Two-pillar approach: potential domestic impact of a paradigm shift in international taxation

The challenges of the digital economy were the primary reason for the implementation of pillars one and two of the BEPS project. The impossibility of delineating a clear boundary between the digital economy and the traditional market led to the substitution of this initial objective with a shift towards revenue allocation and minimum taxation rules, ultimately resulting in a generalised minimum tax project applicable to all sectors of the global economy.

Of potentially greater consequence is the broadening of the application of the BEPS project in accordance with the fiscal sovereignty of participating states, transforming it into a domestic minimum tax. The scope of this tax would encompass any income taxpayer not demonstrating an effective tax rate (ETR) of at least 15%, regardless of whether its activity is confined to the domestic market.

A slowing economy presents risks in the tax consolidation process, as the national tax base is reduced, and, with it, the collection of direct and indirect taxes. Although it is difficult to think that companies in a country with high rates and broad bases would have ETRs lower than 15%, the existence of multiple tax incentives and benefits creates an opportunity to obtain additional resources through the establishment of this tax. This would likely garner broad political consensus, structured under a principle of progressivity and with an impact on the most favoured classes, although this would not necessarily be in line with the reality of the tax.

Trade and industry have accompanied humankind since the beginning of the civilisation process and the consolidation of modern states. The possibility of using products in their natural state evolved into a need to transform them in order to exchange them and improve life expectations and satisfy basic needs.

Trade was used, from its origin, as a source of financing for the incipient orders of power in the fiefdoms, ‘city-states’, and ‘metropolis-colonies’, and continues to be a fundamental component of tax collection in modern states.

The transformation processes find their initial turning point with the first industrial revolution, in the 17th century, also known as the ‘coal revolution’, which gave birth to a new social group: the ‘entrepreneurs’. The business sector continued its expansion with the ‘gas revolution’ in the 19th century, the electric and electronic revolutions of the mid-20th century, and the ‘internet revolution’ at the end of the 20th century and the beginning of this era. The profits generated by entrepreneurs’ capital are another source of tax revenues. On January 9 1799, the British Parliament approved the first income tax, and this tax spread to practically every country in the world.

Until the internet revolution, domestic trade taxation processes were relatively simple thanks to the implementation of sales taxes. The economic distortions that this could represent with respect to international trade have been resolved since the beginning of the post-war period with the establishment of value added taxes by origin that eliminate or reduce the export burden through exemption or 0% rate mechanisms.

However, the incipient models of income taxation became a barrier to the development of transnational business activities, discouraging and unbalancing transformation for international exchange purposes. Corporate income tax is mostly established in countries under the ‘world income’ modality, which implies the accumulation of income in the taxable base of a resident of a state, regardless of the place or places where it is generated and regardless of whether the income would also have been taxed with the domestic income tax in the other source place.

The negative externality generated by the coexistence of taxing power and its sovereign exercise in different jurisdictions on the same taxable wealth was resolved, with relative efficiency, through the execution of international treaties to avoid double taxation and through the adoption, in the domestic legislation of countries with worldwide income schemes, of rules for the crediting of income tax paid in the source jurisdiction.

There are antecedents of binational or multinational treaties or agreements going back to the end of the 19th century (treaties of reciprocal administrative assistance between Belgium, Luxembourg, the Netherlands, and France of 1882). However, it was not until 1923 that the then League of Nations (today, the UN) created a committee of technical experts to model an agreement to solve the problems of international double taxation in income tax matters, giving rise in 1928 to the first model treaty. Initially structured as a source-based taxation system, it evolved in the following years towards a residence basis with limited effects at source.

In 1963, the OECD issued the Draft Double Taxation Convention on Income and Capital, to be applied on the conclusion or revision of bilateral treaties. In 1977, the OECD issued a new model agreement, which is still in force today.

These bilateral treaty models for the avoidance of international double taxation resolved, with relative efficiency, the negative externalities observed in cross-border business activity due to the overlapping of taxes, under the principle of recognising and harmonising the sovereignty of states over acts performed in their territory (source or territorial taxation) and the same sovereignty exercised over their fellow citizens (residence or personal taxation).

Tax harmonisation is achieved through apportionment rules that grant one of the contracting states the exclusive right to exercise its domestic tax sovereignty over the classified source of income and recognising or limiting the other contracting state’s residual taxing power.

Thus, in the distribution of the various sources of income, those derived from entrepreneurial activity were excluded from the territorial taxing power to be transferred entirely to the sovereignty over the resident, except when this activity is carried out through the constitution of a permanent establishment in the country of the source.

The models encountered challenges in their application, stemming from the two fundamental components on which they are based:

• Residence; and

• Beneficial ownership.

It is well established that the lack of clarity in the conceptualisation of the latter component gave rise to opportunities for tax avoidance or outright tax evasion.

The relative efficiency of treaties in avoiding double taxation was seriously eroded with the fourth industrial revolution, derived from the internet and the evolution of information and communication technologies. This transformed the conventional models of commercialisation, with physical presence in the country of the source, into digital or remote schemes based on the use of intangibles and without requiring a fixed place of business in the states where the source of consumption is located, thus globalising commercial activity, with low costs and great benefits.

In addition, the expansion of jurisdictions with low taxation regimes facilitated the transfer of valuable intangibles, business matrices, and sources of value added to these destinations, locating the profits generated there and reducing the tax collection capacity of countries with a large consumer market.

The tax impact was enormous, according to OECD data, which can be consulted in the BEPS Project Explanatory Statement to the 2015 final BEPS reports. The global income tax collection decreased by an estimated amount of between $100 billion and 240 billion per year, equivalent to between 4% and 10% of the total profit of multinational companies.

Faced with this global problem, in 2012 the OECD formed a multinational group whose objective was to analyse, diagnose, and provide suggestions compatible with state sovereignties to reduce the tax impact observed and derived from the use of low-tax jurisdictions and the strategies resulting from the digital economy.

This group – which quickly expanded to form what is now known as the Inclusive Framework (IF), with more than 130 countries actively participating – delivered its first results with the issuance of the 15 BEPS actions, which are designed to be included in member states’ domestic legislation and close tax avoidance and evasion loopholes.

However, and this was recognised by the IF, the efforts were not enough to correct the distortions and tax imbalances generated by the digital economy. Therefore, the work continued until 2023, when a ‘two-pillar approach statement’ was issued to address the tax challenges arising from the digitalisation of the economy.

The two pillars focus on restoring to countries their tax collection and taxation capacities eroded by:

• Technological progress;

• The transformation and globalisation of trade patterns; and

• The race to zero taxation resulting from pressure from low-tax jurisdictions.

Although they can be considered complementary, each of the pillars has a different focus and different implementation mechanics, which can be summarised as follows.

Pillar one does not imply a new tax but a redistribution of the current tax burden to correct or compensate for the disproportionate allocation of multinational enterprises’ (MNEs’) profits in jurisdictions with lower tax rates and the erosion of the tax base in countries where substantive activities are carried out because the consumer or user market is located there.

This pillar is instituted under the ‘minimum standard’ principle, which implies that the IF countries must implement it in their jurisdictions within the timeframe set by the group itself.

Pillar two: imposing a global minimum tax on multinationals

Pillar two constitutes a new tax, designed to operate on a multinational basis under an integrated system of minimum taxation on non-routine profits (surpluses or extraordinary profits) of MNEs. While seeking fair tax collection in the market countries where substantive activities are carried out, pillar two seeks to establish a global minimum burden that avoids or reduces tax competition between states and thus slows the race towards ‘zero taxation’.

This pillar is instituted under the ‘common approach’ principle, which implies the sovereign freedom of each state over whether to implement it in its jurisdiction. However, in the case of doing so, it must be implemented according to the requirements and conditions established by the IF.

It should be noted that neither of the two pillars replaces the existing international tax regime or its architecture based on the concepts of ‘residence’ and ‘source’ but, rather, complements it by providing an additional layer of rights and obligations to privilege the burden and allocate it to the right market and in the right amount.

Pillar one is intended to redistribute the residual profits of the world’s largest, most profitable, and globalised MNEs, as it only applies to companies with global revenues in excess of €20 billion and pre-tax profits in excess of 10% of their revenues (profitability), and provided they operate in two or more market jurisdictions.

The redistribution will be made on 25% of the residual profits (those derived from the 10% profitability surplus) based on a factor resulting from dividing the income generated in each jurisdiction by the total global income of the MNE, and only those states in which more than €1 million is generated as income (or €250,000 in countries with a GDP of less than €40 billion) will participate in the reallocation.

The system has rules structured as a ‘protection regime’ to avoid double taxation on residual profits, through tax exemption or imputation mechanisms, so that, endogenously, the current tax burden is maintained and only a redistributive effect is observed.

The systemic design implies that, at least in theory, low-tax jurisdictions that generate unfair tax competition end up with diminished tax bases and ceding taxable base to states with large domestic markets in which consumers or users are potentially located. However, this is not necessarily linked to the population factor, since consumption in large low-income markets is marginal in the overall operation, and in export-orientated countries, this component of the economy does not generate redistribution.

Even with the deficiencies generated by the differences in purchasing power in the domestic market, the redistributive objective of pillar one appears to be laudable and to the benefit of less-developed states. However, it will make foreign investment in them indifferent or non-beneficial, which could unbalance capital decisions in favour of countries that have more solid and robust infrastructure and do not currently grant tax stimuli.

In addition, less-developed economies in many cases do not find endogenous strengths in their taxation system, which would not allow them to integrate, with relative certainty, the redistribution bases to their jurisdictions. Aware of this flaw in the system, the IF established two determination formulas for the calculation of the redistributable income:

• Amount A, to be determined based on the consolidated and adjusted financial statements of the MNEs; and

• Amount B, which will be determined by a formula through the simplified and agile application of the arm’s-length principle in less-complex activities such as marketing and distribution carried out in countries with lower taxation capacities, provided that the subsidiary in question is not the owner of valuable intangibles, that it assumes significant economic risks, or that it has operating expenses greater than 30%.

Amount B is facing the greatest challenges in the IF discussions and although there is consensus on the applicable methods (net operating margin or comparable free price, the latter for commodities), a final definition for its implementation has not yet been established.

Pillar two involves the inclusion in legislation of a new minimum or supplementary tax to be applied to companies with global operations with revenues of more than €750 million.

The legal architecture will be novel compared with existing tax models, as two fundamental components will not be defined in the customary legislative manner:

• The taxable base; and

• The applicable tax rate.

The basis will be determined using the GloBE rules, which rely on adjusted financial results and may differ from the tax basis traditionally defined in the domestic legislation of each jurisdiction.

Unifying the taxable base and dissociating it from that established by each country implies disregarding the tax incentives granted and applied, or applicable, to the companies of the group in the country in which they operate, either as tax residents or as permanent establishments. It also acts as a control mechanism to counter tax burden reductions resulting from aggressive tax strategies.

The second essential component that differs from the traditional tax architecture is the rate of the levy. Unlike what is common in terms of the principle of legal certainty, the rate will not be fixed, unique, or known ex ante, but it will result in a personal, variable, and ex post determination rate.

The rate will result from the difference between 15% and the ETR of the entity in the jurisdiction in question, provided that the latter is lower than the former. To determine the ETR, companies will consider the taxable income determined in accordance with GloBE income and the covered taxes.

According to the GloBE rules, the financial accounting result will be determined in accordance with the accounting standard applied by the parent company and will be adjusted to align the accounting-tax base, eliminating duplications or limitations in deductions, computing intragroup transactions at arm’s-length values, and eliminating the effects derived from negative externalities (illegal payments and fines, among others).

The complexity of the pillar two system does not derive, in the author’s opinion, from the calculation of the complementary or minimum tax to be paid by MNEs, since the rate, although variable, is easy to determine and the base will be known by the companies as it is derived from their own consolidated financial statements. The complexity derives from establishing mechanisms that compensate for legislative deficiencies of the participating states and that would generate loopholes or escape routes from the minimum tax burden.

The pillar two system starts with the establishment in domestic legislation of the legal basis for the collection of a qualified domestic minimum top-up tax (QDMTT). Under this architecture, each MNE will determine the base, rate, and complementary tax payable in each jurisdiction with nexus and will proceed to pay the same.

However, there should be consideration, and this was established, of the case in which a jurisdiction did not establish the QDMTT in its territory and therefore the MNEs would no longer pay the minimum tax in that jurisdiction, generating a transfer of benefits to that jurisdiction to reduce its tax burden or ETR.

For this assumption, the BEPS project provided for the establishment of an income inclusion rule (IIR), which is conceptually similar to the controlled foreign corporation rules in that the ultimate parent entity is taxed in relation to the low-taxed profits obtained by the group in low-tax jurisdictions that do not implement the QDMTT.

The order is established with a top-down approach so that, in principle, the jurisdiction of the ultimate parent company has pre-eminence in tax collection. Thus, assuming that the standalone parent undertaking (SPU) is not subject to an IIR at its place of residence, other jurisdictions in the intermediate or lower parent companies controlled by the SPU will be able to collect the minimum tax.

Finally, there is a second collection mechanism established in the BEPS ‘macro’ rules that operates in default of the QDMTT and the IIR, through the undertaxed taxable income rule, which allows a jurisdiction to disallow income tax deductions on payments that are considered undertaxed until the threshold of the complementary minimum tax is reached.

The mechanisms of pillars one and two, acting in a linked and interoperable manner, achieve the desired tax policy objective of maximising tax collection while minimising distortions on economic agents. This is attained through generality and applying homogeneous effective rates on multinational companies, while making taxpayers indifferent to the tax benefits of low-tax jurisdictions – except for a temporary space – and to the incentives or subsidies that feed the race to zero taxation. At the domestic level, implementation may result in a high-impact instrument for closing tax avoidance gaps.

However, given the uncertainty that currently surrounds all economies due to trade wars and the implementation of tariffs, and tariffs lacking a structured and sustainable support, the introduction of these new tax burdens, whether domestic or global, may result in an additional component of economic deceleration. That result, far from bringing more direct revenue to the states, would lead a loss of tax burden that would deepen the complexity of moving towards tax consolidation.