Ongoing discussions on the reform of the international tax system continue to be dominated by the G20/ OECD’s proposed “two-pillar” solution - which includes the introduction of a new allocation of taxing rights to market states (Pillar 1) and a 15% global minimum tax rate (Pillar 2).
Despite the initial intention to treat the Pillar 1 and Pillar 2 measures as two parts of the same package, there is increasing discussion about the possibility of decoupling Pillar 2 from Pillar 1 and enacting Pillar 2 on an accelerated time scale. That possibility was enhanced by the publication last month of both the Pillar 2 Model Rules (some way ahead of any expected rules on Pillar 1) and the publication by the European Commission of a proposed EU directive to incorporate Pillar 2 into EU law. Further, some states are known to be keen to prioritise Pillar 2 given the pressure on tax revenues following the covid crisis, coupled with the relatively higher tax yields expected from Pillar 2 compared to Pillar 1. At the same time, there remain formidable challenges to any agreement on the detail of Pillar 1 and its implementation. For example, some challenging questions are raised by the need to identify “paying entities” to deal with the elimination of double tax and the need to deal with the intended “tax certainty” measures relating to the prevention of disputes. There also seems to be some scepticism on whether some countries could even implement Pillar 1 without material delays given domestic law timing issues and constitutional issues. These challenges may have the effect of stalling the Pillar 1 measures or causing them to fail.
An obvious question is therefore what would be the implications of a successfully implemented Pillar 2, combined with a stalled or failed Pillar 1? Specifically, in such a case, would there be a fall-off in the momentum or perceived need for the Pillar 1 reallocation of taxing rights to the market? The question is essentially asking if a sufficient “fix” for the various concerns that are regarded as besetting the international tax system could be delivered by the Pillar 2 measures alone.
My answer to this question is that, in the event of a failed or materially deferred Pillar 1, it seems very unlikely that a successful Pillar 2 will stall or reverse the momentum for a re-allocation of taxing rights to the market. There are several reasons for this conclusion.
First, there is some uncertainty about how many states will adopt the Pillar 2 measures given that the adoption of those measures is not mandatory for any state. Given that the historic justification for the OECD work is that states cannot deal with the problems of the international tax system by acting alone, this suggests a critical mass of states is needed to make the package effective. It is also possible some difficulties may remain with the compatibility of the Pillar 2 measures with EU law and double tax treaties.
Second, even if the Pillar 2 measures are widely adopted, the package would deliver little or no response to most of the key problems recognised in the digitalization debate to date. For example, the Pillar 2 measures do not respond to the identified nexus problem concerning the point at which economic activity in a state should properly be regarded as giving rise to a tax charge in that state. Neither would they address the weaknesses of the functions-based transfer pricing rules that act as a barrier to the taxing ability of market states, notwithstanding the perceived participation of remote sellers in the economy of such states. Further, the problems of avoidance activities by MNEs and tax competition activities by states would be constrained within more limited parameters by the 15% minimum tax rate of Pillar 2 but not stopped altogether. Also, all the operational problems of the ALP system (identifying appropriate comparables, inherent complexity, mobility concerns, etc.) would remain, raising the obvious question why Pillar 2 is being used to bolster the ALP system when it is currently thought to be so problematic. These issues are simply not addressed by the core income inclusion rule of Pillar 2: the default allocation of taxing rights to parent states under the income inclusion rule of Pillar 2 does nothing to satisfy the concerns raised by market states (and neither are those concerns met by the newly-introduced “QDMTT rule” which allows source states to capture additional revenue under Pillar 2).
Third, if for some reason the Pillar 1 measures fail or are materially deferred, it seems very likely that many states would rapidly look to pursue alternative destination-based approaches. Most obviously, this would presumably put DSTs back on the table, a point that is emphasised by the limited time for which they are suspended pending a successful Pillar 1 implementation. States may also look to other approaches, possibly based on some of the other proposals for increased market taxation that have been made over the last couple of years.
It seems very likely that many states would respond in the manner suggested above in the event of a failed or materially deferred Pillar 1. This is because the views of many states on what is an appropriate nexus for taxation have now moved on from the traditional idea of nexus based on physical presence. This, in turn, might be due to some normative notion (such as one couched in terms of value creation) or, and probably more likely, due simply to the increasing recognition by states that they actually can readily tax such remote sellers. This means that for many states the destination approach has become appreciably more attractive. Whether through Pillar 1 or otherwise, this seems the likely future direction of travel. Pillar 2 alone is never going to be enough of an answer to the issues raised by the digitalisation debate.