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The Other Pillar 3

Posted on Nov. 2, 2020

If global corporate tax rules were tighter — if digital companies were taxed based on their economic presence instead of their physical location, and if there were a global minimum tax of, for example, 25 percent — how much more tax could developing countries capture?

A new analysis from ActionAid finds that developing countries could collect up to $2.8 billion annually from just three companies: Facebook, Alphabet Inc., and Microsoft. That figure is eye-opening. ActionAid calls it the “tip of the iceberg” considering that it ran a limited analysis involving just the three companies and 20 developing countries.

What does ActionAid take away from this? The organization says any global tax reform must include a global minimum corporate tax rate and the U.N. should handle the logistics, especially now that the OECD has missed its self-imposed October deadline for a political agreement on its ambitious base erosion and profit shifting 2.0 corporate tax reform project.

Several stakeholders are waiting to see what the U.N. — which has compiled its own digital tax proposal — is going to do next. But not all developing countries want to divorce themselves from the OECD’s tax reform process. Notably, Senegal is waiting for an OECD-led solution and will not implement a digital services tax while it waits. South Africa has also signaled that it will not consider a unilateral DST until the OECD delivers its solution.

But there are a lot of variables up in the air for developing countries that are committed to the OECD process. Aside from the general uncertainty surrounding BEPS 2.0 — will the OECD be able to broker an agreement by its new mid-2021 deadline? — it’s unclear just how much developing countries stand to benefit. The OECD’s pillar 1 and pillar 2 economic impact assessments maintain that low-, middle-, and high-income countries will all see revenue gains. The precise breakdown is unclear, however, because the major building blocks, like a minimum tax rate for pillar 2 and the scope of a new taxing right under pillar 1, have yet to be determined. The other issue is that developing countries feel they are running into the same roadblocks as they did during the BEPS 1.0 project.

There are similar criticisms that BEPS 2.0 has been moving too fast and has disregarded developing country proposals, despite the OECD’s efforts to make the decision-making process more inclusive by placing it within the inclusive framework, instead of limiting it to OECD members, as happened during BEPS 1.0.

In recent months the OECD has repeatedly said that there could be a pillar 3 that addresses BEPS issues facing developing countries. It’s worth noting here that this potential third pillar would be different from a pillar 3 proposal floated by Allison Christians calling for a global excess profits tax on multinationals. There hasn’t been much public discussion about a developing country pillar 3, but now that there’s been a delay in the OECD process, it’s certainly possible that the idea may gain more traction. While a pillar 3 for developing countries sounds promising, it leaves many open questions about a potential direction and scope and whether it can truly address developing countries’ needs.

Rumblings of a Pillar 3

Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, keeps circling back to the idea of a pillar 3. In May Saint-Amans said he likes the idea for the least-developed countries — that is to say, African countries, not countries like India or China. In a webcast hosted by the Centre for Tax Policy, Saint-Amans said that he’s floated the idea to the G-20.

“Developing countries have said rightfully that they have not benefitted much from BEPS and BEPS was not an agenda for developing countries. It was not against the interests of developing countries, but it is true that the rules were too sophisticated,” Saint-Amans said. “It’s also true that the debate over the reallocation has not properly taken into account enough the views of developing countries.”

“Small developing countries will need something to be still part of the international consensus and adhere wholeheartedly to the institutions we’ve built, and there, they may need a pillar 3,” Saint-Amans added.

He brought up the idea again in July, adding that this time around the onus is on developing countries to set up the agenda. In September Saint-Amans suggested that a pillar 3 will be important for developing countries in light of the considerable economic losses they have suffered because of the COVID-19 pandemic and associated lockdowns.

Why Now?

BEPS 1.0 was not a fully inclusive solution to a multidimensional problem. The OECD more or less acknowledged this in July in a Tax Cooperation for Development progress report which noted that developing countries’ sense of limited ownership over BEPS 1.0 has been, and continues to be, a major challenge as they work to implement the BEPS actions.

This is particularly problematic for developing countries that rely heavily on corporate income tax receipts and multinational tax compliance to encourage individual tax compliance. For these countries, BEPS sets off a cascading chain of events that can be hard to mitigate.

Five years after BEPS 1.0, the OECD feels the time is right to evaluate how the project has worked for developing countries and what can be improved upon. Not all 15 BEPS action plans have been appropriate for developing countries, but some have. Yet, within those that are useful, there are some weaknesses because of capacity constraints.

For example, BEPS action 6 prevention of tax treaty abuse is useful for developing countries suffering from tax treaty shopping. The OECD’s multilateral instrument is a key part of combating treaty abuse; many countries are using it to comply with action 6. Even so, developing countries have been slow to adopt the MLI: Of the 47 countries that have ratified it, only five are developing countries, although several others have signed the MLI. In a 2019 inclusive framework peer review, the OECD found that the countries that have not taken steps to counter treaty abuse are primarily developing countries. Action 13, country-by-country reporting, has also been embraced by developing countries, who have largely implemented reporting requirements, but several are non-reciprocal jurisdictions and cannot receive CbC reports from other countries.

BEPS 2.0 Compounds the Concerns

These concerns are about to be compounded by BEPS 2.0, which is generating an entirely new set of developing country issues. The OECD’s July report is straightforward about developing countries’ concerns with some of the BEPS 2.0 concepts. Pillar 1’s proposed amount A taxing right over a portion of residual profits of in-scope multinational groups via a reallocation scheme is worrisome to some developing countries because sales revenue may be low in their jurisdictions, and multinationals may generate economic value in ways not captured by pillar 1. While complexity is a concern for everyone, developing countries are particularly concerned about whether they will be able to collect the necessary information from multinationals in order to administer the new taxing right.

The pillar 1 scope, which is still undecided, is also worrisome for developing countries. Pillar 1 targets automated digital services and consumer facing businesses, and some believe the proposal should be broader than consumer-facing businesses. But that concept has yet to be fully defined. Pillar 1 dispute resolution and any potential power imbalances are another long-standing concern.

Amount B, which establishes a fixed return on baseline distribution and marketing activities in market jurisdictions, is intended to give taxpayers greater certainty by reducing administrative burdens for tax officials. The OECD says this could be particularly helpful for developing countries. That’s debatable among critics from developing countries, who counter that amount B simply extends the current, and complex, arm’s-length transfer pricing system. Because it’s not a new taxing right, revenue gains from amount B will likely be modest, according to the OECD. It may be particularly helpful in countries in which the fixed return is higher than current returns, which would likely generate additional revenue, but it’s too early to tell.

A pillar 2 minimum tax rate is another open question, and Ireland’s corporate tax rate of 12.5 percent has been floated as a potential floor. Some are concerned that pillar 2 may not discourage profit shifting if the minimum rate is too low. Some are concerned that pillar 2 gains could be limited. The OECD is thinking about structuring pillar 2 so that the first mechanism to be triggered would be an income inclusion rule that would require a shareholder-level inclusion when the income of a controlled foreign entity is taxed below the minimum rate.

Some source states say that could affect the amount of additional tax they pick up from pillar 2. The OECD has drafted an undertaxed-payments rule as a backstop to the income inclusion rule that would allow tax administrations to block deductions for intercompany payments if the parent company’s effective tax rate dips below the minimum rate. Some developing country stakeholders have pointed out that this provision will be more helpful than the income inclusion rule.

The OECD is estimating that both pillars could boost corporate income tax revenues worldwide by about $50 billion to $80 billion annually. If the effects of the global intangible low-taxed income provision are added, that range jumps to $60 billion to $100 billion.

A look at direct revenue gains illuminates the story for developing countries. The OECD is estimating that globally, pillar 1 will generate $5 billion to $12 billion in direct revenue gains. Pillar 2 will generate substantially more: $23 billion to $42 billion in direct revenue gains. These aren’t particularly big numbers considering that the U.S. GILTI regime is estimated to generate $9 billion to $21 billion alone.

Under pillar 1, low-, middle-, and high-income countries would see some tax revenue gains, and the OECD estimates the proportion of gains would be larger for low-income countries under the reallocation scheme because they currently hold little residual profits in their jurisdictions. If true, it’s a step in the right direction, but pillar 1 occupies a rather small slice of the revenue pie.

Under pillar 2, high-, middle-, and low-income countries would again gain revenue, but high-income countries stand to benefit the most because they house many more multinationals and stand to benefit from the income inclusion rule. The benefit for low- and middle-income countries lies mostly in reduced profit-shifting opportunities. But even this is speculative. As the OECD notes, profit shifting is not just tied to tax factors, and pillar 2 may not entirely kill them. Furthermore, if the pillar 2 minimum rate is too low, the cost of profit shifting may not be enough of a deterrent if multinationals still stand to benefit. While corporate tax rates have trended downward across Europe and in the United States, the opposite is true for many African countries that are inclusive framework members like Nigeria, Kenya, Senegal, and Sierra Leone, which all have 30 percent corporate tax rates, keeping in line with their greater reliance on corporate tax receipts.

Timing Questions

If the OECD does move forward with a pillar 3, looming questions are whether it would address residual concerns from BEPS 1.0 and incorporate some of the feedback from the BEPS 2.0 project, and whether that would make sense. Furthermore, would a potential pillar 3 need to follow the same timeline as pillars 1 and 2? Because pillar 3 is just an idea, no drafting or implementation timelines have been shared, but decoupling it from the other two pillars would relieve some pressure. On the other hand, time is of the essence in developing a solution because of the COVID-19 pandemic and its economic impact.

Meanwhile, the U.N. is conducting parallel work on the digital economy, and it is telling that several stakeholders in developing countries decided to pursue that agenda at the U.N. even though some of the drafting group’s home countries are also inclusive framework members and are involved in BEPS 2.0 talks. Although some developing countries are committed to the OECD process, others appear to be hedging their bets, which suggests a lack of faith in the OECD’s process.

The OECD’s message is that developing countries need to speak up. In its July report, the OECD noted that “while developing countries are largely supportive, there are also aspects of these proposals where developing countries need to defend their interests and make sure their voices are heard.”

But developing countries and civil society organizations with developing country interests have consistently provided feedback to the OECD — they say it’s actually a matter of being heard.

We have seen this dynamic before. During BEPS 1.0 the OECD set up regional working groups and consulted more than 80 developing countries on the process, held developing country workshops, and invited developing countries to OECD working party meetings. In some ways, that outreach was helpful, and the OECD has focused on capacity development as part of the BEPS project.

Yet, despite all that involvement, we are at a place five years later in which the OECD is acknowledging that BEPS did not fit the developing country agenda and perhaps should be reexamined though that lens. If the OECD does create a new developing country pillar, it will need to be clear how a pillar 3 drafting process might be different.

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