OECD announces international agreement on taxation

Update: For details of the agreement reached between the United States and the UK, France, Italy, Spain and Austria for the withdrawal of unilateral digital service taxes, see Pillar One: agreement on withdrawal of digital taxes.

The OECD has announced that OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (Inclusive Framework) have reached formal agreement on the proposed two pillar solution to address the challenges arising from the digitalisation of the economy. The Statement on the Two-Pillar Solution contains broad details of the agreed components of the Pillars and an implementation plan.

136 out of the 140 members of the Inclusive Framework have signed up to the proposals, including most notably Ireland, meaning that it is now supported by all OECD and G20 countries. The main developments since the original June 2021 political agreement include agreement of the level of attribution of profits to the market jurisdiction under Pillar One at 25% and agreement of the minimum tax rate for Pillar Two at 15%.

The intention is to agree a multilateral instrument to bring into effect necessary changes to bilateral treaties in 2022, so that the rules can generally come into effect in 2023. However, there still remain a number of detailed areas of the rules to be negotiated and agreed as part of the multilateral instrument.

Background

Discussions have been taking place for several years at the OECD concerning fundamental changes to the international tax landscape to deal with problems created by the digital economy. The publication of a Policy Note and a Public Consultation in 2019 led to 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). "Secretariat Proposal for a "Unified Approach" under Pillar One”, put forward a proposal to define the scope, tax nexus and a new profit allocation rule for public comment. A public consultation document on Pillar Two, 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, was published in November 2019.

In January 2020, the OECD delivered an update, "Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy", setting out the progress that had been made and this was followed in October 2020 by the publication of two blueprints for Pillar One and Pillar Two, whilst recognising that the original deadline for agreement (end 2020) was now unrealistic. However, political agreement was reached in June 2021 on the two pillar approach and this was followed by the publication of a "Statement on a Two-Pillar Solution to Address the Tax Challenges Arising From the Digitalisation of the Economy". The OECD has now published updated details of the agreement following further negotiations.

Pillar One

Scope: The Pillar One rules will apply to multinational enterprises (MNEs) with global turnover above 20bn euros and profitability (profits before tax) above 10%. As has been widely reported, regulated financial services will be excluded, as will extractives.

Accordingly, Pillar One will only apply to about 100 of the largest MNEs. The intention is that the scope of the Pillar One rules will be widened to cover MNEs with turnover above 10bn euros in the future, though this will be contingent on successful implementation of the first stage, including of tax certainty on Amount A. A review is intended to take place seven years after the Pillar One agreement comes into force, and the review will be completed in no more than one year.

Nexus: There will be a new special purpose nexus rule permitting allocation of Amount A to a market jurisdiction when the MNE derives at least 1m euros in revenue from that jurisdiction. For smaller jurisdictions with GDP lower than 40 billion euros, the nexus will be set at 250,000 euros. The special purpose nexus rule applies solely to determine whether a jurisdiction qualifies for the Amount A allocation.

Quantum: 25% of residual profit, defined as profit in excess of 10% of revenue (Amount A), will be allocated to market jurisdictions with nexus using a revenue-based allocation key. The relevant measure of profit or loss will be determined by reference to financial accounting income, with a small number of adjustments (including taking into account carried forward losses).

Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed. Detailed source rules for specific categories of transactions will be developed to facilitate this process.

Where the residual profits of an MNE are already taxed in a market jurisdiction, a marketing and distribution profits safe harbour will cap the residual profits allocated to the market jurisdiction. Further work on the design of the safe harbour will be undertaken.

Segmentation: Segmentation will occur only in exceptional circumstances where, based on the segments disclosed in the financial accounts, a segment meets the scope rules. This element is aimed at ensuring that the largest MNEs that might not, overall, reach the required 10% profit requirement are nevertheless brought within scope on sections of the business that are profitable by applying the rules to those profitable segments.

Elimination of double taxation: Double taxation of profit allocated to market jurisdictions will be relieved using either the exemption or credit method. The entity (or entities) that will bear the tax liability will be drawn from those that earn residual profit.

Tax certainty: It is intended that affected MNEs will benefit from dispute prevention and resolution mechanisms, which will avoid double taxation, including all the issues related to amounts allocated to market jurisdictions (e.g. transfer pricing and business profits disputes), in a mandatory and binding manner. Disputes on whether issues may relate to these amounts will be solved in a mandatory and binding manner, without delaying the substantive dispute prevention and resolution mechanism.

Amount B: Amount B is designed to provide a standardised remuneration for related party distributors that perform baseline marketing and distribution activities in a manner that is aligned with the arm's length principle. The OECD statement states that he application of the arm's length principle in these circumstances will be simplified and streamlined and work on this will be completed by the end of 2022.

Administration: The tax compliance will be streamlined (including filing obligations) and allow MNEs to manage the process through a single entity.

Implementation: The multilateral instrument through which Pillar One is implemented will be developed and opened for signature in 2022, with the Pillar One measures coming into effect in 2023.

An Annex to the OECD statement contains a more detailed implementation plan for Pillar One and it is clear that this work includes further detailed negotiation on the detailed features of Pillar One including the calculation of Amount A. This also includes the commitment to the removal of all digital service taxes (such as those introduced in the UK and France). It is not clear at this stage how this might impact the intended digital levy put forward by the European Commission in its Business Tax Agenda and which is intended to sit alongside any international agreement.

Pillar Two

Design: The overall design of Pillar Two will consist of:

• two interlocking domestic rules (together the Global anti-Base Erosion Rules (GloBE) rules): (i) an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a subsidiary entity; and (ii) an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a subsidiary entity is not subject to tax under an IIR; and

• a treaty-based rule (the Subject to Tax Rule (STTR)) that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate. The STTR will be creditable as a covered tax under the GloBE rules.

The IIR will allocate top-up tax based on a top-down approach subject to a split-ownership rule for shareholdings below 80%. The UTPR will allocate top-up tax from low-tax subisidiary entities, including those located in the parent jurisdiction under a methodology to be agreed.

The GloBE rules will operate to impose a top-up tax using an effective tax rate test that is calculated on a jurisdictional basis and that uses a common definition of covered taxes and a tax base determined by reference to financial accounting income (with agreed adjustments consistent with the tax policy objectives of Pillar Two and mechanisms to address timing differences). In respect of existing distribution tax systems, there will be no top-up tax liability if earnings are distributed within 4 years and taxed at or above the minimum level.

The minimum effective tax rate used for purposes of the IIR and UTPR will be 15%.

The GloBE rules will have the status of a common approach. This means that Inclusive Framework members:

• will not be required to adopt the GloBE rules, but, if they choose to do so, they will implement and administer the rules in a way that is consistent with the outcomes provided for under Pillar Two, including in light of model rules and guidance agreed to;

• will accept the application of the GloBE rules applied by other members including agreement as to rule order and the application of any agreed safe harbours.

The STTR is seen as an integral part of achieving a consensus on Pillar Two for developing countries. As such, Inclusive Framework members that apply nominal corporate income tax rates below the STTR minimum rate to interest, royalties and a defined set of other payments will implement the STTR into their bilateral treaties with developing members when requested to do so. The taxing right will be limited to the difference between the minimum rate and the tax rate on the payment. The minimum rate for the STTR will be 9%.

Scope: The GloBE rules will apply to MNEs that meet the 750m euros threshold as determined under BEPS Action 13 (country by country reporting). Countries are free to apply the IIR to MNEs headquartered in their country even if they do not meet the threshold. Government entities, international organisations, non-profit organisations, pension funds or investment funds that are ultimate parent entities of an MNE Group or any holding vehicles used by such entities are not subject to the GloBE rules.

The GloBE rules will provide an exclusion for MNEs in the initial phase of their international activity. This will cover MNEs which have a maximum of 50m euros in tangible assets abroad and that operate in no more than 5 other jurisdictions. The exclusion will be limited to a period of 5 years. For MNEs that are within scope when the GloBE rules come into force, the 5 year period will commence at the time the rules come into effect.

Carve-outs: The GloBE rules will provide for a formulaic substance carve-out that will exclude an amount of income that is at least 5% of the carrying value of tangible assets and payroll (this amount will be 8% of tangible assets and 10% of payroll for a transitional period of 10 years, declining annually by 0.2% for the first 5 years and by 0.4%/0.8% for the next 5 years).

The GloBE rules will also provide for a de minimis exclusion for those jurisdictions where the MNE has revenues of less than 10m euros and profits of less than 1m euros.

The GloBE rules also will also provide for an exclusion for international shipping income using the definition of such income under the OECD Model Tax Convention.

Simplifications: To ensure that the administration of the GloBE rules are as targeted as possible and to avoid compliance and administrative costs that are disproportionate to the policy objectives, the implementation framework will include as yet unspecified safe harbours and/or other mechanisms.

Implementation: Pillar Two should be brought into law in 2022, to be effective in 2023 with the UTPR coming into effect in 2024. Again a detailed implementation plan is included in an Annex to the OECD statement.

Comment

This formal agreement on Pillar One and Pillar Two is a significant milestone in the project and international tax developments over the last decade. Pillar One only applies to around 100 MNEs and not financial institutions so the initial impact of the rules is likely to be limited for most multinationals. However, the principles of Pillar One may impact how tax authorities view marketing and distribution returns and provide additional reference points, numerical tests and arguments to challenge positions for MNEs below the Pillar One threshold.

Pillar Two’s status as a common approach with a lower revenue threshold for in-scope multinationals may lead to complexities as countries implement proposals with the various optional requirements and exclusions. Whilst this is intended to provide flexibility, the mechanism and impact for each multinational will depend on the countries it operates in and implementation of Pillar Two will need to be considered further.