Are you ready for the challenges ahead of you?

Aamer Rafiq Transfer Pricing and Tax Policy, Partner, PwC United Kingdom 22 October, 2020

The work that the Organisation for Economic Cooperation and Development (OECD) has been carrying out over the last few years in overhauling the international tax system (particularly around the digitalisation of the economy) is now reaching a critical tipping point. On the 12th October, the Inclusive Framework (IF) released their Blueprint documents around this work. These are by no means consensus documents and this, in itself, points to some of the issues inherent in the work done to date and what this could mean for the future.

The IF agreed to “swiftly address the remaining issues with a view to bringing the process to a successful conclusion by mid-2021.” Although no agreement has been reached on the substance of the Blueprints, the reports provide a “solid foundation for a future agreement” and reflect “convergent views on a number of key policy features, principles, and parameters of both Pillars, and identifies remaining political and technical issues where differences of views remain to be bridged, and next steps.”

The bottom line is that financial services (FS) companies now have the information they need to start planning for a more complex future and potentially higher effective tax rates (ETRs).

Background to the project

To recap, the purpose of the OECD work on international tax reform was to address the perception that,  over the past 30 years, companies have been allowed to generate significant profits in relation to a jurisdiction without paying a commensurate amount of tax there.  The OECD’s work has comprised two aspects (or pillars as the OECD refers to them):

Pillar I looks at reallocation of taxing rights. This approach essentially takes a portion of the group consolidated financial profits and, on that basis, allocates a share of profit to market jurisdictions.

Pillar II looks at creating a system whereby a multinational group would be subject to a minimum effective tax rate on income arising in low tax jurisdictions. In summary, the OECD work looks at four aspects:

  • The income inclusion rule (IIR) operates as a top-up tax when income of controlled foreign entities are taxed below an effective minimum tax rate. 
  • The switch-over rule (SoR) complements the IIR by removing treaty obstacles in situations where a jurisdiction uses an exemption method that could frustrate a top-up tax being applied to branch structures. 
  • The undertaxed payments rule (UTPR) serves as a backstop to the IIR through application to certain constituent entities. 
  • The subject to tax rule (STTR) would help source countries protect their tax base by denying treaty benefits for deductible intra-group payments made to jurisdictions with low or no taxation.

The IIR and UTPR (collectively, known as GloBE) under Pillar II would be applicable to multinational enterprise (MNE)  groups with more than €750 million in annual gross revenues. The tax base uses the financial accounts of the parent entity to calculate an ETR after taking into account covered taxes (broadly of an income nature), as well as allowing for recognizing losses and providing for a formulaic substance carve-out to exclude certain fixed returns.

The political dimension

There is a political backdrop to the October 12 publications. Most notably, a few months ago the United States Treasury called for negotiations of Pillar I to be put on hold to enable the US and other countries to focus on responding to the economic issues arising from the COVID-19 pandemic.The clear inference was that it would be difficult to agree on anything before the US elections. Linked to this, at the beginning of June the United States Trade Representative started investigations into digital services taxes considered by several trading partners, including the European Union and the United Kingdom; this added a political dimension to the work at the OECD and negotiations between the country delegates. Whilst most countries other than the US are calling for the work on Pillar I and II to be moved forward, it is now clear any political agreement is more likely to occur in the first half of next year, rather than later this year.

In addition to the Blueprints, the OECD released a new report addressing the anticipated effects the Pillar I and Pillar II proposals might have on countries’ tax revenues and economic investment. The report relies on a combination of firm-level and aggregate data sources, including Country-by-Country Report data, and predicates its Pillar II modelling using a 12.5% minimum tax rate. Taking into account the combined effect of the Pillar II proposals and the US Global Intangible Low-Taxed Income (GILTI) regime, the total effect could represent US$ 60-100bn per year of new revenues (or up to around 4% of global corporate income tax  revenues). The exact revenue gains, of course, would depend on the final design and parameters of the two pillars, the method of implementation, and the behavioural response by multinationals and governments. 

Regarding the potential investment effects, the report argues that Pillar II could lead to a relatively small increase in the average post-tax investment costs of multinationals. The OECD report estimates only a small negative impact on global investment based on its belief that the proposed pillars would mostly affect highly profitable MNEs whose investment is less sensitive to taxes. The report further states that the impact is expected to fall “on MNEs engaging in profit shifting in the case of Pillar Two.” Overall, the OECD predicts that the negative effect on global GDP stemming from the expected increase in tax revenues associated with Pillar I and Pillar II is estimated to be less than 0.1%.

What happens next?

The Pillar II Blueprint recognizes that a number of issues remain open for political decision, including: 

  • The need for some co-existence mechanism of the GloBE rules with the US GILTI regime;
  • The amount of the minimum rate; and
  • Whether calculation of ETR should occur on an aggregate versus jurisdictional level.

The Blueprints will be discussed at the 14-15 October virtual G20 Finance Ministers’ Meeting. Based on the documents sent to the G20, the finance ministers will likely offer an extension of time to negotiate a consensus political agreement until some time in 2021. The Pillar I and Pillar II Blueprints will be subject to a public consultation from Oct 12 through December 14, with a virtual consultation to take place in January 2021.

What do the Blueprints say for the financial services industry?

For Pillar I, the positive news for the financial services industry is that the current Blueprint indicates that financial services will be outside the scope of Pillar I (at least in respect of Amount A, which deals with the reallocation of ‘non-routine’ profits to market jurisdictions). This is on the basis that FS firms generally have a physical presence in the countries where they have an economic presence due to the highly regulated nature of the business. As such, they generally do not generate significant profits in a jurisdiction without having a physical presence. This is in line with the paper released by the OECD in January 2020. Pillar I will instead focus on ‘automated digital services’ and ‘other consumer facing businesses’, subject to certain nexus standards and revenue thresholds.

For Pillar II, at present, no industry or sector carve outs are envisaged. However, the Pillar II Blueprint includes a carve-out for investment structures within the asset and wealth management sector. There has been a lot of dialogue with the investment management industry on investment structures, on the basis that it is a commonly accepted principle that such structures are not generally subject to tax, to ensure that there is no distortion in investing indirectly compared to investing directly, and that including investment structures would introduce unintended distortions into the capital markets. It is also clear that it is not the policy intention of Pillar II to introduce a minimum tax to investment structures.

The impact for FS clients is all about Pillar II and the minimum tax regime. Here are some highlights:

  • Geographic footprint of your organisation will be key and could impact ETRs. Much of the Pillar II work was initially more of a European initiative but this has gained more traction with other countries. Clearly, those with a wider geographic footprint, and particularly industries that utilise offshore jurisdictions are also likely to be impacted significantly. Depending on the overall tax profile of the market jurisdictions we can expect that, on average, the ETR for financial services companies will increase.
  • The significant reliance on financial and accounting information will increase compliance burdens. There is a very large reliance on accounting information and there is an assumption implicit in the Blueprint that data is available within organisations. Given this will need to be done on a jurisdictional blending basis, these calculations will also need to be done for each entity potentially (subject to simplified administrative processes). This will undoubtedly mean the creation of new financial processes to carry out the necessary calculations, as well as increased compliance requirements for different jurisdictions.
  • Organisations may be forced to make hard commercial decisions. Given the potential consequences as detailed above, organisations will need to assess the benefits of interacting with economies against the resultant consequences as outlined above and also the collateral impact, such as regulatory and reputational concerns. 

So, what should financial services companies be doing at this moment? 

The Pillar II Blueprint presents significant detail on how the minimum tax regime could work. It’s likely that there may be jurisdictional nuances but the overall framework is broadly built out. There is now sufficient detail to begin modelling scenarios and conducting sensitivity analysis in order to determine what the overall impact could be from an ETR impact for your organisation. Finally, the impact of complying with these requirements should not be underestimated, especially given the underlying calculations and data requirements that will be needed and the fact that implementing such a system could take significant resources and time.

Aamer Rafiq
Partner, Tax Policy & Transfer Pricing, PwC UK

To get the latest on these developments visit our OECD Pillars 1 and 2 update webpage. Regular content including alerts, bulletins, videos and related resources will be featured here.