A serious issue
Government deficits in EU countries – as well as in the US and other major economies – rose significantly with the COVID-19 pandemic. According to official figures released by the Eurostat[1], the government deficit to GDP ration in the EU climbed from 0.5% to 6.9% in 2020, while government debt rose from 77.2% in 2019 to 90.1% in 2020. Government expenditure in the euro area was equivalent to 53.8% of the GDP and new investments are planned for the digitalization of the economy, decarbonizing, and the decline of the middle class.
This trend of increasingly high government expenditures – both in Europe and the US – is the context in which tax evasion has become even more important. Professor Gabriel Zucman, a professor of economics at UC Berkely has recently estimated that more than half of the foreign profits of US MNEs lie in tax havens[2]. The concept of tax havens may itself be subject to a discussion amongst academics and tax practitioners. While it is understandable that jurisdictions like Bermuda and Cayman Islands may qualify as tax havens, I would not follow Zucman in including Netherlands and Luxembourg to the list. This may nevertheless be a subject for future discussions.
Zucman examined Foreign Affiliated Trade Statistics – also known as transnational corporation data – and analyzed how the location of corporate profits would change if shifted profits were allocated to their source countries. Per the study, pre-tax corporate profits in Portugal were of 27US$b in 2015 according to the national account statistics, of which 3US$b were shifted to tax havens which implied a corporate income tax revenue loss of 9%, obtained by applying the statutory corporate income tax rate to the amount of shifted profits. Zucman concludes that revenues would increase by about 20% in high-tax EU countries and 10% in the US.
At a time when both the US and the EU are struggling with the debt burdens, the governments are understandably eager to bring in a few of these lost proceeds back home.
Minimum corporate tax deal
On October 31, heads of the G20 nations approved the new global minimum corporate tax, in a historic summit in Rome that marked the greatest move ahead in more than a century on corporate taxation. Earlier on October 8, the deal had been signed by 136 countries in the OECD/G20 Inclusive Framework on BEPS.
The countries agreed on a two-pillar solution to address the tax challenges arising from the digitalization of the economy.
Pillar One
The first pillar covers the distribution of tax revenues, particularly for those companies that do not pay tax in countries where they obtain large revenue because less sophisticated tax systems required companies to be physically present to be liable for tax. The important fundamentals of Pillar One can be grouped into two components:
- Amount A – a novel taxing right for market jurisdictions (where clients are located) over a share of residual profit calculated at an MNE group level, and
- Amount B a fixed return for certain baseline routine marketing and distribution activities
In-scope companies are the MNEs with global turnover above 20 billion euros and profitability above 10% (i.e. profit before tax/revenue) calculated using an averaging mechanism with the turnover threshold to be reduced to 10 billion euros, contingent on successful implementation including of tax certainty on Amount A, with the relevant review beginning 7 years after the agreement comes into force, and the review being completed in no more than one year. Two sectors are excluded: extractive industries and regulated financial services.
For in-scope MNEs, 25% of residual profit defined as profit in excess of 10% of revenue will be allocated to market jurisdictions with nexus using a revenue-based allocation key. This means revenue will be sourced to the end market jurisdictions where goods or services are used or consumed.
The measure of taxable P&L of the in-scope MNE will be determined by reference to financial accounting income, with a small number of book-to-tax adjustments. Losses will be carried forward, but it is still uncertain for how many years. While in the US a net operating loss can be carried forward indefinitely (but limited to 80% of taxable income), in most the EU this rule varies from country to country.
It is also not clear what are the accounting standards to which the taxable income will be assessed. While there are not material discrepancies between IFRS 15 and ASC 606 in US GAAP, it is not uncommon to find some relevant differences on the expense side of the determination of income.
There is an intention to streamline the tax compliance (including filing obligations) which would allow in-scope MNEs to manage the process through a single entity, but the precise specifics of this “fair share” pillar still must be operated. In any case, the likely outcome is that larger companies will no longer be able to pay all of their taxes in low-tax territories while paying no tax in other countries where they make most of their revenues from deals.
Pillar Two
Pillar Two consists of two interlocking domestic rules (together the Global anti-Base Erosion Rules (GloBE) rules): (a) an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a constituent entity; and (b) an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR.
This pillar also includes a treaty-based rule (the Subject to Tax Rule (STTR)) that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate. The STTR will be creditable as a covered tax under the GloBE rules.
The minimum tax rate used for purposes of the IIR and UTPR will be 15%. As a result, all participant nations must impose at least a 15% tax on the revenues of any companies headquartered in their territory. This will decrease the motivation for the big corporations covered by the pact (multinationals with annual revenues of at least €750m) to move their operations to tax havens to avoid tax; and will require them to pay a bigger part of their earnings in tax at home countries.
Pillar Two should be brought into law in 2022, to be effective in 2023, with the UTPR coming into effect in 2024.
Some practitioners have been discussing whether this minimum corporate tax may somehow reduce the “race to the bottom” that some countries have been taking for decades to attract more business activity. Perhaps more interesting will be to assess how eurozone countries (that already cannot count on a specific monetary policy that address their needs) will adapt to an era where their remaining economic instrument (tax policy) will also be of limited use.
Only the beginning
This global minimum corporate tax deal signs just a start. There was initially a possibility that the 15% global minimum tax could be increased progressively over time. However, in order to bring together more participants, nations pledged to not increasing the minimum rate further. In Portugal for example the 15% rate is lower than the current corporate tax rate: it will be a challenge for the country to impose a higher rate on companies, which may result on a reduction of corporate tax revenues. The issue may be more serious in other countries that rely more on corporate income tax and less on personal taxation revenue.
In spite of all of the downsides, there is hope that this deal signs the beginning of a new successful fight against worldwide tax avoidance, as well as an essential move ahead into mutual international collaboration.
Rafael Graça
13th December 2021
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[1] https://ec.europa.eu/eurostat/documents/2995521/11563331/2-21102021-AP-EN.pdf/257365fa-8a66-cab8-f60c-06ca9c916a7a?t=1634741973718