FULGENCE SSENDAGALA KAJUBI: Tax Challenges in the Digitalized Economy and the Two-Pillar Solution

You may recall that in our first to third episodes, we have been elaborating the effects of international taxation more especially on the Multinational Enterprises. Many areas have been tackled including the taxation of digitalized economies, the effects of globalization, the impact of technologies, the application of BEPS by multinational to shift the profits  in low tax havens or areas where there is no taxes at all and the OECD 15 point Action plans to address the BEPS challenges.

 In addition to the BEPS Action Plan, international efforts against tax evasion and avoidance have been strategized by the  OECD/G20 through the  Inclusive Framework on BEPS. It must be noted that given the fact that the developing countries have a higher reliance on corporate income tax as a source  of their revenues which means that  they suffer from BEPS too. The World has become a global village due to the development in technology, many businesses operate internationally hence, governments must act together to tackle BEPS and restore trust in domestic and international tax systems.

Thus  working together in the OECD/G20 Inclusive Framework on BEPS, over 135 countries and jurisdictions are implementing 15 Actions to tackle tax avoidance, improve the coherence of international tax rules, ensure a more transparent tax environment and address the tax challenges arising from the digitalization of the economy. The inclusive frame work on BEPS is intended to make sure that the BEPS package of 15 measures tackle tax avoidance, improve the coherence of international tax rules goes in line with collaboration and ensure a more effective and transparent tax environment.

 Many countries on the continent including Africa have joined the framework with the urge of addressing the tax challenges arising from the digitalization of the economy. The Inclusive Frame work came up with the Two-pillar plan that was intended to reform the international taxation rule and ensure the multinational enterprise pay a fair share of their tax regardless of their presence in any jurisdiction. The total number of countries/jurisdiction participating in the agreement so far are above 135

The rationale for the two-pillar plan or package included the following;

1. To ensure that a fairer distribution of profits and taxing rights among countries with respect to the largest multinational enterprises including digital companies is adhered to
2. It would re-allocate some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether firms have a physical presence there.
3. Pillar Two seeks to put a floor on competition over corporate income tax, through the introduction of a global minimum corporate tax rate that countries can use to protect their tax bases. 

Like many proposals the two-pillar solution contains a number of points on which members of the OECD/G20 Inclusive Framework on BEPS must still agree. A complete set with an implementation plan to develop model legislation, guidance and a multilateral treaty was done in 2022, with implementation to commence from 2023

The agreed key components of each Pillar are outlined below.

Pillar One 

This pillar details the key components by detailing what the scope will be, the Nexus, Quantum Revenue sourcing, Tax base determination, Segmentation, Marketing and distribution profits safe harbour ,Tax certainty, Amount A& B, Administration, Unilateral measures  and the implementation plans. 

Scope 

In pillar two statement to address the tax challenges of digitalization, the scope for companies will be the multinational enterprises. 

The global turnover for these multinationals must be above 20 billion euros and profitability in terms of profit before tax above 10% with the turnover threshold to be reduced to 10 billion euros. Note also that the contingent on successful implementation including of tax certainty on Amount A, with the relevant review beginning 7 years after the agreement comes into force, and the review being completed in no more than one year, In this scope all the Extractives and Regulated Financial Services are excluded. 

Nexus 

There will be a new special purpose nexus rule permitting allocation of Amount A to a market jurisdiction when the in-scope MNE derives at least 1 million euros in revenue from that jurisdiction. For smaller jurisdictions with GDP lower than 40 billion euros, the nexus will be set at 250 000 euros. The special purpose nexus rule applies solely to determine whether a jurisdiction qualifies for the Amount A allocation. 

Amount A applies to MNEs with Revenues exceeding EUR 20 billion and a profitability greater than 10%. It reallocates 25% of the MNE’s profit in excess of 10% of its Revenues to market jurisdictions in which the MNE satisfies the quantitative nexus test, subject to adjustments under the marketing and distribution profits safe harbour. These profits will be allocated in proportion to the amount of Revenues the MNE derives from those jurisdictions as determined under specific revenue sourcing rules  It goes ahead to allocate the Compliance costs which includes on tracing small amounts of sales that would be limited to a minimum

Quantum 

For in-scope MNEs, between 20-30% of residual profit defined as profit in excess of 10% of revenue will be allocated to market jurisdictions with nexus using a revenue-based allocation key

Revenue sourcing 

Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed. To facilitate the application of this principle, detailed source rules for specific categories of transactions will be developed. In applying the sourcing rules, an MNE must use a reliable method based on the MNE’s facts and circumstances. 

Tax base determination 

The relevant measure of profit or loss of the in-scope MNE will be determined by reference to financial accounting income, with a small number of adjustments.  Any Losses will be carried forward. 

Segmentation 

Segmentation will occur only in exceptional circumstances where, based on the segments disclosed in the financial accounts, a segment meets the scope rules. 

Marketing and distribution profits safe harbour 

Where the residual profits of an in-scope MNE are already taxed in a market jurisdiction, a marketing and distribution profits safe harbour will cap the residual profits allocated to the market jurisdiction through Amount A. Further work on the design of the safe harbour will be undertaken, including taking into account the comprehensive scope. 

Elimination of double taxation 

Double taxation of profit allocated to market jurisdictions will be relieved using either the exemption or credit method. 

The entity (or entities) that will bear the tax liability will be drawn from those that earn residual profit. 

Tax certainty 

In-scope MNEs will benefit from dispute prevention and resolution mechanisms, which will avoid double taxation for Amount A, including all issues related to Amount A (e.g. transfer pricing and business profits disputes), in a mandatory and binding manner. Disputes on whether issues may relate to Amount A will be solved in a mandatory and binding manner, without delaying the substantive dispute prevention and resolution mechanism. 

Consideration will be given to an elective binding dispute resolution mechanism for issues related to Amount A for developing economies that are eligible for deferral of their BEPS Action 14 peer review and have no or low levels of MAP disputes.

Administration 

The tax compliance will be streamlined. These will include filing obligations and allow MNEs to manage the process through a single entity. 

Unilateral measures 

This package will provide for appropriate coordination between the application of the new international tax rules and the removal of all Digital Service Taxes and other relevant similar measures on all companies. 

Implementation 

The multilateral instrument through which Amount A was implemented, developed, and opened for signature in 2022, with Amount A coming into effect in 2023. 

Strategic approach for the Two-Pillar Solution 

There are different gaps in the existing rules, which each pillar intends to address which have been allowing the MNEs to avoid paying taxes through their strategic tax planning methodologies. We can try to understand this by looking at each pillar once again and carefully try to see how it has played its role.as below

Pillar one.

• Its major aim is reallocation purposes of the profits earned by these MNES. It demystifies the precedence of Permanent establishments and advocates for the reallocation of part of the profits earned by these MNEs to countries of the source rules in nature. This is to say where they sell their products and provides their services focusing on their consumers. If not the MNES would earn many profits in any market without the fair tax payments in that jurisdiction.

• Pillar One, the agreement includes a commitment to reduce the scope threshold in 7 years 

• The nexus threshold which is the point at which developing countries would see an allocation under Pillar One from an in-scope MNE  is set at a low level from (EUR 1 million, reduced to EUR 250 000 for the smallest countries.

• This is intended to maximize the number of countries that will see revenue benefits; an elective option on tax certainty which will help ensure that countries which have no or only very small numbers of disputes are not tied up in mandatory dispute resolution processes. 

• Pillar one also includes a commitment to develop simplified, streamlined approaches, with a particular focus on the needs of low capacity countries, to the application to transfer pricing rules to certain arrangements that are very often the subject of tax disputes. 

• Evolving countries will gain revenue. With a rate of 15%, the global minimum tax is expected to generate additional global tax revenues per year.

Conclusion

We should note that each pillar addresses a different gap in the existing rules that allow MNEs to avoid paying taxes. It applies to the biggest and most profitable MNEs and re-allocates part of their profit to the countries where they sell their products and provide their services, where their consumers are located. Without this rule, these companies can earn significant profits in a market without paying much tax in such locations. 

Note that Pillar Two will be elaborated in our next write up

The writer is a Certified Tax Advisor & a Member of the Institute of Certified Public Accountants of Uganda (ICPAU )