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OECD BEPS Framework: Recent Development

Addressing tax issues arising in the digital economy has been a priority of the international community since past several years. It aims to deliver a consensus-based solution and ensure Multinational Enterprises (MNEs) pay a fair share of tax in the jurisdiction they operate. After years of intensive negotiations, the Organization for Export Co-operation and Development (OECD) / G20 has recently introduced a major reform in the international tax framework for taxing the Digital Economy.

The OECD / G20 inclusive framework on Base Erosion and Profit Shifting (BEPS) [“IF”] has issued a Statement, on 8th October 2021, agreeing on a two pillar-solution to address the tax challenges arising from the digitalization of the economy. There are 136 countries, including India, out of a total of 140 countries, representing more than 90% of the global GDP, that have agreed to this Statement. All members of the OECD countries have joined in this initiative and there are four G20 country members  (i.e. Kenya, Nigeria, Pakistan & Sri Lanka) who have not yet joined. The broad framework of the two-pillar approach as per the Statement is as follows:

 

Pillar One

 

Introduction and applicability:

  • Pillar One focuses on fairer distribution of revenue and allocation of taxing rights between the market jurisdictions (where the users are located), based on a ‘’special purpose nexus’’ rule, using a revenue-based allocation.
  • Applicable to large MNEs with a global turnover in excess of  Euro 20 Billion and profitability above 10% (i.e. profit before tax)[1]. This revenue threshold is expected to be reduced to Euro 10 Billion, upon successful review, after 7 years of the IF coming into force.
  • The regulated financial services sector and extractive industries are kept out of the scope of Pillar One.

 

Calculation Methodology:

  • Such allocation will help determine the ‘’Amount A’’ under Pillar one.
  • The special-purpose nexus rule will apply solely to determine whether a jurisdiction qualifies for Amount A allocation based on which 25% of residual profits, defined as profit in excess of 10% of revenue, would be allocated to the market jurisdictions using a revenue-based allocation key.
  • Allocation vis-à-vis nexus rule will be provided for market jurisdictions in which the MNE derives at least Euro 1 Million  of revenue  [Euro 250,000  for smaller jurisdictions (i.e. jurisdiction having  GDP lower than Euro 40 Billion )]
  • Profits will be based on financial accounting income, subject to:
    • Minimal adjustments; and
    • Carry forward of losses
  • Detailed revenue sourcing rules for specific categories of transactions shall be developed to ensure that revenues are sourced to end market jurisdiction, where goods or services are consumed.
  • Safe harbour rules will be separately notified, so as to cap the allocation of baseline marketing and distribution profits of the MNE, which may otherwise already be taxed in the market jurisdiction.

 

Tax Certainty:

  • Rules will be developed to ensure that no double taxation of profits gets allocated to the market jurisdiction, by using either the exemption or the credit method.
  • Commitment has been provided to have mandatory and binding dispute prevention and resolution mechanisms to eliminate double taxation of Amount A and also resolve issues w.r.t transfer pricing and business profits disputes.
  • An elective binding dispute resolution mechanism for issues related to Amount A will be available only for developing economies, in certain cases. The eligibility of jurisdiction for this elective mechanism will be reviewed regularly.

 

Implementation:

  • Amount A will be implemented through a Multilateral Convention (MLC), which will be developed to introduce a multilateral framework for all the jurisdictions that join the IF.
  • The IF has mandated the Task Force on the Digital Economy (TFDE) to define and clarify the features of Amount A (e.g. elimination of double taxation, Marketing and Distribution Profits Safe Harbour), develop the MLC, and negotiate its content so that all jurisdictions that have committed to the Statement will be able to participate.
  • MLC will be developed and is expected to be open for signature in the year 2022, with Amount A expected to come into effect in the year 2023.
  • IF members may need to make changes to domestic law to implement the new taxing rights over Amount A. To facilitate consistency in the approach taken by jurisdictions and to support domestic implementation consistent with the agreed timelines and their domestic legislative procedures, the IF has mandated the TFDE to develop model rules for domestic legislation by early 2022 to give effect to Amount A.
  • The tax compliance will be streamlined allowing in-scope MNEs to manage the process through a single entity.

 

Unilateral Measures:

  • The MLC will require all parties to remove all digital service tax (DST) and other similar taxes (eg: Equalisation levy from India perspective) with respect to all companies and to commit not to introduce such measures in the future.
  • No newly enacted DST or other relevant similar measures will be imposed on any company from 8 October 2021 and until earlier than 31 December 2023 or coming into force of the MLC.

 

Pillar Two

 

Introduction:

 

  • Pillar Two consists of Global anti-Base Erosion Rules (GloBE) to ensure large MNEs pay a minimum level of tax thereby removing the tax arbitrage benefit which arises by artificially shifting the base from high tax jurisdiction to low tax jurisdiction with no economic substance.
  • Pillar Two is a mix of several rules, viz. (i) Income Inclusion Rule (IIR); (ii) Undertaxed Payment Rule (UTPR); and (iii) Subject to Tax Rule (STTR).
  • IIR imposes a top-up tax on parent entity in respect of low taxed income of a constituent entity
  • UTPR denies deductions or requires an equivalent adjustment to the extent low tax income of a constituent entity is not subject to tax under an IIR.
  • STTR is a treaty-based rule which allows source jurisdiction to impose limited source taxation on certain related-party payments subject to tax below a minimum rate. The STTR will be creditable as a covered tax under the GloBE rules.
  • There would be a 10-year transition period for exclusion of a certain percentage of the income of intangibles and payroll which will be reduced on year on year basis
  • GloBE provides de minimis exclusion where the MNE has revenue of less than Euro 10 Million and profit of less than Euro 1 Million and also provides exclusion of income from international shipping.

 

Calculation Methodology:

 

  • Pillar Two introduces a minimum effective tax rate (ETR) of 15% on companies for the purpose of IIR and UTPR and would apply to MNEs reporting a global turnover above Euro 750 Million under country-by-country report.
  • The IIR allocates top-up tax based on a top-down approach, subject to a split-ownership rule for shareholdings below 80%. The UTPR allocates top-up tax from low-tax constituent entities, including those located in the Ultimate Parent Entities (UPE) jurisdiction. However, MNEs that have a maximum of EUR 50 million tangible assets abroad and that operate in no more than 5 other jurisdictions, would be excluded from the UTPR GloBE rules in the initial phase of their international activity.
  • IF members recognize that STTR is an integral part of Pillar Two for developing countries and applies to payments like interest, royalties, and a defined set of other payments. The minimum rate for STTR will be 9%, however, the tax rights will be limited to the difference between the minimum rate and tax rate on payment.
  • GloBE rules would not be applicable to Government entities, international organizations, non-profit organizations, pension funds or investment funds that are UPE of an MNE Group or any holding vehicle used by such entities, organizations, or funds.

 

Implementation:

  • Model rules to give effect to the GloBE rules are expected to be developed by the end of November 2021. These model rules will define the scope and set out the mechanics of the GloBE rules. They will include the rules for determining the ETR on a jurisdictional basis and the relevant exclusions, such as the formulaic substance-based carve-out.
  • An implementation framework that facilitates the coordinated implementation of the GloBE rules is proposed to be developed by the end of 2022. This implementation framework will cover agreed administrative procedures (e.g. detailed filing obligations, multilateral review processes) and safe-harbors to facilitate both compliance by MNEs and administration by tax authorities.
  • Pillar Two is proposed to be effective in the year 2023, with the UTPR coming into effect in the year 2024.

 

FM Comments :

 

With the introduction of the OECD/G20 inclusive framework on BEPS, OECD expects revenues of developing countries to go up by 1.5-2% and increase in overall reallocation of profits to developing countries of about USD 125 Billion. India, being a huge market to large MNEs, has always endorsed this global tax deal. However, with the introduction of this framework, India will have to abolish all unilateral measures, such as equalization levy tax and Significant Economic Presence (digital permanent establishment) provisions. MNEs will also have to re-visit their structure to ring-fence their tax positions based on the revised digital tax norms.  This Statement lays down a road map for a robust international tax framework w.r.t taxing of the digital economy,  not restricted to online digital transactions.

References

[1] Calculated, using an “averaging mechanism”, details of which are awaited.

Image Credits: Photo by Nataliya Vaitkevich from Pexels

With the introduction of the OECD/G20 inclusive framework on BEPS, OECD expects revenues of developing countries to go up by 1.5-2% and increase in overall reallocation of profits to developing countries of about USD 125 Billion. India, being a huge market to large MNEs, has always endorsed this global tax deal.

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The Other Face of Digitalization: Changes to Tax Laws and More

Very often, speeches and articles begin by alluding to an environment of significant change, that brings in its wake, opportunities as well as higher levels of uncertainty. The wave of digitalization triggered by the emergence of various technologies is often cited as a prime example of this change. Digitalization has undoubtedly proved its worth in the past 18 months. Enabling remote working for millions of employees in various industries, enhancing the convenience of online banking, creation of new mobile payment options, virtual video/audio conferences are all examples of how digitalization has transformed the global society.

But there is a flip side to this too. Big Tech companies are growing rapidly, not just in terms of influence but also their financial muscle. To put it in perspective, the combined market capitalization of the top five Big Tech companies- i.e., Apple, Microsoft, Alphabet (Google’s parent), Amazon and Facebook was around US$9 Trillion as of 1 October 2021[1]. By comparison, the market cap of India’s top five companies was around US$750 Billion.

Tax laws need to keep up with the “digital economy”

The pandemic has severely dented government revenues worldwide, while expenses have ballooned. This has led to spiraling fiscal deficits, that have their own consequences. Given that most corporate tax regimes worldwide evolved keeping conventional businesses in mind, and that digital economy businesses are very different in nature, a new corporate tax playbook is clearly needed.

Given its large number of digitally-savvy consumers, a country like India is often one of the top three markets for digital economy companies such as Amazon, Facebook, Netflix, etc. But the nature of their business is such that they can carry out business in India (or any other jurisdiction) without having a significant place of business in that jurisdiction. So while countries like India contributed to revenues, low local operating costs meant higher profits. But this did not translate into higher taxes for India because MNCs registered companies in countries with lower tax rates and assigned IPR to these companies. The subsidiary operating in India would then pay a royalty to this overseas company. This is not illegal under the letter of existing tax laws, but it does lead to low tax revenues.

The Tax Justice Network estimates that India loses US$10.1 Billion annually due to abuse of tax laws; the US is believed to lose five times that amount (US$49.2 Billion). It is interesting that the same study identifies the Netherlands, the Cayman Islands, China, Hong Kong and the UK as the largest enablers of tax abuse. (source: “How global Tax Rules may reshape India”, The Mint, 23 September 2021).  

Change is already in the air

India was, in fact, a pioneer of sorts, when it introduced the equalization levy (a sort of digital service tax) in 2016 to bring some of the revenues of these digital companies into the tax net. Many other countries followed suit. Not surprisingly, there are now more concerted efforts to plug loopholes that Big Tech in particular is able to exploit to avoid tax in jurisdictions with higher tax rates. A major step to address this situation was announced in July 2021 by the OECD and G20. The move envisions a minimum corporate tax rate of 15% worldwide as well as a new framework for allocating more rights to tax digital economy companies to countries housing digital consumers- i.e., ensure fairer taxation of businesses in those jurisdictions where they earn profits.

Stop press!

Talk about timing! Just as I thought I had finished writing this blog, I saw the news that the OECD has finalized the framework for this major international tax reform. A new global minimum corporate tax rate of 15% has been set and will apply to companies whose revenues exceed 750 million Euros. Additionally, MNCs with global sales above 20 billion Euros and profitability above 10% will also be covered by the new rules. Model rules are expected to be formulated in 2022 and the new regime is to take effect in 2023.[2]

Including India 136 countries (that together account for 90% of global GDP) have backed this framework. Once such a regime comes into effect, individual countries will be required to withdraw any digital taxes they levy- e.g., India’s equalization levy.

While this kind of thinking will have a far-reaching impact on digital businesses and the global economy, new tax laws are not the only drivers of major change. If the recent testimony to the US Senate by whistleblower Ms. Frances Haugen is any indication, Facebook and other companies may soon face tougher laws around advertising and targeting specific segments of users. And given Google’s dominant position in the search business, competition laws too will inevitably get tougher. And as seen by India’s tough stand on Mastercard, data localization requirements too will become increasingly stringent. And finally, of course, data privacy laws too will evolve. The popular saying “May you live in interesting times” (incidentally, there’s no credible evidence that this was indeed a Chinese curse, as is often claimed) seems to have had the current period in mind. Even if it didn’t, we do live in interesting times- that’s for sure.

I wish you all a Happy Navratri/Durga Puja.

  1. https://www.statista.com/statistics/1181188/sandp500-largest-companies-market-cap/
  2. https://economictimes.indiatimes.com/news/economy/policy/oecd-deal-mncs-will-be-subject-to-a-minimum-tax-of-15-from-2023/articleshow/86876192.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

Photo by fabio on Unsplash

The pandemic has severely dented government revenues worldwide, while expenses have ballooned. This has led to spiraling fiscal deficits, that have their own consequences. Given that most corporate tax regimes worldwide evolved keeping conventional businesses in mind, and that digital economy businesses are very different in nature, a new corporate tax playbook is clearly needed.

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