Two-pillar solution for Tax challenges arising from Digitalisation of Economy and consensus of majority of OECD/ G20 member countries (including India) 

Executive summary

Certainty is one of the basic cannons of taxation.

With the globalisation of economy when Multi National Enterprises (MNEs) starting setting up businesses across the globe, levy of tax in multiple countries was definitely a huge challenge. The availability of provisions under Double Taxation Avoidance Agreements (DTAA) between countries were not sufficient to address the scenario. The concept of Permanent Establishment (PE) was subjected to multiple interpretations. Countries started establishing multiple ways to tax MNEs including that of Transfer Pricing (TP), Arm’s Length Pricing (ALP), Place of Effective Management (POEM), etc.,

If globalisation was a challenge, digitalisation of delivery of services added further complexity into it wherein MNEs don’t have to be present in a country to carry out their businesses. Countries then started levying taxes like equalisation levies.

MNEs started treaty shopping to reduce their global tax outflows.

Also Read:Two pillar solution to tax challenges for digital economy – Part 2

All these brought so much uncertainty on the taxes to be paid by MNEs across the globe.

On 1 July 2021, the OECD/G20 Inclusive Framework (IF) on Base Erosion and Profit Shifting (BEPS) has agreed upon a Statement on a two-pillar solution to address the tax challenges arising from the digitalisation of the economy (the Statement).  A detailed implementation plan together with remaining issues will be finalised by October 2021. While not all the members of IF have agreed to it, 130 out 139 member countries have agreed to join the IF[1]. This note summarises the agreed key components of each Pillar.

Subsequent to the issue of the Statement, the Government of India (GoI) released a press release highlighting that the principles underlying the two-pillar solution indicates India’s stand for a greater share of profits for the markets, consideration of demand side factors in profit allocation, the need to seriously address the issue of cross border profit shifting and need for subject to tax rule to stop treaty shopping.

History to the advent of two-pillar solution

One may recall that OECD released the Final Reports on all the 15 elements of BEPS Action Plan, way back in October 2015.  Final Report on Action 1, Addressing the Tax Challenges of the Digital Economy (DE), provided OECD conclusions regarding the digital economy and recommended next steps. However, it expressed the view that special rules designed exclusively for digital economy would prove unworkable in the ever‑changing digital world. Since then, continuous work has been carried out with an aim to address the tax challenges of Digital Economy.  Those actions are summarised in a table form below:

Time frame Activity
Oct 2015 Issue of final report on Action 1 containing recommendations
March 2018 Interim report which sets out the IF jurisdictions agreed direction of work
Jan-Mar 2019 Policy note indicating focus of IF jurisdiction on two central pillars
May 2019 Release of programme of work to develop a consensus solution
Nov – Dec 2019 Public consultation and meetings on Pillar one and Pillar two
Jan 2020 Draft statement on two-pillar approach and consultation meetings
Oct 2020 Series of documents on BEPS 2.0 project, including blueprint on Pillar Two
Oct 2020 – Jan 2021 Public consultation and meetings on blueprint of two pillars
July 2021 Issue of statement on two-pillar approach

Outline of Pillar one and Pillar two framework[2]

a. Pillar One – Re-allocation of taxing rights

Pillar One will ensure a fairer distribution of profits and taxing rights among countries with respect to the largest MNEs, including digital companies. It would re-allocate some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether firms there have a physical presence there. Under Pillar One, taxing rights on more than USD 100 billion of profit are expected to be reallocated to market jurisdictions each year.

b. Pillar Two – Global anti-base erosion mechanism

Pillar Two seeks to put a floor on competition over corporate income tax, through the introduction of a global minimum corporate tax rate that countries can use to protect their tax bases. The global minimum corporate income tax under Pillar Two – with a minimum rate of at least 15% – is estimated to generate around USD 150 billion in additional global tax revenues annually. Additional benefits will also arise from the stabilisation of the international tax system and the increased tax certainty for taxpayers and tax administrations.

Impact and way forward

This welcome move of the IF member countries results in adopting global minimum tax with a limited impact on MNEs carrying out real economic activities with substance. It acknowledges the need to continue discussions to churn out design elements and to crease out the technical details, within the agreed framework by October. Excluding MNEs in the initial phase of their international activity, from the above framework, to be explored. Further, some significant issues viz. including share of profit allocation and scope of subject to tax rules, remain open and need to be addressed.

India is in favour of the solution which is simple to implement and simple to comply. At the same time, India believes that solution shall result in allocation of meaningful and sustainable revenue to market jurisdictions, particularly for developing and emerging economies. India will continue to be constructively engaged for reaching a consensus based ready to implement solution with Pillar one and Pillar two as a package by October and contribute positively for the advancement of the international tax agenda. MNEs should follow these developments as well as monitor actions taken by countries to implement these proposed rules to evaluate the impact of the changes to their businesses.

It is hoped that these initiatives will reinforce one of the basic cannons of taxation namely ‘certainty’.

Annexure summarising the agreed points under the Statement

Pillar one

Scope: MNEs with global turnover above €20 billion and profitability (i.e., profit before tax/revenue) above 10% (in-scope MNEs). Exclusions are provided for the extractive and regulated financial services industries. The turnover threshold may be reduced to €10 billion, contingent on successful implementation of the new rules including tax certainty, after undertaking review which would begin seven years after the agreement comes into force and would be completed in not more than a year.

Segmentation: Segmentation would be applied in exceptional circumstances where, based on the segments disclosed in the financial accounts, a segment of an MNE would meet the scope rules.

Allocation to market jurisdiction: For in-scope MNEs, between 20-30% of residual profit, which is defined as profit in excess of 10% of revenue, would be allocated to market jurisdictions where there is nexus. For purposes of this allocation, profit or loss would be determined by reference to financial accounting income (with a small number of adjustments), and losses would be carried forward.

Special purpose nexus rule: The new rules for allocation to a market jurisdiction would be applicable if the in-scope MNE derives at least €1 million in revenue from that jurisdiction. A lower threshold of €250,000 would apply in the case of smaller jurisdictions that have a gross domestic product lower than €40 billion. For this purpose, revenue would be sourced to the end market jurisdiction where goods or services are used or consumed, with detailed sourcing rules to be specified.  Double tax relief is to be provided under the exemption or credit method for profit allocated to market jurisdictions under the new rules.

Tax compliance: MNEs would be allowed to manage the tax compliance process with respect to the new rules through a single entity.

Further work required on Amount B: The Statement indicates that work on Amount B, relating to a simplified approach for the application of the arm’s-length principle to in-country baseline marketing and distribution activities, is to be completed by the end of 2022 and will focus in particular on the needs of low-capacity countries.

Unilateral measures: The Statement provides 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.

Implementation: The multilateral instrument through which the above new rules are to be implemented will be developed and open for signature in 2022, to ensure new rules to become effective in 2023.

Pillar two

Pillar Two has two elements, namely GloBE rule and STTR.

Global anti-Base Erosion Rules (GloBE) rules and a set of interlocking rules namely, Income Inclusion Rule (IIR) that allows parent entities to impose a top-up tax on low taxed income of a constituent entity, and the Undertaxed Payments Rule (UTPR) that denies deductions or requires an equivalent adjustment for low-tax income that has not been subject to tax under an IIR.

GloBE rules have the status of a common approach and IF jurisdictions would not be required to adopt these rules, but, if they choose to do so, they have to implement and administer the rules in a way that is consistent with the agreed design and accept the application of such rules by other Inclusive Framework members.  The GloBE rules would apply to MNEs with total consolidated group revenue of at least €750 million in the immediately preceding fiscal year, threshold as determined under BEPS Action 13 (country by country reporting). Countries are free to apply the IIR to MNEs headquartered in their country even if they do not meet the threshold.

An exclusion from the GloBE rules would be provided for investment funds, pension funds, governmental entities, non-profit organizations, and investment funds that are Ultimate Parent Entities (UPE) of an MNE Group or any holding vehicles used by such entities, organisations or funds.

The rights to impose a top-up tax would be allocated to jurisdictions under a top-down approach under the IIR (with special rules for split ownership situations) and under a methodology to be agreed under the UTPR.  The GloBE top-up tax would be determined using an effective tax rate (ETR) test calculated at the jurisdictional level, with a common definition of covered taxes and a tax base measured by reference to financial accounting income (with adjustments to be agreed and mechanisms to address timing differences). In case of existing distribution tax systems, no top-up tax would apply if earnings are distributed within three to four years and taxed at or above the minimum level.

The minimum tax rate for purposes of the IIR and the UTPR would be 15%. The GloBE rules would provide for a formulaic substance carve-out that would exclude income in the amount of at least 5% of the carrying value of tangible assets and payroll (in the transition period of 5 years, at least 7.5%). International shipping income would be excluded.

As the Pillar Two rules are to apply on a jurisdictional basis, consideration will be given to the conditions under which the US Global Intangible Low-Taxed Income (GILTI) regime will co-exist with the GloBE rules, in order to ensure a level playing field.

Subject to Tax Rule (STTR): Allows jurisdictions to impose a withholding tax on certain related-party payments that are taxed at a low adjusted nominal rate. Although the STTR is described second, it would apply before the GloBE rules and thus take priority over those rules.

With respect to the STTR, the minimum rate would be ranging from 7.5% to 9% and the taxing right allocated to the source country under the STTR would be limited to the difference between the minimum rate and the tax rate on the received payment.

STTR is an integral part of achieving a consensus on Pillar Two for developing countries, hence, IF members with nominal corporate income tax rates below the STTR minimum rate for interest, royalties and certain other payments are to agree to implement the STTR into their bilateral treaties with developing members when they are requested to do so.

IF members are to agree and release an implementation plan, that will include model GloBE rules together with the possible development of a multilateral instrument for coordination of such rules, an STTR model provision together with a multilateral instrument to facilitate adoption, and transitional rules including the possibility of deferred implementation of the UTPR, with a view to brig Pillar Two into law in 2022, to be effective in 2023.

[1] Barbados, Estonia, Hungary, Ireland, Kenya, Nigeria, Peru, Saint Vincent and the Grenadines, and Sri Lanka are nine members of IF not joined the Statement as of Today

[2] Refer Annexure for summary of agreed points under the Statement

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