Finance ministers from the G7 countries reached a landmark agreement on key areas of international tax reform. Matt Stringer looks at what was agreed, and what it means for the UK and for your businesses.
G7 finance ministers alongside the International Monetary Fund, World Bank Group, Organisation for Economic Co-operation and Development (OECD), Eurogroup and Financial Stability Board met in London over 4 to 5 June, intent on reaching agreement and solidifying their commitment to a global consensus on the heavily debated OECD Pillar 1 and Pillar 2 proposals.
Let's consider the key questions you need answers to following the decision:
Has this come out of the blue?
No. The G7 tax agreement talks were around the follow up to the Base Erosion and Profit Shifting (BEPS) project, led by the OECD over the last decade. Many of the BEPS action items were implemented in 2013 to 2020 and have been widely publicised. Anti-hybrid rules, corporate interest restriction, and the multi-lateral instrument for tax treaties are all good examples.
The first action item in BEPS was tackling the tax challenges of the digital economy – the broad premise that the world has changed from brick and mortar businesses - and that 'digital' means that international tax frameworks don't always work fairly with modern-day multinational businesses. In summary though, Action Item 1 was badged as “a bit hard for now" and so shelved.
A lot more work and thinking took place, and, in 2019, we saw the first mention of the two “Pillars” as to how the OECD might plan to 'fix' these tax challenges in the digital economy.
The premise of Pillar 1 is that “market jurisdictions” may be under-rewarded in current transfer pricing methodologies. Where a business' markets are (ie, customers) may not have been as important in decades gone by, but now, customers can add value for a business in new ways..
Customers create social content, provide our data, and offer other digital footprints, which in turn, is valuable for businesses. Pillar 1 proposes to adjust the allocation of taxing rights between countries to allocate profits to the countries where this additional value might be being created.
In addition to the above, Pillar 2 looks to a new set of rules to ensure that multinational businesses pay a minimum level of tax. Despite all of the BEPS actions that have come to pass to tackle base erosion and profit shifting, many of the largest multinational businesses around the world continue to avail overall effective tax rates on a global scale that are less than the headline rates in their major markets.
Although more and more difficult to achieve, countries with no or low corporate income tax continue to house profits of some multinational groups. A key part of these rules is an 'income inclusion' rule: a de facto top up tax for a parent jurisdiction where subsidiary levels charge an effective rate of tax less than the desired rate.
After many OECD meetings, detailed blueprint proposals were published for both pillars in October 2020, and there is a desire to conclude on a set of rules by mid 2021.
What was agreed at the G7?
The G7 countries reached consensus on the two broad principles of Pillar 1 and Pillar 2, and set some minimum standards that they commit to seeing within the new rules. These were:
For Pillar 1
Multinational businesses with a profit margin of over 10% should allocate 20% of that 'extra margin' to their marketplace jurisdictions to be taxed there
For Pillar 2
A minimum rate of at least 15% should apply on a country-by-country basis
Does the law change now?
There are a few more steps before we see these rules applied. As this agreement was only between G7 countries, we now need to see these concepts taken to the wider G20 and OECD countries for full agreement.
This will be more difficult than at G7, given the countries in G7 all have corporate income tax rates of over 15% and are significant marketplace jurisdictions themselves. Other countries who will be 'losers' rather than 'winners' when it comes to where taxes would be allocated under a new system will need to be convinced.
How new laws actually come to pass is then a big step. After OECD agreement on the rules, like the original BEPS papers, countries’ domestic laws and treaties then all need to be updated to make this 'actually happen'.
Another point to bear in mind is that the two statements coming out of G7 are very simplified – and there are huge numbers of detailed design principles that need to be agreed upon before the results of this work come to pass.
Many of those design questions are considered in great detail in the blueprint, but include:
Which groups should be within the scope of new rules at all? Groups with more than EUR 750 million revenues, or even larger?
Which marketplace jurisdictions need to be considered? Is there a revenue threshold or size of economic nexus in the market to be within Pillar 1 scope? How is the amount allocated?
Which figures do we use for either test? Accounting data? What about differences in tax and accounting rules globally to applying a consistent approach?
How do we calculate an effective tax rate to compare to the Pillar 2 minimum; and on whose principles and on which data, including Controlled Foreign Company taxes and withholding taxes? Who gets to apply any top up tax, and how?
How should the rules be applied to specific industries, such as the Financial Services industry?
What does it mean for the UK?
Newspapers and political parties will focus heavily on the Pillar 2 minimum rate and the figure chosen (15%, or greater?). Economic analyses actually show that the Pillar 2 changes are likely to leave the UK tax take somewhere around where it is today.
Our already robust framework around Controlled Foreign Company rules, Diverted Profits Tax (DPT), Offshore Receipts in respect of Intangible Property (ORIP) and other areas means that UK headed groups are more unlikely than most to have low effective tax rate profits sat in subsidiaries.
There will be exceptions, of course. However, HM Treasury appears to be more relaxed about what is achieved here as a revenue raiser. Pillar 2 appears to be most significant for the US; hence the focus from the US Government on a successful implementation of Pillar 2 worldwide.
Contrastingly, the UK has been a firm supporter of Pillar 1, and economically this appears to be the rule that is likely to generate more significant tax revenues for us. A globally applied Pillar 1 would mean the UK repeals its digital services tax and applies the Pillar 1 approach instead. As a large customer market for some of the largest US multinationals, we can expect the UK to benefit from Pillar 1.
What should you be doing now?
Businesses smaller than the country-by-country reporting (CbCR) threshold of EUR 750 million revenues are unlikely to be impacted directly by these changes. Those who are larger than this should be paying close attention and thinking about potential impact.
It may be wise to start modelling effective tax rates per jurisdiction on accounting profits to see where Pillar 2 exposure might be, as well as considering the size of marketplace jurisdictions under Pillar 1, if global profit margin is over 10%.
While there was a lack of substantively new information from the G7 talks, it's an indicator of a big step in the right direction to seeing successful agreement on these Pillars in the months and years to come.