The OECD is optimistic about a two-pillar package being negotiated into the summer. However, some countries are wary of signing up to another set of rules without clarity of the order of how those rules will be applied.
Speaking at an online conference held by Oxford University’s Centre for Business Taxation on May 5, Victoria Perry, deputy director at the Fiscal Affairs Department of the IMF, called the rule order question “the elephant in the room” for developing countries.
“Civil societies and tax groups working with them are opposed to the notion that the income inclusion rule [IIR] will take precedence over the undertaxed payments rule [UTPR] where residence countries will get first crack at whatever the top-up is, based on minimum tax under pillar two,” she said.
“Though the subject to tax rule comes first, it doesn't entirely fix this issue since in many cases it would require treaty re-negotiation and doesn't apply to all the payments that seem to be important for developing countries,” she added.
Perry pointed out that several low-income countries in sub-Saharan Africa that belonged to the Inclusive Framework already had unilateral variants of the UTPR. “Those that belong would have to agree to eliminate or not impose their existing undertaxed payments rules if pillar two goes forward with the income inclusion rule taking precedence,” she said.
“Rule orders of income inclusion rule and the undertaxed payments rule, is ongoing work but its components are pretty stable, both in design and understood functionality,” said Achim Pross, head of the International Cooperation and Tax Administration division at the OECD’s Centre for Tax Policy and Administration.
Civil societies and tax organisations working with developing countries have proposed a change in rule order with a compromise, where the IIR rule favours residence countries and the undertaxed payments rule favours source countries.
“Their proposal would eliminate the difference, allocate some additional taxing rights to each country, which they refer to as a minimum effective tax rate proposal [METR]. Aside from compromising so that there's no priority of residence and source, it brings in a formula apportionment approach and a unitary tax base,” said Perry.
With 137 members of the Inclusive Framework who have their views on minimum taxes, the cost of the proposed minimum tax is seldom addressed. “We shouldn't be fooling ourselves to think we could broadly enact more taxes and not change taxpayer behaviour,” said Mindy Herzfield, professor of tax law at the University of Florida.
“If what we're trying to do is impose more taxes on foreign earnings of resident companies, we’re making foreign investment, making outbound investment more expensive. Necessarily, we're taxing it more. So, we must assume that a corollary will be less outbound investment,” said Herzfeld.
Many low-income countries don't want to minimise their ability to offer effective investment incentives. So, there's a tension between applying the minimum tax to all profits, which would make the effect of such investment incentives lower versus just applying it to economic rents in excess profits.
“From the point of view of maximising their revenue they should be for the former but from the point of view of offering effective investment incentives they should really be for the latter,” said Perry.
The rationale for leading with the income inclusion rule is that it makes compliance and administration much easier than the undertaxed payments rule, according to Pross.
“The rule order is sometimes exaggerated. We shouldn't assume that rule order determines who gets the money. I don't think we will see an income inclusion rule without some form of an under taxed payment rule. I know that some civil societies have other ideas, but it is a simpler way. Companies already file country-by-country (CbC) reports that generate a certain level of compliance cost that we can leverage off,” said Pross.
“The undertaxed payments rule is the more complicated rule as it has more coordination with countries and more risks of double taxation with information not as easily available to tax administrations,” said Pross explaining how a solid minimum tax in several countries could do away with excessive rules, essentially "decluttering the system".
Low capacity countries who want the undertaxed payments rule more need some sort of simplification according to Perry. “Trying to figure out the relevant effective tax rate to decide whether you have an undertaxed payment is very difficult,” said Perry.
Perry believes that the idea of a substance carve-out is also aimed at advanced countries. “Low-income countries want a system that would let them reduce the effective tax rate on certain investments, but not have it captured by the minimum tax,” she said.
“There's tax sovereignty and then there's telling them they shouldn't have these tax incentives because they need the tax base. It's very hard to say that to people if they feel they have to compete with each other for direct foreign direct investment,” she added.
IMF officials believe that even with the proposed rule order, low-income countries should benefit under the IIR because it reduces the incentive to lower their tax burdens on investment. This effect is stronger if pillar two goes forward on a country-by-country basis, rather than a blended basis.
The importance of minimum tax rates for developing countries is to reduce the level of tax competition, but these countries might have to give up offering effective investment incentives in the process.
