The day before the OECD inclusive framework finalized its two-pillar international tax reform project, Ireland’s deputy prime minister, Leo Varadkar, appeared before his country’s House of Representatives to drop some blunt opinions about the project.
He’d been fielding testy questions from lawmakers asking why the government had opposed a 15 percent global minimum tax and hamstrung international negotiations, but was poised to agree at the 11th hour. They didn’t like how Ireland had boxed itself into a corner, defending its low 12.5 percent corporate tax rate when its allies and neighbors found it indefensible. The lawmakers also didn’t like the message the government was sending to everyday Irish taxpayers and the world, quibbling over a 2.5 percentage point increase when the “writing was on the wall,” according to one politician, that most of the inclusive framework was ready to accept the plan. But Varadkar told them that things aren’t always as they seem.
“In reality these negotiations have been about other things. They’ve been about larger countries trying to get a bigger share of the pie and taking that share of the pie off us. It hasn’t been about ensuring that countries in the developing world get a fairer share of taxation. It’s been about larger countries, big countries, wealthy countries, who think that we’re getting too much and they want to take some of that off us,” Varadkar said.
That statement may come as a surprise to Silicon Valley or to the U.S. Treasury, who championed a global minimum tax to divert some of the world’s attention away from U.S. digital companies. But let’s fact-check Varadkar’s statement.
The political truth of the OECD’s October 8 agreement partially rests in the OECD’s official statements and releases and partially rests in the statements that individual governments have been making about the deal. What has been adopted, and what has been left out, provides a better picture of the negotiations, what was valued, and which arguments were permitted to be most persuasive.
Pillar 1
Scope
Both the United States and developing countries strongly influenced the final scope of amount A. Initially, amount A will apply only to multinationals with at least €20 billion in global turnover and profitability above 10 percent. That narrow scope will capture only about 100 companies, a small enough pool to allow the OECD to evaluate how multinationals and governments alike are implementing the new rule. This was not the initial plan. Earlier OECD documents suggest a much more unwieldy proposal distinguishing between automated digital services companies and consumer-facing businesses. But the smaller scope reflects suggestions the U.S. Treasury sent to the OECD in April, proposing to include only the 100 largest and most profitable companies worldwide.
In a nod to developing countries that wanted a larger scope, the first seven years of amount A will be a trial period and the OECD will lower the threshold to €10 million after that time if a review finds that amount A is working and being implemented as intended. It’s not as large as what developing countries had hoped for — the African Tax Administration Forum (ATAF) suggested a €250 million threshold — but the larger concession for developing countries lies in the nexus thresholds.
Pillar 1 will have a new special-purpose nexus rule that sets the threshold at €1 million for high-income jurisdictions and a much smaller €250,000 nexus for smaller jurisdictions with less than €40 billion in annual GDP. Developing countries had asked for this, and importantly the United States supported it. In April Treasury said it was “prepared to be flexible regarding nexus thresholds to ensure that pillar 1 benefits developing countries.”
Quantum
The quantum of amount A is a compromise, largely championed by France. Twenty-five percent of residual profit (which is defined as profit exceeding 10 percent of revenue) will be allocated to market jurisdictions with nexus using a revenue-based allocation key. The OECD had always referred to a 20 to 30 percent range, but it decided to adopt the middle-of-the-road option after facing pressure from multiple sides (including the United States) that wanted a lower rate, and countries like Brazil, India, and Turkey that wanted the rate to be at least 30 percent. Developing countries had indicated that the quantum was a critical issue, and although they didn’t receive their wish, some representatives like ATAF expect the arrangement will still generate benefits for developing countries.
“ATAF . . . acknowledges that the agreement will result in some of the profits of the largest most profitable digital companies being taxed in African countries where they have users of services provided by those digital companies such as social media platforms and search engines even where the users do not pay for such services and where those businesses do not create sufficient physical presence status in those countries,” the organization said in a statement.
Dispute Resolution
In the lead-up to October, ATAF signaled concern over the OECD’s planned mandatory dispute resolution framework for amount A. In a compromise for developing countries, the inclusive framework said it would consider an elective binding dispute resolution mechanism for a small group of developing countries that are eligible for deferral of their base erosion and profit-shifting action 14 peer review and have no or low levels of mutual agreement procedure disputes.
The G-24 group of developing countries said it supported the elective solution, cognizant that the new rules need certainty and stability. ATAF went a step further and said the elective solution should be the default option for all lower-income countries, not just countries that meet the OECD guidelines.
The final decision does not incorporate ATAF’s suggestion, but there’s new language added: “The eligibility of a jurisdiction for this elective mechanism will be reviewed regularly; jurisdictions found ineligible by a review will remain ineligible in all subsequent years.” The extended ineligibility language gives more certainty to developing countries, and the commitment to consistently review eligibility presumably will give them greater opportunities to offer feedback on the review process and its criteria. ATAF called it “a major achievement for Africa,” but Nigeria, which has so far declined to sign the final agreement, feels otherwise. About two weeks before the October agreement dropped, some Nigerian officials explained that the dispute resolution provision was one of several reasons why the country could not endorse the project.
“Our law specifically states that government revenue can only be determined by the federal High Court in Nigeria, not any other arbitral process,” according to Mathew Gbonjubola, director of the tax policy and advisory department of Nigeria’s Federal Inland Revenue Service.
Gbonjubola, who delivered those remarks before the West African Tax Administration Forum, has been closely involved with the OECD’s negotiations, as a deputy chair of the inclusive framework’s steering group.
Pillar 2
Global Anti-Base-Erosion Rules
One of the biggest changes to the global anti-base-erosion (GLOBE) rules is that no top-up tax will apply if earnings are distributed within four years and are taxed at or above the minimum level. This was inserted to appease Estonia, which has a distribution tax system and lobbied heavily for its local subsidiaries of international groups to have a prolonged tax postponement period, “which would allow companies more flexibility to decide on their cash flows throughout the economic cycle, rather than obliging us to tax profits immediately,” the government said.
In the final agreement the OECD also decided to exclude from the undertaxed payments rule multinationals that are in the initial phase of international activity. The OECD is defining that as multinationals with no more than €50 million in tangible assets abroad, and that operate in a maximum of five other jurisdictions. But the exclusion is time-limited and applies only for either the first five years the rule comes into effect or the first five years in which a multinational comes into the scope of the GLOBE rules.
That decision was requested by China, according to the Financial Times. But developing countries are concerned this could affect whatever revenue they might generate from the rule. “This has potential for being misused by [multinational enterprises] who can structure their operations such that their tangible assets are kept . . . below €50 million and their operations limited,” the South Centre said in response. “Strong anti-abuse rules are required to prevent this.”
Those concerns are compounded by the final rule order, which is unchanged from the July initial agreement. The undertaxed payments rule, which would deny a deduction or impose source-based taxation (including withholding tax) for a payment to a related party that’s not subject to tax at or above a minimum rate, will be triggered second as a backstop to the income inclusion rule. This allows parent jurisdictions to apply a top-up tax on amounts taxed under 15 percent. Developing countries had argued that source countries should have greater taxing opportunities by applying the undertaxed payments rule before the income inclusion rule, but the OECD did not adopt that suggestion.
Implementation of the undertaxed payments rule was another hotly contested issue. In July the OECD noted that the undertaxed payments rule might be delayed until after the income inclusion rule, raising objections from Hungary, which said that might hurt EU countries because EU rules do not allow differentiation between a parent and subsidiary. “Within the EU, any differentiation between the parent and the subsidiary would go against fundamental freedoms,” Norbert Izer, state secretary for tax affairs at the Hungarian Ministry of Finance, wrote in a July op-ed. “Consequently, the EU could only adopt the rules by covering parent entities from the beginning — a serious disadvantage for EU-based MNEs.”
Switzerland, which is not an EU member, partially prevailed when it argued that the GLOBE rules should apply in stages to accommodate its legislative process. Per the final agreement, the undertaxed payments rule will apply in 2024, one year after the income inclusion rule. However, in a letter to the OECD, the Swiss government said it wants a longer implementation period for the entire two-pillar project.
The government is concerned that it may have to change its constitution, in addition to making domestic tax law changes, which must follow the country’s democratic legislative process. It therefore requested a three-year implementation period from the date the OECD finalizes its multilateral agreement and model regulations. However, the OECD on October 8 announced that its multilateral convention for amount A will go into effect in 2023, and it is unclear whether that will change.
Rate and Substance-Based Carveout
In July the OECD said the minimum rate would be at least 15 percent, but several countries, including Switzerland and Ireland, successfully lobbied the inclusive framework to remove the phrase “at least” — a significant concession. Irish Finance Minister Paschal Donohoe believes the change will provide tax certainty to inclusive framework members, but only time will tell, particularly for countries with corporate rates much higher than 15 percent.
There’s nothing stopping countries from adopting higher minimum tax rates and there’s nothing stopping countries from banding together to set regional minimum rates to protect their economies, as has been discussed by the IMF and others.
Another major change concerns the GLOBE rules’ formulaic substance carveout, which will eventually exclude income equaling 5 percent of the carrying value of tangible assets and payroll. Initially, the OECD crafted a short, five-year transition period that would exclude 7.5 percent of tangible assets and payroll. Now, a 10-year transition period will apply, and a larger percentage of income will initially be excluded. To start, 8 percent of tangible assets and 10 percent of payroll will be excluded, declining annually by 0.2 percentage points for the first five years; and 0.4 percentage points for tangible assets and 0.8 percentage points for payroll for the last five years.
That change was requested by several members including Hungary and Switzerland. But what is unclear is just how much influence some low-tax Caribbean nations like the Cayman Islands had in that formulation.
Subject-to-Tax Rule: Still an Open Question
From the outset, the OECD has suggested that its subject-to-tax rule (STTR) rate would range between 7.5 and 9 percent. Developing countries were hoping for a higher rate but didn’t get it. Most developing countries are using 10 to 15 percent withholding rates in their treaties on interest and royalties, so the STTR rate at 9 percent may not be particularly effective in combating BEPS. The one place in which developing countries are still hoping to exert some influence is over the scope of the STTR, which will cover interest, royalties, and a defined set of other payments. ATAF and others have urged the OECD to include all payments for services and capital gains under the STTR, all items they say present substantial BEPS risks.
In the meantime, ATAF says it will closely monitor the STTR progress and continue to advocate for including service payments and capital gains as the OECD embarks on technical work. More details about this open question should appear soon. The OECD says it will develop a model treaty provision for the STTR by the end of November.
What Does the Outcome Say?
No one expected to receive everything they requested, but some countries clearly received more than others. We know because they have said so. When Estonia announced that it had joined the agreement, it said it did so only after ensuring that pillar 2’s global minimum tax “would affect Estonian entrepreneurs as little as possible.”
“As a result of the successful negotiations, the minimum tax will change nothing for most Estonian entrepreneurs and only applies to subsidiaries of large international groups,” Prime Minister Kaja Kallas said in a statement.
Hungary indicated the same, as Finance Minister Mihály Varga announced that his country only joined the agreement after seeing its demands on the GLOBE substance carveout realized, according to Reuters.
Meanwhile, developing countries have been more tempered in their statements, if they’ve issued any at all, because they cannot make such strong claims. The OECD’s final changes to pillars 1 and 2 illustrate that while many countries received some of what they asked for, it appears that developing countries received concessions that were more ancillary to their main requests. What remains to be seen is whether that dynamic will shift, as the OECD shifts into its implementation phase.