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TII SPECIAL
A peep into Global Tax Reforms Architecture
By Pratap Singh, Principal CIT
Jun 24, 2024

 

THIS article aims to present an overview of the global tax reforms underway, exploring its challenges, key initiatives, and potential outcomes. It explores the importance of international cooperation under UN/G20/OECD, in addressing tax avoidance and ensuring that businesses contribute their fair share to the societies in which they operate.

In the realm of international economics, the architecture of global tax reform stands as a crucial frontier in shaping the future of economic equity and stability. As nations grapple with the complexities of a globalized and digitalized economy, the need for a fair and effective tax framework becomes increasingly evident. This article delves into the key elements, challenges, and potential outcomes of global tax reform, highlighting its significance in the contemporary world.

Understanding the Current Landscape

The present tax laws, were made around traditional business firms or so called brick mortar companies and are based on old tax agreements, enshrined in the global network of bilateral tax treaties. However, business models have evolved as a result of digitalisation and globalisation. Today, everything, right from starting a business to selling products/services, is digitally managed without the need for physical presence. Thus, it is imperative that the current international tax laws be reformed to take care digitalization of economy. The current international tax landscape is characterized by a patchwork of rules and regulations that often favor multinational corporations over smaller enterprises and individual taxpayers. This fragmentation allows for tax avoidance and profit shifting, where companies exploit gaps and mismatches in tax rules to minimize their tax liabilities.At the heart of the issue lies the concept of base erosion and profit shifting (BEPS), a practice where multinational corporations artificially shift profits to low-tax jurisdictions to reduce their overall tax burden. This phenomenon not only deprives countries of much-needed tax revenues but also undermines the principle of tax fairness and equity.

These tax challenges were first identified as a focus area of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, leading to the 2015 BEPS Action 1 Report, entitled as "Addressing the Tax Challenges of the Digital Economy". More than 130 countries in the Inclusive Framework have been working on the Two Pillar approach. As an outcome, the OECD Secretariat, on 12 October 2020, released a package comprising a report on the Pillar One and Pillar Two solution. On 5 June 2021, the G7 countries announced a political agreement on Pillar One and Two. This was followed by a statement by the Inclusive Framework on 1 July 2021, announcing a consensus by 130 countries. Pillar One provides taxing rights to market jurisdictions on part of the residual profits earned by MNE groups with an annual global turnover exceeding €20 billion and 10 percent profitability. Pillar Two requires MNE groups with an annual global turnover exceeding €750 million to pay at least 15 percent tax.

Challenges in Global Tax Reform

Achieving consensus on global tax reform is fraught with challenges, primarily due to the diverse economic interests and priorities of different countries. Developing nations, for instance, often seek to attract foreign investment through lower tax rates, whereas developed economies aim to prevent profit shifting and ensure a more equitable distribution of tax revenues. Moreover, the digital economy presents unique challenges to traditional tax frameworks. The rise of digital giants has highlighted the inadequacy of current tax rules, which struggle to capture value generated from intangible assets and online transactions. Addressing these challenges requires innovative solutions that reflect the evolving nature of economic activities in the digital age.

Indian Initiative:

With a view to club loopholes and leakage of revenue on account of digitalization and globalization of economy, India first brought in provisions of equalization levy @6%, in the year 2016, in respect of digital advertising by global MNCs like google, on their portals. Later the equalization levy was extended to sale purchase of goods or provision of services or data downloading etc., @2% in the year 2020, which was resented by global MNEs. Prior to that India had brought in concepts like significant economic presence, deemed PEs, agent PEs etc., to take care of leakage of revenue by global companies without physical presence in the country. India also actively participated in formulation of global tax rules, whether pillar one or pillar two solution or MLI provisions, and has been an important voice on global foras like UN/G20/OECD etc.

Key Elements of Global Tax Reform

In response to these challenges, international organizations such as the OECD have spearheaded efforts to reform global tax rules. In October 2020, the OECD outlined a "Two Pillar" approach to remaking the international tax system. The executive branches of nearly 140 countries have signed on, including the US. The proposal is intended to change the taxation of multinational businesses by raising effective tax rates and reallocating taxing rights away from some countries to others. Pillar One aims to change where some companies pay taxes, selectively moving toward a system based on customer location instead of business activities. Pillar Two includes a series of new rules that enforce a global minimum tax of 15 percent. Key elements of the BEPS project include:

1. Country-by-Country Reporting (CbCR): In December 2022, the Inclusive Framework agreed a significant simplification to the GloBE Rules with the Transitional CbCR Safe Harbour which is based on financial information used for purposes of Country-by-Country (CbC) Reporting. In December 2023, the Inclusive Framework had released further guidance related to the use of the Transitional CbCR Safe Harbour under the GloBE Rules which provided that intragroup payments need to be treated consistently in the payer and recipient jurisdiction.

2. Transfer Pricing Guidelines: Provide guidance on how multinational corporations should price transactions between related entities to prevent artificially inflated or deflated profits.

3. Digital Taxation: Proposes new rules to ensure that digital businesses contribute their fair share of taxes, regardless of their physical presence in a particular jurisdiction

The Organisation for Economic Co-operation and Development's (OECD) Inclusive Framework on Base Erosion Profit Shifting (BEPS) has been continuously evolving to develop an agreement on a two-pillar approach to help address tax avoidance, ensure coherence of international tax rules, and, ultimately, a more transparent tax environment. Today, BEPS 2.0 also looks to address the challenges arising from the taxation of the digital economy.

Pillar One, which applies to large multinationals, will reallocate certain amounts of taxable income to market jurisdictions, resulting in a change in effective tax rate and cash tax obligations, as well as an impact on current transfer pricing arrangements. In October 2023 the OECD released draft text for the Multilateral Convention to Implement Amount A of Pillar One. The proposed rules threaten to further destabilize the international tax system while not replacing the most discriminatory digital services taxes. Pillar One would reallocate an estimated $205 billion of large multinational corporate profits to countries where customers are located and away from where the firms have a physical and productive presence. This would be done with a complicated formula based on a company's sales, marketing, and distribution in each jurisdiction. Amount A of Pillar One applies to companies with more than €20 billion ($22 billion) in revenues, falling to €10 billion ($11 billion) after seven years, and a global profit margin above 10 percent.

Amount A is intended to replace a patchwork of digital services taxes, which some countries currently charge large technology firms based on revenue and users in their country. Pillar One also includes Amount B, which could provide a more formulaic transfer pricing method for marketing and distribution. Work on Amount B continues. The timing for the introduction of Pillar One is unknown and depends on its acceptance by a critical mass of jurisdictions. Further digital services taxes and other similar measures are to be repealed under the agreement, but the identification and timetable are not yet clear. Further the scope of covered businesses has moved far from the original intention of highly digitalized business models. Extractives and regulated financial services are exempt, but other industries are generally in scope.

Pillar Two aims for global minimum tax rate of 15%, to ensure that income is taxed at an appropriate rate and has several complicated mechanisms to ensure this tax is paid. On 20 December 2021, the OECD/G20 Inclusive Framework (IF) on Base Erosion and Profit Shifting (BEPS) released Model Global Anti-Base Erosion (GloBE) rules (Model Rules) under Pillar Two. These Model Rules set forth the "common approach" for a Global Minimum Tax at 15 percent for multinational enterprises with a turnover of more than EUR750 million. The IF has released further guidance on the Model Rules throughout 2022 and 2023, including Commentary, an Implementation Framework, and Administrative Guidance. Pillar Two comprises five new rules that work together to enforce a global minimum tax rate of 15 percent on businesses with more than €750 million ($825 million) in revenues. Pillar Two is estimated to raise between $155 billion and $192 billion in global tax revenue each year.

The first new rule under pillar two is the Qualified Domestic Minimum Top Up Tax (QDMTT), a minimum tax allowing countries the first right to tax their domestic entities at a 15 percent rate on a novel tax base. Second, the Income Inclusion Rule (IIR) requires parent companies to include in their taxable income the profits of their foreign subsidiaries that have not been taxed at the minimum 15 percent rate. Third, the Undertaxed Profits Rule (UTPR) allows countries to increase taxes on a business's domestic subsidiary if a related entity in another jurisdiction pays a tax rate below 15 percent. The final two components of Pillar Two include the denial of tax treaty benefits to companies in noncompliant jurisdictions (the Subject to Tax Rule, or STTR) and anti base erosion reporting rules on corporate structure, country by country income, and taxes paid. A number of uncertainties remain, but Pillar Two is likely to be launched soon by a few tax jurisdictions indicating a radical shift in the tax landscape.

Potential Outcomes and Implications

The successful implementation of global tax reform could yield several significant outcomes. First and foremost, it would help restore public trust in the fairness of the tax system by ensuring that all businesses, regardless of size or industry, contribute their fair share. This, in turn, could alleviate budgetary pressures on governments and enable them to invest in public services and infrastructure. Furthermore, global tax reform could promote greater economic stability by reducing incentives for tax arbitrage and encouraging investment in productive activities rather than tax planning strategies. By creating a level playing field for businesses, reform efforts could also foster competition based on innovation and efficiency rather than tax advantages.

Conclusion

As we navigate the complexities of a globalized economy, the need for a robust and inclusive tax framework has never been more apparent. By embracing the principles of fairness, transparency, and cooperation, we can lay the groundwork for a more prosperous and sustainable future for all. The global tax reform discussed above, represent a critical step toward building a fairer and more equitable economic architecture. By addressing the challenges posed by profit shifting and the digital economy, reform efforts have the potential to reshape the international tax landscape for the better. However, achieving meaningful reform will require continued collaboration and commitment from policymakers, businesses, and civil society stakeholders worldwide. As the world evolves, it is imperative for tax policies to adapt in a manner that upholds economic dynamism, encourages innovation, and maintains jurisdictional competition. India has contributed significantly in development of the above rules and for the first time it is in a role of a rule maker rather than rule taker.

(The views expressed are personal of the author and not of his Department)

 
 
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