Many Europeans and Americans believe that multinational corporations (MNCs) are making excessive profits and not paying their “fair share” of taxes. For many Americans, the core concern is that MNCs are offshoring profits to tax havens and thereby eroding the US tax base. Europeans have a different perspective. They contend that successful US MNCs, especially digital giants like Google, Amazon, and Facebook are not paying adequate taxes on earnings from European users of their services.
To address these deeply held beliefs, the Organization for Economic Cooperation and Development (OECD), a research organization sponsored by the world’s leading industrial democracies, initiated what it calls the Base Erosion and Profit Shifting (BEPS) project in 2013. The initiative enlisted support from the Group of Twenty (G-20) economies.
Recently, the OECD advanced two proposals called Pillar One and Pillar Two. The G-20 Finance Ministers and Central Bank Governors, meeting in Saudi Arabia in February 2020, agreed to negotiate the two proposals and committed to achieving consensus by the end of 2020. This blog summarizes the two pillars, concluding that consensus on Pillar One will be very difficult but agreement should be achieved on Pillar Two.
Pillar Two would add to US and global corporate tax revenues by raising the minimum tax on global profits paid by MNCs
The OECD’s Pillar Two proposal aims to ensure that MNC group profits pay a minimum tax rate, say 12.5 percent, to home country and host country tax collectors combined. For example, if an MNC’s current global effective tax rate—the taxes paid to home and host countries combined—is 10 percent of global profits, the proposal requires the MNC to pay 2.5 percent additional corporate tax to the home country.
This proposal echoes provisions in the tax cut law enacted in the United States during President Donald Trump’s first year in office, which had two provisions aimed at capturing offshore profits of big US-based companies. Officially known as the US Tax Cuts and Jobs Act of 2017 (TCJA), the law introduced two tax obligations known as the Global Intangible Low-Taxed Income, or GILTI, and Base Erosion and Anti-Abuse Tax, or BEAT. Because Pillar Two is consistent with those provisions, the Trump administration has endorsed the proposal. If agreed, Pillar Two would probably not require the renegotiation of bilateral tax treaties, though it would call for modest changes in US tax law, which would require legislation by Congress.
Likewise, other countries would have to amend their tax laws. According to the OECD’s latest assessment, assuming a 12.5 percent minimum tax rate, Pillar Two would add 2.7 percent to global corporate tax revenues by raising the minimum tax on global profits paid by some MNCs.
Pillar One proposal to give countries new rights to tax MNC digital profits is highly contentious
Compared with Pillar Two, the Pillar One proposal is complex, politically fraught, and faces rough terrain. It would reallocate, between countries, several types of profits earned by MNCs in the digital age. The proposal reclassifies global MNC profits into Amounts A, B, and C.
Amount A would create a new method for allocating global corporate profits and thereby imposing corporate tax when an MNC has “sustained and significant involvement in the economy of a market jurisdiction.” The OECD uses revenue thresholds in each market to define the level of an MNC’s involvement and hence its exposure to profit reallocation in favor of the market jurisdiction, or country where it generates its revenues. Differing thresholds, depending on the industry, would determine the MNC’s deemed “routine profit.” All profits exceeding this “routine profit” would be deemed “nonroutine or residual profit.” Pillar One gives each market jurisdiction the right to include a portion of this “nonroutine profit,” called Amount A, in its tax base.
Under Pillar One, the criteria for setting nonroutine thresholds, and formulas for reallocating profits between jurisdictions, are supposed to be agreed before the end of 2020—a tall and highly unlikely order. Amounts B and C would deal with profits generated by distribution and marketing activities. An essential technical issue, acknowledged by the OECD, is how to resolve interactions between Amounts B and C, and their interaction with Amount A, to avoid multiple taxation of the same tax base. Complicated rules are envisaged, which will delight tax accountants and lawyers.
Amount A is the most politically contentious aspect of Pillar One. It could reallocate a good chunk of profits of successful US firms—for example Google, Apple, Amazon, and Facebook—out of the US Treasury’s domain to the tax base of other countries. When Congress gets reports from the Joint Committee on Taxation (JCT) that show the potential loss of the US tax base for high-profile US firms, some members may be shocked. Democratic presidential candidates are counting on higher corporate taxes to pay for new programs. Republicans would rather see US tax collected on “residual profits” through mechanisms like GILTI and BEAT, rather than consigning that tax base to finance ministries abroad.
On the other hand, Amount A could also reallocate to the US Treasury some profits of non-US MNCs—for instance, Alibaba and Tencent (which are Chinese), Samsung (Korean), and Spotify (Swedish). The JCT will need to work through the arithmetic of tax base lost versus tax based gained, but at least there would be some offset in the US favor. According to the OECD’s latest assessment, global corporate income tax revenues are expected to increase by only about 0.3 to 0.7 percent if the nonroutine profit threshold in Amount A is set at 10 percent, and if 20 percent of such residual profit is allocated to market jurisdictions. For high-income economies, changes in corporate income tax revenues are estimated to range from a loss of 0.1 percent to a gain of 1.1 percent.
If OECD countries reach a consensus, in order to implement Pillar One, each country would have to enact complex statutes to redefine its corporate tax base and then renegotiate its bilateral tax treaties. At this juncture, US Treasury Secretary Steven Mnuchin opposes Pillar One. As an alternative to Pillar One, Mnuchin has proposed a safe harbor provision, but details are scant.
OECD proposals would not end tax competition among countries
Overall, adoption of the OECD proposals would not put an end to tax competition among countries. But it might change the tactics. Broadly speaking, the proposals would authorize higher tax revenues by augmenting domestic tax bases in most countries (though probably not in the United States). Each member country would still be free to set its own domestic tax rate at or above the agreed Pillar Two minimum and, importantly, define deductions from the tax base and credits against tax due.
To attract corporate activity and business investment, rather than cutting the rate (as has been done in recent decades), countries might enact new and complicated deductions and credits—for example, tied to the remuneration of local employees or local expenditures on R&D and physical investment.
OECD negotiators should explore a variant of the French digital services tax as an alternative to Pillar One
All told, despite its good intentions, the OECD edifice is enormously complex. The only sure winners are accounting firms and tax lawyers. Given the complexity, it seems unlikely that the 135 countries participating in the negotiations can agree on new rules by the end of 2020, as committed in the January 2020 statement.
Pillar One is especially complex and politically fraught. The negotiators should put Pillar One aside and seek a much simpler way of taxing digital firms. For example, some variant of the French digital services tax (DST) might be agreed internationally, with a low rate of tax on digital revenues (say 1.5 percent) equally applied to domestic and foreign firms. At President Trump’s urging, French President Emmanuel Macron suspended the French DST until 2021. The OECD negotiators should explore a variant of the DST as an alternative to Pillar One.
Meanwhile, OECD participants can hammer out details of Pillar Two and seek to avoid double or multiple taxation of the same tax base. This effort would deliver worthwhile progress on the tax front.
1. MNCs subject to the proposed reallocation are mainly large “consumer-facing” firms. Extractive business and commodity firms will be excluded. Financial services may also be carved out. OECD aims to define the exact scope by end of 2020.
2 As an example, Germany would have the legal right to include in its tax base some share of Apple’s global profits, calculated by the proportion of iPhones sold to Germans.
3. Amount B reallocates part of the profit generated by distribution and marketing activities to market jurisdictions. The OECD proposes that each market jurisdiction could include in its tax base a share of profits generated by such activities. Amount B would be calculated as a baseline percentage of such profits generated in the market jurisdiction. As an example, France could include in its tax base a portion of Amazon’s profits attributable to sales in France. If a market jurisdiction believes the taxable profit from local distribution and marketing activities exceeds the baseline scenario set by Amount B, the country could argue for an additional taxable profit, called Amount C, to be included in its tax base.
4. For example, Apple’s operating income from sales in the United States in fiscal year 2019 ($35.1 billion) accounts for only roughly 40 percent of its global operating income ($86.0 billion). These figures suggest that a good portion of Apple’s profits could be reallocated, under Amount A, to other countries.