By Neetu Vinayek and Sanjay Shukla
One of the victims of current geo-political uncertainty is the deferral of revolutionary changes in the cross-border tax regime, called Pillar 1 and Pillar 2 changes. Originally envisaged being effective from 2023, as per the recent OECD publication, the effective date of implementation of these changes is now proposed to be from the year 2024. It is important for Multinational Companies (MNCs) to understand what these changes are, how it is going to affect their businesses, and what steps they should undertake to address these changes.
Pillar One (Taxing rights to market jurisdiction)
Under the current tax regime, a non-resident, which sells goods or provides services in India, can opt to be governed by the tax treaty between its home country and India. For various income streams, tax treaties provide the taxing right to the home country and not to India. The primary argument for this taxing right was that the tax should be levied where production factors are located and not where the market is situated. For example, a non-resident manufacturer selling goods to India on FOB basis may contend that the goods sold by it are manufactured outside India, shipped outside India, and delivered outside India. In these circumstances, where no function has been undertaken in India, India cannot tax any profits as no value-added production factors or activities are in India. These principles stood the test of time and were considered adequate for traditional business operations. However, after the global recession in 2008, certain countries opposed these principles of taxation on the ground that the market itself is a contributor to the profits of MNCs, and accordingly market should also get the right to tax such profits.
Pillar One rules are introduced to recognize the market economy’s contribution to such profits and shall apply to MNCs with a group turnover of more than EUR 20 billion. As per these draft rules, an MNC is required to first compute super profits (profits in excess of a prescribed percentage of turnover) on its consolidated turnover and then attribute these super profits to market jurisdiction as per the turnover in those respective market jurisdictions (i.e., countries where such goods are sold). The taxes are required to be paid in the market jurisdiction as per profits so attributed basis the prescribed mechanism. As per such a prescribed mechanism, taxes paid in market jurisdiction needs to be given credit in the home country of the non-resident.
OECD estimates that in view of the Pillar One rules, taxing rights on more than USD 125 billion of profits would be re-allocated each year to the consumer countries (i.e., market jurisdictions). The developing countries are expected to benefit from such implementation as compared to developed countries. As per the OECD July 2022 report, stakeholder comments would be sought on the draft Pillar One rules. The comments would be reviewed by October 2022. Pursuant to the same, Pillar One rules would be finalised and implemented through amendments in the tax treaties by 2024.
Various MNCs operating in India in a remote manner, such as through the online sale of products, equipment, goods, etc. may get impacted once Pillar One becomes effective. The large Indian MNCs would also be impacted as they would be required to work out their taxes in foreign countries as per amended tax rules.
Pillar Two (Minimum tax in each country)
Pillar Two is designed to ensure that MNCs pay a minimum level of tax in each country they operate in, regardless of where they are headquartered. Pillar Two consists of 2 parts, viz. GLoBE rules and Subject to tax rules (STTR).
GloBE rules stipulate that each MNC is required to compute the Effective Tax Rate (‘ETR’) in each jurisdiction in which it operates. If ETR is lower than 15% then it needs to pay tax either in that jurisdiction or in the headquartered country from which MNC operates or in other countries (if neither operating jurisdiction nor headquartered jurisdiction levy differential taxes). There are a complex set of rules to compute ETR as well as the country which can levy taxes.
GLoBE rules are close to completion and expected to be effective from 2024 onwards by incorporating them by each country in their domestic legislation. GLoBE rules would be applicable to MNC groups with a consolidated turnover of more than EUR 750 million.
Under STTR rules, tax treaty benefits may be denied if payments to group companies attract a nominal tax rate of less than 9 percent. Such rules shall come into effect by way of an agreement between countries, like Pillar One Rules.
Given the above, all MNCs must examine the impact of Pillar Two, prepare for additional tax compliance burden and re-evaluate their legal structure and/ or operating business model if it results in tax less than 15 percent for certain countries. This could also impact MNCs operating in India. For example, certain non-residents file their returns on a deemed income basis, whereby the tax is computed based on turnover in India and not on net profits. There could arise a situation whereby the ETR of such non-residents in India is less than 15 percent since tax in these cases is computed on turnover and not on profits. In this situation, MNCs might be required to pay additional GloBE Taxes. Similar can be a situation for an India-headquartered MNC which has operations in a low-tax country, say Cayman Islands.
The two Pillar solution represents a historic development and seeks to dramatically change the old tax laws. While the implementation of the two Pillar solutions may have certain tax and operational challenges, the minimum tax rate may benefit developing countries.
Given the above, it would be advisable for MNCs to study these rules and examine their operating structure to see if there is any tax leakage on account of such new rules which are proposed to be implemented in the year 2024, and where required, make representations to OECD for suggestions. Further, it is necessary to examine if the information systems are designed in such a way that data required for the computation of income tax and implementation mechanisms are available. If not, it would be prudent to ascertain the readiness at the earliest.
(Neetu Vinayek is a Tax Partner, EY India and Sanjay Shukla is Manager, EY India. Views expressed by the authors are their own.)