OECD’s two pillar tax approach needs rework to gain acceptance

The current global transfer pricing (TP) regime allows multi-national enterprises (MNE) to account for only a routine profit in a ‘market’ or ‘source’ jurisdiction for tax purposes and park a substantial portion of their super-profits in low tax jurisdictions (‘tax havens’) using ‘legitimate’ and ‘layered’ structures.

Over the last decade or so, the Organization for Economic Cooperation and Development (OECD)/G20 countries, under their base erosion and profit shifting (BEPS) project, have made a serious attempt to arrive at a framework to make the MNEs pay their fair share of taxes. During this decade, the digital economy also rapidly emerged as a mainstay business model, disrupting the global supply chain and mobility of resources. Globally, tax authorities endeavoured to adapt swiftly and stay in step with the evolving landscape. The OECD’s Two Pillar approach emerged as the favoured means for navigating this new reality. India joined the Inclusive Framework of OECD and voiced the views of the Global South in these discussions.

After many rounds of negotiations, the Two Pillars approach is on the brink of achieving a significant milestone in its journey. Pascal Saint-Amans, a former executive at OECD who spearheaded the project until last year, in his article in the Mint (11 May 2023), expressed hope that the negotiations would conclude under the Indian G20 presidency.

At this juncture, it is valuable to reflect on the trajectory it has traversed thus far and critically evaluate whether it will successfully attain the intended objectives that it had set forth at the start of its journey.

‘Pillar One’ focuses on allocating taxing rights among countries and seeks to undertake a coherent and concurrent review of the profit allocation and nexus rules. Even though this was originally planned to cover all digital companies, in its current form, it would cover only a few larger MNE groups (with a threshold of global revenue of $20 billion and profitability over 10%).

Leaving aside many of the technical aspects on which there is still a need to build consensus, there are many aspects of Pillar One that would come in the way of its effectiveness:

One, the allocation of taxing rights under the formulaic approach may not necessarily reflect the true economic activities or value creation in a market jurisdiction.

Two, the amount to be reallocated (‘Amount A’—25% of profits over 10%) may be too little. India may receive too little allocation in return for withdrawing the equalisation levy. On the contrary, it may reallocate some genuine profits out of India.

And three, it may entail significant complexity and administrative burden for both tax authorities and MNEs and is a likely magnet for litigation as there are too many subjective parameters. The mandatory and binding dispute resolution mechanism may compromise India’s sovereign right to (determine) tax.

‘Pillar Two’ is a levy of top-up tax for the difference between the minimum rate of 15% and the MNE’s effective tax rate (ETR). This is expected to benefit the advanced economies, which are victims of their own design of enabling MNEs to incorporate entities outside their home jurisdiction and artificially park profits in tax havens. For India, Pillar Two is inconsequential without a fair and strong Pillar One, and both should be implemented as a package because:

One, Pillar Two will not address situations where foreign MNEs shift profits from India as the top-up tax would be payable in the headquarters’ jurisdiction, not India. Even the subject-to-tax rule (STTR) will not be of benefit due to its narrow scope.

Two, India has a worldwide system of taxation for Indian MNEs, and strict residency rules discourage abusive and round-tripping structures.

Three, India attracts investments based on its underlying economic strength and potential, balanced tax structure and the rule of law. Even after the reduction in 2019, corporate tax rates are well above 15%.

As opposed to OECD’s Two Pillar approach, the United Nations has a solution spearheaded by India. In April 2021, the UN Tax Committee finalised a tax treaty solution (‘Article 12B’) for taxing income from automated digital services by withholding tax on a gross basis. This is likely to generate far higher revenues than the OECD approach and, more importantly, does not restrict sovereign taxing rights of source countries like India. However, this would wholly depend on bilateral agreements and the possibility of the home/residence country state agreeing to give up its taxing rights in favour of the source country.

It is not that the OECD should abandon the Two Pillar approach, but it must be re-oriented to address the concerns of the Global South. India has always favoured a consensus solution that is simple to implement and comply with. At the same time, the solution should result in meaningful and sustainable revenue allocation to market jurisdictions, particularly for developing and emerging economies. It is worthwhile for OECD to align its efforts towards a simpler, sustainable, and flexible solution to elevate the chances of a deal.

These are the authors’ personal views.

V. Anantha Nageswaran, K. Balasubramanian and Smarak Swain are, respectively, chief economic advisor, joint secretary and director in the department of revenue, Government of India.