Global developments – a government perspective (aligning the ducks)
Allen & Overy, Luxembourg
Report on a conference session at the eleventh annual IBA Finance and Capital Markets Virtual Conference
Steve Edge Slaughter and May, London
Paul Oosterhuis Skadden Arps, Slate, Meagher & Flom, New York
Mike Williams HM Treasury, London
Felicie Bonnet OECD, Paris
Marc Clercx European Commission, Brussels
The big global tax issues – what does the next five years hold?
Steve Edge opened the session by introducing the panellists, emphasising that global developments in the field of taxation are driven at a supra-governmental level.
Felicie Bonnet and Marc Clercx represented the Organisation for Economic Co-operation and Development (OECD) and the European Commission, respectively. Mike Williams represented Her Majesty’s Treasury for the United Kingdom's government. There was no representative from the United States government; it did not want to comment publicly on Pillars One and Two at that time. Instead, Paul Oosterhuis commented from a US perspective in a personal capacity.
Edge recalled the origins of, and progress made on, the original base erosion and profit shifting (BEPS) project, which sought to counteract international tax arbitrage – the exploitation of differences between countries’ tax systems by multinational enterprises (MNEs). He noted the OECD’s commendable work in marshalling the support of countries around the world to close down such arbitrage opportunities.
The OECD/G20 Inclusive Framework on BEPS (IF) now provides for a two-pillar solution to further address the tax challenges.
The Pillar One initiative has developed out of an attempt at making sense of the fact that companies operating digitally did not pay the same taxes as companies operating physically within the same jurisdiction, and there are various ways of making sense of digital taxation.
Pillar Two is often described as a measure to counteract aggressive tax avoidance, but it also looks like a limitation on tax competition. There is an interesting debate on what should be the appropriate tax rate; the currently envisaged rate sits at 15 per cent, subject to the substance carve-out.
Pillar One – what are the remaining issues and what is the most likely outcome? How has the change of direction left those keen to tax, or reconcile the taxation of, digital operators?
For the record, under Pillar One, taxing rights above 25 per cent of the residual profit of the largest and most profitable MNEs would be reallocated to the jurisdictions where the customers and users of these MNEs are located. These measures will come with a ‘marketing and distribution profits’ safe harbour that will limit the residual profits allocated to the market jurisdiction. Tax certainty will be ensured by:
- dispute resolution mechanisms; and
- removal by all participant jurisdictions of all digital services taxes and other similar rules.
The panel discussion thus focused on the issues surrounding the implementation of Pillar One in the US, the UK and the European Union.
The US perspective
Oosterhuis introduced his remarks by saying that the main question from a US perspective will be whether legislation on Pillar One will be adopted by the US Congress. He explained that the following aspects should be considered as key in this respect.
A key issue would be whether the US business community pushes for the implementation of Pillar One, which could happen for either of the following reasons:
- Companies may support Pillar One because they are worried about tax initiatives and unilateral measures that countries might take if Pillar One does not happen. Oosterhuis, however, indicated that this does not currently seem to be a large concern for the US business community; or
- Companies subject to Pillar One may see some advantages by benefiting from a mandatory and binding dispute/conflict resolution mechanism, which provides for tax certainty. But Oosterhuis noted that insufficient details are available to be able to assess to what extent this would be the case.
The main point for the US Congress will be to assess whether implementation of Pillar One will benefit the US Treasury. There are two key factors which Oosterhuis anticipated would influence this.
The first would be the mechanism for choosing from which jurisdiction taxing rights are reallocated to market countries; the competing approaches under consideration were thought to be a proportionate reallocation of excess profits (which would be revenue-negative for the US) and a tracing approach where jurisdictions give up taxing rights over excess profits that relate to market countries (which would be revenue-neutral or modestly positive for the US). The difference in outcome would be because most in-scope multinationals (other than pharmaceuticals) are cost-sharers who book only profits in respect of US sales in the US; profits in respect of foreign sales are not recorded in the US and, hence, the US would not be required to cede significant taxing rights under a tracing approach.
The design of the so-called ‘marketing and distribution profits’ safe harbour would also play an important role – particularly in relation to pharmaceuticals where the US has a large trade deficit. For Pillar One to be revenue-neutral or modestly positive for the US, it would be important that pharmaceuticals would either need to adjust their transfer pricing to fall into the safe harbour or have an Amount A in the US.
Oosterhuis added that digital services taxes (DSTs) are an unwelcome outcome from a trade perspective and could lead to trade sanctions. However, US businesses do not generally bear the economic burden of DSTs as these tend to be passed on to local customers. The US Treasury also issued new foreign tax credit rules in December 2021 which clarify that DSTs are not a creditable tax. These rules also mean that, if the US does not implement Pillar One, it may become difficult for US companies to obtain foreign tax credits in respect of Amounts A that are taxed in other countries.
The UK perspective
Williams recalled that, as the UK Chancellor Rishi Sunak said, there is a strong sense that Pillar One is the first big change to international tax rules in 90 years. While the adopted approach was not perfect, it reflects the consensus of more than 130 member jurisdictions. He noted that, if Pillar One was not implemented, there would neither be an alternative better approach which could be agreed, nor would it be possible to just return to the prior status quo. Williams further noted that Pillar One had already helped lessen disputes around DSTs; for example, the UK and a number of other countries reached a transitional agreement with the US in October 2021.
Like Oosterhuis, Williams said that tax certainty and the elimination of double taxation are important parts of Pillar One. In respect of the latter, the way in which one determines the jurisdictions from which profits are reallocated to market countries will be important. Williams noted that pro-rata reallocation may be perceived as unfair and that, ideally, one would first re-allocate any profits which had been shifted out of the market and into another jurisdiction. Only thereafter would one move other profits based on real economic activity (although the quantification of those different types of profits is rather challenging and something with which they are grappling).
Williams stated that the multilateral convention implementing Pillar One (MLC) is expected to be signed by the end of June 2022. The UK is expected to ratify the MLC quickly, based on its quick ratification (13 months) of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI).
The EU perspective
Clercx confirmed that the EU Commission strongly supports the implementation of Pillar One and Pillar Two. In relation to Pillar One, the Commission is also looking to develop a legal instrument to support this process. This would have to be agreed unanimously by the Member States, but it is thought that this should be achievable given that most Member States are active participants of the IF. The Commission would expect to focus on the model rules to be published by the OECD, which it would expect to follow closely, while providing further clarification on their application in the EU as necessary.
Clercx acknowledged that Pillar One is different from Pillar Two in that its implementation requires the MLC, and Pillar One will work only if a ‘critical mass’ of jurisdictions sign up to and ratify the MLC.
Edge asked Clercx if he could foresee whether some EU countries would have a more reluctant approach (comparable to the US). Clercx confirmed that the Commission announced its desire to use Pillar One to generate additional resources, which should be an interesting element for Member States.
Pillar Two – what is the likely outcome? Where does this leave bona fide tax competition?
Pillar Two introduces global anti-base erosion rules (GloBE) that provide for a global minimum tax of 15 per cent on all MNEs with an annual turnover of more than €750m. Under this section, the panel discussed:
- the OECD perspective;
- the interaction between Pillar Two and the US global intangible low-taxed income (GILTI) regime; and
- the challenges on implementation and views from the UK and EU perspectives.
The OECD perspective
Bonnet stated that Pillar Two reflects a political willingness and large support from countries – even if some consider that a 15 per cent effective tax rate (ETR) is not high enough. She said that this common approach will serve as simplification of the rules and will avoid multiplication of bilateral conventions between signing countries. She then presented the following regarding what to expect from Pillar Two:
- a systemic change, to ensure taxation and reduce the incentive for profit shifting;
- a dynamic analysis, where a significant part of the income derived from the application of domestic corporation tax rates will not be shifted; and
- for governments, the changes and work on tax base and tax rates will be regulated without affecting some tax incentives (eg, substance incentives and de minimis exclusion).
Bonnet concluded by explaining that Pillar Two limits tax competition (rather than prohibiting it entirely). In particular, the substance based carve-out and, to a lesser extent, the de minimis exclusion, allow countries to continue to provide for certain incentives. She also confirmed that the 15 per cent should be considered a ‘good rate’.
The US perspective: interaction with the US tax rules
Oosterhuis said that the probability of the US version of Pillar Two (ie, certain changes to the US GILTI regime) being enacted this year was about 50 per cent. If it was enacted, there would still be certain differences, which could be worrisome in respect of whether the revised GILTI regime could be regarded as a Pillar Two-compliant income inclusion rule. These differences include the following:
- revised GILTI would still be based on US tax accounting, whereas Pillar Two is based on financial accounting. But as US tax rules tend to recognise revenue earlier and deductions later than financial accounting, Oosterhuis thought that there should be no cause for concern for other countries; and
- revised GILTI would not take into account deferred taxes in the same way as Pillar Two. However, as that could mean that US companies are paying more GILTI earlier, Oosterhuis again thought that there should be no cause for concern for other countries.
Another potential issue, even with revised GILTI, would be the potential application of the undertaxed payments rule (UTPR) in respect of US companies’ US operations. In particular, the energy tax credits included in the new legislation plus foreign-derived intangible income provisions that will not be eliminated could push the ETR on US operations below 15 per cent, which could result in exposure to the UTPR. Whether this is regarded as appropriate is something which needs to be considered by the US government and US businesses.
If the GILTI regime was not revised as proposed, it would not be Pillar Two compliant and there would be exposure for US groups under Pillar Two. In this respect, there would be an added complication for companies paying GILTI of how to attribute GILTI (charged on a globally blended basis) to individual jurisdictions for the purpose of applying other countries’ Pillar Two rules.
Another open question would be whether Puerto Rico would be regarded as part of the US for the purposes of Pillar Two; if that was the case, the overall tax rate applicable to operations in the US (plus Puerto Rico) can be above 15 per cent, even though Puerto Rico’s corporation tax rate is significantly lower. Williams, however, later noted that he would expect Puerto Rico to be treated as separate from the US for these purposes, much like the UK’s dependencies and territories which would be treated as separate from the UK.
In response to the question of whether the implementation of Pillar Two is likely to have an impact on US companies’ investment decisions, Oosterhuis noted that it might do so in some cases. He noted that, as a result of the 2017 reforms in the US and the implementation of Pillar Two, the tax rate differential between the US (21 per cent) and other jurisdictions (minimum of 15 per cent) would decrease to 6 per cent from today’s 8.5 per cent or more.
General comments on the UK and EU implementation projection
Williams stated that Pillar Two can be conceptualised as setting out the order in which countries may step up to tax otherwise undertaxed profits. He considered the progress made by the OECD, the EU and the UK in developing the relevant rules to be encouraging, particularly if one bears in mind that political agreement was reached only in October 2021.
In respect of the co-existence between GILTI and Pillar Two, he noted that the assumption underlying the work on Pillar Two was that GILTI would be revised to align it more closely with Pillar Two, in particular by moving to a 15 per cent rate and a jurisdiction-by-jurisdiction basis. Even if those changes were made, Williams noted that there would be points to work through. If GILTI was not revised, it would be more difficult – particularly in relation to the elimination of double taxation. It is unclear how one would match GILTI, charged on a global basis, with Pillar Two, which would be charged on a jurisdiction-by-jurisdiction basis.
Clercx explained that reaching agreement between the Member States on the draft directive for the implementation of Pillar Two is a priority for the French presidency. He also explained that there was some pressure for the Commission to produce a draft instrument on Pillar One and have it approved before the summer, in order to meet the ambitious timeline set by the OECD, which everyone is still working towards – although it remains to be seen whether it will actually be possible to meet in practice.
Edge agreed with this and noted that the complexity of the proposals, especially the interaction between Pillar One and Pillar Two, should not be underrated. Edge noted that, in the EU, state aid rules limit tax competition to a certain extent (which he thought could be justified as a matter of principle where the application of different rules could distort the internal market). He wondered whether the founders of the EU would welcome the Pillar Two proposal for its effect of limiting tax competition. Clercx responded that, from the Commission’s perspective, it would seem a good idea.
What does the future hold? The ‘crystal ball’ discussion
Edge introduced the closing discussion by asking the panellists what they predict for the future.
The EU perspective
Having noted that tax measures still require Member States’ unanimous approval, Clercx said that it was hoped that EU measures on Pillar One and Pillar Two will proceed smoothly through the Council. But the Commission also has certain other initiatives lined up, such as the Unshell initiative (ATAD 3), which was also published in December 2021 and expected to be discussed in the Council in the first half of 2022. If the two pillars are successfully implemented, the Commission will look to build on this momentum to propose a common tax base (BEFIT) to be established across the Union.
The OECD perspective
Bonnet stated that the future will hold more multilateralism in international taxation. The October 2021 agreement on the two Pillars was historic because multilateralism achieved something unprecedented, and because it necessarily includes a commitment to continued international coordination as the rules are implemented and applied. She noted that the implementation and application of the two Pillars is likely to keep the OECD busy for the next five years.
The US perspective
Oosterhuis reiterated that there is, at most, a 50 per cent chance that the legislation required for the revision of GILTI will be passed. He estimated that there was probably less than a 10 per cent chance that anything would be enacted in the US this year on Pillar One. If neither is enacted this year, Oosterhuis considered it unlikely that the US would revisit it until 2025, when major tax legislation will be required because a number of tax provisions in the 2017 reforms will expire. He noted that, while the expiring provisions relate mostly to individuals, tax packages tend to be comprehensive, so one would expect that any measure in 2025 would also cover corporate taxes.
The UK perspective
Williams concluded the discussion by stating his expectation that countries and the EU will continue with the implementation of the two Pillars. He highlighted environmental taxes as the next big issue; there is going to be pressure to reform tax systems to support decarbonisation of the climate and the economy. The challenge will be to do so while:
- preventing double taxation;
- preserving countries’ rights;
- ensuring consistent approaches among jurisdictions; and
- limiting related tax compliance costs.