By: Gonzalo Manzano
With the frenetic, progressive, and massive irruption of the Internet in the world, business paradigms worldwide began to change drastically. With connectivity, it is no longer necessary to wait months to receive an answer to a business offer, nor is it necessary to mobilize large amounts of bills in briefcases to pay for big deals. Phone calls no longer require a cable to be made, and it has even been possible to replace face-to-face meetings with video capture calls; the vertical integration of production chains has also accelerated and become more widespread.
This change also burst into the economy as a new universe, immaterial, with huge amounts of information arriving from one side of the world to the other in seconds thanks to small, ordered electronic pulses that became data. This new market and digital economy opened up new business opportunities, new products, and new ways of creating wealth. All this immateriality also led to eliminate the tangibility of business, which was an obvious premise when establishing any tax policy: wealth paid taxes where it was produced or by whom it was produced; but since the “place” did not physically exist or there was no certainty in “the person” who produced it, what country could demand that tax? Where is the income produced in this digital economy? Who should pay the tax?
By way of reaction, over the last 14 years, the Organization for Economic Trade and Development (OECD) has focused its tax objectives on generating proposals for member countries (it has even tried to influence outside that group) that reduce the incentives that generate aggressive tax planning, mainly by multinational companies. These efforts have focused on reducing competition between different tax jurisdictions through global standardization of tax rules, and on changing the policy that determines where companies must pay their taxes.
Initially, the systematization of these efforts materialized in the “BEPS Plan” (Base Erosion and Profit Shifting Avoidance Plan), which condensed the ideas into 15 proposed actions for OECD countries that address various aspects of the current global market reality, such as Digital Economy (Action 1), Hybrid Instruments (Action 2), Transfer Pricing (Actions 8, 9, 10 and 13), International Treaties (Actions 6 and 15), among others. Each of them set standardized parameters that, if applied in more and more countries, would imply controlling tax avoidance to a certain extent.
Later, the evolution of these actions resulted in two independent plans: Pillars One and Two. In this series of articles, we will try to systematize these plans, find out their benefits and problems, and learn about their particular implications for developing economies such as those in Latin America. In broad terms, Pillar One focuses on changing the rules on where large multinationals pay taxes, while Pillar Two seeks to establish a global minimum tax. On this occasion, we develop the first of them, in the simplest possible terms. In the following articles, we will comment on the second, present opinions and try to discover strengths, weaknesses, and opportunities for improvement.
The focus of Pillar One is on taxing the income of companies with global profits of €20 billion or more on income taxed in the place where their clients or customers are located.
The basic principles of international taxation have traditionally been two: the worldwide income principle, and the territoriality principle. The choice of one or the other determined which income could be taxed, and which could not. In the worldwide income principle, the main question to be defined is the residence of the person or company, since the principle states that the income of a person/company will be taxed in each tax jurisdiction, to the extent that he/she is a resident of that jurisdiction, regardless of where the income is generated. In some jurisdictions (such as the United States), the principle is even more drastic, in the sense that it is not the residence of the person/company that matters, but his/her nationality (something like “it does not matter where you reside or where you earn the money, if you are a national, you pay taxes here”). In contrast, the territoriality principle disregards who the taxpayer is or where he/she comes from, being concerned with where the income originates: if it is produced within the jurisdictional territory, he/she pays the taxes of that jurisdiction.
In the digital economy, these principles are radically questioned, since they are not sufficient: if the sale is online, where is the income generated; if company ACME 1 sells, ACME 2 distributes, and company ACME 3 produces, and the three are in different jurisdictions, which of them generates the income? Questions such as these do not have a simple answer, since the interests of some countries will necessarily be affected, to the benefit of others. There, Pillar 1 proposes another formula: where the consumer/customer is located, the tax can be levied.
The rule is relatively simple: the income of companies with global profits (before taxes) of more than €20 billion and profitability over 10%, those profits over 10% of profitability, would be taxed at a rate of 25% based on the location of their customers, with this tax being distributed among the jurisdictions in which they are located.
However, a minimum market share threshold is also established for jurisdictions to access a share of that residual tax to be distributed: at least €1 million of the company’s net income must originate in their jurisdiction; or at least €250 thousand of the income, in case of jurisdictions with a GNP of less than €40 billion. Then, the distribution rules are further complicated by the fact that, depending on the type of transaction, the methods of calculation of each share to be distributed differ. And although there is a general distribution rule, there are many exceptions.
In these cases, this residual tax can generate double taxation, as can occur with respect to other income taxes. As a solution, double taxation would be eliminated by generating tax credit for taxes paid in the consumer’s jurisdiction, or directly, by applying exemptions in the countries that tax this income after the residual tax.
In addition to these mechanisms to avoid double taxation, it is proposed that the companies affected by this residual tax should have recourse to a dispute prevention and resolution system that is binding on the parties, to guarantee the effectiveness of this mechanism for these companies.
It could be said that this second iteration of the OECD to avoid the reduction of the tax base and profit shifting attempts to remove the “tax” item from the economic evaluation of new businesses, and at the same time redistribute the tax revenues generated for jurisdictions at a global level, but this “standardization” of taxes could reduce the competitiveness of attracting foreign direct investment in developing countries, or even reduce their opportunities, if these markets do not represent an attractive destination for these large companies.