved by Inclusive Framework² countries and laid down two pillars on which further was required to be done. Pillar 1 is the profit allocation in case of highly digitalised businesses and Pillar 2 is the development of a Global Anti-Base Erosion or the ‘GLOBE’ proposal. In respect of pillar 1, three proposals were considered by the PoW namely “user participation”, “marketing intangibles”, and “significant economic presence”.

OECD’s public consultation document on Secretariat Proposal for a “Unified Approach” under Pillar One

Building on the public consultations and consistent with the objective of developing a consensus solution to Pillar 1 issues, the Secretariat prepared a proposed “Unified Approach” combining the elements of all these three proposals. The OECD floated a public consultation document providing an overview of the proposed unified approach³.

It is important to bear in mind that this is a proposal developed by OECD secretariat⁴ and does not represent the approach agreed by members. The broad contours of the “Unified Approach” are below.

• • Scope: Large consumer-facing businesses. There may be certain carve-outs like extractive industries
• • New Nexus: Not dependent on physical presence but largely based on sales. Could have threshold including country specific threshold.
• • New Profit Allocation Rule: Going beyond the Arm’s length Principle (“ALP”) for attributing a portion of non-routing profits to market jurisdiction. A three tier profit allocation mechanism is proposed under the proposal as below:

  − Amount A: Portion (percentage) of deemed residual profit

  − Amount B: Fixed return for distribution functions

  − Amount C: Additional return based on TP analysis. Introduction of Binding and effective dispute resolution mechanisms

Firstly, the scope of this approach is to cover highly digital consumer facing business models but includes certain B2B models. Extractive industries are assumed to be out of the scope. Secondly, the approach proposes a new nexus rule - not dependent on physical presence but largely based on sales. It would be designed as a new self-standing treaty provision and may have country specific sales thresholds.

Thirdly, the approach propose going beyond the ALP and using a simple formulaic approach. The departure from the ALP appears to be for the determination of ‘residual profits’. The approach consists of three tier profit allocation mechanism consisting of Amount A, B and C.

Amount A is a share of deemed residual profit allocated to market jurisdictions using a formulaic approach, i.e. the new taxing right. This constitutes the primary response of the unified approach to the tax challenges of the digitalisation of the economy⁵. Amount B is a fixed remuneration for baseline marketing and distribution functions that take place in the market jurisdiction. Amount C would be additional return over compensation of Amount B, if any, based on transfer pricing analysis. Amount C would also involve developing binding and effective dispute prevention and resolution mechanisms relating to all elements of the proposal.

The underlying objective is to improve tax certainty for taxpayers as well as tax administrations especially for countries which don’t have enough resources to monitor and administer a complex profit allocation system.

Given that the proposal amounts to fundamental rewriting of the international tax rules, it would be useful to see whether countries are able to reach a consensus. The PoW and the consultation paper note that ‘the stakes are very high. In the balance are: the allocation of taxing rights between jurisdictions; fundamental features of the international tax system, such as the traditional notions of permanent establishment and the applicability of the arm’s length principle; the future of multilateral tax co-operation; the prevention of aggressive unilateral measures; and the intense political pressure to tax highly digitalised MNEs.’

Pillar 2: Global Anti-Base Erosion or the ‘GLOBE’ proposal

Pillar 2 calls for the development of a co-ordinated set of rules to address ongoing risks from structures that allow MNEs to shift profit to jurisdictions where they are subject to no or very low taxation. The four component parts of the GloBE proposal are:

1. an income inclusion rule that would tax the income of a foreign branch or a controlled entity if that income was subject to tax at an effective rate that is below a minimum rate;
2. an undertaxed payments rule that would operate by way of a denial of a deduction or imposition of source-based taxation (including withholding tax) for a payment to a related party if that payment was not subject to tax at or above a minimum rate;
3. a switch-over rule to be introduced into tax treaties that would permit a residence jurisdiction to switch from an exemption to a credit method where the profits attributable to a PE or derived from immovable property (which is not part of a PE) are subject to an effective rate below the minimum rate; and
4. a subject to tax rule that would complement the undertaxed payment rule by subjecting a payment to withholding or other taxes at source and adjusting eligibility for treaty benefits on certain items of income where the payment is not subject to tax at a minimum rate.

These rules would be implemented by way of changes to both domestic law and tax treaties and would incorporate a co-ordination or ordering rule to avoid the risk of double taxation that might otherwise arise where more than one jurisdiction sought to apply these rules to the same structure or arrangement.

The PoW released by OECD in May 2019 notes that while the measures set out in the BEPS package have further aligned taxation with value creation and closed gaps in the international tax architecture that allowed for double non-taxation, certain members of the IF consider that these measures do not yet provide a comprehensive solution to the risk that continues to arise from structures that shift profit to entities subject to no or very low taxation.

In that sense, Pillar 2 is a residuary framework and seeks to address the BEPS concerns remaining even after BEPS 1 (ie, 15 Action plans and the MLI) and Pillar 1. One of the most important rules under the proposed Pillar 2 – the income inclusion rule – builds on the controlled foreign company (CFC) regime. Generally, CFC rules help determine when a domestic corporation has enough control of a foreign subsidiary to tax its earnings under domestic law and which earnings and how much of those earnings are taxed⁶. In other words, CFC is an anti-abuse provision to tax passive income parked in an offshore subsidiary in no or low tax jurisdiction. This is an important distinction as the proposed Pillar 2 is supposed to apply to all types of income, whether passive or active. The OECD sought public comments on the following points:

• whether financial accounts can be used as a starting point for tax base determination, as well as different mechanisms to address timing differences
• the level of blending under the GloBE proposal, that is the extent to which an MNE can combine high-tax and low-tax income from different sources taking into account the relevant taxes on such income in determining the effective (blended) tax rate on such income; and
• experience with, and views on, carve-outs and thresholds considered as part of the GloBE proposal.

Update by OECD on 31st January 2020

Given that a lot of tech giants that would be impacted especially by Pillar 1 proposal are domiciled in the United States of America (“US”) – the global community was eagerly waiting for the US’s reaction to the both these proposals. As a background, it is important to note that while the USA was not part of BEPS 1 but is a part of the IF. The Tax Cuts and Jobs Act (“TCJA”) of 2017 was significant and brought the US tax framework at par with a global post BEPS era framework.

With this background, the US’ secretary of the treasury wrote a letter to the OECD stating that US has serious concerns regarding potential mandatory departures from arm’s-length transfer pricing and taxable nexus standards - longstanding pillars of the international tax system upon which U.S. taxpayers rely. Instead, the US advocated that goals of Pillar 1 could be substantially achieved by making Pillar 1 a safe-harbor regime. The letter also stated that US supports a GILTI⁷ like Pillar 2 solution.

In its reply, OECD replied that the consultations within the IF had not contemplated the notion that Pillar 1 could be a safe-harbour regime. Further, this may impact the ability of IF member countries to move forward within the tight deadline of achieving a consensus based solution by 2020.

In view of the above and for continuing discussions on Pillar 1 and Pillar 2, the IF met on 29-30 January 2020 and issued a statement on the Two Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy. Some important points from the update and the revised PoW issued by OECD on Pillar 1 are as below:

• The businesses that will fall within scope of the new taxing right under Amount A will be those that fall into the two categories: (a) Automated digital services; (b) Consumer-facing businesses.
  
  The former would comprise of business models such as online search engine; social media platforms; online intermediation platforms, including the operation of online marketplaces, irrespective of whether used by businesses or consumers; digital content streaming; online gaming; cloud computing services; and online advertising services. The latter would cover businesses that generate revenue from the sale of goods and services of a type commonly sold to consumers, i.e. individuals that are purchasing items for personal use and not for commercial or professional purposes.
• There will be many groups with diverse activities, some of which will meet the definitions above, some of which will not. This may be addressed by the segmentation of those activities into different business lines to which Amount A would be separately applied.
• In contrast to the traditional transfer pricing “separate entity” approach, the calculation of Amount A will be based on a measure of profit derived from the consolidated group financial accounts.
• After determining the residual profits, it would be necessary to determine the allocation key to allocate this profits to applicable market jurisdictions. This allocation key will be based on sales of a type that generate nexus. Specific revenue-sourcing rules to support its application by reference to different business models will need to be developed. For example, for online advertising such rules will, when possible, deem revenue to arise in the jurisdiction where the advertising is viewed rather than the jurisdiction (if different) where the advertising is purchased. Revenue sourcing will also be considered to address sales through independent distributors in order to avoid possible distortions.
• Elimination of double taxation: Given that Pillar 1 views MNE group as a whole for calculation of Amount A rather than individual entity or individual country. The application of existing methods in tax treaties for elimination of double taxation would be inherently difficult. Among other things, it will be necessary to determine which jurisdiction will have an obligation to eliminate any resulting double taxation; and, if there is more than one jurisdiction, the quantum of the relief to be provided by each.
• There will be no significant interaction between Amounts A and B. For an MNE group in scope and liable for Amount A to market jurisdictions, the interaction between Amount A and Amount C may occur each time its activities in scope are subject to a transfer pricing re-assessment. Further work will be undertaken to identify the interaction between Amount A and Amount C.
• Securing tax certainty is an essential element of the unified approach and is a fundamental part of the design of Pillar One. The work will include the exploration of innovative and inclusive processes to provide such tax certainty to taxpayers and tax administrations alike. It is agreed to explore an innovative approach under which tax administrations of the IF would provide early tax certainty for Amount A, for instance through the establishment of representative panels which would carry on a review function and provide tax certainty. This would require work on the process and governance of such panels to ensure appropriate representation of Members and effective, transparent, and inclusive processes.
• The agreed outcome under Pillar 1 may need to be implemented by way of another multilateral instrument. It is expected that any consensus-based agreement must include a commitment by members of the IF to implement this agreement and at the same time to withdraw relevant unilateral actions.
• An alternative approach to Pillar One implementation will be considered. Under this alternative global safe harbour system, an electing MNE group would agree, on a global basis, to be subject to Pillar 1.

Conclusion / Way Forward

Ever since the report issued by the league of nations in 1920s, a fundamental premise of the international tax system has been the prerequisite of an MNE constituting PE (mostly by a sustained physical presence) in source country for allocating taxation rights to the source country. This fundamental rule is set to change involving a host of other issues – some as outlined above. This initiative by the OECD and the IF comes at a time when multilateralism is under attack from all quarters – some examples include India not joining the Regional Comprehensive Economic Partnership (RCEP), US getting out of the Paris climate deal and the Trans-Pacific Partnership. Hence, the ability to reach a consensus based solution and parting with tax sovereignty at least in a limited sense seems challenging.

After the 2008 global financial crises and in order to stimulate demand, many countries went on a spending spree and ran huge fiscal deficits. As such, the proposals are expected to increase tax revenues across the globe.

An important part of the OECD PoW released in May 2019 was to carry out more in-depth analysis of each proposal and their interlinkages with a particular focus on the importance of assessing the revenue, economic and behavioural implications of the proposals in order to inform the IF in its decision making. On 13 February 2020 – OECD gave a high level update on the economic analysis & impact assessment done so far. Some of the conclusions are:

• The combined effect of Pillars 1 & 2 would lead to a significant increase in global tax revenues
• Estimated global net revenue gain up to 4% of global CIT revenues or USD 100 billion annually, depending on reform design
• The revenue gains are broadly similar across high, middle and low-income economies, as a share of corporate tax revenues. However, investment hubs would experience some loss in tax revenues
• Failure to reach a consensus-based solution would lead to further unilateral measures and greater uncertainty
• More than half of the profit reallocated comes from 100 MNE groups

A recent working paper by the International Monetary Fund⁸ highlights that several small economies play an outsized role in the global FDI network: the Netherlands, Luxembourg, Hong Kong SAR, Switzerland, Singapore, Ireland, Bermuda, the British Virgin Islands and the Cayman Islands jointly host more than 40% of global FDI although their combined share of global GDP is only around 3%.

One certainly hopes that the unfinished agenda of BEPS 1.0 is completed by the so called BEPS 2.0 (Pillar 1 and Pillar 2) and taxing outcomes are more closely aligned with value creation. Anything otherwise threatens to destabilize the already in retreat globalisation. ■