What’s in the New Global Tax Agreement?

April 7, 2022

In recent years, countries have been debating significant changes to international tax rules that apply to multinational companies. Following a July 2021 announcement by countries involved in negotiations at the Organisation for Economic Co-Operation and Development (OECD), in October there was a further agreement on an outline for the new tax rules by more than 130 jurisdictions.

Large companies would pay more taxes in countries where they have customers and a bit less in countries where their headquarters, employees, and operations are. Additionally, the agreement sets up the adoption of a global minimum tax of 15 percent, which would increase taxes on companies with earnings in low-tax jurisdictions.

Governments are now in the process of developing implementation plans and turning the agreement into law.

The OECD proposal follows an outline that has been under discussion since 2019. There are two “pillars” of the reform: Pillar 1 changes where large companies pay taxes (impacting roughly $125 billion in profits); Pillar 2 includes the global minimum tax (increasing tax revenues by an estimated $150 billion, globally).

Pillar 1 contains “Amount A” which would apply to companies with more than €20 billion in revenues and a profit margin above 10 percent. For those companies, a portion of their profits would be taxed in jurisdictions where they have sales; 25 percent of profits above a 10 percent margin may be taxed. After a review period of seven years, the €20 billion threshold may fall to €10 billion.

Amount A is a limited redistribution of tax revenue from countries that currently tax large multinationals based on the location of their operations to countries where those companies have customers. U.S. companies are likely to be a large share of the companies in scope of this policy.

The U.S. could lose tax revenue because of this approach. However, U.S. Treasury Secretary Yellen has previously written that she believes Amount A would be roughly revenue neutral for the U.S. For this to be true, the U.S. would need to collect significant revenue from foreign companies or from U.S. companies that sell to U.S. customers from foreign offices.

Recent draft rules outline where companies will pay taxes under Amount A. The rules include approaches for identifying the final consumer even when a company is selling to another business in a long supply chain. The draft rules also allow companies to use macroeconomic data on consumer spending to allocate their taxable profits.

Pillar 1 also contains “Amount B” which provides a simpler method for companies to calculate the taxes on foreign operations such as marketing and distribution.

Pillar 2 is the global minimum tax. It includes three main rules and then a fourth rule for tax treaties. These rules are meant to apply to companies with more than €750 million in revenues. Model rules were released in December 2021.

The first is a “domestic minimum tax” which countries could use to claim the first right to tax profits that are currently being taxed below the minimum effective rate of 15 percent.

The second is an “income inclusion rule,” which determines when the foreign income of a company should be included in the taxable income of the parent company. The agreement places the minimum effective tax rate at 15 percent, otherwise additional taxes would be owed in a company’s home jurisdiction.

The income inclusion rule would apply to foreign profits after a deduction for 8 percent of the value of tangible assets (like equipment and facilities) and 10 percent of payroll costs. Those deductions would be reduced to 5 percent each over a 10-year transition period.

Because the Pillar 2 rules rely primarily on financial accounting data there will be differences from tax calculations. These book/tax differences mean that the Pillar 2 rules account for timing differences by focusing on deferred tax assets which can include net operating losses and capital allowances. However, those deferred tax assets are required to be valued at the 15 percent minimum tax rate.

Like other rules that tax foreign earnings, the income inclusion rule will increase the tax costs of cross-border investment and impact business decisions on where to hire and invest around the world—including in domestic operations.

The third rule in Pillar 2 is the “under-taxed profits rule,” which would allow a country to increase taxes on a company if another related entity in a different jurisdiction is being taxed below the 15 percent effective rate. If multiple countries are applying a similar top-up tax, the taxable profit is divided based on the location of tangible assets and employees.

Together, the domestic minimum tax, the income inclusion rule, and the under-taxed payments rule create a minimum tax both on companies that are investing abroad and on foreign companies that are investing domestically. They are all tied to the minimum effective rate of at least 15 percent, and they would apply for each jurisdiction where a company operates.

The fourth Pillar 2 rule is the “subject to tax rule,” meant to be used in a tax treaty framework to give countries the ability to tax payments that might otherwise only face a low rate of tax. The tax rate for this rule would be set at 9 percent.

For Pillar 1 to work well, it would be simpler if all countries adopt the rules in the same fashion. This would avoid companies having to deal with multiple approaches across the globe. The outline mentions a streamlined system that might require a sort of clearinghouse for Amount A payments and credits alongside a dispute resolution mechanism.

Pillar 2 is more optional. The outlined version of Pillar 2 is more like a template rather than a requirement for countries to adopt exactly what is described. If enough countries adopt the rules, though, then much of corporate profits across the globe would face a 15 percent effective tax rate.

Both Pillar 1 and Pillar 2 represent major changes to international tax rules, and the outline suggests that the changes should be put in place by 2023. The outline specifically states that digital services taxes and similar policies will need to be removed as part of implementing Pillar 1. The U.S. Trade Representative has negotiated with some countries that have digital services taxes to ensure a smooth transition. Countries would have to write new laws, adopt new tax treaty language, and repeal some policies that conflict with the new rules.

The United States is exploring changes to its own, unique approach, but it is currently unclear if or when those changes will be adopted. Though the Biden administration has supported the global agreement, it may be challenging to get Congress to follow through on implementing these policies.

The Build Back Better legislation which included changes to partially align Global Intangible Low-Tax Income to the income inclusion rule has failed to pass Congress. Even the changes to GILTI proposed in Build Back Better did not rely on financial accounting rules, which is the approach of the Pillar 2 model rules.

President Biden’s most recent budget assumes the Build Back Better legislation does pass and adds a new domestic minimum top-up tax which would apply in cases where a foreign jurisdiction uses an under-taxed profits rule to tax U.S. companies.  It is not yet clear whether Congress will take up these additional proposals from President Biden.

Tax treaty ratification requires 67 votes in the Senate, which will make adoption of Pillar 1 challenging if there is not broad bipartisan support for the new rules.

On the other side of the Atlantic, the European Union (EU) is also debating the rules and implementation timelines. The package will require unanimous agreement among the 27 EU member states in the Council of the EU. However, unanimity has proven elusive.

On March 15th, finance ministers failed to reach a unanimous agreement on Pillar 2. Sweden, Poland, Malta, and Estonia all objected. By the next meeting, on Tuesday, technical compromises relieved Swedish, Maltese, and Estonian objections. However, Poland once again vetoed the agreement on the grounds that EU’s legislative process should link Pillars 1 and 2.

Even though it was rejected, it is important to note that the compromise proposal would have given member states until the end of 2023 to implement the Pillar 2 rules.

To date, the European Commission has only produced a proposal on Pillar 2. This is primarily because the details of Pillar 1 are still being negotiated at the OECD level. A proposal to implement Pillar 1 is expected in the summer.

The agreement represents a major change for tax competition, and many countries will be rethinking their tax policies for multinationals in light of it. However, with both the U.S. and EU hitting roadblocks in their respective legislative processes, it is unclear when or even if the agreement will be implemented. If implementation fails, a return to a world of distortive European digital services taxes and retaliatory American tariffs could be on the horizon.

Note: This post was originally published on July 1, 2021 but has been updated on April 7, 2022 reflect the latest details on the global tax agreement.

 

Launch Resource Center: Base Erosion & Profit Shifting (BEPS)


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