Will 2021 Be the Year of Breakthrough Tax Reform?
It’s hardly news that many of the world’s most powerful brands have long played the international tax system like a violin, legally avoiding tax bills on the profits they’ve made in high-tax jurisdictions. Nor is it news that the OECD has been trying for years to patch these loopholes with a layered global tax proposal that, at this point, might be more confusing than all of Stephen Hawking’s theories combined. And yet, against all odds, we stand at the precipice of a complete rewrite of the entire international taxation rulebook. How did we get here—and more importantly, where are we going?
A century ago, when the global tax model was taking shape, only a small number of businesses had a footprint (typically, a factory) in more than one country. The concept of “presence” was physical. You were taxed where you had operations. In today’s digital economy, however, presence is often virtual. That’s because digital companies, a description that fits most of today’s richest multinational enterprises (MNEs), derive many of their profits from intellectual property—a nebulous asset that exists both everywhere at once and nowhere in particular. Many of these companies have parked their profits and their crown jewels—their intangibles—in the cheapest location, regardless of “economic substance” (i.e., commensurate physical activity).
Case in point: Even though the vast majority of the profits of U.S.-based global giants have been earned in higher-tax jurisdictions, many have set up their European headquarters in Ireland—whose 12.5% headline rate and 6.25% patent box rate have proved irresistible. (For some, that works out to an average 2% effective tax rate.) Or, consider the Cayman Islands (population: 63,000), where corporations said they earned $58.5 billion in profits in 2017 out of a few empty office buildings.
For eight years, the OECD has been working on a series of strategies to put an end to this practice of base erosion and profit-shifting (BEPS). After much wrangling—and much arm-twisting from the most powerful economies on Earth—they have advanced a two-track approach aimed at addressing the two sides (or “Pillars”) of the problem: (1) that companies aren’t paying enough (or any) tax in the places where they are making their money, and (2) that they are legally gaming the global system to avoid paying even a base amount of taxation, no matter where they are headquartered.
How likely is this complex plan to succeed? On the following pages, we unpack the evolution of the OECD’s two pillars, discuss where countries stand with them today, and look at what it all might mean for MNEs.
The OECD’s Twin Pillars: Potential Financial Impacts
The scope of Pillar One—focused on stopping companies from shifting profits to low-tax jurisdictions—has been substantially narrowed since its ambitious beginnings, when it would have covered 8,000 MNEs, in all sectors. It’s now slated to cover only the most profitable, global companies (specifically excluding those in regulated financial services or extractive industries) with annual revenues over €20 billion and profit margins over 10%—a very high bar. This elite group would then be required to reallocate between 20% and 30% of their residual profits (profit in excess of 10% of revenue) to the actual countries where they make sales.
Despite its narrow scope, the financial impact of Pillar One is undeniable—it will lead to a redistribution of billions of dollars in tax revenues. According to a July 2021 study, 78 of the world’s 500 largest companies (two-thirds of which are U.S.-based) will pay an additional $87 billion annually. One-third of that sum will be owed by just five companies: Apple, Google parent Alphabet, Microsoft, Intel, and Facebook. The fact that Pillar One is now so targeted makes it easier for all signatories to agree to it. Good thing, because, unlike Pillar Two, Pillar One requires unanimous approval.
Pillar Two has emerged as the more significant change agent. Its proposed minimum corporate tax rate of at least 15%—applicable to companies with a global turnover of more than €750 million—is slated to yield revenues of well over $275 billion a year, touching approximately 10,000 companies and virtually every country (at the time of writing, 133 of 139 have signed the OECD agreement). And it is backstopped against potential abuse, with a provision imposing headquarter countries to top-up the company’s tax bill to the minimum rate, should any individual nation seek to undercut the agreement—a built-in disincentive for countries to opt out.
The Rubber Meets the (Rocky) Road
The problem with global consensus—especially when it involves international tax deals—is that it translates to something different for every country that signs on. It also lays bare the power dynamics involved with locking in such an ambitious reform, so that even if all countries agree to the same deal, in the end—as the ads say—“Your results may vary.”
The process by which we’ve arrived at this moment offers clues to its potential outcome. After seeking a 21% tax on U.S.-based companies’ foreign income—partially as a way of financing its domestic spending priorities—the Biden Administration said it would accept a global rate as low as 15%, reasoning that with an international corporate minimum tax that is “functionally set at zero” in “a race to the bottom” (in the words of U.S. Treasury Secretary Janet Yellen) any progress counts as real progress. Then, in June 2021, finance ministers from the seven most advanced economies—the U.S., Japan, Germany, France, U.K., Italy, and Canada (the G7)—announced that they had agreed to “at least” a 15% global minimum tax rate for multinationals. And, while the G7 communiqué was more a pronouncement than an actual agreement, it set the ball rolling. Only a month later, in a move widely hailed as historic, 130 nations—including early outliers India and China and tax havens Switzerland and the Bahamas—also signed on to the latest OECD framework.
The ball then kept rolling from Paris to Venice, where, just over a week later, the finance ministers of the G20—which collectively account for more than 60% of the world’s population and 80% of global GDP—formally threw their support behind the plan, creating, by mid-July, what appears to be unstoppable momentum toward some form of implementation of the OECD’s twin pillars.
Now the clock is ticking ahead to the October G20 meeting in Rome. While the OECD hopes the new rules will be in place by 2023, it has neither the political authority nor an enforcement mechanism to make that happen—and any change negotiated to win the approval of an essential country can just as easily set off a chain reaction of carve-outs or countermoves from others. So, getting the technical work done (the OECD’s “detailed implementation plan”) in time and a final sign-off from the G20 heads of state will be critical.
From Rome, the hill gets steeper and the road, rockier. Assuming the G20 ekes out a final agreement, the action will then move to individual jurisdictions, each one of which will have to pass legislation amending its tax code to comply. In the United States, the deal will be complicated by domestic opposition from the GOP and some in the business community: If the changes President Biden seeks to sign into law require renegotiating tax treaties, he would need a two-third majority (67 votes) in the deadlocked Senate to pass—unless he is able to attach the legislation to a larger budget-reconciliation proposal. As with every other aspect of this high-wire reform process, everything hangs in the balance.
The European Union is widely expected to seek to enact the agreement through EU-wide legislation. That requires all 27 member states to sign on, and at least three of them—Ireland, Hungary, and Estonia—show no sign of doing so. Of these holdouts, Ireland (with a 12.5% corporate tax rate) and Hungary (9%) have been the loudest. No surprise: those low rates have been central to their economic model for years.
Ireland holds a unique position within the bloc. Of the €12 billion in corporate taxes the country received in 2020, half came from the 10 largest multinationals in the world. It is the European home to 24 of the 25 world’s biggest pharmaceutical companies. And it has a lot to lose: Under the OECD plan, about €2-3 billion of tax revenue would flow to other EU economies. Still, Ireland is likely to bow to reality, calculating that cooperation—and winning as many concessions as possible along the way—is its best strategy. (It didn’t hurt when Biden agreed to lower his initial proposed global minimum tax from 21% to 15%.) The Emerald Isle is hardly a Celtic Cayman: Ireland’s resident Big Tech and Big Pharma companies have invested enormous sums to establish headquarters there. Collectively, U.S. firms employ an estimated 180,000 workers and indirectly support another 144,000 jobs in Ireland.
Accommodating Hungary’s recalcitrance may pose a greater problem. The country is already at loggerheads with the EU on a number of political, cultural, and human-rights issues—areas where it has found an ally in fellow former Eastern Bloc state Poland. Although Poland did sign on to the OECD framework, both countries argue that national corporate tax rates are a sovereign right, and that the “substantial economic activities” taking place in their jurisdictions should not be lumped in with countries whose economic model is based primarily on tax minimization. Contentious negotiations lie ahead.
Carve-Outs and Wild Cards
While EU unanimity is necessary if the bloc is to adhere to a global minimum tax, not all OECD countries would need to sign. But in reality, since all OECD nations are not created equal, objections from any one of the G20 nations in particular will have to be resolved before the accord can be signed.
China is, as ever, a wildcard. With a basic corporate tax rate of 25% for most companies, Beijing reportedly wants to retain its broad system of tax incentives for high-tech and economic development—and insisted on carve-outs for companies paying well below the 15% minimum. On the other hand, as a major consumer market for U.S. high-tech products like personal computers and devices, China stands to benefit from the Pillar One reforms: It is estimated to have lost over $50 billion in tax revenue in 2015 alone due to profit-shifting.
It’s not just individual jurisdictions that can warrant carve-outs: Specific industries can be exempted globally as well. Regulated financial services, extractive businesses for Pillar 1 and the global shipping in for Pillar 2 get a pass—yet many fear these exemptions could simply open another loophole to be creatively exploited by companies with deep pockets and armies of tax lawyers.
Who Wins? Who Loses? Who Knows?
Despite the noble intent of the OECD to benefit all countries through comprehensive, fair tax reform, in the end, the big winners—no surprise—will be headquarter countries like the U.S. and its fellow G7 members. With only 10% of the world’s population, these seven nations stand to receive the lion’s share (60%) of the additional revenues. And of these, the U.S. stands to benefit the most—not only in recouping tax revenues but also in keeping the taxable profits of its multinationals out of the hands of other nations.
While the EU’s top three member states—Germany, France, and Italy—may similarly profit, the body may not emerge unscathed. The unanimity requirement across 27 very different countries and cultures—once so vital to its stability and sense of unity—has become a straitjacket when big political or economic decisions have to be made. The perennial conflicts between the bloc’s haves and have-nots—undergirded by the capital flows from richer to poorer and intensified by heightened conflicts on cultural and rule-of-law issues—are bursting into the open under the pressure of the proposed reforms. Meanwhile, Ireland, with its feet in both camps, is facing a decision about how to maintain its successful business model while seeking to build its stature as a major European team player.
And what of the 800-pound tech gorillas who are—let’s face it—the reason why these reforms are finally seeing the light of day?
A superficial reading points to a unilateral financial loss: They would have to pay more taxes, and in more places. But the truth is, the Apples, Facebooks, Amazons, and Googles of the world—and those that aspire to be—also have a lot to gain from more certainty around compliance and the taxes they will owe. And they can plainly see the writing on the wall. With plummeting popularity, a host of European governments imposing digital services taxes to capture a piece of the pie, a new administration in Washington eager for post-pandemic revenue, and a web of constantly shifting OECD proposals swirling around, most of these digital giants at this point are hoping to avoid getting further enmeshed in the crossfire. Some, like Facebook, are making a virtue of a necessity and expressing vocal support for the change. That’s not just a case of altruism or reputational laundering. The upside for Big Tech is simplicity and stability around global taxation—the lack of which has been a kind of tax in itself.
What This Means for MNEs
While nobody yet knows the outcome of this process, one thing is for sure: MNEs will need to keep a close eye on these developments, and prepare the ground—and their stakeholders—for unprecedented change. With tax laws likely to evolve in virtually every country you do business in, it’s essential to model the potential financial impact of the combined OECD pillars—in terms of not only your effective tax rate but transfer pricing, as well. You might end up rethinking your entire value chain, R&D jurisdictions, and tax models. No matter which way this goes, it’s safe to assume your compliance costs will rise.
Against all odds, a reform plan long seen as worthy but quixotic has gained traction—and real momentum. Suddenly, fundamental questions such as where corporations choose to operate, where and how much they get taxed, and what incentives governments might be allowed to offer to lure them, are on the table. If the reform effort is successful, the consequences will be profound: It will amount to nothing less than a reshaping of the global economic body via its vascular system—tax revenue—and no two countries will experience it the same. Which way will it go? We need only wait for October’s crucial G20 meeting to find out.
Mimi Song, Chief Economist, CrossBorder Solutions
Mimi Song has more than 20 years of experience developing innovative and intelligent transfer pricing solutions for multinational corporations. As a practitioner with both consulting and industry know-how, Song understands the administrative burdens imposed on taxpayers and customizes compliance solutions that strategize long-term sustainability with appropriate risk management. At CrossBorder Solutions, Song is responsible for managing client relationships and ensuring the successful implementations of solutions. She also leads discussions with world-renowned transfer pricing experts on the company’s weekly podcast, The Fiona Show, and has been the star of in-depth speaking engagements at the company’s frequent round tables, as well as Transfer Pricing University. At the original iteration of CrossBorder Solutions, Song served as vice president of professional services. Following the sale to Thomson Reuters, she was a vice president at Duff & Phelps before becoming the head of transfer pricing at the Bank of Tokyo-Mitsubishi UFJ. She has written numerous articles on tax and transfer pricing for Bloomberg and Treasury & Risk, among others, and has been quoted as an economic expert for Forbes and CNN.