On June 5, the G7 finance ministers agreed in principle upon global tax reforms, and this is being described as historic by many. The agreement covers two pillars: the first requiring MNCs to pay taxes in countries where they operate and not just where they have their headquarters; and the second pillar commits to a global minimum corporate tax of at least 15 percent on a country-by-country basis. This proposal will be put forth for discussion in the G20 meeting in Venice in July, and while the details of the agreement would be key, a broader assessment suggests that this could boost tax revenues significantly across major economies, including in India.
The discussion on such reform has been under way for quite some time now. However, the pandemic seems to have accelerated the pace of reaching a broader agreement on the issue. This is because countries have embarked on an unprecedented spending spree to support their economies which have been hit hard by COVID-19-induced restrictions. This has led to gaping fiscal holes — amounting to 14.9 percent of GDP for the United States, 16.9 percent for the United Kingdom and 7.2 percent for the Eurozone. Government debt levels have surged, and deficits are expected to remain elevated in the near term as countries pump prime economic activity. Governments are, thus, looking at ways to bolster their fiscal capabilities and reforming the global tax system has the potential to boost their coffers.
The gains are quite significant. Estimates by the UK’s Tax Justice Network suggest that the G7 countries would gain $168bn in increased corporate income tax with a 15 percent global minimum corporate tax rate (Pillar 2), while all other countries would gain $107bn. The US would gain at least $84bn annually — boosting its corporate income tax collections by 21 percent. The UK, Germany and France’s corporate tax collections would increase by 15-30 percent.
The two pillars ingrain principles of fairness that are fundamental to any taxation system. Pillar 1 is expected to lead to a division of profits to the user jurisdictions, such that MNCs (particularly big tech companies that have limited physical presence) with at least a 10 percent profit margin would have to reallocate 20 percent of the profit above the 10 percent margin across countries, and this would be subject to taxes in those countries. Pillar 2 would help crack down on the alleged tax evasion by MNCs that arises out of locating in countries that offer low taxes. This would level the playing field and reduce the effectiveness of tax incentives offered by countries.
India stands to gain from the changes in the global tax system. International trade and transactions, in general, have been more tax favourable to developed countries. This is because, for most part of recent industrial history, the flow of valuable trade, services and technology has been largely from developed to developing countries and international tax rules have tended to restrict taxation rights in ‘source’ (developing) countries in favour of ‘resident’ (developed) countries being recipients of income.
Over the years, with increasing economic importance of countries such as China and India, there has been an attempt in course correction through modified rules of international taxation, but it has largely played ‘catch up’ with the traditional business models by seeking to levy flat tax rates on incomes such as royalties, technical service fees, dividends and interest typically paid out by companies in developing countries to providers of technology or owners of capital in developed countries. This pace of glacial progress has recently accelerated with the extraordinary growth of digital commerce.
After several decades, the time-tested rules of requiring a physical place of business to exist in a source country (where income is derived from customers located there) to have a legal right on taxation of such income are slowly giving way to ‘digital’ presence as a threshold for taxing such income. (This aspect has been one of the important pillars of the Base Erosion and Profit Shifting (BEPS) project of the OECD).
India is likely to gain in tax revenue on this account, given the size of its market and the growth opportunities it offers. In fact, the country has been on the forefront to legislate in her domestic tax laws the concept of ‘significant economic presence’ (SEP) to create the ability to levy tax on income generated in India (from Indian customers) by foreign digital commerce companies.
Further, a global minimum corporate tax rate of 15 percent is also expected to be beneficial to India. The Tax Justice Network estimates the country to gain at least $4bn (Rs 300 bn), equivalent to ~6 percent of FY21 corporate tax collections. However, we will need to focus on capacity building and timely resolution of disputes. Besides, it would not hurt FDI to India or create any adverse or incremental tax liability in the hands of foreign investors given that the minimum tax rate for new manufacturing business has recently been legislated at 15 percent (plus surcharges).
At the same time, in respect of outbound investments, it will prevent base erosion of tax in the country as the government will be able to claw back any shortfall in tax paid below 15 percent by an overseas business owned by an Indian resident, once the global threshold rule becomes operational.
Overall, countries with a moderate tax rate system stand to benefit at the cost of ‘tax havens’ with low or nil tax rates.
Just one important caveat — while the modalities are still far from over, given the complexities of the final legal framework and the number of countries involved, the process must not impinge upon predictability — the bedrock of investment decisions and flows.