Contemplating a new world of tax and its implications
20 December, 2019
The G20/OECD project to create a tax system fit for the digital age will change everything about how international businesses are taxed.
Operating in a world of constant flux and complexity is the norm for global business, but a change is on the horizon that will test even the most hardened of multinationals. In the next few years, the current international tax system will likely be torn up and replaced as recommendations put forward by the G20/OECD Inclusive Framework project make their way into laws, treaties, and other regulations and guidelines.
Three critical points about the project:
- if implemented as proposed, it will change the way international businesses are taxed
- it will affect most large multinational businesses irrespective of sector, even those with a ‘traditional’ business model
- it will happen soon.
The work to adapt the international tax system to reflect the challenges of a digital economy arose from discussions among G20 countries and the rest of the OECD Inclusive Framework about base erosion and profit shifting (BEPS). The public and governments were asking key questions about where a multinational, based in one country, should be taxed when it sold goods and services in another country via one or more digital platforms. That original BEPS work culminated in a major report in 2015. Since then, the discussions have expanded into wider market-based value creation and the potential desire to ensure minimum tax rates on certain income.
There’s no doubt that a debate was due; innovation has outpaced a regulatory and tax system that was designed for physical business. Digital business, unlike its physical counterpart, is characterised by intangible assets, scale without mass, and data as a primary value-creating asset — which means that companies may have a substantial economic presence in a jurisdiction without ever being taxed there. As more and more jurisdictions take their own steps to address that widely recognised consequence of a digitalised economy, the current project is an attempt to create international consensus.
The project has considerable momentum and, critically, widespread political support — which means that developments could happen quickly. Writing in the closing days of 2019, we’re expecting an announcement of high-level political agreement on the project in the next few weeks, which could mean that the major rules will be agreed in the second half of 2020, with implementation beginning in 2021.
There is a chance, of course, that an agreement won’t be reached, but that doesn’t mean the status quo will prevail. Instead, a number of countries have indicated that they will move unilaterally, taking measures that fall outside existing tax treaties and creating a new storm of uncertainty, complexity and risk for global businesses.
Some countries have proposed or implemented a variation of a digital services tax, suggesting that highly digitalised companies could be taxed on a part of their turnover (rather than profit) relating to each respective country at a rate of between 2% (UK proposal) and 7.5% (in Turkey). A desirable goal for the G20/OECD Inclusive Framework project would be to have an approach that would at least be consistent and coordinated, minimising the risk of double taxation.
How the tax system will change
If the project proposals meet with international approval, multinationals will be affected by two aspects, or ‘pillars,’ of the proposals.
Pillar I deals with the reallocation of taxing rights: where (and how much) tax should be paid. Companies, in addition to paying more where they do have a physical presence, could be taxed in markets where they don’t have a physical presence. It’s difficult to overstate what a change this represents. For 100 years, businesses have been taxed based on where physical activity takes place. Under the current proposals, tax would be based on where goods are sold or services provided.
In practice, this would mean that rather than taking a pure ‘transfer pricing’ approach based on the prices that independent persons would charge each other, organisations would need to allocate a proportion of group-consolidated financial profits to market jurisdictions. As well as fundamentally changing the tax profile for many businesses, this would also bring added complexity. A benchmark rate of return (or benchmark rates) would be applied to routine marketing and distribution functions, with transfer pricing calculations still to be made for any other cross-border functions, but a formula would then need to be applied to allocate a portion of global profits to market jurisdictions. The current proposals consider the application of a filter for consumer-facing activities that would make the formula complex, but the attempt to identify end-user value may yet be recast.
Pillar II will be designed to create common rules that limit the impact of certain tax competition and introduce the concept of a minimum effective tax rate for various income. This may expand on the work already done in the BEPS project by introducing new rules, including:
- income inclusion, which would allow a jurisdiction to tax the income of a foreign branch or controlled entity if that income was subject to a low effective tax rate in its jurisdiction of establishment or residence
- denial of deductions, which would mean that multinationals would not be able to claim certain tax deductions (or treaty relief from withholding tax) on some payments, including royalties and interest, unless those payments were subject to an effective or minimum tax rate.
What does the project mean for you?
These proposals have wide-ranging implications for multinational businesses. On a micro level, they greatly increase the complexity of ordinary tax planning and add considerably to the compliance burden. The potential for more tax disputes between jurisdictions will increase, and for multinationals their ERP systems will need to be adapted, and the approach to data collection and configuration could change.
But there are other implications that go beyond the tax function, touching operations and even the business model. Multinationals may want to reconsider how they organise their supply chain and where they carry out critical work, particularly R&D and central management functions, with an eye to tax rates in different countries. They may want to reconsider the jurisdictions that they invest in, and rebalance the mix of insourced and outsourced functions. The proposed changes could also have an impact on the cost of capital, which could trigger a rethink on deals strategy.
Deciding how to approach the new tax landscape is a critical, board-level issue. Many important decisions will need to be made in the next couple of years, at a time when the stakes are already high. The world’s businesses are under intense scrutiny from a wide range of stakeholders and once an international agreement is reached, the level of interest will only increase.
Communication will be vital, beginning with the tax function explaining clearly what the changes mean, and how the organisation will adapt. Making sure that all stakeholders understand the implications of the changes will help mitigate reputational and financial consequences.
Navigating the complexity and risks of the changes ahead requires both an understanding of the technical requirements of the new tax system and a clear strategy to drive the business forward while continuing to meet the compliance responsibilities. PwC is tracking the changes under review by the project across our global network in 157 countries. By doing so, we can gauge the effect they will have on the world’s tax and trade systems and their implications from a wider business perspective. We’re here to support you and show you what’s possible in this new world of tax.
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