OECD Public Consultation on Pillar Two: a global anti-base erosion proposal

The OECD has published a public consultation document on its work on Pillar Two of its current programme on the tax challenges arising from the digitalisation of the economy. Pillar Two is seeking solutions to the ongoing risks from structures which allow MNEs to shift profits to low tax jurisdictions through additional global anti-base erosion (GloBE) proposals.

The public consultation invites feedback on any aspect of the OECD’s work on Pillar Two, although the consultation itself focusses on three specific design elements: the use of financial accounts as a starting point; the use of blending high and low tax rates of tax; and any specific exemptions and thresholds that should be considered.

As with the Pillar One proposals, the Pillar Two proposals have the potential to fundamentally change the international tax landscape for MNEs. Unlike Pillar One, however, there does not yet appear to be any specific timeframe for these proposals, which are at a much earlier stage of development. Indeed, whilst the work on Pillar Two falls under its tax challenges of digitalisation programme, it seems at this stage to be much less focussed on the digital sphere than Pillar One. As such, it is very much worthwhile potentially affected MNEs engaging with the process in a way that may affect its long-term design.

Background

Despite determining in its final Report on BEPS Action 1 that it would not be feasible to ring-fence the digital economy for tax purposes, international pressure has continued to mount over the tax treatment of the digital economy as a number of jurisdictions have concluded that more is needed to ensure fair taxation of digital business. As a result, in March 2018, the OECD returned in its Interim Report to the question of whether, and if so what, further measures to tackle taxation of digital services were needed.

Impetus for an international consensus has continued to mount since then as the EU Commission put forward proposals to address the tax treatment of companies operating in the digital economy and several jurisdictions have commenced implementation of unilateral, domestic measures, such as France’s current Digital Services Tax and the UK’s proposed Digital Services Tax.

This continued political pressure led to the publication of a Policy Note in January 2019, quickly followed by a Public Consultation which set out a number of proposals for reform, grouped under two pillars: revised profit allocation and nexus rules (Pillar One); and a global anti-base erosion proposal for a minimum level of taxation (Pillar Two).

On 9 October 2019, the OECD published a public consultation document seeking to put forward a unified approach with respect to Pillar One. Further details on this consultation can be found at A new tax nexus: the OECD's proposed Unified Approach. The OECD has now published a further public consultation document on Pillar Two.

Pillar Two

The purpose of the Pillar Two proposals is to “comprehensively address remaining BEPS challenges by ensuring that the profits of internationally operating businesses are subject to a minimum rate of tax”. A minimum tax rate on all income would reduce the incentive for taxpayers to engage in profit shifting and for jurisdictions to engage in a “harmful race to the bottom on corporate tax rates”, so risking shifting the tax burden to less mobile tax bases. In particular, this is seen as posing a particular threat to developing countries with small economies. As with Pillar One, there is a desire to put forward a co-ordinated international solution to avoid the potential proliferation of uncoordinated and unilateral action by individual jurisdictions.

In essence, the GloBE proposal is intended to operate as a top-up to an agreed minimum fixed rate of tax for MNEs. The actual rate to be applied under GloBE is yet to be determined, however.

There is recognition that the changes being considered would require changes to both domestic laws and tax treaties and will need to incorporate rules for ensuring that double taxation is avoided. There is also a recognition that the eventual proposals should be consistent with the “principles of design simplicity that will minimise compliance and administration costs”.

There are four elements to the GloBE proposals under Pillar Two:

• an income inclusion rule that would tax the income of a foreign branch or a controlled entity if that income was subject to tax at an effective rate that is below a minimum rate;
• an undertaxed payments rule that would operate by way of a denial of a deduction or imposition of source-based taxation (including withholding tax) for a payment to a related party if that payment was not subject to tax at or above a minimum rate;
• a switch-over rule to be introduced into tax treaties that would permit a residence jurisdiction to switch from an exemption to a credit method where the profits attributable to a permanent establishment (PE) or derived from immovable property (which is not part of a PE) are subject to an effective rate below the minimum rate; and
• a subject to tax rule that would complement the undertaxed payment rule by subjecting a payment to withholding or other taxes at source and adjusting eligibility for treaty benefits on certain items of income where the payment is not subject to tax at a minimum rate.

The Programme of Work so far has identified some key design issues that need to be addressed. Since some of the wider technical and design aspects depend on these policy choices, the OECD is requesting comments on three specific issues at this stage (whilst recognising that further consultation will be necessary following further development of the proposals).

Use of financial accounts

Determining the tax base is clearly a fundamental prerequisite to the GloBE proposals. The Programme of Work starts from the proposition that, in principle, the tax place should be determined by reference to CFC rules or domestic CT rules in the shareholder’s jurisdiction. However, this approach would mean that subsidiaries of MNEs would need to recalculate their income each year in accordance with the tax rules in their parent’s jurisdiction. It is recognised that not only is this likely to result in a significant compliance cost and burden, but also “situations where technical and structural differences between the calculation of the tax base in the parent and subsidiary jurisdiction result in an otherwise highly-taxed subsidiary being treated as having a low effective rate of tax for reasons unrelated to the policy underlying the GloBE proposal”. This might be due to timing differences on recognition of income or losses, for example.

Accordingly, to simplify the process, the Programme of Work considers starting with the relevant financial accounts and applying agreed adjustments as necessary. “The income so determined would be used in the denominator of the effective tax rate fraction. Then, the numerator of the effective tax rate fraction could be based on the actual tax liability or the tax expense accrued for accounting purposes, which may need to be further adjusted to remove accruals of tax related to a different period.”

Chapter 2 of the consultation document seeks feedback on a number of features of the potential use of the financial accounts as the starting point for determining the tax base. These include:

• whether it is appropriate to use the accounting standards of the ultimate parent of the MNE group;
• what to do where the ultimate parent is not obliged to and does not produce consolidated accounts;
• how to determine whether the financial reporting standard used by the parent is acceptable (if not IFRS);
• what permanent differences between the accounts and the tax position should be recognised (such as non-deductible expenses and exempt sources of income); and
• how to deal with temporary, timing differences in the recognition of income or expenses (for example, due to depreciation and carried forward losses). On this, the consultation seeks feedback on options for (i) the carry-forward (or back) of excess taxes paid or losses; (ii) the use of deferred tax accounting; or (iii) the use of multi-year averaging of the effective tax rate.

Blending

Because the GloBE proposal is based on an effective tax rate (ETR) test, it must include rules that stipulate the extent to which the taxpayer can mix low-tax and high-tax income within the same entity or across different entities within the same group (blending). Blending could, in principle, be done on either a narrow or broad basis, from a complete prohibition on blending to full blending of all foreign income. However, a broad approach to blending that allowed an MNE to mix income and tax across different entities and jurisdictions would generally have the effect of reducing an MNE’s potential tax liability under the GloBE proposal and, in essence, allow an MNE to avoid a charge to tax even though a certain portion of its total income may be subject to tax at a low rate.

Chapter 3 of the consultation seeks feedback on a range of options for blending ranging from:

• blending at the entity level (requiring determination of the income and tax of each entity in a group and applying the ETR at the entity level);
• blending at global group level (under which an MNE would aggregate all of its foreign income and tax and apply to the ETR); or
• blending at a jurisdictional level (requiring apportionment of income and tax to different jurisdictions and application of the ETR at that level).

As well as seeking feedback on the particular approach to blending that the OECD should seek to progress, the consultation identifies a series of more specific issues that also warrant feedback at this stage, including:

• how to allocate income between branches and head office;
• how to allocate the income of tax transparent entities;
• how to deal with CFC taxes etc that arise in jurisdictions where either an entity or a jurisdictional approach is taken; and
• how to deal with dividends and other distributions if a jurisdictional or entity approach is adopted.

Carve-outs

The Programme of Work calls for the exploration of possible carve-outs as well as thresholds and exclusions to restrict application of the GloBE proposal. These are seen as important in ensuring that the design does not involve excessive compliance costs for MNEs and tax administrations. However, they must also take into account existing international obligations, such as the fundamental freedoms in the EU.

Bearing these points in mind, the consultation seeks feedback generally on the design and scope of any thresholds and exclusions and, in particular, mentions a number of specific options including:

• carve-outs for regimes compliant with the standards of BEPS Action 5 on harmful tax practices;
• carve-outs for returns on tangible assets;
• carve-outs for controlled corporations with related party transactions below a certain threshold;
• thresholds based on the turnover or other indications of the size of the group;
• de minimis thresholds to exclude transactions or entities with small amounts of profit or related party transactions; and
• the appropriateness of carve-outs for specific sectors or industries.

Comments

Comments on the public consultation document should be addressed to the International Co-operation and Tax Administration Division, Centre for Tax Policy and Administration and submitted by Monday 2 December 2019 by e-mail to taxpublicconsultation@oecd.org. A public consultation meeting on the developments under Pillar Two will be held on 9 December 2019 at the OECD Boulogne in Boulogne-Billancourt. The objective is to provide external stakeholders an opportunity to provide input on the ongoing work.

The proposals under Pillar Two are wide-ranging and, in some cases, novel. The application of a minimum effective rate of tax at an international level would be a major development and is likely to have as yet unidentified consequences. However, there appears a long way to go before any real agreement may be forthcoming. The consultation at this stage is focussed on some of the fundamental, but early, design details and recognises that further consultations on any design choices will be necessary in the future.