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Bracing for Impact

6 min readBy: Daniel Bunn

Thursday, the OECD is expected to present preliminary results on the impacts of both Pillar 1 and Pillar 2 approaches to changing international tax ruleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s. The results will be preliminary mainly because the actual policy parameters of the proposals are yet to be determined. Ahead of that presentation from the OECD, two recent pieces of analysis can help to frame the sort of results we might see Thursday.

Though both approaches to measuring the impact are limited by the data and the authors’ assumptions (constraints that the OECD also faces), the general message can provide context for when the OECD shares its results this week.

Pillar 1 Analysis

Last week, in Tax Notes International, Kartikeya Singh, W. Joe Murphy, and Gregory J. Ossi of PwC released an analysis of Pillar 1 reallocation based on IRS country-by-country data for 2016.

The OECD’s Unified Approach under Pillar 1 would change which countries have the right to taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. multinational profits. Among other proposals, Pillar 1 includes a reallocation of taxing rights based on the level of profitability and where a company makes its sales. This means a highly profitable company with sales in numerous jurisdictions would likely end up paying more taxes to the jurisdictions where it has sales than it does under current rules.

The goal of the PwC analysis is to get a rough estimate of the amount of taxable profits that would potentially be in scope under Pillar 1 as well as a measure for how much of that taxable profit would be reallocated under the new rules.

Essentially, they measure how much of the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. would be lost by countries (relative to current taxing rights) and gained by others based on the new taxing right under Pillar 1.

The authors make several simplifying assumptions that, depending on what the OECD decides, may or may not align with the actual policy outcomes.

These assumptions include:

  1. Reallocation under Amount A only occurs for countries with at least 1 percent of global residual profits.
  2. The profitability threshold for Amount A residual profits is 10 percent.
  3. The reallocation amount for residual profits is 10 percent.
  4. The baseline return for Amount B is 2.5 percent.

Because the authors are dealing with aggregate country data rather than company data, they choose to avoid a threshold question for Pillar 1 which is which industries are in scope or not.[1]

The authors arrive at two key estimates. First, they find that the total profits that could be captured by Amounts A and B range between 19.8 percent and 32.5 percent of pretax income.[2] This range captures the differences among industries. Second, they estimate that, between 2.2 percent and 8 percent of those pretax profits would be allocated to market jurisdictions.[3]

Pillar 1 Income and Reallocation (Shares of Pretax Income)

Source: Kartikeya Singh, W. Joe Murphy, and Gregory J. Ossi, “The OECD’s Unified Approach- An Analysis of the Revised Regime for Taxing Rights and Income Allocation,” Tax Notes International, Feb. 3, 2020.

Manufacturing Wholesale, Retail, and Related Information Professional Services Other Services
Income Subject to Pillar 1 Amount A and B 24.1% 32.5% 24.1% 25.4% 19.8%
Reallocated Pillar 1 Income 5.0% 8.0% 6.2% 7.2% 2.2%

One way to interpret these numbers is that the vast majority of profits would still be taxed under current rules, and that market countries may not get a significant slice of revenue from Pillar 1.

The authors note that broader conclusions should be limited in the same way that the data upon which the analysis is based is limited. In addition, they do show that varying the assumptions mentioned previously leads to different impacts for different industries.

Pillar 2 Analysis

Another piece of analysis published last week concerns Pillar 2. Using several data sources, economist Michael P. Devereux and his coauthors estimate how much revenue could be generated from the Global Anti-Base Erosion (“GloBE”) proposal which includes a global minimum tax and a tax on base-eroding payments.

The paper provides an in-depth review of the policy motives for Pillar 2, the revenue implications of the proposal, how the proposal could impact profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. , and relevant considerations for EU law.

On the revenue implications, the authors rely on financial accounting data from macro and micro sources to study effective tax rates both before and after adoption of the GloBE proposal. They split their analysis into reviewing the effects of a country-by-country approach and a global “blended” minimum tax approach.

Using a minimum tax rate of 10 percent, they find that a country-by-country minimum tax would yield additional worldwide tax revenue of approximately $32 billion, or 14 percent of taxes currently paid by foreign-controlled entities. The blended approach with a 10 percent minimum tax threshold would bring in revenues equating to an extra 4 percent of foreign taxes paid.

The authors point out that their estimates are uncertain and do not account for controlled-foreign-corporation rules or the new U.S. tax rules. This is partially because they rely on data from years prior to that reform effort.

In the context of these data limitations, the authors show that as the minimum rate increases (in their simulations) revenues raised from the policy increase disproportionately in a non-linear fashion (the higher the rate, even more revenue is raised). Additionally, they argue that both the cost of capital and effective average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. s would rise with the adoption of the GloBE.

This result adds to the evidence of the trade-offs between reducing profit shifting and attracting business investment. The authors note that even a low-level minimum tax increases the cost of capital, which would depress investment activity.

Evidence-based Policymaking?

Both previously mentioned studies are helpful examples of the type of work we can expect to see from the OECD. Though they are limited by both data and assumptions, the OECD will face similar limitations. As policymakers work to fine-tune the proposals under both Pillar 1 and 2 the impact assessment should be a critical part of that discussion.

Beyond the evidence discussed in this post, policymakers should also consider compliance burdens and the potential that the adoption and implementation of these policies could get messy.

The potential for a significant new compliance burden and tax cost paired with relatively little revenue under Pillar 1 and impacts on business investment decisions under Pillar 2 seem likely, but the limits of the data and the current state of the policy discussion leave many open questions.

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[1] For Amount A, the OECD is focusing on automated digital services, and consumer-facing businesses. The authors do explicitly exclude the financial industry and mining industry because they are likely to be excluded from Pillar 1 as a whole.

[2] The authors calculate the share of taxable profits using two different measures of profits. One is pretax profits from the country-by-country data, and the other is estimated Earnings Before Interest and Tax (EBIT). The EBIT shares of potentially reallocated income range from 14.5 percent to 23.9 percent.

[3] The corresponding EBIT estimate range is from 1.6 percent to 5.9 percent.