The 137 countries comprising the OECD’s Inclusive Framework recently agreed to continue exploring the two sets of proposals grouped under Pillars I and II on a “without prejudice basis”. The quest for reform rolls on, at least for the time being. How it will end is anybody’s guess. The need for reform is undeniable - but countries’ perceived interests and preferences diverge. Technical challenges, an ambitious timeframe, business lobbying, domestic political pressures, looming unilateral measures, the threat of trade wars and other factors pull in different directions, making the outcome hard to predict.
In this blog, we focus on the key issues arising in one of the two proposals on the table: Pillar II, the Global Anti Base Erosion Proposal (GloBE). We draw on the report that we have recently published with several other CBT researchers.
Pillar II has two main elements. The first is an income inclusion rule. If a company in State A has an affiliate in State B which is subject to an effective tax rate below a certain threshold, then under this rule State A would levy an extra tax on the income of the affiliate to bring it up to the threshold. The second is an undertaxed payments rule. Under this rule if the company in A made a payment to the affiliate in B and the receipt in B is subject to an effective tax rate below a certain threshold, then A would either deny a deduction or impose a tax on the payment.
Casual followers of the proposal may have heard that countries disagree on whether the proposal should include a “substance-based carve-out” and “blending” (“blending” involves the aggregation of profits taxed at different rates and potentially in different countries) - and may have assumed that these are mere technical issues. But they are far more than that; they determine the very nature of the proposal and the objectives it seeks to achieve. Their inclusion or rejection would lead to markedly different international tax systems.
To see this we have to investigate the objectives of the proposal. These have been stated as addressing both tax avoidance and tax competition.
In principle, including a substance-based carve-out would make the GloBE consistent with the aims of the BEPS project of combating tax avoidance. The 2013 BEPS Action Plan stated that “no or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it.”
But lower tax rates may also reflect competition over real economic activities. To combat tax competition, countries would have to agree to a strong form Pillar II, without a substance-based carve-out, and without blending across countries. With either of these, countries might still have an incentive to reduce their tax rates to attract real economic activity. So combating tax competition requires there to be no substance-based carve-out and no blending. But addressing tax competition by agreeing to a GloBE proposal without these features would constitute a dramatic departure from the policy which members of the OECD, the EU Commission and others advocated with such determination only a few years back. Countries arguing against a substance-based carve-out presumably believe that “no or low taxation” is now a cause of concern.
Not including a substance-based carve-out can also be perceived – and appears to be so perceived by some countries – as denting countries’ tax sovereignty. It would effectively mean that countries are not free to choose to tax the profit generated by real activities within their borders at the rate of their choosing. It might be countered that some countries are pressured by competitive forces to tax this profit at a low rate, and the GloBE without a substance-based carve-out or blending may reduce the pressure on them to do so. But others may prefer a low tax rate, particularly if they can offer only limited non-tax benefits. The GloBE without a substance-based carve-out or blending would effectively take this option away from them.
We should also be wary about the direction of this proposed reform. It moves in a diametrically opposed direction to Pillar I – towards taxation in the country of the parent, as opposed to the country of the market (although it might be argued that real aim is to raise tax rates in low tax countries). The combination of both Pillars I and II – together with everything in the existing system, which would remain – would mean that multinational profit is potentially subject to taxation everywhere. It is already difficult to discern the principles underlying the existing system of where profit is taxed; the only principle that might justify adding Pillars I and II would be to try to increase the probability that profit is taxed somewhere, anywhere.
Moving in both directions simultaneously would add further complexity to a system which is in serious danger of caving under the sheer weight of its labyrinthine rules. Developing countries and others with limited resources and capacity already struggle to operate the existing rules due to their complexity. This will make matters worse.
There is a clear advantage of Pillar I over Pillar II: the relative immobility of the new location in which profit would be taxed. Customers – especially individual consumers – are relatively immobile. Parent companies are not. Subject to anti-inversion rules and exit taxes, companies can move their headquarters, and of course new businesses can set up anywhere. This mobility may fundamentally undermine the GloBE for two related reasons.
First, all – or certainly most – countries would need to implement it. If one country did not, multinationals would have an incentive to move their parent company to that country. And there would also have to be considerable harmonisation of the details, including, for example, the rules to calculate the threshold rate.
Second, as part of tax competition, individual countries would have an incentive to resist implementing the proposal - and if they joined, they would have an incentive to defect. (It has been suggested that the undertaxed payments rule addresses this concern by acting as a stick to compel countries to adopt the GloBE. But, looking carefully at the details, this seems unlikely.) We should aim for a tax system which countries have an incentive to join - rather than one into which they have to be strong-armed and from which they have a continuing incentive to defect.
Recent relevant research from the Centre for Business Taxation:
The OECD Global Anti-Base Erosion (GloBE) proposal, Michael P. Devereux, François Bares, Sarah Clifford, Judith Freedman, İrem Güçeri, Martin McCarthy, Martin Simmler and John Vella.