The Organization for Economic Co-Operation and Development (OECD)/G20 Base Erosion and Profit Shifting Project recently announced an international tax agreement that could significantly impact the taxation of multinational enterprises (MNEs).
The agreement, which was signed by 136 countries including the United States, is the product of several years of negotiation and is comprised of two pillars.
Pillar One. Under Pillar One, taxing rights over 25% of the residual profit of the most profitable MNEs will be allocated to the countries where goods or services are used or consumed.
This special nexus rule will apply to MNEs with global revenues of more than 20 billion euros (“turnover threshold”) and profitability of more than 10% (“profitability threshold”) that derives at least 1 million euros in revenue from a particular market jurisdiction (“nexus threshold”). The nexus threshold will be reduced to 250,000 euros for market jurisdictions with a gross domestic product of less than 40 billion euros. The turnover threshold could be reduced to 10 billion euros after seven years. It is anticipated that Pillar One will reallocate more than $125 billion in profits to market jurisdictions annually.
Pillar One constitutes a deviation from current international tax rules, which typically require that a company’s profits be taxed only in countries where the company has a physical presence. Per the OECD, these physical presence rules, a product of the 1920s, are inadequate to address the increasing digitalization of the economy, which allows MNEs to engage in very profitable businesses within countries where they lack a physical presence. This disconnect between rules and reality has led many market countries recently to enact digital services taxes, which the OECD sees as having the potential to limit global economic growth going forward.
Once implemented, Pillar One also will include detailed source rules for certain types of transactions, a mandatory dispute resolution process, a streamlined approach to the application of the arm’s length principle in certain situations, and a requirement that digital services taxes be repealed.
The OECD anticipates that a multilateral convention to implement Pillar One will be concluded sometime in mid-2022 with the hope that enough jurisdictions ratify the convention so that it would be in effect in 2023. Changes to domestic law also may be required.
Pillar Two. Under Pillar Two, a global minimum tax of 15% generally will be imposed on MNEs with annual consolidated group revenue of at least 750 million euros.
Domestically, Pillar Two will consist of an Income Inclusion Rule, which will impose tax on a parent entity with respect to a subsidiary’s low-taxed income, and an Undertaxed Payment Rule, which will deny deductions or require equivalent adjustments if a subsidiary’s low-taxed income is not taxed under the Income Inclusion Rule. A treaty-based Subject to Tax Rule will allow limited source taxation on related party payments taxed below a minimum rate of 9%. There also will be a formulaic carve-out for income that is a certain percentage of the carrying value of tangible assets and payroll within a country as well as a de minimis exclusion for jurisdictions from which MNEs derive revenue of less than 10 million euros and profits of less than 1 million euros.
Pillar Two is intended to provide a floor for global tax competition and is expected to create approximately $150 billion in new global tax revenue annually.
Model rules for the domestic implementation of the Income Inclusion Rule and Undertaxed Payment Rule and a model treaty provision for the Subject to Tax Rule are expected by the end of November 2021.
Observations. While certainly ambitious, the OECD’s international tax agreement has an uncertain future. The agreement is one only in principle, leaving specifics for a later date. Each country would have to sign off on these specifics for the changes outlined in Pillar One and Pillar Two to become effective, and there is already some opposition in the United States to the changes even as outlined.
The agreement, if implemented, could increase the complexity of the international tax system. Pillar One requires new source rules and dispute resolution procedures specific to those MNEs subject to the special nexus rule. It is unclear how these new rules and procedures would interact with those that are broadly applicable outside of Pillar One. Pillar Two also would require more guidance on how the various rules (Income Inclusion Rule, Undertaxed Payment Rule, and Subject to Tax Rule) are to be applied and coordinated.
While the uncertainty surrounding this international tax agreement might seem to warrant a wait-and-see approach, taxpayers should take the time now to examine how it could affect them so as not to be caught flat-footed if the agreement does indeed become law.
For more information on tax treaties, see Freeman Law Treaty Resources.
Also see the Freeman Law International Tax Symposium.
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