Far-reaching changes to the international tax framework could be agreed as early as mid-2021 after a key OECD/G20 group (the Group) renewed its commitment to addressing the tax challenges of the digital economy.
Last year we outlined the potential for a long-term, OECD consensus solution to the tax issues posed by the digital economy in a publication looking at New Zealand's options: whether to go it alone on a digital services tax, or to await the outcome of the Group's ambitious programme to address the tax challenges arising from digitalisation. Over 135 jurisdictions are working together through the Group to tackle base erosion and profit shifting (BEPS) in the modern commercial environment.
In a statement published this week, the Group – called the Inclusive Framework on BEPS – affirmed its commitment to this programme of work and highlighted substantial progress in building consensus around changes to the international tax framework. The statement was accompanied by reports on the two 'pillars' of the project, which respectively focus on the taxation of digital businesses and a proposed global minimum tax, released for public consultation. The reports outline areas where consensus has been reached, and identify the outstanding political and technical issues where further work is needed.
Taxation of digital businesses
The first report, Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint, outlines a number of proposed amendments which the Group believes will promote a more sustainable international tax framework for the digitalised world.
The most significant of these changes would involve the grant of a new taxing right on certain business profits to countries where the consumers of qualifying goods or services are located – that is, the market or user jurisdictions – regardless of whether the taxpayer business has any physical presence in that country. Another significant change from the status quo would be that the profits taxable in the market/user jurisdiction (known as "Amount A") would be calculated using the consolidated financial accounts of the multinational group as the starting point, rather than at the level of the individual group entities.
The Pillar One proposals would also introduce a new, simplified approach for determining the income attributable to certain marketing and distribution activities carried out by members of a multinational enterprise in a jurisdiction (known as "Amount B"), which would supplant the arm's-length approach to income allocation and avoid the need for complex transfer pricing analyses in respect of such activities.
If adopted, these changes would be implemented by way of a multilateral convention, which would amend the global tax treaty network accordingly.
A number of political and technical issues remain to be resolved around the Pillar One proposals. These include issues relating to the scope of the new rules, where the current proposal is that they will apply to automated digital services, such as those provided by the digital giants, and consumer facing businesses, who exploit digital technology to engage with customers and increase profitability. The outstanding issues also include how much of the business profit should be reallocated to market/user jurisdictions, and the potential for new procedures to improve tax certainty (such as mandatory binding dispute resolution).
A global minimum tax
The second report, Tax Challenges Arising from Digitalisation – Report on the Pillar Two Blueprint, outlines a number of proposals intended to ensure that all large multinational businesses pay at least a minimum level of tax on their global income. As with a number of recent BEPS measures, the definition of large multinational businesses would be based on a €750 million annual gross revenue threshold.
Two measures form the core of the Pillar Two proposals: the Income Inclusion Rule (IIR) and the Undertaxed Payment Rule (UTPR):
The IIR would apply to an entity that has a foreign branch or subsidiary that pays a low level of foreign tax on its profits. To the extent that the income was subject to foreign tax at an inadequate rate, top-up tax would be payable in the residence jurisdiction in order to ensure that a minimum level of tax was paid. The US's Global Intangible Low Taxed Income Regime (GILTI) would be treated as an IIR for the purpose of the Pillar Two amendments.
The UTPR would apply only where the relevant entity was not subject to an IIR. Broadly speaking, it would deny deductions where a related-party payment was made to a foreign company that was not subject to the minimum tax rate on that receipt.
These measures would be complemented by the Subject to Tax Rule (STTR), a rule favoured by many developing countries. The STTR would act to deny tax treaty relief, where the availability of such relief was dependent on an amount of income being “subject to tax" in a particular jurisdiction, by effectively defining the term “subject to tax" as meaning “subject to tax at a specified minimum rate".
The mechanism by which the Pillar Two proposals would be implemented is yet to be determined, but could include model legislation, standard documentation and guidance, and potentially a multilateral convention.
Comment and next steps
The statement by the Group concludes by indicating its intention to swiftly move to a consensus solution on the Pillar One and Pillar Two proposals, with a view to reaching final agreement by mid-2021. If international agreement can be reached, the introduction of Pillar One and Pillar Two measures would represent one of the most significant international tax developments in history.
It remains to be seen how the apparent progress in securing international consensus may impact domestic taxation policy, particularly in relation to the New Zealand-specific digital services tax currently under consideration by the Government. Last year, the Government indicated that a digital services tax would be “seriously considered" if insufficient progress on an internationally agreed solution was made within the year. If progress towards a mid-2021 international agreement stalls, a domestic measure such as a New Zealand specific digital services tax may regain momentum.
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This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.