Simplifying the OECD Two-Pillar Solution - Series 1

The concept of transfer pricing is necessary to understand why the Organization for Economic Cooperation and Development (OECD) has come up with the OECD two-pillar solution. Transfer pricing in simple terms means the pricing of transactions between companies that are related. Two companies can be said to be related if one of the parties directly or indirectly participates in the management, control, or capital of the other; or the same person(s) directly or indirectly participates in the management, control, or capital of both parties. The general principle of transfer pricing is the Arm’s Length Principle (ALP) which states that related companies should transact with each other the same way they would have transacted if they are unrelated.

Related companies can strategically shift profit from a high tax jurisdiction to a low or no tax jurisdiction for tax avoidance. To illustrate, say a parent company operates in country A and has two subsidiaries in country B and country C. Imagine that the corporate income tax rate for Country A is 15%, Country B is 30%, and Country C is 20%. We can establish that subsidiary B is operating in a high-tax jurisdiction while the parent company is operating in a low-tax jurisdiction.?Now, let’s assume that the parent company sells its product to other unrelated parties for $10,000, it can choose to sell to its subsidiary in country B for $15,000. The effect of this is that the parent company will record higher revenue which will be taxed at a low rate while the subsidiary in country B will record high costs which will reduce the profit and also reduce the tax to be paid. When related parties engage in this kind of arrangement it is referred to as ‘Base Erosion and Profit Shifting (BEPS)’.?Base Erosion is the practice of reducing the taxable base and profit shifting is moving profit or shifting profits from a high tax jurisdiction to a low or no tax jurisdiction. Let’s assume that the parent company also gives the subsidiary in country B a loan with an interest payment at the rate of 10%. Say in the open market, the interest rate for a similar loan is 5%, the effect of this would mean that country B will have a large interest payment deduction than normal which would reduce the profit (tax base). This is also an example of Base Erosion.

Usually, tax authority would go against BEPS practices because it would lead to loss of revenue since tax is levied as a percentage of the company income/profit and when the profit is low, the tax would also be low. According to the OECD, BEPS practices cost countries 100-240 billion USD in lost revenue annually, which is equivalent to 4-10% of the global corporate income tax revenue.

BEPS is a trending issue because of digitalization and globalization. Many multinational enterprises (MNEs) now operate digitally and some do not even have a physical presence in some countries of operations. ?The new technologies have facilitated tax avoidance through the shifting of profits by multinational enterprises (MNEs) to low or no-tax jurisdictions. It is now challenging to determine where taxes should be paid ("nexus" rules based on physical presence) and what portion of profits should be taxed ("profit allocation" rules based on the arm's length principle). For example, some companies make revenue from countries even without having a physical presence in that country, so sometimes knowing what amount of their profit should be subjected to tax for that jurisdiction can be challenging. Many countries have come up with the digital service tax to ensure that MNEs carrying out their business without a physical presence in a country is appropriately taxed. This sometimes can lead to double taxation or double non-taxation.

To tackle the tax challenges arising from digitalization, the OECD has come up with a comprehensive consensus-based solution that deals with both the allocation of taxing rights and other BEPS issues. This would secure and sustain the international income tax system and increase tax equity among traditional and digital businesses and this was how the two-pillar solution emanated. The Two-Pillar Solution is to reform international tax rules and ensure that multinational enterprises pay a fair share of tax wherever they operate even without having a physical presence.

Each pillar addresses a different gap in the existing rules that allow MNEs to avoid paying taxes. First, Pillar One applies to the biggest and most profitable MNEs and re-allocates part of their profits to the countries where they sell their products and provide their services. Without this rule, these companies can earn significant profits in a market without paying the appropriate tax for the economic activities carried out in that jurisdiction. Under Pillar Two, a much larger group of MNEs (any company with over EUR 750 million of annual revenue) would now be subject to a global minimum corporate tax of 15%. With the new rules, companies operating in a low-tax jurisdiction or otherwise would have their profits taxed at a minimum rate of 15%.

In my next article, each of the two-pillar solution would be extensively discussed.?