Taxation in a digitalised economy
Taxation in a digitalised economy In the second of their two part article, Gavin Gafan, Senior Tax Manager and Vickram Khatwani, Tax Director, Deloitte, focus on the proposals of the OECD’s Pillar Two
On 5 June 2021, the G7 group of largest economies communicated a high-level agreement on global tax reform, including the reallocation of the global residual profits of the largest businesses to market jurisdictions and a minimum effective tax rate on profits in each country in which businesses operate.
These reforms follow from the G20/OECD “Two Pillar” approach addressing the tax challenges arising from the digitalisation of the economy. The OECD has published two detailed “Blueprints” on potential rules for addressing these challenges.
In July 2021, the OECD Inclusive Framework on Base Erosion and Profit Shifting (“Inclusive Framework”), released a statement confirming that, as of 5 July 2021, 131 jurisdictions (including Gibraltar) have agreed to this “Two Pillar” approach.
In the last edition of this publication, a summary of the Blueprint on Pillar One was provided, covering the allocation of taxing rights between jurisdictions, which considered several proposals for new profit allocation and taxable presence (nexus) rules.
The second Blueprint, on Pillar Two, proposes a set of interlocking international tax rules designed to ensure that large multinational businesses pay a minimum level of tax on all profits in all countries as set out below.
A.The Income Inclusion Rule and the Undertaxed Payments Rule
These rules have been designed to ensure that large multinational groups pay tax at a minimum level in each jurisdiction in which they operate, and is governed by the following:
- Income Inclusion Rule – This principle rule triggers additional ‘top-up tax’ payable in a group’s parent company jurisdiction where the profits of group companies in any one jurisdiction are taxed at an effective rate below a global minimum tax rate; and
- Undertaxed Payments Rule – This captures any low-taxed group companies not controlled by a parent company subject to the Income Inclusion Rule.
- The minimum tax rate for the purposes of the Income Inclusion Rule and the Undertaxed Payments Rule will be at least 15%.
B. The Subject to Tax Rule
This is a separate rule which has priority over the above cited rules. Applied on a payment-by-payment basis, paying jurisdictions will be able to charge a ‘top-up tax’ in respect of specific types of intra-group payments made to other group companies, where the recipient jurisdiction has a nominal tax rate less than the minimum tax rate.
The minimum tax rate for the Subject to Tax Rule will be between 7.5% and 9%.
Scope and operation of the Income Inclusion Rule and Undertaxed Payments Rule
The Inclusive Framework statement of July 2021 confirmed that multinational groups with consolidated revenues of at least EUR 750 million (or equivalent) would be in scope of these rules. Several entities/organisations are excluded from scope, which include but are not limited to investment funds, pension funds, governmental entities, international organisations and non-profit entities.
Any tax due under the Income Inclusion Rule would be calculated and paid by the ultimate parent company to its tax authority. Where the parent company jurisdiction has not implemented this rule, payment would need to be calculated and made by the next intermediate holding company in the ownership chain. The tax due is the ‘top-up’ required to bring the overall tax on the profits in each jurisdiction, where the group operates, up to the minimum effective rate. A similar rule (switch-over rule) is expected to allow parent jurisdictions to top up the tax on income of overseas Permanent Establishments (PE) to the minimum rate.
The Undertaxed Payment Rule applies in cases where the effective tax rate in a jurisdiction falls under the minimum rate, but where the Income Inclusion Rule has not been applied either by the ultimate or intermediate holding company. In this instance the required ‘top-up tax’ is allocated to other group companies by employing a formula-driven approach based on the amounts of deductible payments made by other group companies to the low-taxed company.
Effective Tax Rate (ETR)
The annual ETR required for any given jurisdiction will account for:
- Total covered taxes – These are taxes on a group company’s income or profits (domestic and foreign taxes). Indirect, digital services, employment and property taxes are not covered taxes; and
- Profit or loss before tax – This would be for each group company as used in the preparation of the parent company’s consolidated financial statements subject to a small number of adjustments.
The Blueprints also includes carry -forward provisions (e.g. on losses) to reduce the effect on temporary differences on the volatility of effective tax rates; formula-based profit carve-outs; simplification measures aimed at reducing the number of jurisdictions for which detailed annual effective tax rate calculations are required; simplified Income Inclusion Rules for associates and joint ventures.
Scope and operation of the Subject to Tax Rule
This rule allows for the taxation at source (i.e. withholding tax) as well as adjustment of the eligibility for treaty benefits on certain items of income where a payment is undertaxed in the jurisdiction of the recipient.
The rule applies to payments between connected persons, where the tax rate applicable to the recipient company, is below the agreed minimum rate.
The rule may apply to certain categories of payments deemed to be high-risk from a base erosion perspective, including but not limited to interest, royalties, insurance/reinsurance premiums, brokerage/financing fees, and fees for the supply of marketing, procurements, agency or other intermediary services.
Consistent with other Pillar Two rules, investment funds, pension funds, governmental entities, international organisations and non-profit entities may be excluded from scope. In addition, payments made to or by individuals are not within scope.
At their most recent meeting, the G7 agreed that the minimum effective tax rate in each country in which a business operates should be at least 15% (whereas the OECD Blueprint on Pillar Two was silent on what the minimum effective tax rate should be). Following this, the Inclusive Framework released a statement confirming that 131 jurisdictions agreed to the “Two-Pillar” approach.
Notwithstanding the inroads made to date, it is expected that significant further technical work is needed, and going forward, the Inclusive Framework members will agree and release an implementation plan, under which it is contemplated for Pillar Two to be brought into law in 2022 and to be effective in 2023.