Historic agreement on international taxation
On 1 July 2021, in an historic agreement, 130 countries have agreed to a statement providing a framework for reform of the international tax rules. These countries are members of an Inclusive Framework of 139 countries, sponsored by the OECD. The agreement is a significant departure from the standard international tax rules of the last 100 years which largely require a physical presence in a country before that country has a right to tax and does not have a floor for tax competition by stipulating a minimum rate. The agreement will set the framework for international company taxation for the next two or three decades, but there are important issues still to be worked out.
It is envisaged this additional detail will be negotiated in the next three months and finalised by October 2021 with the changes coming into effect in 2023.
The agreement has two components which are referred to as Pillar One and Pillar Two. Pillar One reallocates a portion of the profits of very large MNEs with a global turnover above 20 billion euros to market countries whether or not the MNE has a physical presence in that country. The amount to be allocated is yet to be agreed, but it will be between 20 percent and 30 percent of profits above a 10 percent threshold of profit. The total amount to be reallocated globally is expected to be about $USD 100 billion.
Extractives and Regulated Financial Services have been excluded. This exclusion is of particular importance to Australia as it means that the right to tax profits from our large mining countries remains unchanged. If this were not the case, there would have been a potential reallocation of taxing rights to China and India on mining profits.
We are likely to pick up a small amount of additional revenue from the reallocation of profits. This amount would be small because the Australian market for very large MNEs is generally small compared to their global footprint.
One important change on this proposal is that new rules will be developed for solving disputes in a mandatory and binding manner. Traditionally, countries have near complete sovereignty over their right to tax. Now this sovereignty is in part being displaced by a desire to have a strong global dispute resolution mechanism.
Another important element is that the agreement sets a timeframe for determining whether the 20 billion euro threshold should be reduced to 10 billion euros. This review is due to take place around 2030. What is interesting is that over the longer term the number of companies impacted by the new rules is likely to expand.
Pillar Two is a global minimum tax for MNEs with a global turnover of more than 750 million euro. The rate is to be “at least 15 percent” and is determined on a country by country basis. It is estimated that this will raise $US 150 billion of additional tax globally.
Ireland, which has a tax rate of 12.5 percent, was one of nine countries that did not sign-up to the agreement. They did not do so on the basis that they believe that the minimum rate should be 12.5 percent.
The way in which the global minimum tax works is that if a subsidiary of a MNE is taxed at less than the minimum rate, say 15 percent, then the parent of the subsidiary pays top-up tax to bring it up to the minimum rate. However, if the parent is located in a jurisdiction that has not signed up to the rules, then deductions for payments to that company are adjusted to ensure that the minimum tax rate is achieved. There are other rules to ensure a minimum tax rate applies to payments of interest and royalties which will require changes to tax treaties which is a complex process.
Extractives and Regulated Financial Services are not excluded from Pillar Two, although government entities, pension funds and certain investment funds are excluded. International shipping is also excluded, but not airline travel.
Australian MNEs will need to review their structures to see if they remain optimal. They will also need to ensure that their systems are able to meet the additional compliance burden.
Where Australian MNEs have taken advantage of tax incentives by locating operations in a particular jurisdiction, they will need to consider the impact of these rules. While there is a proposed carve-out based on the value of tangible assets and payroll, the rates to be applied are yet to be determined and may not be significant.
There will be much negotiation on the detail of these rules over the next three months, but it should be said that the agreement of 1 July 2021 is quite remarkable in the entire history of taxation.