In recent years, countries have debated significant changes to international tax rules affecting multinational companies. Last October, after negotiations at the Organisation for Economic Co-Operation and Development (OECD), more than 130 member jurisdictions agreed to an outline for new tax rules.
Large companies would pay more taxes in countries where they have customers and less in countries where they have headquarters, employees, and operations. Additionally, the agreement sets out a global minimum tax of 15 percent, which would increase taxes on companies with earnings in low-tax jurisdictions.
Governments are currently developing implementation plans and turning the agreement into law.
The OECD proposal follows an outline that has been discussed since 2019. There are two “pillars” of the reform: Pillar One changes where large companies pay taxes (impacting roughly $125 billion in profits); Pillar Two introduces the global minimum tax (increasing tax revenues by an estimated $150 billion, globally).
Delays in implementation and disagreement on the policy details have pushed the timeline for Pillar One to mid-2023 and Pillar Two to 2024 at the earliest.
Pillar One contains “Amount A” which would apply to companies with more than €20 billion in revenues and a profit margin above 10 percent. For those companies, a portion of their profits would be taxed in jurisdictions where they have sales; 25 percent of profits above a 10 percent margin may be taxed. After a review period of seven years, the €20 billion threshold may fall to €10 billion.
Amount A is a limited redistribution of tax revenue from countries where large multinationals operate to countries where they have customers. U.S. companies constitute a large share of these companies.
The U.S. could lose tax revenue because of this approach. However, U.S. Treasury Secretary Janet Yellen has previously written that she believes Amount A would be roughly revenue neutral for the U.S. But for this to be true, the U.S. would need to collect significant revenue from foreign companies or from U.S. companies that sell to U.S. customers from foreign offices.
Recent draft rules outline where companies will pay taxes under Amount A. The rules include approaches for identifying final consumers even when a company is selling to another business in a long supply chain. The draft rules also allow companies to use macroeconomic data on consumer spending to allocate their taxable profits.
Pillar One also contains “Amount B” which provides a simpler method for companies to calculate the taxes on foreign operations such as marketing and distribution.
Pillar Two is the global minimum tax. It includes three main rules and a fourth for tax treaties. These rules are meant to apply to companies with more than €750 million in revenues. Model rules were released in December 2021.
The first is a “domestic minimum tax” which countries could use to claim the first right to tax profits currently being taxed below the minimum effective rate of 15 percent.
The second is an “income inclusion rule,” which determines when the foreign income of a company should be included in the taxable income of the parent company. The agreement places the minimum effective tax rate at 15 percent, otherwise additional taxes would be owed in a company’s home jurisdiction.
The income inclusion rule would apply to foreign profits after a deduction for 8 percent of the value of tangible assets (like equipment and facilities) and 10 percent of payroll costs. Those deductions would be reduced to 5 percent each over a 10-year transition period.
Importantly, Pillar Two rules rely primarily on financial (i.e., “book”) accounting data rather than tax accounting data. These book/tax differences mean that the Pillar Two rules account for timing differences by focusing on deferred tax assets which can include net operating losses and capital allowances. However, those deferred tax assets must be valued at the 15 percent minimum tax rate.
Like other rules that tax foreign earnings, the income inclusion rule will increase the tax costs of cross-border investment and impact business decisions on where to hire and invest around the world—including in domestic operations.
The third rule in Pillar Two is the “under-taxed profits rule,” which would allow a country to increase taxes on a company if another related entity in a different jurisdiction is being taxed below the 15 percent effective rate. If multiple countries are applying a similar top-up tax, the taxable profit is divided based on the location of tangible assets and employees.
Together, the domestic minimum tax, income inclusion rule, and under-taxed profits rule create a minimum tax both on companies investing abroad and foreign companies investing domestically. They are all tied to the minimum effective rate of at least 15 percent and would apply to each jurisdiction in which a company operates.
The fourth Pillar Two rule is the “subject to tax rule,” meant to be used in a tax treaty framework to give countries the ability to tax payments that might otherwise only face a low rate of tax. The tax rate for this rule would be set at 9 percent.
For Pillar One to work, all countries must adopt the rules in the same fashion. This would avoid companies dealing with different approaches across the globe.
Pillar Two is more optional. The outlined version of Pillar Two is like a template that countries can use to design their rules. If enough countries adopt the rules, then a significant share of corporate profits across the globe would face a 15 percent effective tax rate.
Both Pillar One and Pillar Two represent major changes to international tax rules. The outline specifically states that digital services taxes and similar policies will need to be removed as part of Pillar One. The U.S. Trade Representative has negotiated with some countries that have digital services taxes to ensure a smooth transition. Countries would have to write new laws, adopt new tax treaty language, and repeal policies that conflict with the new rules.
So far, Congress has chosen not to implement changes in line with the global tax deal. Though the Biden administration supports the agreement, Congress left those changes out of the Inflation Reduction Act which passed in August.
Tax treaty ratification requires 67 votes in the Senate, making the adoption of Pillar One challenging without broad, bipartisan support for the new rules.
On the other side of the Atlantic, the European Union (EU) has been debating rules and implementation timelines. The current Pillar Two implementation proposal requires unanimous agreement among the 27 EU member states in the Council of the EU—and unanimity has proven elusive. After Hungary vetoed the proposal in June, the Czech Presidency of the Council is planning another vote on Pillar Two at its October meeting.
If a Member State again vetoes the proposal, the EU could move to enhanced cooperation on the file. This procedural change would allow a group of nine or more Member States to unanimously implement the proposal without needing agreement from all 27 countries.
Another, less organized option is for each country to unilaterally implement its own version of Pillar Two outside of an EU legislative mechanism. Germany recently announced its intention to do so in a likely attempt to change Hungary’s veto calculous at the October meetings.
The UK introduced draft legislation in July, but the new Prime Minister, Liz Truss, made a point about backing out of the global tax deal during her campaign.
Because of existing rules, just one large economy adopting the rules would dramatically impact multinationals across the globe. It would also create pressure for other countries to adopt some version of the rules.
The agreement represents a major change for tax competition, and many countries will be rethinking their tax policies for multinationals. However, it is unclear when—or even if—the agreement will be implemented. Both the U.S. and EU have hit roadblocks in their respective legislative processes and the chief negotiator at the OECD, Pascal St. Amans, has unexpectedly announced his retirement. If implementation fails, a return to a world of distortive European digital services taxes and retaliatory American tariffs could be on the horizon.
Note: This post was originally published on July 1, 2021 but was updated on September 7, 2022 to reflect the latest details on the global tax agreement.