by Rakesh Nangia, Neha Malhotra

The Global Consensus

Recognizing that in the digital era, taxing rights can no longer be confined to physical presence, the world, in 2017, set out to formulate a solution for taxation of digital economy that is universally accepted. 8th October 2021 was an important juncture – 136 members of OECD/ G20 Inclusive Framework (IF), representing more than 90% of the global GDP, have finally achieved a consensus on several key aspects of the two-pillar solution. Broadly, Pillar One would formulaically reallocate profits of around 100 of the world’s largest and most profitable Multilateral Enterprises (MNEs) to market jurisdictions, regardless of the entities’ physical presence. Pillar Two on the other hand, seeks to restrain competition over corporate income tax amongst countries through the introduction of Global Minimum Tax. The OECD estimates that under Pillar One, taxing rights on more than $125 billion of profit will be reallocated to market countries each year. Likewise, Global Minimum Tax under Pillar 2 is expected to generate around $150 billion additional global tax revenues annually. Additional benefits in the form of stabilisation of the international tax system and the increased tax certainty for taxpayers and tax administrations, are also expected to be attained.

What’s new?

In July 2021, the IF reached a milestone with the adoption of a broad framework for the two-pillar solution. Certain key decisions were left for further deliberation and finalization in October. True to its word, the OECD, in its recent statement, has tied up several loose ends and has enumerated previously unresolved quantitative parameters.

The solution sets out that MNEs having global turnover in excess of 20 billion Euros and pre-tax profitability of 10% of turnover, would be covered by the new virtual nexus rules. Extractives and Regulated Financial Services have been specifically excluded from the scope. It has been agreed that 25% of residual profits of an in-scope MNE, in excess of routine profits comprising of 10% of revenue, shall be allocated to the market jurisdictions with nexus, using revenue-based allocation key. Mandatory arbitration for effective and speedy dispute resolution in respect of ‘Amount A’ has also been agreed upon. Separately, under Pillar Two, global minimum tax rate has been pegged at 15%. The rate would apply as a standard tax rate to a defined corporate income base worldwide. Governments would still be able to set their corporate tax rates, but if companies shift profits to low/ no tax jurisdictions, then their country of residence would get the right to ‘top-up’ their taxes to the agreed global minimum tax rate, thereby eliminating advantage due to shifting profits.

A second round of Multilateral Convention (MNC) would be rolled out to facilitate the treaty changes and effectuate the two-pillar approach. The unilateral measures taken by various countries thus far to levy tax on digital transactions would be repealed in a phased manner and no new Digital Taxes would be imposed by the signatories till the enforcement of MLC.

Plenty to do

With the October statement and implementation plan in place, the process is expected to gather momentum towards the operational phase involving negotiation, signature, ratification and adoption of MLC. Consensus is eagerly awaited on several open issues that remain unaddressed. For instance, it is not clear as to how Transfer Pricing Provisions and dispute resolution mechanisms such as Advanced Pricing Agreements (APAs) would co-exist with the proposals.

The statement reveals that segmentation, for determining Pillar One scope will occur only in ‘exceptional circumstances’. However, what shall constitute ‘exceptional circumstances’ is yet to be defined. The proposal for dispute resolution in respect of Amount A is also interesting, since many countries including India may not be open to an international dispute resolution.

Further, it has been provided that where the residual profits of an in-scope MNE are already taxed in a market jurisdiction, a marketing and distribution profits safe harbour will cap the residual profits allocated to the market jurisdiction through Amount A. Marketing and Distribution profits safe harbour design still needs to be deliberated upon.

Imposition of tax involves two essential elements- a tax base on which tax is levied and a tax rate. While agreement on tax rate has been achieved, a definite standard base/ taxable income would need to be defined. Profit determination happens to be the starting point for both Pillar One and Two (i.e. for determination of in-scope entity, profit attribution, effective tax rate etc.). However, the accounting rules/ standards to be followed while computing ‘profits’ remain in the pipeline.

Discussion shall also be required regarding the possible interplay of 3 treaties simultaneously- the Bi-lateral Treaties between two nations, the MLI if in force and the MLC for Digital Taxation. Additionally, clarity is needed regarding the definition of ‘extractives’ and ‘regulated financial services’ that have been excluded from the new MLC framework. The work with respect to Amount B is also expected to be wound up by 2022, which involves the application of arm’s length principle to the in-country baseline marketing and distribution activities, with particular focus on the needs of low capacity countries.

Although the motive of the two-pillar approach was to address the tax challenges arising from digitization, but the solution does not restrict itself to digital businesses only. Thus, businesses engaged in sale of goods and services through digital modes shall also fall within the virtual nexus rule, subject to prescribed thresholds. Incidentally, the recently updated UN model convention has kept its scope curtailed, to only ‘digitally driven businesses’ and does not apply to physical goods or customised services provided digitally. The model would have been easier to adopt and administer, however, all countries seem to have compromised for the overall interest and to achieve a global consensus.

What is in store for India?

The world was already embracing digitization rapidly, the emergence of the COVID 19 pandemic accelerated the process. Digital business including online advertisement, digital content services, online gaming, search engines, online teaching, cloud computing, etc. has grown multi-fold. This led to the undertaking of unilateral measures such as the Equalisation Levy (EL) and Significant Economic Presence (SEP) to tax digital businesses. However, these measures do not garner support from other countries across the globe. The office of the United States Trade Representative (USTR) initiated investigation against the taxation of digital services adopted by countries, including India on the grounds that it ‘burdens and restricts commerce by subjecting US companies to additional tax burdens’. In such a scenario, a consensus based solution seems to be the best way forward to attain the twin objective of attaining tax certainty and ensuring a level-playing field.

Considerably, the two-pillar approach seeks to tax only the ‘largest and most profitable MNEs’, while the prevailing EL encapsulates more corporates in the tax net on account of lower threshold. However, in view of the ambiguity around the EL
provisions, despite three phases of amendments, a universal law appears to outshine.

Overall, achieving a global consensus in itself is significant and historic development. All countries seem to be willing to help each other rather than prospering at the cost of other. The next few years would be crucial for digital businesses as the world
awaits the end result of the ambitious project.

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Our Experts

Rakesh Nangia

Chairman

Neha Malhotra

Executive Director