In 2015, the Organization for Economic Co-operation and Development (the ‘OECD’) first presented its comprehensive Action Plan on Base Erosion and Profit Shifting, abbreviated to the ‘BEPS’. At present, many of the initiatives proposed within the context of the BEPS have been successfully implemented. Specifically, Russian tax legislation has been modified to incorporate provisions concerning controlled foreign companies (CFCs), ‘three-level’ documentation to monitor transfer pricing, Country-by-Country reports on multinational enterprises (‘MNEs’), and the automatic exchange of tax information.
Nevertheless, BEPS Action 1 described the challenges which tax administrations in various countries were facing in connection with the digitalization of economies, as well as the general approaches to addressing such challenges. Given that those challenges were primarily created by MNEs, which account for the lion’s share of income that is subsequently used in tax planning techniques, the following solutions have been proposed:
- Granting the right to levy taxes on MNEs’ income to those states in which MNEs obtain a substantial proportion of income without a physical presence (predominantly, the supply of digital services and distance selling of goods);
- Establishing a minimum rate of taxation for MNEs at the global level;
- Restricting the right to use benefits of tax treaties stipulated for passive income.
The above solutions were drawn up and set out in detail within the scope of Pillar 1 and Pillar 2 concepts.
Although the concepts themselves were first presented back in 2020, they have become a priority only now. The countries that participated in drawing up these documents agreed upon a certain number of key provisions of future reform in October 2021. The model rules determining the procedure for the application of a minimum rate of global tax to MNEs (the ‘GloBE Rules’) should have been published at the end of November 2021.
If the concepts are put into practice, they will completely alter the landscape of the corporate taxation of MNEs.
Below, we have highlighted the main provisions of the changes proposed. The full description of the concepts takes over 500 pages and cannot be reproduced within the scope of our overview for obvious reasons.
Pillar 1 is a new tax nexus which allows for MNEs’ revenues from business activities to be taxed in a state where such MNE has no physical presence. According to the current rules, MNEs’ revenues from active business operations can be taxed in a source state only if an MNE has a subsidiary or a registered office (either a branch or a representative office), or if its activities give rise to a permanent establishment, in that state.
In other words, revenues of a hypothetical Amazon company which it derived from the sale of goods to Russian customers are presently subject to corporate income tax at the place of registration of either the company or its offices. Once Pillar 1 is implemented, a certain portion of such revenues will be reallocated to the Russian Federation, which will be able to charge taxes on it. Consequently, Pillar 1 is focused on major corporations which pay their taxes at the place of their registration, with no account being taken of the actual location of the end consumers of their goods/services.
Discussions are still ongoing over certain aspects of the concept; however, the key parameters have already been approved:
- The new tax will be charged only on the largest MNEs with a global turnover above 20 billion euro and profitability of at least 10%.
- Types of activity. The concept will apply to the revenues an MNE has generated from the supply of automated digital services and the sale of goods to end consumers. Companies that are engaged in the mining activity or supply of financial services are expressly exempted from tax. Nor will revenues from customized professional services (legal, marketing, etc.) be subject to tax.
- A link to jurisdiction. The right to charge new tax will be given to those jurisdictions where an MNE’s revenues from relevant types of activity amounts to at least 1 million euro. For jurisdictions whose GDP is lower than 40 billion euro, the threshold will be set at 250,000 euro.
- The tax base and payment of taxes. Under Pillar 1, the tax base will be an MNE’s residual profits, i.e., the MNE’s revenues from activities in the jurisdictions which were granted the right to charge tax minus 10%. 25% of an MNE’s residual profits will be allocated among the jurisdictions in proportion to the revenues generated in the relevant jurisdiction (‘Amount A’). The concept does not establish any specific tax rates. It is presumed that tax will be charged based on the corporate income tax rate of the relevant state. A specifically designated company within an MNE’s structure will pay the tax.
So that disputes over the assessment of Amount A are promptly resolved, it is proposed that a specific panel will be set up to include delegates from tax administrations of various jurisdictions.
Pillar 1 also provides for such a concept as ‘Amount B’. This is a fixed marginality figure of marketing and distribution activity which, as expected, will simplify the tax administration of companies engaged in relevant activities as regards transfer pricing and control over compliance with thin capitalization rules. Nevertheless, detailed rules for assessing Amount B are at the stage of active development and will be presented later.
Despite the OECD’s optimism over the speedy adoption of Pillar 1 and, as a consequence, the procedure for allocating Amount A among states, many countries doubt that the rules will in fact be adopted and are developing their own draft laws concerning the taxation of revenues of foreign corporations derived from ‘digital’ activities in the relevant state.
Pillar 2 involves introducing a minimum rate of corporate income tax and, consequently, determining unified rules for assessing the tax for MNEs. As already mentioned above, these rules are referred to as the ‘GloBE Rules’. According to the GloBE Rules, the minimum tax rate on MNEs’ profit will be 15%. It is also proposed that the minimum rate of withholding tax should be increased to 9% with respect to certain payments made within the scope of bilateral tax treaties.
The reform will be carried out by publishing model GloBE Rules to which states may either simply accede or fully implement in their national legislation, as well as by introducing relevant changes in tax treaties.
The operation of Pillar 2 is based on the introduction of three main rules:
- The Income Inclusion Rule (‘IIR’)
The IIR will operate as follows: if the effective tax rate for a company within an MNE’s structure is less than 15%, tax in the amount of the difference between the effective rate and the minimum rate will be paid additionally by the MNE’s parent company to the budget of the state in which such parent entity is registered. The rule will also be applied similarly in a situation when an MNE has several (or even many) entities in its structure with an ‘insufficient’ effective taxation rate. Therefore, the level of the minimum tax burden for an MNE will be set globally, and all taxes under tax arrangements of subsidiaries in low-tax jurisdictions will be additionally paid by the MNE’s parent company. This step will also help to eliminate competition over major taxpayers among countries when they establish preferential tax rates.
The IIR will apply to MNEs whose revenues for the previous financial year were at least 750 million euro.
Each state has the right to establish a lower threshold for MNEs to which the IIR applies.
The GloBE Rules expressly provide for an exception: the IIR should not apply to investment and pension funds, governmental authorities, or to international and not-for-profit organizations. If any of the above is a parent company of a group, the obligation to pay additional tax will be shifted to its subsidiary (sub-holding).
No additional tax under the IIR will be applied to jurisdictions where an MNE’s revenues do not exceed 10 million euro and its profit does not exceed 1 million euro.
2. The Undertaxed Payment Rule (‘UTPR’)
The UTPR is a secondary rule with regard to the IIR and applies only if the IIR does not apply to an MNE’s parent entity. MNEs that meet the threshold of 750 million euro are covered by the UTPR.
The UTPR’s mechanism operates as follows: if an effective tax rate of a company from an MNE’s structure is less than 15%, other companies of the group will be accrued additional tax, or they will be disallowed the deduction of costs with respect to intra-group payments made to the company with an ‘insufficient’ effective tax rate. Based on the parameters of its taxation system each state should individually develop a mechanism for charging additional tax payments under the UTPR.
The UTPR will not apply to MNEs that are in the initial phase of their international operation, defined as those MNEs that hold at least 50 million euro of tangible assets abroad and that operate in no more than 5 other jurisdictions. This exception is for a maximum period of 5 years.
The UTPR does not take into account jurisdictions where an MNE’s financial figures do not meet the threshold criteria: revenues of 10 million euro and profit of 1 million euro.
- The Subject to Tax Rule (‘STTR’)
This rule is the OECD’s response to requests from developing countries. Given that the parent entities of most MNEs are located in developed countries, the GloBE Rules primarily protect the fiscal interests of such countries. Moreover, many MNEs enter markets of developing countries via countries with preferential tax treatment (for Russia, for example, these are primarily Cyprus and the Netherlands). Such a business structure enables MNEs to withdraw some of the profits from developing countries by making payments as ‘passive’ income (interest, royalties, etc.) which are frequently taxed at reduced rates. The STTR is aimed at levelling out the tax benefits when business is arranged in such a way.
In general terms, the STTR allows a state that is the source of a payment to charge additional withholding tax if the minimum tax rate for such payment is below 9%. Let us consider a practical example: if the withholding tax rate on interest payments in Russia is 5%, and no tax is levied in the recipient country on interest that was received from abroad, Russia will be entitled to charge an additional 4% of withholding tax so that the minimum tax rate on the interest came to 9%.
The STTR does not apply to all payments made within the scope of tax treaties. The operation of this rule is limited only to interest, royalties and other specifically listed types of payments among affiliated legal entities. If either the payer or payee is an individual, the STTR will not apply. As for the remaining cases, the OECD expressly states that the application of the STTR should not be universal but should be limited to minimum thresholds to be established with respect to the amount of a payment (or of payments) and the companies involved in the transaction. Nevertheless, the question of minimum thresholds remains open.
The STTR will be implemented by a standard clause being incorporated in bilateral tax agreements or by choosing the relevant option in the multilateral instrument (MLI).
The GloBE Rules also establish a unified approach to the assessment of an effective taxation rate for companies within an MNE. It actually means that an MNE should assess its tax burden twice: first, according to the rules of its jurisdiction of incorporation and, second, according to the GloBE Rules.
It is expected that the new rules will come into effect in 2023. Before this, the OECD is intending to develop and submit for signing a Multilateral Convention (MLC) which will determine the procedure for implementing the new taxation right of states within the scope of Pillar 1 and the procedure for assessing Amount A. The GloBE Rules should also be adopted in 2022, while bilateral tax treaties and the MLI should also be adjusted in terms of a standardized STTR clause.
However, as we have noted above, neither the draft GloBE Rules nor the standardized STTR clause have been published as at 1 December 2021. There is a likelihood that the tentative deadline for the concepts to come into effect will be shifted.
We are continuing to monitor how the situation is developing.
 Word ‘Pillar’ refers to basic taxation principles for multinational enterprises (MNEs) during the digital era.
 Approximately 140 countries.
 As at 1 December 2021, the GloBE rules have not yet been published.
 Provided that the entity is a resident of a state that has also acceded to the GloBE rules.
 The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, abbreviated as the ‘MLI’.