The global tax agreement that was reached last year continues to move slowly and uncertainly. Although the global minimum tax gets a lot of attention in the media (and in my own writing, to be honest), there is another important element to the agreement. The Global Minimum Tax (also known as OECD Pillar 2) would set a floor for effective tax rates globally, and OECD Pillar 1 would change the rules governing where large corporations owe taxes.
In changing the rules on where companies owe tax, three issues continue to catch my eye as the proposals move forward:
- How does this fit in with the existing rules?
- What happens to taxes on digital services?
- Who decides where companies pay?
To answer these questions, it is necessary to explore the operation and the objectives of the first pillar of the OECD.
In recent years, a new type of tax has emerged on the world stage: the digital services tax. The European Commission’s proposal for such a tax targeted large, mostly American digital companies with a 3% tax on revenues (rather than profits). The proposal was not adopted by the EU, but some countries quickly began to introduce similar taxes. Large countries such as France, Italy and the United Kingdom have taxes in place.
The United States government viewed the taxes as discriminatory against American businesses and threatened to retaliate with tariffs.
In addition to this tax and trade dispute, there has been a growing number of tax disputes between multinationals and governments over the amount of tax that might be due on activities such as local marketing and distribution.
This situation with a tax and trade war and ongoing conflicts around the world has been described as “chaotic” by tax experts.
Enter the first pillar of the OECD. The big goals behind the first pillar are to change where businesses pay taxes and provide exclusions and to create a set of procedures and rules to deal with the chaos.
The rules would initially impact companies with global revenues above €20 billion (US$20.4 billion at the current exchange rate) and profitability above a 10% margin. The income threshold would be halved after a review in the seventh year of the policy.
It uses a formula to reallocate where companies owe taxes on their profits (called the OECD’s first pillar Amount A). The formula takes 25% of profits above a 10% margin and allocates that share to jurisdictions based on the share of sales in the jurisdictions. The objective is to shift part of the taxable profits from the jurisdictions where the profits are currently accounted for, i.e. where they are produced, and to move them to the jurisdictions where the sales are made.
In some cases, sales and profits are already aligned, and the rules will take this into account with another formula that looks at where a company’s assets and employees are located.
Another part of the first pillar (called amount B) would make it easier to identify the amount of tax that could be due on marketing and distribution activities in the countries.
In all of the first pillar proposals, there is a desire to create tax certainty in the process of additional rules.
So now back to the three questions. How does the first pillar fit in with the existing rules? The simple answer is that it’s on top of those existing rules, so of course it’s not straightforward for taxpayers. Businesses would continue to calculate their taxes due under the existing rules and file taxes in relation to the current rules. Also, they would start calculating the additional tax owed in some countries and less tax owed in others based on how the Amount A formula works.
And what happens to taxes on digital services? The answer here is both positive and negative. The most recent policy document on the first pillar is clear on the need for countries to remove taxes on digital services. It also makes clear that countries accepting the first pillar will commit not to adopt similar policies. That would be a significant achievement in line with bipartisan Congressional concerns in recent years. However, as with many things in the first pillar, there is still work to be done to specifically define the policies to which this refers. Does it include streaming taxes and digital advertising taxes in addition to standard digital services taxes? This should be the case, but the list is not yet completely established.
Finally, who decides where companies pay? In general, the design of the first pillar is based on a formula to determine where businesses will have to pay additional taxes (and where they will get an exemption or credit for existing taxes paid). However, when there are disagreements over numbers, as there surely will be, there needs to be a process and apparatus in place to adjudicate between concerns and competing issues.
A document outlining how this might work gives the ability for a panel of experts to have final authority over disputes. Representatives of the governments involved in the dispute would be involved at other stages, but unresolved disputes over the allocation of taxable profits could come to the office of experts who do not represent any government. The group of experts would have to meet multiple technical and experiential requirements and they would be selected from expert groups comprising country nominees.
Another option would be to continue to include government officials in the final review. This would keep governments that have an interest in the negotiations involved. Expert advisers would still be involved in the process, but without final decision-making power.
A third option would be to use a mix of government officials and experts to resolve disputes.
This question is particularly important for the United States because American companies are likely to make up the majority of businesses and profits under the rules. According to research by economists at the Center for Business Taxation at the University of Oxford, this US share of Amount A profits is 64% and totals $56 billion.
The first pillar is convoluted and it’s hard to identify narrow elements to criticize because the whole project is incredibly complex, built on existing rules (which have their own problems), and the promise of solving the chaos seems small by to the challenge of complying with the proposed approach.
Trade-offs are everywhere in economic policy. In this case, the available choices continue with the current level of chaos and uncertainty and adopt a set of rules that introduce new complexities on top of the existing convoluted system, confer authority on a set of experts rather than to individuals representing governments, and sort of deliver some certainty at the end of it all.
The public may have little sympathy for the additional regulatory costs and uncertainties faced by large multinationals, but the Tax Foundation defines tax policy based on four principles: simplicity, transparency, neutrality and stability. Pillar One’s design violates all of this in different ways.
It’s unclear if there is another way out of the international tax chaos, but as University of Virginia tax law professor Ruth Mason recently said at a tax policy conference, ” there are limits to human understanding, and this agreement can reach those limits.” and “rules that no one can understand are not responsible rules”.