Tremendous Opportunities and Legitimate Concerns

G-24 Demands Regarding the OECD Two-Pillar Framework Should be Prioritized for a Sustainable Agreement

This is the second in a two-part blog series about U.S. international tax reform occurring alongside negotiations under the Organization for Economic Cooperation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting (IF) to create a two-pillar solution to address the digitalization of the economy and to create a global minimum corporate tax.

This second part of the blog provides an update on the OECD process heading into a critical October and highlights legitimate concerns raised about the participation and benefit afforded by the process to developing nations, which should be addressed in connection with any final framework.

OECD Update

On July 1, 2021, the OECD released a statement on a two-pillar solution to address the tax challenges arising from the digitalization of the economy and to create a global minimum corporate tax. Currently, 134 of 140 IF participating countries have signed on to the statement, and none of the noticeable holdouts including Ireland, Estonia, Nigeria, Kenya, and Hungary have left the negotiations. In reality, both Pillar 1 and Pillar 2 are meant to upgrade historical international tax practices that are fatally flawed in light of the highly mobile income that has been created by a more digitalized and globalized economy, as is discussed further below.

Pillar 1 of the proposal defines an excess profit amount (above 10%) for multinational enterprises (MNEs) with global revenue above EUR 20 billion, subject to reduction 7 years following the agreement, and allocates between 20-30% of this amount to “market jurisdictions” for taxation. Nexus—the economic connection that creates the right to tax—is typically established when a MNE derives EUR 1 million in revenue from goods or services being used or consumed in the relevant market jurisdiction. However, for smaller jurisdictions with GDP less than EUR 40 billion, nexus is established when a MNE derives EUR 250,000.

Pillar 2 proposes a global minimum tax of “at least” 15% for MNEs with greater than EUR 750 million in revenue. The minimum tax works by allowing headquarter countries of MNEs to impose a “top-up” tax on low-taxed income of constituent entities on a country-by-country basis, and is akin to a modified form of the U.S. global intangible low-taxed income (GILTI) tax (though, the OECD refers to this as the “income inclusion rule” or, “IIR”). An undertaxed payment rule (UTPR) denies deductions or requires an equivalent adjustment for low tax income of a constituent entity that is not subject to tax under an IIR. A separate treaty-based subject to tax rule (STTR) allows paying (source) jurisdictions to impose limited top-up taxation on certain undertaxed related party payments, and benefits countries that may not necessarily be the residence for MNEs.

The IF has targeted the end of October to establish a more final “agreed framework.” That is an ambitious target based on the remaining open items discussed below. To achieve this goal, our tentative understanding is that an IF plenary session is to occur on October 8, with several working groups scheduled to meet between now and then. We expect to see a more “final” framework around this session, and countries like Ireland have already indicated that they have seen an updated and encouraging framework. Then, the G20 Finance Ministers are scheduled to meet on October 12 and 13, and the G20 heads of state are to meet from October 30-31 in Venice, Italy. Pillar 1 and 2 are then to be implemented through treaties (maybe) or law through 2022 (with additional technical details having to be sorted out) and effective in 2023.

How Did we Get Here?

Whether we are a month away from a final framework for the two-pillar approach, or whether we are just a month away from being that much closer to an international agreement, the amount of effort put forth by IF nations to get to this point is commendable. Just a year ago, it was unclear whether this process had a viable path forward. The election of President Biden and his appointment of Treasury Secretary Yellen (and teams at both the White House and Treasury) helped to unlock the process and jolt it forward. Importantly, needed U.S. international tax reforms being advanced by President Biden are both benefitted by the OECD process moving forward (though, should not be dependent on it doing so), and can help to ensure that a more meaningful OECD agreement is reached.

As Professor Ruth Mason notes, in its current form, the OECD framework represents a monumental shift from the way the world taxes multinational income. Since the 1920s, the focus of international tax rules has been on residence or “source” state taxation—the latter generally requiring a MNE’s physical presence to tax it. Tax agreements between countries have generally been bilateral. These rules historically benefitted the wealthier countries that were likely to host corporate headquarters for big, profitable MNEs. Allocating profits to “market jurisdictions” and contemplating a global agreement on a minimum tax rate changes international tax paradigms that have lasted for 100 years.

Where, exactly, are we?

Before finalizing any framework in October or otherwise, big open questions remain. For Pillar 1, among other open questions, negotiators must decide on (1) the allocable amount of excess profits to be subject to market tax and (2) rules around whether certain profitable segments of less profitable MNEs might be subject to allocation.

For Pillar 2, among other open questions, negotiators must decide on (1) a minimum global rate; (2) the STTR minimum rate and scope that will allow non-HQ (or parent tax residence) countries for MNEs to impose a top-up tax on undertaxed related party payments, and (3) the rate for the substance-based carve-out in the framework that allows MNEs to annually exempt from tax “at least 5% (in the transition period of 5 years, at least 7.5%)” of the carrying value of tangible assets and payroll in applicable jurisdictions.

Additionally, legitimate concerns that have been raised by a variety of groups about the participation and benefit afforded by the process to developing nations need to be addressed. The principle and primary authors of the reform are G7 and G20 nations, and there is no shortage of historical reasons (in addition to the 1920s tax compromise) to suspect that a cadre of the wealthiest nations in the world would not always pursue the best path for their less fortunate neighbors. This has revealed itself in a Pillar 1 that by its design will likely only apply to 78 corporations (allocating likely only around $140 million in taxes to low-income countries) and a Pillar 2 tax that is really designed to benefit the wealthy MNE HQ countries entitled to the lion’s share of its top-up taxes (i.e., the G7 and China).

In response, the G-24—representing leading developing economies including current deal holdouts Kenya and Nigeria—has clearly distilled the following demands:

  • The allocable amount under Pillar 1 needs to be larger (and/or apply to a larger pool of taxpayers).
  • The elective binding dispute resolution mechanism for developing economies contemplated by the July statement should be included.
  • The removal (and implicit prohibition) of unilateral digital service taxes should be gradual along with implementation of the OECD rules, and this removal should be considered contingent on adequate revenue being raised due to other proposed Pillar 1 and Pillar 2 changes.
  • The STTR in Pillar 2 should be simple, formulaic, avoid unnecessary thresholds and exclusions (including regarding type or character of payment), and apply with a higher minimum rate.
  • Finally, the global minimum tax should be higher than 15%.

As an indication of the serious and justified frustration felt by the G-24, the G-24 stated that any solution not meeting these demands “shall not be sustainable even in the medium run.”

Why Did we Get Here?

In addressing the open OECD framework questions and the demands of the G-24, it makes sense to ask why are we here? What is the reason, if any, for shifting a 100-year-old global tax paradigm? Things changed. Globalization increased. The internet happened. Had these changes only impacted developing countries, it is entirely unlikely that the OECD IF would have surfaced; yet, the changes have impacted wealthy countries, too, like the United States, France, and Germany. Some countries attempted to combat this change by levying digital transaction taxes. As the headquarter country for most of the largest digital-based MNEs, the U.S. has labeled these taxes as discriminatory and trade skirmishes have ensued. While claims about the discriminatory nature of these taxes are seriously problematic, the digitalization and globalization of the economy has encouraged the U.S. and others to coalesce around the broader two-pillar approach currently being pursued.

Current international tax rules work to the disadvantage of governments globally, supporting tax competition between nations (resulting indirectly in lost revenue) and somewhere in the realm of $100 to $240 billion in direct annual corporate tax avoidance. The result has been called a “global tax race to the bottom.” This race and a range of related challenges merit a coordinated global response and a change in the way we think about taxing MNEs.

Among these related challenges are the pervasive threats of corruption and illicit financial flows, a global pandemic, and climate change. Tax evasion, financial secrecy, corruption, and illicit financial flows are inseparable scourges, and more comprehensive estimates of the total global corporate tax revenues lost as a result of tax haven abuse encouraged by the current international tax system total between $500 and $600 billion annually. The cost of this missing $600 billion is borne disproportionately by developing nations, but wealthy nations suffer as well. It bears repeating from part 1 of this blog series, that the U.S. Treasury alone may be leaking around $70 to $100 billion per year to profit-shifting. These missing resources are desperately needed right now.  

The recently released Pandora Papers demonstrate that the two-pillar approach is but one of several necessary components in creating a framework in which all global citizens—including MNEs—must play by the same rules to ensure our mutually assured success (rather than the opposite).  The Pandora Papers represent a massive trove of documents confirming how our secretive (domestic and international) financial systems allow criminals, world leaders, and others to hide billions of dollars from authorities in a way that eviscerates the social contract.  While the Pandora Papers show that MNEs are not the sole perpetrators of these types of abuses and that governments have a responsibility to change legal systems that encourage these practices, MNEs play a role in helping to create and make extremely profitable the business of financial secrecy. This role might be viewed as something that should be characterized as criminal (at worst), or as behavior that legitimizes these harmful practices and interferes with the political will to implement change (at best). Success in implementing an equitable, representative two-pillar solution (and U.S. leadership in doing so at the OECD level and through related domestic reforms) can help ensure success of future collective efforts to root out illicit financial flows, corruption, and financial secrecy; failure to do so, could jeopardize other collective efforts to address these very issues.

Developing nations are struggling to pay for and administer Covid-19 vaccines to their citizenry. As this pandemic has revealed all too well, vaccines don’t recognize borders. At a cost of $50 to $70 billion to vaccinate the rest of the world, there is no reason why wealthy OECD nations wouldn’t help see vaccination through all over the world. That this sum is paltry compared to the corporate tax revenues missing each year as a result of the current international tax system should be a call to action to ensure a fair final OECD framework is realized.

Climate change is a singular threat to the global economy, as well as to human health and open societies. IMF researchers estimate that the additional annual global investment needed to combat the worst effects of climate change could exceed $1.5 trillion. The OECD has this number at $6.9 trillion annually. Every cent of recovery of a missing $600 billion in global government revenues contributed to by the current international tax system could represent a critical investment in climate resilient infrastructure or the ability to better regulate climate destructive practices all over the world. And while wealthy nations should bear some level of responsibility to developing nations in helping to stem a climate change problem that wealthy nations disproportionately helped to create, wealthy nations should also realize that global tax reform that empowers developing nations is a boon. A ton of CO2 emitted in Lagos has the same global warming effect as a ton of CO2 emitted in Midland, Texas. So, it should be evident that the U.S. has an interest in ensuring that Nigeria has the revenue it needs to invest against climate destruction.

Where do We Go from Here?

This month might signal a beginning to the end of the global tax race to the bottom. Much is left to be negotiated, though. Serious equity concerns also persist around the process and the current framework. Without an equitable final framework, it is hard to imagine that any agreement will be sustainable, as per the G-24 warning.

Indeed, the entire world has a great interest in making sure that any final OECD MNE tax framework is equitable and sustainable in light of its essential role in combatting the costs and nature of collective challenges like illicit financial flows, corruption, the pandemic and climate change that can only be successfully addressed collectively. Without representative, collective action, the OECD risks a response that cannot rise to these historic challenges, and it also jeopardizes other necessary efforts to ensure that global financial systems stop working to create markets borne in secrecy for the benefit of MNEs, world leaders, global elites, and criminals to the detriment of everyone and everything else, including our democratic societies and our planet.

G-24 concerns should be taken seriously and broadly incorporated into any final two-pillar solution.  If the OECD is not up to this challenge, then the calls for a different venue for these negotiations under the United Nations will only get louder.  Based on the commendable work done by the Treasury and the White House to get to this point, here’s to hoping for an OECD solution that will address these concerns and other open questions going forward.