Death and taxes are certain, but how do you pay “right taxes in the right place”? The OECD countries have been talking about avoiding “unfair tax competition” for some time. Yet economies actually compete to attract investment through the provision of tax inheritance. Whether we are looking at tax havens that have no or negligible income taxation or countries that do not tax intellectual property profits, we have many ways that companies can protect their profits in low-tax areas.
The second challenge arises from the old way of thinking, which provides for the taxation of companies at their registered office and ignores the fact that market sovereignty should also have a right to profit taxation regardless of whether a permanent establishment exists or not. So it was only a matter of time before the old tax system gave way to a new one.
The first steps in this direction were taken by the OECD when it reached significant consensus (without US involvement) on the Profit Reduction and Profit Shifting Project (BEPS). The OECD has developed a roadmap in which it recognizes that tax treaties are instruments for avoiding double taxation and cannot be used for double non-taxation.
It developed the Primary Purpose Test (PPT), which required businesses to demonstrate that the primary purpose of choosing a tax residence was not tax planning. It developed the Multilateral Instrument (MLI), which enabled countries to amend tax treaties without having to negotiate bilaterally. While much remains to be done – especially with regard to taxing the digital economy – countries like India have unilaterally levied taxes such as the equalization levy.
The Biden government’s proposal for a minimum global tax rate of 15% and the G7 finance ministers’ agreement last week to reform the global tax system to ensure that “the right companies pay the right taxes in the right place” must be considered in the Light of the above developments that preceded it.
The two key proposals announced in London are the minimum global tax rate that companies must pay on a country-by-country basis; and the proposed profit allocation mechanism where the market jurisdiction (the place where the goods are sold) has the right to tax at least 20% of profits that exceed a margin of 10% of MNCs.
These steps are a step in the right direction. They confirm the position that India and other developing countries have taken on the right of market jurisdictions to tax profits. A global consensus also ensures that MNCs are not caught between conflicting government demands and taxed twice or more.
However, before the proposals can be implemented, several issues need to be addressed. First of all, the applicable tax rate must be determined by each country. Then what is needed is a framework for redistributing profits, which over 125 countries must agree to. While the G7 framework will provide direction, it will be interesting to observe the country-specific reactions to the discussions that are due to take place at the G20 finance ministers’ meeting in Venice on July 9-10.
For example, when determining a company’s profit, are they book profits or tax profits? If the latter, is profit calculation based on accounting standards or home country tax laws accepted by everyone? Or will each country recalculate the profits?
Will company-wide profits be acceptable, or does one have to consider deals in market jurisdiction based on segment profits? Several MNCs write development expenses off to their accounts. Will that be acceptable? What happens to MNCs with margins less than 10%?
Will they leave the scope of the new rules? Given the track record of companies’ ability to reach consensus on such issues, it is hoped that the framework developed by the G7 will not remain just a framework and a workable solution will be developed in due course. What position will the developing countries take on this? Should India accept the proposed profit sharing rule, it could incur significant losses.
For example, if an MNC were to make a 15% profit, India could tax 20% of 5% of profits under the proposed framework. The compensatory levy, on the other hand, is 2% or 6% of sales.
The road to a unified global tax framework has only just begun. A consensus between OECD members and the G20 is likely to emerge by the end of 2021. A global consensus, especially on redistributing profits, will be the next big step. It won’t be an easy exercise. After that, we will see tax treaties change.
While the G7 framework is indeed a “giant step”, much remains to be done before a consensus can be reached on a minimum tax rate and a basis for redistributing profits.