For years, governments across the globe have tried to counteract the actions of big corporations undertaken to avoid incurring a hefty tax bill, but for taxman’s actions to go in vain. Well, as is the nature of things, everything runs its due course of time, before it comes to a halt. This is what the proposed Global Minimum tax rate intends to do.
When the news of this tax rate being approved by the G-7 countries (G-7 or the “Group of Seven”, including USA, Canada, UK, France, Italy, Germany, and Japan) broke out in the first week of June, the agreement drew praise from across the member nations. The move was heralded as the final crackdown on tax havens and low tax jurisdictions, but a few experts remain skeptical as this may only increase the leeway for corporations to siphon off and conceal more profits, if drafted poorly.
Normally, in order for this agreement to take concrete shape, it would require the approval of member States in the upcoming G-20 meet in July at Rome, which would further be subject to adoption by the over 130 member nations in the OECD/G20 Inclusive Framework on BEPS. Additionally, buy-in would also have to come in from the Republican party if the changes necessitated negotiations in existing tax treaties, which would require two-thirds vote in the Senate for ratification. Moreover, a slight majority in the Congress, an 50-50 Senate and a distaste among the opposing party candidates in the House may pose some serious challenges. Accordingly, one can see that even after proposing the minimum tax and getting a G-7 agreement, much work is required to be done, and deliberations may see the existing agreement being changed by a great deal.
However, the agreement was lauded by corporate executives and spokespersons, who said that the proposal went a long way to ensure certainty and insulation from political instability across nations and double taxation but did express concerns over the finality of the agreement. Abolition of the existing digital tax levies (such as France’s 3% tax on digital services revenue earned in France by companies, and India’s own Equalization levy of 6% on advertisement services by offshore digital firms to Indian businesses and 2% on other e-commerce supplies by non-resident firms) was a common highlight in the views expressed on behalf of the MNEs (Multi National Enterprises).
Similarly, the agreement would also disrupt the existing tax structures of countries like Ireland, Bosnia, Cyprus, Bahamas, Cayman Islands and BVI, countries which have lower/NIL tax, by impinging on their right of a sovereign to decide the nation’s tax policy, their only tool to draw foreign investment and stimulate activity in the economy.
Understanding the provisions:
To understand the above reactions and arguments, one would have to closely inspect the proposed changes discussed in the G-7 meet between the Finance Ministers of all the member States and analyze the provisions in their intended sense. Here is an excerpt from the official “G-7 Finance Ministers & Central Bank Governors Communiqué”:
“Shaping a Safe and Prosperous Future for All
16. We strongly support the efforts underway through the G20/OECD Inclusive Framework to address the tax challenges arising from globalization and the digitalization of the economy and to adopt a global minimum tax. We commit to reaching an equitable solution on the allocation of taxing rights, with market countries awarded taxing rights on at least 20% of profit exceeding a 10% margin for the largest and most profitable multinational enterprises. We will provide for appropriate coordination between the application of the new international tax rules and the removal of all Digital Services Taxes, and other relevant similar measures, on all companies. We also commit to a global minimum tax of at least 15% on a country by country basis. We agree on the importance of progressing agreement in parallel on both Pillars and look forward to reaching an agreement at the July meeting of G20 Finance Ministers and Central Bank Governors.”
From the above excerpt, the two pillars of the agreement intend to:
- Tax MNEs with a greater than 10% profit margin, in countries where they operate (market jurisdictions), not only where they are headquartered, based on 20% of the profit above the 10% margin reallocated to the market jurisdictions and taxed according to their laws.
- Level the playing field and crack down on tax avoidance by adoption of a minimum tax rate of 15% on a country-by-country basis.
To better understand this draft proposal, consider the following example:
- A Inc, incorporated in USA, pays a 28% tax on it’s corporate earnings calculated according to the tax law prevailing in the United States.
- It’s subsidiary, A Ireland Ltd, incorporated in Ireland, drawing it’s revenues from operations in Europe, Middle East and India, subject to tax as per the Irish tax code at 12.5%.
- Another subsidiary, A holdings BV, registered in the Netherlands, accrues it’s revenues by payments received from Irish subsidiary in form of Royalty payments for which A Ireland Ltd, claimed expense deductions, and does not withhold taxes on the same as per the Dutch-Ireland DTAA.
- This round of royalty payments is spun again, when Dutch subsidiary makes payment to A Co. Ltd. in Ireland, branch of ABC Co. Ltd. incorporated in the Cayman Islands (a tax-free country). Again, the taxes are not withheld due to the Dutch-Irish DTAA.
- However, this time, the entity in possession of royalty receipts is a non-resident, since the Irish operation is just a branch of the non-resident foreign company.
Enumerating the implications of Pillar 1 and 2 of the proposed agreement, using hypothetical figures, we have:
Accordingly, taxes paid by the companies are as follows:
- A Ireland Ltd. would still be eligible to claim the benefit of deduction with respect to royalty paid to affiliated enterprise as the relevant tax has been withheld as per the DTAA. Similarly, the deduction of expense to A Holdings BV would also be available in respect of payment made to non-related entity A Co. Ltd.
- A Co. Ltd. being registered in a tax-free country would now face the minimum tax rate, i.e., 15% of 500 million. Accordingly, the incentive for incorporating companies in tax-havens is eliminated.
- However, consider this, no royalty payments are made by A Ireland Ltd., i.e., they chose to pay tax on $ 500 million. @ 12.5%. Now, they would not be able to do so, since signatories to the agreement would have to increase their domestic corporate tax rates to the minimum level.
- Adding to point 3. say the A group of companies have their Global net profit margins at 11%, then as per Pillar 1, the registered company’s profit would be reallocated to market jurisdictions to the extent of 20% of such margin, i.e., 0.2% of their overall profits to their countries of operation, in our example, countries in the EU, Middle East and India, to be taxed at their corporate tax rates.
- The calculations have been done at flat rates to enable easy understanding of the provisions.
- Although, the “Double Irish” has been made defunct, such is taken for illustrative purposes. Similar BEPS tools like the “Single Malt” and “CAIA: Capital Allowances”, which are prevalent today, draw their structures from the Double Irish.
Concerns with the agreement:
There remains a lot to be answered, experts have raised issues about the viability of the agreement as it would mean removal of the digital taxes. The provisions would also contradict the directions of the DTAAs countries have with one another and the Multilateral Instruments to Prevent Base Erosion and Profit Shifting in force. Some other red flags which may require resolution are:
- Would the withholding tax requirements (based on gross turnover upon payment made for automated digital services) under Article 12B of the UN Model Double Taxation Convention still persist?
- The real share of increase in tax revenues will come from Pillar 2. However, it is argued that all countries may not have such a high tax appetite, and ultimately this may end up corporations leaving those developing countries which were once relaxed when it came to collecting taxes. Examples for the same can be easily found when tech companies left the Silicon Valley in California in favor of reduced tax rates in Texas.
- What will be decided as the tax base? Would it be accounting profits or will the tax base require derivation from domestic provisions, or would a new set of rules be published to arrive at the same? 15% is a tax rate that pleases the corporations in terms of certainty, but what will the 15% be applied to will also draw criticism if it is not something that pleases them.
- These minimum rates will hurt the entrepreneurial spirit and prevent start-ups from being successful and ultimately disrupt the technology space with constant innovations.
- And there is the age old argument against taxation itself, about an entity having to remit its funds to the government where it could have been used in a more useful investment opportunity but not now and will thus hurt employment.
Hence, one would not be wrong to say that the agreement is still in its rudimentary stages and would have to undergo a lot of alterations, before it sees the light of its day.
India’s stand in the G-7 agreement:
Given the G-20 meeting is to be held in July, 2021, India would have to carefully consider the impact of this proposition on its tax revenues, before it jumps the gun in either being the agreement’s advocate or opposing the same.
India sure did avoid a bullet when the proposed rate was lowered to 15% from the earlier rate of 21% which would have not played well given the provisions of Section 115BAB. India had already found itself in hot water earlier this year, when the USA had imposed 25% retaliatory tariffs on Indian goods, in exchange for India having imposed the Equalization levy of 2% on e-commerce transactions which were outside the ambit of tax treaties. However, such have recently been withdrawn for 6 months, possibly to curry favor for the global minimum tax rate.
The pillars have their fors and againsts when it comes to India. Pillar 1 would require India to do away with its Equalization levies, but Pillar 2 would make India a lucrative investment destination, now that other tax-havens no longer are ‘tax-havens’.
Necessity is the mother of invention.
We find application of this quote every year, in February, when the government comes out with the budget, trying to plug the loopholes in the tax law. This agreement serves to do the same. It is not encouraging to see corporations use tax-havens and avoid paying taxes. To put it in the words of the POTUS, “a company profiting in billions of dollars should not pay a lower tax rate than fire fighters and teachers.” This COVID pandemic has brought the global economy ever closer, and the countries look to do their part to stimulate a conjoint recovery.
But, having said that, I would quote, “where there is a will there is a way”. In my opinion, these convoluted and complex tax planning structures set up by the MNEs are here to stay, perhaps in their more advanced and mutated anatomies.
Author: Ashish Hasrajani