A global consensus also ensures that MNCs are not caught between conflicting claims of governments and be subjected to double or multiple taxation.
CEO, Dhruva AdvisorsWhile death and taxes are indeed certain, how does one pay ‘right taxes at the right place’? OECD countries have, for quite some time, been talking about avoiding ‘unfair tax competition’. And yet, economies have been indeed competing to attract investments by providing tax shelters. Whether we look at tax havens that have no or negligible taxation of income, or at countries that do not tax profits from intellectual property (IP), we have many ways in which corporations shelter their profits in low-tax jurisdictions.
The second challenge comes from the old school of thought that provides for taxation of companies where their home base is situated, and disregards that market jurisdiction should also have a right to tax profits irrespective of whether there is a permanent establishment or not. So, it was only a matter of time that the old tax regime gave way to something new.
The first steps in that direction were taken by the OECD when it got a significant consensus (with the US not participating) on the project of base erosion and profit shifting (BEPS). OECD came up with a road map in which it recognised that tax treaties were instruments for avoiding double taxation, and could not be used for double non-taxation.
It evolved the principal purpose test (PPT), which required entities to show that the primary purpose of choosing a tax residence was not tax planning. It evolved the multilateral instrument (MLI), which enabled countries to amend tax treaties without having to go through bilateral negotiations. While much work remains to be done — especially on the taxation of digital economy front — countries like India have moved unilaterally to impose taxes like the equalisation levy.
The Biden administration’s proposal of a global minimum rate of tax of 15%, and last week’s agreement by G7 finance ministers to reform the global tax system to ensure that the ‘right companies pay the right tax at the right place’ needs to be viewed in the light of the above developments that preceded it.
The two key proposals announced in London are the global minimum rate of tax companies need to pay on a country by-country basis; and the proposed profit allocation mechanism, where the market jurisdiction (place where the goods are sold) will have the right to tax at least 20% of profits that exceed a 10% margin of MNCs.
These steps are in the right direction. They validate the stand that India and other developing economies have been advocating, regarding the right of market jurisdictions to tax profits. A global consensus also ensures that MNCs are not caught between conflicting claims of governments and be subjected to double or multiple taxation.
That said, several issues need to be addressed before the proposals can be implemented. For starters, the rate of tax to be applied has to be decided by each country. Then, a framework is needed to reallocate profits that has to be agreed to by 125-plus countries. While the G7 framework will provide a direction, it will be interesting to watch the country-specific reactions at the discussions scheduled to take place in the G20 finance ministers’ meet in Venice on July 9-10.
For example, when one is determining profits of an enterprise, is it accounting profits or tax profits? If it is the latter, will the computation of profits as per accounting standards or tax laws of the home country be accepted by everyone? Or will each country recompute profits?
Will the enterprise-wide profits be acceptable, or will one have to consider the operations in the market jurisdiction on segmental profits basis? Several MNCs write off developmental expenses in their accounts. Will this be acceptable? What happens to MNCs having margins of less than 10%?
Will they be outside the ambit of new rules? Given the track record of the ability of companies to reach consensus on such issues, one hopes that the framework evolved by G7 does not remain just a framework, and a workable solution is evolved in due course. So, what stand will developing countries take on this? If India was to accept the proposed profit allocation rule, it could be at a considerable loss.
For example, if an MNC was to make a profit on 15%, under the proposed framework, India can tax 20% of 5% of the profits. In contrast, the equalisation levy is 2% or 6% of turnover.
The journey towards a unified global tax framework has just begun. A consensus between OECD members and G20 will likely emerge by end-2021. Evolving a global consensus, particularly on the reallocation of profits, will be the next big step. It will not be an easy exercise. After that, we will see tax treaties being amended.
Thus, while the G7 framework is indeed a ‘giant step’, a lot of ground needs to be covered before there is a consensus on a minimum rate of tax and a basis for reallocation of profits.