Taxes: Stepping up Enforcement and Ending the Global ‘Race to the Bottom’
January 11, 2022
The path was paved in 2021 for unprecedented tax developments in the coming years for large businesses, especially for multinationals and investment businesses operating across borders. The year ended with what appeared to be significant progress in the OECD/G-20 “inclusive framework” project, with nearly 140 countries working to fundamentally change some of the ways in which they will tax multinational businesses. 2022 may also bring other new taxes and new tax regimes, amidst enhanced investigations and enforcement action in key jurisdictions like the United States and the European Union.
With the COVID-19 pandemic continuing to weigh on fiscal budgets globally, governments will at some point soon need to recoup lost revenue. The most likely path appears to be new taxes and increased enforcement targeting the world’s largest and most successful enterprises.
Developments Toward Global Agreement on Corporate Taxation for Multinationals
The push for global tax reform received a significant boost in 2021, with broad international consensus reached on the principles of a “two-pillar solution” intended to come into effect, for the most part, in 2023.
Pillar One is aimed at large multinational businesses that have customers in jurisdictions where the business has no or minimal physical presence. Regulated financial services and extractive industry businesses are exempt, and other multinationals are subject to the rules only if they have “global turnover” (i.e., gross revenues) above €20 billion and profitability (i.e., profit before tax/revenue) above 10%. Where the rules apply, 25% of the group’s residual profits (i.e., profits in excess of 10% of revenue) may be allocated to and taxed in market jurisdictions even if the group does not have sufficient presence there to create a taxable nexus under current rules.
For now, the financial thresholds for entry into the regime should mean that Pillar One will have little impact for most businesses, with only approximately 100 global groups likely to be affected. However, there are some knock-on consequences (like the abolition of unilateral digital services taxes as a quid pro quo for the new regime) that will be of wider interest. The next-largest tranche of multinationals should also be aware that the turnover threshold could be reduced to €10 billion once the regime has been operating for a few years.
Pillar Two has the potential for a more far reaching impact. Its purpose is to ensure that large multinationals pay a minimum 15% level of tax on their worldwide income wherever they are headquartered or have their business operations. The rules will apply to multinationals with €750 million or more in consolidated revenues, although sovereign, nonprofit and charitable entities, and pension, investment and real estate funds will be excluded.
The main tool to achieve Pillar Two’s global minimum tax is a global anti-base erosion regime consisting of two components: an income inclusion rule (IIR) and an undertaxed payments rule (UTPR). The idea is that in-scope taxpayers calculate their effective tax rates in the jurisdictions where they operate and pay a top up tax for the difference between their effective tax rate per jurisdiction and the 15% minimum rate. The IIR will generally charge the top up tax in the jurisdiction of the ultimate parent company; the UTPR will act as a backstop if IIR rules do not pick up all of the group’s low-taxed income and will require adjustments (such as a denial of a deduction) to increase tax levels in subsidiary jurisdictions.
There will be limitations, including a de minimis exclusion for jurisdictions where revenues and profits are low, and a substance carve out that excludes certain amounts of income based on the carrying value of tangible assets and payroll.
A further rule is also being developed that would allow developing countries to deny treaty benefits in respect of interest, royalties and certain other payments that are subject to corporate income tax at below 9% in the recipient country, in effect creating a right to tax the difference.
Much work remains to be done on finalizing the detail of the new rules and in providing guidance for taxpayers. It is also worth noting that individual jurisdictions or blocs might adopt local minimum top up taxes on similar but not identical principles. The EU, for example, has announced that it will apply income inclusion rules to purely domestic groups and to multinational groups.
Particular challenges present themselves in the United States. The Biden administration has been one of the most forceful champions of Pillar Two but ended 2021 with a failure to get Congress to enact the Build Back Better Act (discussed further below), which would have brought U.S. tax law into compliance with Pillar Two. Thus, the United States begins 2022 with international tax rules (known as GILTI and BEAT) that conflict with Pillar Two’s IIR and UTPR. The impact of this on the success of Pillar Two (and the timeline for its effectiveness) is unclear.
The United States’ Build Back Better Act
In the United States, the focus in 2021 was on whether the Biden-endorsed Build Back Better Act (BBB), with its far-reaching tax law changes, would be enacted and, if so, with what modifications and when. As of this writing, it appears to be virtually certain that the BBB will not be enacted in its current form. Yet, boards of directors will want to understand how the BBB’s tax provisions would affect their companies, because these provisions could be enacted in 2022 as part of a revised BBB or as part of another legislative package.
The tax provisions in the BBB are almost entirely revenue raisers (i.e., tax increases) intended to (i) fund the social spending provisions that are the heart of the BBB and (ii) achieve certain international and domestic policy objectives (including bringing the U.S. rules into compliance with Pillar Two, as mentioned above). The BBB’s international provisions would make significant changes to the international tax rules enacted at the end of 2017 (by the Trump-era tax reform known as the TCJA). The TCJA basically re-wrote the international provisions of U.S. tax law. In the view of the Biden administration and other Democratic proponents of the BBB, the TCJA has encouraged U.S. businesses to move operations and revenue into foreign low-taxed jurisdictions, contributing to what is referred to as a global “race to the bottom” – that is, non-U.S. jurisdictions lowering their tax rates to attract businesses and jobs and multinationals responding by restructuring operations to take advantage of the tax savings. The BBB was designed to reverse this and therefore is full of provisions that would increase the U.S. taxes on income derived by U.S.-headed multinationals from their non-U.S. subsidiaries. The BBB would also increase the U.S. taxes paid by foreign-headed multinationals with U.S. operations by targeting, among other things, payments made by these U.S. operations to the foreign parent or foreign affiliates. These provisions include changes that would bring the U.S. rules into almost full alignment with the OECD’s Pillar Two rules discussed above.
The BBB provisions in their current form include:
- A new alternative “minimum tax” equal to 15% of financial statement book income, applicable to corporations with profits over $1 billion;
- A new 1% excise tax on corporate stock repurchases;
- Modifications to the GILTI rules applicable to U.S. corporations with non-U.S. subsidiaries, including increasing the tax rate on the non-U.S. income to 15% computed on a country-by-country basis;
- Modifying the rules that apply a lower rate to U.S. corporations’ Foreign-Derived Intangible Income (FDII) so that the rate is closer to the normal corporate tax rate;
- Modifications to the Base Erosion and Anti-Abuse Tax (BEAT) applicable to multinationals that make payments from the U.S. to their non-U.S. affiliates; and
- Modifications to the rules limiting interest deductions to apply a new additional limitation on multinationals that have significant leverage in their U.S. entities.
The BBB’s tax provisions have been of concern to businesses in 2021, not only because of the tax increases but also because of the increase in complexity and uncertainty. Since the TCJA was enacted at the end of 2017, the Treasury Department, the IRS and businesses have devoted an enormous amount of time and resources to trying to understand, interpret, adapt to and apply these rules. The BBB would make changes to virtually all of the TCJA provisions and enact a handful of entirely new rules; all of the BBB changes are complex, and there are significant gaps and ambiguities. Accordingly, the multi-year process that followed enactment of the TCJA would start all over again, and businesses would face uncertainty about the meaning of the new rules while the process was playing out.
The tax departments of most multinationals have already spent the better part of 2021 assessing the potential impact that the BBB’s tax provisions would have on them. If these provisions are enacted in 2022, the focus for business stakeholders will be on the regulatory rule-making process, whether to undertake structural and operational changes in response to the new laws, and trying to develop tax expense projections with sufficient certainty.
The United States – Digital Assets
The Infrastructure Investment and Jobs Act (the Infrastructure Bill) enacted on November 15, 2021, imposes new information reporting requirements on transactions in cryptocurrencies and other digital assets. One provision is aimed at centralized exchanges and requires information reporting, starting in 2023, of transfers of cryptocurrencies and other digital assets. Another provision, effective starting in 2024, will require persons that receive $10,000 or more in digital assets in connection with a trade or business to report the transaction under the existing rules for receipt of $10,000 or more in cash. The penalties for noncompliance are significant and include criminal sanctions.
These changes were motivated by lawmakers’ conviction that digital assets were facilitating noncompliance and significant tax evasion, but have been widely criticized as applying too broadly and requiring many blockchain participants to report information they may not have. Although Congress declined to narrow the text, the Treasury Department and the IRS have signaled that they are willing to work with the industry to better define the scope of the new requirements.
Joint Tax Audits and Increased Cooperation in the European Union
Following initiatives at the level of the OECD and the European Commission, on the enforcement side we expect to see an increase in joint audits conducted by Member States of the European Union.
A legal framework for joint audits was introduced in 2021 with a new Directive on administrative cooperation in the field of taxation (known as DAC7). DAC7 allows the competent tax authorities of one EU Member State to request joint audits with the competent authorities of other EU Member States. Such joint audits would be conducted in a pre-agreed and coordinated manner and in accordance with the law and procedural requirements of the Member State or States where the activities of the joint audit take place.
The joint audit provisions of DAC7 need to be transposed into national law by December 31, 2023, so groups with operations in multiple EU Member States should ready themselves for investigations under DAC7 by 2024.
One other noteworthy aspect of DAC7 is the introduction of a new mandatory reporting obligation for operators of digital platforms, requiring those with a nexus in the EU to identify certain sellers and to report information about income realized by their sellers from certain relevant activities (e.g., the sale of goods, the rental of immovable property, the provision of personal services and the rental of any mode of transport). These provisions need to be transposed into national law by December 31, 2022.
- Groups with entities operating in low-tax jurisdictions should work through the details of the OECD minimum tax rules and implementing rules in the EU and other local jurisdictions. The world’s largest multinational groups in scope for new taxation in market jurisdictions will already be up to speed, but those in the next tier should remain alert to the possibility of entry criteria broadening in due course.
- U.S.-headed multinationals with non-U.S. subsidiaries and foreign-headed multinationals with U.S. operations will want to understand how the tax law changes proposed in the BBB would affect their groups. Even though the legislation has failed to pass in 2021, it is possible that some or all of the provisions will be enacted in 2022.
- Groups operating on a cross-border basis in the EU should prepare for an increase in tax investigations, and the prospect of coordinated joint audits conducted by more than one Member State.