Globalization and digitalization have changed the picture of today’s international tax system. MNEs fragment production and spread economic activities across several countries. The relevant implication of such business models for Corporate Income Tax (CIT) may be the shift of profits from high-tax jurisdictions to low-tax jurisdictions.
Whereas aggressive tax planning is arranged by MNEs, governments also play an important role because as a result of such developments in business models, they are engaged in tax competition to attract this mobile capital, be it through “real” foreign investment or the establishment of “artificial” shell companies.
Addressing the challenges of digitalization of the economy has been at the heart of global debate through the BEPS project and the Inclusive Framework (IF). The members of IF agreed to assess two proposals in two pillars which would form the basis for a consensus on tax challenges that arise from digitalization. Pillar One discusses a new nexus approach for the allocation of profit of specific business fields such as automated digital services and consumer-facing businesses, whereas Pillar Two establishes the introduction of a global minimum effective tax rate on profits of the multinational groups.
Pillar Two is part of the ongoing efforts by the international community, led by the OECD, to combat tax avoidance and base erosion. It aims to establish a global minimum tax rate and introduces the concept of the “Global Anti-Base Erosion” (GloBE) proposal. The primary objective of Pillar Two is to ensure that multinational enterprises (MNEs) pay a minimum level of tax regardless of where they operate or where they shift their profits.
The impact of Pillar Two on Aggressive Tax Planning (ATP) structures and its effectiveness from a Harmful Tax Competition perspective
The implementation of Pillar Two in practice has had a significant impact on ATP structures and has been viewed as an effective measure in addressing harmful tax competition.
From the perspective of ATP structures, Pillar Two has significantly curtailed the effectiveness of such arrangements. ATP structures are typically used by multinational corporations to exploit gaps in tax laws and shift profits to low-tax jurisdictions. These structures often involve complex arrangements, such as hybrid mismatches, interest deductions, or controlled foreign company rules, to minimize tax liabilities.
Pillar Two directly addresses these strategies by introducing two interrelated rules: the Income Inclusion Rule (IIR) and the Undertaxed Payment Rule (UPR). The IIR requires jurisdictions to include income in the tax base of a taxpayer if it is subject to an effective tax rate below the globally agreed minimum rate. This ensures that income is not artificially shifted to low-tax jurisdictions. The UPR complements the IIR by denying deductions or imposing withholding taxes on certain payments made to jurisdictions that do not meet the minimum tax rate threshold. These rules effectively limit the ability of ATP structures to achieve tax advantages.
The implications of carve-outs
The inclusion of carve-outs in Pillar Two can have implications for harmful tax practices and ATP structures, potentially influencing their effectiveness and the overall impact of the measure.
Carve-outs refer to exceptions or special provisions within Pillar Two that allow certain types of income or entities to be exempted from the minimum tax requirements. These carve-outs are typically introduced to accommodate specific policy considerations or to address legitimate concerns raised by certain jurisdictions.
The implications of carve-outs on harmful tax practices and ATP structures can vary depending on the nature and extent of the exemptions granted. Here are a few possible implications:
Persistence of Harmful Tax Practices: Carve-outs can create opportunities for jurisdictions to continue engaging in harmful tax practices. If certain income types or entities are exempted from the minimum tax requirements, it may enable jurisdictions to attract investment and profit shifting by offering preferential tax treatment. This can perpetuate a competitive environment that encourages aggressive tax planning and erosion of tax bases.
Resilience of ATP Structures: Carve-outs may preserve the viability of ATP structures in specific circumstances. If certain income or entities are excluded from the scope of Pillar Two, multinational enterprises can potentially exploit these carve-outs to continue utilizing complex tax planning strategies and shifting profits to low-tax jurisdictions. This undermines the effectiveness of Pillar Two in addressing base erosion and profit shifting.
Complexity and Administration Challenges: The introduction of carve-outs can add complexity to the implementation and administration of Pillar Two. Determining the eligibility and applicability of carve-outs requires clear definitions and guidelines, which may vary across jurisdictions. This complexity can create challenges in ensuring consistent and effective enforcement of the minimum tax rules, potentially leading to loopholes and disputes.
Potential Policy Trade-Offs: Carve-outs can reflect policy trade-offs made during the negotiation process. While these exemptions may address specific concerns or accommodate diverse national tax systems, they could dilute the overall impact and effectiveness of Pillar Two in combating harmful tax practices and ATP structures. Balancing the need for consensus among participating jurisdictions and achieving the desired level of tax fairness can be challenging.
It is important to note that the extent and implications of carve-outs will depend on the specific details and provisions included in the final agreement reached by the participating jurisdictions. The careful design and implementation of carve-outs will be crucial to mitigate unintended consequences and ensure that Pillar Two remains an effective tool in addressing harmful tax competition and ATP structures.
The application of the carve-outs in Pillar Two was subject both to strong support and criticism. Some jurisdictions believe that such carve-outs would weaken the main objective of Pillar Two which is putting a floor to tax competition and others believe that carve-outs are inevitable.
The adoption of Pillar Two would not be at a fully global scale as developing countries need to compete over CIT rates to attract capital. As long as there is no global consensus over a global ETR it seems that the ATP structures introduced are going to be resilient by migrating to jurisdictions that do carve-outs mentioned above. The application of carve-out protection of genuine business activities, however defining the jurisdictional ETR formula in a way that inclusion or exclusion of carve-out in the denominator is ambiguous, is an effective way to circumvent GloBE rules at least in theory.
As low ETR is one of the criteria for recognition of states tax behavior as harmful competition, one may be able to assume that harmful tax competition regarding low ETR rates may continue even after Pillar Two to some extent. Although the rules apply multi-layer CFC-like taxation, if it is assumed that 15% minimum ETR is the border between harmful tax competition and tax competition as a positive feature, it can be concluded that Pillar Two effectiveness from a prevention of harmful tax competition perspective, is based on the EU jurisdiction that applies it. To be more specific the application of rules does not guarantee the minimum taxation of 15% if the MS transposing Pillar Two chooses to calculate ETR in a manner that leads to an inflated rate.
The full impact of Pillar Two on ATP structures and harmful tax competition will only be evident once it is implemented and integrated into domestic tax systems. The success of this measure will depend on the commitment and cooperation of jurisdictions worldwide, as well as effective enforcement mechanisms to ensure compliance.
For advice on the intricacies of Pillar Two implementation, contact one of our professionals.
Author: Roya Rezaiee, Junior Associate, TPA Global