International taxation is undergoing a transformation the likes of which have not been seen for a century, responding to challenges of globalization and digitalization that the current international tax regime is ill-equipped to handle. Twenty-five years have passed since the OECD shot the first arrow across the bow, twenty-five years during which the discourse has expanded to include over 140 countries in the Inclusive Framework and the goals of the project have been constantly evolving. Whether and to what extent the transformation will come to fruition and, if it does, will survive the test of time is a matter of speculation.
The latest iteration on the subject is the Pillar Two Global Minimum Tax Model Rules released on December 22, 2021. In this week’s feature article, three scholars from the Oxford University Centre for Business Taxation examine how the Model Rules deal with two of the more controversial questions relating to Pillar Two: the extent to which it will allow countries to engage in tax competition, and which countries will collect the tax revenue that it generates.
It focuses on two critical elements of Pillar Two: the Substance-Based Income Exclusion (SBIE) and the Qualified Domestic Minimum Top-Up Tax (QDMTT). The authors argue that the addition of the QDMTT moves source countries to the head of the queue to collect the top-up tax generated by Pillar Two, that Pillar Two effectively creates a floor on source country tax competition, and that Pillar Two increases the incentives for countries to reduce their corporation tax (as opposed to their QDMTT) perhaps all the way to zero.
The authors explain that when considering tax competition, countries balance the marginal benefit against the marginal cost of a change in their domestic rate. To determine marginal cost and benefit, the authors compute the reduction in the global tax liability of a multinational enterprise (MNE) for each $1 of tax revenue foregone by the source country. Their analysis shows that should source countries reduce their QDMTT below 15%, the MNE will receive no benefit, as the difference will be taken by the top-up tax in its home country. Pillar Two thus establishes a floor for source country QDMTT and, consequently, the source country will be the sole beneficiary of Global Minimum Tax. On the other hand, because any tax on income covered by the SBIE will be borne directly by the MNE, competitive forces will likely drive the tax rate of this type of income down, possible to zero.
The authors concede that their analysis does not cover all the considerations that will be taken into account by countries when determining their response to the introduction of Pillar Two. It simply identifies two incentives that countries may be expected to have following the instruction of that Pillar. The incentive to reduce corporate tax – to the exclusion of QDMTT – is likely to be even stronger than it is under the current tax regime, when $1 of revenue foregone does not necessarily provide $1 worth of benefit to MNEs. However, countries are also expected to have an incentive to introduce a QDMTT which will thus act as a floor to competition.
They conclude by pointing out that the incentive to substitute corporate tax with the QDMTT is a by-product of Pillar Two but, in their words, “is momentous and merits further thought.”
The authors’ clear and concise explanation of the incentives created by the Pillar Two Model Rules and the likely outcome of their adoption (along with a more technical analysis in the appendix) is a welcome addition to the literature. There is however one point with regard to which they might have elaborated a bit further. On a number of occasions they mention that that under the Model Rules, source countries would have an incentive to reduce their corporate tax – as opposed to the QDMTT – “perhaps even all the way to zero.” They do not consider whether source countries would have an incentive to reduce their effective corporate tax rate to less than zero and if so, how that might be done. If source countries would have the means, motive, and opportunity to do so, this would have major implications for the viability of the proposed regime.
The ongoing discourse with regard to the future of the international taxation is a fascinating topic with important ramifications for all aspects of tax law and policy. If the current project does yield real-world results, it will most likely significantly affect the structure not only of what is traditionally within the realm of international taxation, but of purely domestic taxation as well. Stay tuned.