The OECD/G 20 Inclusive Framework on BEPS (which currently includes 141 countries) continues to work toward a two-pillar solution to international tax reform. This approach is summarized in the October 8, 2021 Statement on a Two-Pillar Solution To Address the Tax Challenges Arising from the Digitalisation of the Economy.
Pillar 1 is focused on shifting more taxing rights from residence countries to market countries (that is, the countries where goods or services are used or consumed). This regime is intended to reallocate more than US $125 billion of profits from approximately 100 of the world’s largest and most profitable multinational enterprises (MNEs) to countries worldwide. In particular, under so-called amount A, 25 percent of “residual profits” (that is, profits exceeding a threshold of 10 percent of revenues) would be allocated to market countries, to be attributed in accordance with a revenue-based allocation key, and subject to certain de minimis exceptions. Profits would be computed by reference to financial accounting income, with some adjustments.
Initially, this regime would apply only to MNEs with global revenues above €20 billion. However, contingent on “successful implementation,” this threshold is to be reviewed in seven years and could be reduced to €10 billion. So-called extractives and “regulated financial services” would be excluded from the regime.
Under a “marketing and distribution profits safe harbour,” the residual profits allocated to a market jurisdiction under amount A could be capped if they are already taxed in that jurisdiction (for example, if they are attributable to a permanent establishment in that jurisdiction). However, further work is under way on the design of this safe harbour and on various other definitional and implementation matters, including mechanisms to address double taxation and tax certainty (that is, dispute prevention and resolution mechanisms).
In addition, under so-called amount B, the application of the arm’s-length principle (that is, transfer-pricing rules) to in-country “baseline marketing and distribution activities” will be “simplified and streamlined,” with a particular focus on “low capacity countries.” Here, too, additional work is being undertaken and is expected to be completed by the end of 2022.
There remains considerable uncertainty as to whether pillar 1 will be adopted in the United States (and other countries). Canada is moving ahead with its alternative digital services tax (which will come into effect for 2022 and subsequent taxation years if pillar 1 is not successfully adopted by the end of 2023). The United States has indicated that it may impose retaliatory tariffs against countries (such as Canada) that impose digital services taxes—on the basis that such taxes unfairly discriminate against US-based MNEs.
Pillar 2 proposes a 15 percent global minimum tax. This regime is intended not to eliminate tax competition but to put multilaterally agreed limitations on it. Through these limitations, this regime is intended to raise around US $150 billion in new revenues annually, from a broader range of MNEs than those affected by pillar 1 (though qualifying international shipping income is excluded), and these revenues are to be allocated among countries through a complex set of interlocking and alternative charging provisions.
The global minimum tax is also designed to operate on the basis of adjusted financial accounting income and adjusted accounting tax expense, with a view to calculating an “effective tax rate.” A form of minimum tax would arise if the effective tax rate is lower than 15 percent on a jurisdiction-by-jurisdiction basis. Because there are various differences in many countries between financial accounting income and taxable income, even a country with a much higher nominal tax rate can have an effective tax rate for financial accounting purposes that is below the minimum rate. Examples of factors that give rise to such differences include the impact of accelerated tax depreciation, bonus depreciation, certain tax credits, and other items. A limited substance-based income exclusion provides that the minimum tax does not apply on income of up to 5 percent of the aggregate of payroll costs and tangible asset costs. (During a 10-year transitional period, the exclusion will be based on higher percentages—beginning at 10 percent of payroll costs and 8 percent of tangible asset costs, and declining over the period.) Companies that incur losses for tax purposes may nevertheless be taxable under the global minimum tax.
The global minimum tax comprises two main rules: an income inclusion rule (IIR) and an undertaxed payments (or profits) rule (UTPR)—together, the global anti-base erosion (GloBE) rules. A separate, treaty-based “subject to tax rule” (STTR) may also apply to deny reduced withholding taxes on certain payments that are not subject to tax at a rate of at least 9 percent. (The 2022 budget notes that the STTR is not expected to affect Canada.) Primary taxing rights will generally remain with a source country (that is, the country where underlying income is earned), under its normal tax rules or under a permitted “qualified domestic minimum top-up tax” (QDMTT). However, if that source country does not tax the relevant income at a sufficiently high rate, the country in which the ultimate parent company of the group is resident (or an intermediate parent country) will generally be permitted to impose a top-up tax (TUT) under the IIR. (There is also a priority rule for countries in which a “partially owned parent entity” is located.) While the IIR is generally not applied to earnings in the jurisdiction of the ultimate parent entity, that jurisdiction may choose to apply a domestic IIR. To the extent that any portion of the TUT is not paid under the IIR in a relevant parent country, the UTPR would then apply on a residual basis. Any residual TUT is allocated among residual countries that have implemented a qualified UTPR and in which an MNE has operations (including a parent country) according to the relative proportion of the MNE group’s employees (by number rather than payroll costs) and the value of tangible assets in the jurisdiction.
The UTPR represents a significant departure from current international tax principles: the proposed regime could allow Canada (and other countries) to tax the income of a sister company or parent company regardless of the country’s lack of nexus to that income. It remains to be seen whether this approach is contrary to existing treaty obligations. For example, saving clauses, such as article 27(3) of the Canada-UK tax treaty, that allow Canada to tax a Canadian resident on its share of the income of a controlled foreign affiliate in which it has an interest do not appear to apply to income of a non-resident sister company or parent company.
The GloBE rules are intended to apply consistently, such that the amount of TUT in respect of a constituent entity is generally the same regardless of which GloBE rule is being applied or which jurisdiction is applying it (though see below for comments on the US GILTI regime).
As has been noted, the GloBE rules also contemplate that the source country may impose a QDMTT. By imposing a QDMTT, the source country could ensure that it (rather than a parent country or another country in which the group has operations) has priority to collect any TUT, although this is not entirely clear: the rules also contemplate that taxes imposed under a controlled foreign corporation (CFC) regime (such as Canada’s FAPI rules) are included in the covered taxes of the jurisdiction to which GloBE income is allocated—thus potentially reducing TUT. The mechanism for doing this is unresolved, especially where the CFC taxes are paid in an intermediary jurisdiction.
Although the global minimum rate is 15 percent, several countries have chosen to maintain lower tax rates in light of the substance-based income exclusion. In addition, countries may choose to impose lower tax rates on MNE groups that are not subject to the GloBE rules—for example, if these groups have consolidated income below the €750 million threshold. Paying taxes locally may also be preferable to many MNEs, given that this is more consistent with the location of their real economic activity.
Many countries, including Canada, use tax incentives or government grants to attract and promote investment. Pillar 2 may effectively claw back these incentives. This may compromise a country’s ability to promote domestic investment and to attract foreign investment through income tax measures, or it may result in countries shifting toward non-income tax incentives that are less heavily affected by pillar 2.
At present, countries with tax rates close to 15 percent may seek to attract foreign investment through their relatively favourable tax rates coupled with other factors (for example, a favourable regulatory environment). The introduction of the GloBE rules may render these jurisdictions even more competitive, by eliminating the current tax advantage of jurisdictions with lower rates and non-taxing jurisdictions.
It is anticipated that many high-tax countries will adopt a comprehensive version of the GloBE rules, although it remains to be seen how far these countries will benefit from doing so. Given their existing high tax rates, it is unlikely that these countries will collect significant TUT in respect of domestic entities through a QDMTT, except in sectors that enjoy significant tax incentives (which may be restructured). Furthermore, it is unlikely that high-tax countries will have much TUT to collect in respect of subsidiaries in low-tax countries if most of those low-tax countries enact a QDMTT (or otherwise modify their domestic tax rules), especially if the low-tax countries also introduce non-income tax incentives. As a result, taxpayers may still have an incentive to shift income (and underlying economic activity) from high-tax countries to lower-tax countries, though the tax benefits of doing so may decrease. The result could then be (1) no collection of materially new taxes by the high-tax countries; (2) an increase in taxes collected by low-tax countries; and (3) a decline in economic returns repatriated to the ultimate parent company and its shareholders.
All countries (including Canada) should re-evaluate the tax incentives they offer in the context of the GloBE rules. Unless they are redesigned, the GloBE rules may negate the benefits that these tax incentives were intended to offer. Consider, for example, a country that offers an R & D tax credit that does not meet the definition of a qualified refundable tax credit (QRTC) under the GloBE rules. A QRTC is considered income under the GloBE rules, while a non-QRTC is treated as a reduction to tax expense. Thus, a QRTC has a smaller impact on the reduction of the effective tax rate, and thus on triggering TUT. A country’s R & D tax credit might be redesigned to qualify under the definition of QRTC. Moreover, high-tax countries such as Canada could consider attracting new investment through special low-taxed regimes (such as a patent box regime—the implementation of which, according to the 2022 budget, is being considered by Canada), given that the jurisdictional blending of low-taxed income in a high-tax country may prevent the TUT from arising.
A shift to non-tax incentives may also occur, which will make it difficult to compare different jurisdictions in terms of the attractiveness of investing in them, because non-tax incentives can be fragmented and less transparent and their benefits can be difficult to compare across MNEs.
The Canadian government has indicated a clear desire to proceed with pillar 2. However, it is not entirely clear what benefits Canada will obtain from doing so. First, Canada initially anticipated a significant increase in tax revenues, though it recognized in the 2022 budget that this increase is currently difficult to estimate (particularly because most financial modelling is static—without taking into account the anticipated responses of other countries and MNEs). As noted above, to the extent that source countries enact a QDMTT (or otherwise modify their income tax regimes), there may be very little TUT to collect in Canada under an IIR (or UTPR). Regardless, the economic returns to Canadian-based MNEs will likely decrease to the extent that additional taxes are paid to other jurisdictions.
Second, incentives to locate economic activities abroad (rather than in Canada) will likely remain—particularly for (1) MNEs to which pillar 2 does not apply, (2) MNEs that may realize a material benefit from the substance-based income exclusion, or (3) corporations that otherwise find the 15 percent minimum tax rate sufficiently attractive compared with the domestic Canadian tax rate.
Third, as Canada and other countries adopt pillar 2, the relative competitiveness of US-based MNEs will likely improve. It is anticipated that the US GILTI regime will be permitted to co-exist with the GloBE rules (assuming that proposed amendments to apply GILTI on a country-by-country basis are enacted)—possibly in a manner that provides a comparative benefit to US-based MNEs. In addition, as a result of the enactment of the GloBE rules, competitors to US MNEs (such as MNEs based in Canada) will now be subject to a new global minimum tax.
Fourth, the collection of any QDMTT (or new income taxes) by traditional low-tax jurisdictions could allow those countries more funding and flexibility to potentially attract investment through other incentives (such as reduced personal taxes; reduced VAT or other indirect taxes; subsidized education; and health care)—which could continue to attract investment to those jurisdictions (and away from Canada). Countries will need to ensure that any new non-income tax incentives are not closely linked to the taxes collected under the GloBE rules, or else they could potentially taint the “qualified” status of those taxes.
Fifth, the GloBE rules may encourage the segmentation of businesses that are seeking to fall below the €750 million consolidated revenue threshold so as to avoid the application of the rules. The “cliff” effect disadvantages those businesses that exceed that threshold by even $1.
Additional work on the GloBE rules remains to be done as part of the implementation framework.
Finally, the Canadian government indicated in the 2022 budget that Canada intends to implement the GloBE rules in 2023 (together with a QDMTT), with a UTPR to follow in or after 2024. Canada has also launched a consultation on pillar 2. Interested parties are invited to send written representations by July 7, 2022. Industry associations and MNEs affected by pillar 2 should consider making submissions before this deadline in order to ensure that their voices are heard, especially because these rules may significantly affect Canada’s competitiveness globally and because of the current challenging economic environment.
Patrick Marley
Osler Hoskin & Harcourt LLP, Toronto
Penelope Woolford
KPMG LLP, Toronto
International Tax Highlights
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