THE OECD PILLARS THAT ARE ABOUT TO CHANGE THE INTERNATIONAL TAX WORLD
Author: Patrick Grant McLennan
The OECD’s Pillars 1 and 2 represent the biggest changes to the international tax paradigm since the initial model tax treaties of the late 1920s. Read our article to see whether the move away from the tax treaty system means that the days of low-tax jurisdictions are due to come to an end.
After much anticipation in the tax world, on 12 October 2020 the Organisation for Economic Cooperation and Development (OECD) released the blueprints on Pillars 1 and 2 ? the recommended approach to the taxation of the digital economy. The public was requested to provide input by 14 December, which will have passed by the time this article has gone to press. Now, the tax world is in another waiting game for the finalised reports, which are due to be completed mid-2021.
Perhaps now is a good time to reflect on the potential structural changes which may result from the implementation of the Pillars. A key aim of the Pillars is to address structural issues related to the taxation of the digital economy, particularly attributed to perceived base erosion and profit shifting (BEPS) from high-tax jurisdictions to low-taxation jurisdictions (with little to no substance). If implemented, the Pillars will represent a shift from the existing tax treaty network to a multilateral and consensus-based approach, reliant on complex formulaic-type mechanisms and a mixture of quantitative and qualitative scoping factors. Will these changes shift the attractiveness of low-tax jurisdictions for corporate structuring? Probably not. However, to understand this hypothesis, we need to explore how the world got to the current international tax infrastructure and the facts that led up to the OECD Pillars.
How did we get here?
The modern tax treaty network, including the concepts of alleviating issues of double taxation, go back nearly 100 years to the aftermath of World War I and the creation of the League of Nations, the ill-fated predecessor of the United Nations. Amongst many factors, war and subsequent tax burdens (to largely fund rebuilding efforts) pushed the concept of double taxation to the forefront of policymakers? and businesses’ concerns. The threat of double taxation was viewed as a hindrance to the movement of capital, which could otherwise help war-ravaged economies rebuild. In an effort to address these issues, the League, which is often reviled for its post-war peace-keeping efforts, entered into the fray of double taxation.
The League of Nations subsequently published a number of commercial reports on double taxation, including the Double Taxation and Tax Evasion Report, presented by the General Meeting of Government Experts on Double Taxation and Tax Evasion (1928). In essence this provided the model treaty for the prevention of double taxation in the sphere of ?impersonal or personal taxes?. As a result, hundreds of international tax treaties were entered into through 1939.
The 1920s was a short-lived era in international cooperation; not necessarily due to issues of double taxation, but the economic and political fallout from the Great Depression and its aftermath, and the rise of fascism in Europe and the outbreak of World War II.
It was not until the post-World War II era (roughly 1945 through to the 1960s) that international cooperation was, again, taken seriously. This era is best known for the subsequent founding of some of the key international institutions that we still recognise today, including the United Nations, World Bank, International Monetary Fund, General Agreement on Tariffs and Trade (now the World Trade Organisation), and the OECD.
The first draft OECD Model Tax Convention occurred in 1963 and, then, only a few dozen tax treaties were in place. However, now, according to the OECD, over 3 000 treaties are in place, which generally follow the OECD approach.
Flash forward to today
The world?s economy looks very different than it did in the 1920s and 1940s?1960s. Not only are we trading more services and tangible goods across borders due to the facilitation of more globalised trade (communication and travel advancements also helping to enhance these), but the digital economy is more relevant than ever. Now, we are interacting with friends and family via the internet and, specifically, social media networks like Facebook; purchasing products through e-commerce marketplaces like Amazon; or even double-checking historical facts (e.g., for this article) through Google. Even 30 years ago, these things would have been largely unfathomable.
The previous ?founding? eras for the current tax treaty system, the 1920s and 1940s – 60s, did not account for this digital economy. While the system accounted for physical presence, or nexus, in devising tax treaties, they may not cater for a transaction, or entire business for that fact, where the user?s or consumer?s activities are in South Africa, but the enterprise is located in Seattle (for example).
Hence, the OECD Pillars are here to address this very issue. In fact, the first paragraph of the blueprint on Pillar 1 reads: ?[W]eaknesses in the current rules create opportunities for base erosion and profit shifting (BEPS), requiring bold moves by policy makers to restore confidence in the system and ensure that profits are taxed where economic activities take place and value is created?.
Here, in the form of the Pillars, are the first steps in the bold moves. Whilst the Pillars rely more or less on the infrastructure of the existing tax treaty network, they also seek to confront their pitfalls in light of the characteristics of a twenty-first-century economy. The Pillars represent a large-scale change to the way we look at the international tax system, and a multilateral and consensus-driven solution, rather than one that is based on bilateral negotiations of tax treaties.
In short, Pillar 1 focuses on nexus and profit allocation, whereas Pillar 2 is focused on a global minimum tax intended to address remaining BEPS issues. Pillar 2, referred to as Global Anti-Base Erosion (or GloBE) is an international tax framework where countries can tax income earned in other countries if that income is taxed below a minimum effective rate. The Pillars represent the updated work related to BEPS Action 1, which identified the various broader tax challenges related to the digital economy. As such, if the Pillars are addressing BEPS, does that mean that tax authorities will see a movement of profits away from low-tax jurisdictions?
Goodbye low-tax jurisdictions?
It is suggested that many multinational enterprises operating in the digital economy are the perpetrators of BEPS, not only due to the inadequacy of the existing international tax infrastructure to deal with the digital economy, but also through complex corporate structures that often utilise companies in low-tax jurisdictions. Famous cases include Apple (in Ireland) and Amazon (in the EU).
Will low-tax jurisdictions become less relevant for multinational enterprises, particularly those party to the ?digital economy?? The bold answer to this is no. First, and mostly obvious, people do in fact live and work in jurisdictions with low corporate tax rates. For example, Dubai, United Arab Emirates, which is often seen as a ?low-tax jurisdiction?, is home to over 3 million people and two of the world?s major global airlines and has become a global hub of technology innovation. (The World Expo was supposed to occur there in 2020, but was delayed due to the ongoing pandemic.) If tax authorities think they will make places like Dubai less attractive by only focusing on tax, they are in for a surprise, or at the very least they will be let down.
Remember, taxation is one of many factors multinational enterprises consider when it comes to corporate structuring. Companies, or at least the ones I have interacted with, are concerned about tax certainty rather than tax rates ? they want to do business. There are other factors that are also significantly important. According to the 2019 World Bank ?ease of doing business? index, this includes the ease of:
Starting a business
Dealing with construction permits
Getting electricity
Registering property
Getting credit
Protecting minority investors
Paying taxes
Trading across borders
Enforcing contracts
Resolving insolvency
Furthermore, in terms of the ?paying taxes? category ? the ?sub-factors? focus on more procedural items (like timing to comply with refunds and tax return corrections) rather than the rate at which tax is paid. The top five countries in the index are New Zealand, Singapore, Hong Kong, Denmark and South Korea. Of these, only Singapore and Hong Kong are sought as ideal locations for multinational enterprise tax structuring, but the others have, arguably, high corporate income tax rates.
I would add to the World Bank?s index that such factors as protection of intellectual property and capital, limited or ease of exchange control, proximity to key suppliers and supply chains, and government transparency and the strength of government-adjacent institutions (including an independent and efficient judiciary) are also critical to business decision-making. In fact, they are probably more important factors.
So, will the Pillars force companies to rethink structuring their businesses in low-tax jurisdictions? Probably from a technical and compliance standpoint ? because change is coming. However, taxation will not be the only factor to force wholesale changes. The infrastructure exists through the tax treaty network to reduce the uncertainty around double taxation (but not eliminate it). The Pillars may bring this up to speed with the characteristics of a twenty-first-century (digital) economy. However, low-tax jurisdictions are likely here to stay.
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This article first appeared on Jan/Feb 2021 edition of Taxtalk
