In the fourth quarter of 2021, 137 countries reached a ground-breaking agreement on the reform of international aspects of Corporate Income Tax (CIT) within the OECD-coordinated Inclusive Framework (IF) on BEPS (Base Erosion and Profit Shifting). Thirty-one of these are Latin American and Caribbean (LAC) countries, and they are currently working to ensure that the voluntary political agreement translates into international conventions and domestic legislation so that the package can take effect in 2024 as announced recently by OECD in Davos.
The reform is good news for LAC and other developing countries, since it can contribute to increase tax collection from large multinational companies. Preliminary estimates suggest that the impact could exceed $3 billion for LAC per year.
In brief, the reform aims to fulfil two initiatives: the first is to introduce a mechanism for sharing a portion of the profits generated by the largest and most profitable “mega” multinational companies (MNEs), so that they contribute to the tax authorities of the countries where there is a critical mass of users of their services, even if the multinational does not have a permanent establishment there. The second measure is to implement a Global Minimum Tax on corporates so that the accounting profits of multinationals are subject to an effective minimum tax rate of 15%.
These two measures are intended to undo two Gordian knots: (i) the growing degree of digitalization and new business models that provide services and access to user information, which allow companies to have a significant participation in a market without having a physical presence (scale without mass) there and (ii) that it is still possible for companies to reduce their tax liabilities by transferring profits to low-tax countries, which highlights the weaknesses of the current mechanisms (transfer pricing, thin capitalization rules, etc.). In an open and globalized economy, these two problems affect all countries.
Description of Pillars 1 and 2
In essence, Pillar 1 creates a mechanism for distributing the so-called “Amount A”, a fraction (25%) of residual profits, which affects approximately the 100 largest (with a turnover of more than 20 billion euros) and most profitable (more than 10% of profit on sales) multinationals in the world. The administration of the tax would require a single tax return (consolidated balance sheet of the mega MNE) to be filed with the tax authorities of the country where the ultimate parent company is domiciled, and the information would be shared with the other countries.
Each country will have the right to tax the residual profits (Amount A) that correspond to its share of the mega-MNE sales. Amount B focuses on the remuneration of routine marketing and distribution activities carried out in the market jurisdiction by a related party of the MNE; the details of this important aspect are still being defined. Finally, a multilateral convention will regulate the administrative powers of the tax authorities to contribute to legal certainty and dispute prevention.
Pillar 2 seeks to prevent the erosion of the tax base and its transfer to countries with a lower tax burden. Hence if a state does not exercise its right to tax at an adequate level, rules (IIR – Income Inclusion Rule) can be applied to reallocate the taxing rights to another jurisdiction that will tax it. A complementary rule (UTPR – Undertaxed Payments Rule), aimed at preventing the parent companies of MNEs from migrating to tax havens to avoid tax, is to deny deductions by their subsidiaries if the income going to the parent company is taxed at a level below the stipulated minimum.
These Pillar 2 rules, which affect some 8,000 multinationals (their application threshold is lower than Pillar 1) and are collectively referred to as GloBE (Global anti-Base Erosion) rules, introduce a new global minimum income tax for MNEs that should ensure an effective rate of 15% on accounting profit regardless of the jurisdiction in which the income is booked.
New features of the proposal
It is important to acknowledge that is a very innovative proposal. Most notable in Pillar 1 is the generation of an income transfer mechanism which meets the progressive criteria outlined in the United Nations Sustainable Development Goals. Another significant measure is the application of unitary taxation, i. e., the treatment of mega-enterprises as taxable entities, the introduction of a formula to allocate income, the recognition of the user’s contribution to value creation and the resulting right to tax of the market country.
Of note in Pillar 2, is the scope of application. It includes about 8,000 large multinationals (turnover over 750 million euros) that represent 90% of the taxable base of MNEs, excluding pension funds, state-owned companies, and the shipping industry. The most important innovation, acknowledging the weakness of the existing mechanisms, such as transfer pricing and thin capitalization rules, is the transfer of income from low tax countries to other countries with taxation rates over 15%.
Another noteworthy element of Pillar 2 is that it allows the application of a “qualified domestic minimum top-up tax” (QDMT) in the market jurisdictions where MNEs operate in order not to assign taxes to the countries of their parent companies. Finally, not all profits are subject to tax, only the residual accounting profit is subject to tax, exempting from taxation routine income attributable to fixed assets and labor (so-called carve-outs).
Reform challenges
The proposal also poses significant challenges. The first is that Pillar 1 applies exclusively to mega-enterprises but the application of digital service taxes (DST) to any other company is banned by the agreement generating a lack of treatment (deregulation) which contradicts the proposal´s main objectives in tax policy.
A second problem is the volume of Amount A, since the formula excludes routine profits (set at 10% of sales) and, of non-routine profits, 75% is retained by the country where the company is domiciled and distributes 25% to the other markets where the company operates. These percentages are the result of political negotiations and, consequently, debatable, particularly since knowledge mega-enterprises look set to become ever larger in the future and will reside mostly in developed economies, limiting the laudable redistributive function.
Likewise, the CIT becomes more complex with the inclusion, together with the general regime, of several special regimes: mega-enterprises, which are subject to Pillar 1, very large companies, which are subject to Pillar 2, and small and micro-companies, with their simplified regimes. Additionally, due to the combination of the carve-out in Pillar 2 and the QDMT, it is likely that tax incentives will survive.
Complexity will increase the costs of compliance for taxpayers and control for administrations, multiplying the opportunities for avoidance. In addition, the agreed measures will consolidate the divergence between corporate taxation, where territoriality predominates, and personal taxation, where worldwide income prevails.
At an institutional level, credit must be given to the OECD-IF for the technical and political effort invested to achieve consensus in a process for which there are few precedents (learning by doing) in the tax field. However, we know that developing countries need support to develop further their analytical capacities and so achieve a truly effective participation in the development of international standards.
Finally, this new taxation requires a regulatory framework that protects consumer rights, data privacy and the defense of competition, bearing in mind that the knowledge economy has at its core the human-being, and very specifically their privacy and biology.
Impact on tax collection
Various authors have estimated the impact of the reform on revenue. Preliminary estimates suggest that Pillar 1 could yield between $438 and $1,038 million annually for Latin America and the Caribbean, while Pillar 2 revenues appear to be more significant for the region and could reach between $2.1 and $2.25 billion a year.
It should be noted that the calculations are influenced by the absence of data by company and are only available at country level as of 2017 for five jurisdictions. They also do not include the introduction of a general QDMT.
Conclusions and recommendations
We also suggest reconsidering the current ban on implementing the Digital Services Tax on companies with revenues below the agreed thresholds.
For countries, we recommend weighing the desirability of participating in Pillar 1 against less aligned alternatives, such as the Digital Services Tax.
Regarding Pillar 2, our main recommendation is to establish the ¨qualified domestic minimum top-up taxes” (QDMT), to avoid ceding revenue to third jurisdictions due to the establishment of the Global Minimum Tax (GMT). Another policy that will need to be reviewed concerns tax incentives to encourage investment, especially if the QDMT has not been approved by a country. Furthermore, to level the playing field in a jurisdiction, a QDMT could be applied to all firms (over a sales threshold) ensuring a minimum income tax of 15% on accounting profits. In fact, this will help to reduce the negative impact of redundant CIT incentives but does not substitute the need to reevaluate their design.
Electronic Invoicing for Cross-border Transactions
To facilitate this process of transparency and tax control, we propose electronic invoicing for all cross-border transactions of goods, services, intangibles and financing, and promoting the exchange of information between all jurisdictions involved in the ultimate beneficial ownership and country-by-country reporting by large multinational firms. At the same time, successful management of the reform requires a review and modernization of the international aspects of tax administration.
In addition, we consider that international cooperation and the institutional framework supporting it need to be strengthened to deal with the asymmetries between countries in policymaking, and implementation. This will enhance the important progress achieved to date.
All the countries in the region will have to analyze their international tax policies and determine whether to sign up to the new international consensus or to continue with autonomous tax policies, running the risk of undermining their international trade and financial integration. We wish to emphasize our commitment to our member countries, and we are ready to support them in the analysis and implementation of adjustments to their tax policies.
This blog is based on the publication (in Spanish) New International Corporate Taxation. Challenges, Alternatives and Recommendations for Latin America and the Caribbean.
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