Issue 297: 2021 10 21:Taxing Business

21 October 2021

Taxing Business

International action at last.

By John Watson

It doesn’t exactly stir the blood.  There is no derring-do.  There are no scantily clad foreign adventuresses with a revolver in one hand and a dry martini in the other.  It is unlikely to terminate any political careers or lead to any executions or conquests, and yet the news that 136 countries have agreed to support OECD proposals for the taxation of multinational businesses is as exciting as anything in this month’s papers.

To recap for a second, the rules surrounding international taxation were designed in the 20th century for the pre-digital economy.  In those days it seemed sensible to tax profits where the work or assets which created them were situated but, with the advent of multinational businesses and with modern communications, these rules have proved to be out of date.  Crucial assets like intellectual property are often owned by subsidiaries in tax havens so that the huge profits attributed to them go untaxed.  It has proved possible to keep tax in the customer’s jurisdiction to a trivial level by minimising a group’s presence there – an unsatisfactory system where the customer base is the one thing you cannot move and multinationals are often in competition with local firms.

So, how did governments react?  A number of countries including the UK began to create their own digital services taxes to at least extract some revenue from the cyber industries, and the OECD was tasked to come up with a global plan.  It did so in July and it is that plan which is the subject matter of the new agreement; the idea is that the local taxes should disappear with the OECD’s proposals being implemented towards the end of next year.  There is a lot to go through before then.

For a start, the deal needs to be ratified by Congress and other countries too will have to enact legislation.  That sounds like a nightmare, but public feeling on tax avoidance by large companies is strong and the agreement the week before last has put the wind firmly in the OECDs sails.  Then there is lots of detail.  It is one thing to agree in principle and quite another to come out with model legislation which, if enacted by participating countries, will prove sufficient to protect the new tax base against the efforts of international lawyers and accountants.  It is worth reflecting on these for a minute.

As those who have followed this topic (and that will include assiduous readers of this column) will know, the proposals have two pillars.  The first applies only to groups whose global turnover exceeds €20 billion and whose profit margin (pre-tax) is more than 10%.  Such groups will now find themselves taxed in jurisdictions to which they sell goods or services of a substantial value.  Normally the required nexus for sales to a particular jurisdiction is €1 million.  Where, however, the jurisdiction has a GDP of less than €40 billion, the nexus level is reduced to €250,000.  Where a multinational group is caught by the legislation, 25% of its excess profits, that is profits in excess of 10%, is allocated to those jurisdictions where it has achieved the nexus rather than to the place where those profits are generated.  To that extent those jurisdictions will benefit from tax on its activities.

To avoid double taxation, the taxation of profits in consumer jurisdictions has to be matched by a reduction of the profits taxed in the jurisdictions where the work or intellectual property behind those profits is situated and it is here that the wide acceptance of the rules is so crucial.  The 136 countries which have signed up are not merely agreeing that they will obtain more tax by reference to their consumers but also that they will lose tax on profits locally created but where the sales are made abroad.

So how does this new consumer tax base need to be protected?  A multinational group cannot easily change the markets into which it sells so it should be difficult to avoid the legislation completely.  An alternative would be to reduce the level of profits by increasing group debt by, for example, arranging for the group to be acquired by a leveraged acquisition vehicle.  Expect, then, to see restrictions on refinancing.

An alternative approach might be to split a group into two independently owned entities so that the profits arose in the one which made no international sales.  Again, expect to see anti-avoidance provisions dealing with this subject.

One of the interesting things about this pillar of the legislation is the exclusion of extractive groups and financial services.  The first is not surprising in that if you work a mine the profit should be, and is already, taxed in the jurisdiction where the mine is situated.  The second seems to be based on the idea that applying the new code to financial services would be too complicated to be practicable.  That too is probably right.

The second pillar of the reforms is the minimum corporate tax rate of 15%.  Here the only exclusion is for shipping profits.  This seems to be because of concern that otherwise the registration of all ships would be attracted to jurisdictions which kept out of the agreement and applied very low rates.  Although 15% is much above the rate of tax paid by many multinationals it is not high enough to stop tax avoidance being worthwhile.  Corporation tax rates are often above that and, where they are, it will still be worth, subject to what is said below, trying to design a structure which ensures that the profits arise in a 15% country.  Was the 15% level designed with a view to keeping tax lawyers and tax accountants in business by leaving worthwhile savings on the table?  No, the rate was exhaustively negotiated between those countries which sought to attract business with a low rate of corporation tax and those which did not.  It is not wonderful but it’s better than where we were – apparently to the tune of $150 billion a year across the globe.

The obvious avoidance step would be to place activities in those jurisdictions which do not adopt the new rate, and to prevent this a compensating “top up tax” is to be charged on the parent companies of multinational groups with revenues over $750 million.  There are various flexibilities here but the most important is the right of a country to set its top up tax by reference to a higher rate than 15%.  That enables the parent company to tax group profits at a higher rate.  Provision is also to be made for withholding tax on payments to companies paying tax at below the 15% rate.

The extraordinary thing about all this is not that the OECD has finally come up with coherent proposals but that they have managed to get them agreed so widely.  The OECD has been trying to deal with international tax avoidance for a long time and it is only now that the international pressure has been sufficient to enable them to do so.  How has that pressure being exerted?  Through countries like the UK threatening to go forward with their own regimes unless something was done internationally.  The criss-cross of inconsistent regulation would have been a nightmare for business and at least the proposals mean that multinationals will face a single regime reducing the prospect of eccentric outcomes.  Bezos once pointed out to Boris Johnson it was up to the politicians to set up an international regime for the taxation of multinational enterprises.  At last, through the OECD, they may have risen to the challenge.

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