The importance of this single reform can be gauged from the fact that it took nearly five decades from the original signing of the Vienna Convention on the Law of Treaties to evolve a global consensus on a minimum rate of tax. A major driver for this global consensus is the steady decline in the average OECD statutory rate of tax from over 30% in 2000 to 23% in 2020. In addition, there are numerous tax jurisdictions around the world with zero or negligible tax rates which attract huge investment flows, both legitimate and illegitimate, at the cost of larger countries that typically have moderately high tax rates. A global minimum rate is expected to provide a better level playing field amongst countries allowing them to focus on creating the right physical and commercial infrastructure to attract investments instead of entering into a ‘race to the bottom’ in terms of lower and lower tax rates.
The design of Pillar Two proposals on the global minimum tax rate is as follows:
- Income Inclusion Rule: triggers an inclusion at the shareholder level where the income of a ‘Controlled Foreign Entity’ is taxed at below the effective minimum tax rate.
- Under-Taxed Payments Rule: functions as a backstop to the IIR by allocating taxes in respect of a foreign entity that is taxed at below the effective minimum tax rate and which is not already subject to IIR. The UTPR will be levied through the following mechanisms at the option of the payer jurisdiction:
- denial of deduction to payer entity
- imposition of source-based tax in payer jurisdiction
- Subject To Tax Rule: treaty-based rule which allows source jurisdictions to impose limited source taxation on certain related-party payments (such as royalty, interest, insurance premiums, etc.) subject to tax below a minimum rate.
Implications of Pillar Two for India
- Inbound Investments
In a happy coincidence, the lower corporate tax of 17% introduced by India for new manufacturing units in 2019 is just above the global minimum threshold rate of 15%. Therefore, this proposal will not adversely impact inbound investments into India. In fact, it will allow India to focus on improving various non-tax factors and interventions to attract greater inbound investment flows (for example, the Production linked investment schemes, the Gati Shakti National Master plan for infrastructure, the monetization plan for public sector companies, etc).
- Outbound Investments
To the extent that Indian multinational enterprises will be disincentivized from establishing overseas subsidiaries/group companies in low tax jurisdictions, the proposal of a minimum tax rate will be beneficial for India. However, given the relatively modest outbound investments by Indian companies, it is highly unlikely that India will get a significant share of the estimated $150 billion in new annual global tax revenues on account of this proposal.
Pillar One proposals on profit allocation and nexus rules
A significant evolution in the consensus reached on Pillar One proposals is the wider coverage of profit allocation and nexus rules to all multinational businesses rather than being restricted to only ‘digitized activities’. Taxing rights on more than $125 billion of profit are expected to be reallocated to market jurisdictions each year although it is presently applicable to the top 100 most profitable companies with the scope of expansion after seven years (multinationals with global revenues above €20 billion and profitability above 10%). For these ‘in scope’ multinationals, 25% of residual profits (defined as profit in excess of 10% of revenue) will be allocated to ‘market jurisdictions with nexus’ using a revenue-based allocation key. This proposal, too, is a phenomenal evolution from the over five decades of enshrining the ‘permanent establishment’ basis of taxing rights in tax treaties amongst all countries around the world.
For the very first time, market jurisdictions will get the right on a portion of the profits of ‘in-scope’ multinational enterprises regardless of whether any kind of presence is established in the said market jurisdiction. Since India is a significant market jurisdiction, it can be expected to benefit from the additional taxing rights under Pillar One.
As the G20 communiqué has observed ‘this agreement’ will establish a more stable and fairer international tax system’. Clearly, the global tax reforms agenda has, at last, caught the attention of the highest echelons of political leadership in the G20 countries, and there seem to be high expectations of the outcomes of the project.
What tax professionals will zero in on
For the tax community, though, the lack of technical details makes it very difficult to accurately gauge the true impact of these proposals. While some very important design features are agreed upon, the following technical issues, amongst others, merit particular attention:
- Methodology and basis of profit allocation to market jurisdictions (for example, accounting vs taxable income; overall profits versus segmental profits).
- Whether and to what extent profits will be allocated when a relevant part of the entrepreneurial profits in the supply chain are already allocated to the market (for example, a multinational enterprise operating through a subsidiary in relevant market jurisdiction whose profits are already taxed in that market).
- Which jurisdictions will be surrendering the profits to be reallocated under Pillar One to market jurisdictions.
- Calculation of ‘effective tax rate’ to determine the applicability of Pillar Two.
- Exact mechanics and acceptability of multi-lateral dispute resolution amongst countries.
Much like the centuries-old tradition of the Dussehra festival in India, it is a great reminder of the existing ‘evils’ in society and the need to purge the community from these evils. However, the proposals may not totally end all existing tax evils as there are enough complexities in these proposals to let the habitual tax offenders keep trying out their luck. For the rest of the legitimate businesses (which are in majority of taxpayers, by the way), it is rather critical for them to analyze the impact of these proposals on their existing business models and supply chain and start preparing for implementation by the given deadline of 2023. After all, when the effigies of the ‘evil spirits’ are sought to be burned, it is the conscientious and legitimate businesses who need to steer themselves from any inadvertent harm which may ensue in the entire process.
This article first appeared on BloombergQuint.com on 22 October 2021.
