On why it really is such a big deal

Yesterday, an overwhelming majority of the 139 states that comprise the OECD/G20 Inclusive Framework reached agreement on its two pillar tax reform package. This follows earlier agreement amongst the G7, and there has been an avalanche of hyperbole heralding the “deal” and what it represents. 

The agreement involves, very broadly, a significant change in the existing rules for allocating taxable income between countries, with a new allocation to market states of 20% to 30% of the profits of the largest MNEs that exceed a 10% profit margin, as well as the introduction across the board of a global minimum effective tax rate. 

The deal has been hailed as a momentous and unprecedented agreement that changes the shape of the international tax system. We have been assured that for the first time we are now able to properly tax the digital sector; that the deal will unlock hidden revenues; that a fair system of taxation has been created; and that the deal represents the victory of co-operation between states over state isolationist policies (and hence the end of tax competition). The UK Chancellor, Rishi Sunak, has even gone so far as to suggest we have reached the perfect state of international tax policy nirvana, such that now "the right companies pay the right tax in the right places".

The obvious question is whether these lofty claims about the importance of what has been agreed are justified, particularly when there is still (1) a raft of acutely difficult, detailed, yet important, technical issues yet to be agreed and (2) an outstanding implementation process that is certain to bring some supremely challenging hurdles, not least relating to whether the measures will be enacted in the US? 

In our view, the conclusion about the momentous nature of yesterday’s Inclusive Framework agreement signals is correct - but not, in the main, for the reasons that have actually been recently trumpeted. 

Contrary to some of those proclamations, we think there is a long way to go before we can venture the conclusions that we can properly tax the digital sector, or that a fair system of taxation has been created, and certainly before we are anywhere near being able to conclude that we have the right companies paying the right amount of tax in the right places. We find all these claims, which also rely on the successful completion of the OECD’s work in progress, unconvincing. 

But that doesn’t mean that we disagree with the conclusion about the momentous nature of the announcements made by the G7 and now the Inclusive Framework. Our reasoning is based on a quite different perspective – and it is all to do with the Pillar 1 reallocation of taxing rights to the market and its impact on the foundations of the international tax system, and specifically on the current income allocation rules (the transfer pricing and PE profit attribution measures). 

In recent years, we have seen many states enact unilateral measures that seek to by-pass the existing income allocation system as embodied in the existing network of double tax treaties – for example the UK’s diverted profits tax and the digital services taxes (DSTs) of a growing number of states. 

We have also seen multilateral actions that seem to signal some dissatisfaction with the arm’s length principle (ALP) which is the core principle of the current rules – for example, the rejection of the ALP approach to regulate “excessive interest” in BEPS Action 4, or the rejection of the “transfer pricing” approach in favour of the nexus approach for dealing with the substantial activity requirement in the context of intangible property regimes (patent boxes) under BEPS Action 5.

However, the Pillar 1 agreement is the first time that we see a clear multilateral endorsement by states of an entirely different direction to the international tax policy that has been pursued for the best part of the last 100 years. And this is strongly supported by the G7 states that have a track record over many years of rejecting the sort of change that they are now pursuing.

The current developments involving a new partial allocation of revenues by reference to the market or demand side (rather than as exclusively based on the supply or production side as under the existing system) are the first serious multilateral steps in a paradigm shift relating to the global income allocation system. It is not just the ALP-based rules of transfer pricing and PE profit attribution that are being modified here. The new approach also partially reshapes the existing nexus concept of Article 5 of the OECD Model Tax Treaty, meaning the shift in thinking is fundamental to the existing international tax system as a whole.

Yes, of course the scope of this change is limited and there is a long way to go in the process and many issues to address – but realistically this is the start, not the conclusion, of a process. That is fundamentally because taxing in the market country has many economic benefits due to the relative immobility of the market. If the customer does not move in response to the tax liabilities of the selling business, then the current distortions to the location of real activity are much reduced, as is the opportunity for shifting profit. 

Importantly, a shift to the market country and away from where functions and activities take place is also entirely consistent with tax competition for inward investment. Economic forces are therefore ultimately driving this change; the Inclusive Framework is merely responding. 

That is why our view on these events is not affected by the details of the proposal, or even whether it is successful. The door to material systemic reform of the international tax system has been opened and it seems unlikely that it can now be shut.


As Senior Policy Advisor to the OECD, Richard Collier was instrumental in the design of Pillar 1.  Michael Devereux has been the primary advocate of taxing profit in the market country since publishing an initial paper with Stephen Bond in 2002.