Explained: What the international tax deal to subject MNCs to a minimum 15% tax is all about

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A major tax reform agreed by 136 nations and tax jurisdictions on October 8 will ensure that large multinational corporations (MNCs) such Apple, Alphabet (Google) and Facebook pay taxes at a minimum rate of 15% and a fair share of it in countries where they earn their income. The agreement is commonly referred to as the global minimum tax deal. The accord is historic, as it is the first such agreement after the double tax avoidance convention adopted at the League of Nations almost a century ago.

Discussions to update international tax rules to make them more relevant in the digitalised world where large MNCs shifted large parts of their profits to low tax jurisdictions to reduce their tax outgo began several years ago. The COVID-19 pandemic and the urgency among nations to improve their tax revenues hastened the deal. Tax Justice Network had estimated that $420 billion of tax revenues is lost to tax havens annually.

The tax agreement will come into effect in 2023, but before that domestic tax laws and rules will need to be updated to implement the deal. Here’s a look at what the new tax deal is about.

What was the need for a global minimum tax deal?

For years, multinational corporations have been adopting aggressive tax planning arrangements, which included the use of zero-tax and low-tax jurisdictions or tax havens. In some instances, special purpose entities and shell companies set up in such jurisdictions acted as holding companies for subsidiaries in nations with high taxes on corporate incomes. These special purpose entities would then receive large dividends from subsidiaries, which reduced profits and tax outgo of the subsidiary while bloated incomes of the holding company. This is one instance of profit shifting.

Often MNCs were seen transferring intangible assets such as patents, trademarks and intellectual properties to such special purpose vehicles, which would then receive hefty amounts as royalty from subsidiaries and associates. A third common practice involved loans to subsidiaries for which the special purpose entities would receive interest. Dividend outgo, royalty and interest payments reduce profits shown in the books of subsidiaries and lower their tax liability. These special purpose entities paid taxes on all the transfers they received as income at lower rates than they would have in the home countries of subsidiaries or their headquarters. In some instances, they did not pay any taxes.

Such practices lowered the tax collection of nations where these MNCs did business or were headquartered. Many large MNCs are headquartered in the US or Europe.

India has also been losing tax revenues on incomes earned in the country by the likes of Google and Facebook from digital services such as selling advertisement space. Like several other nations, India introduced an equalisation levy, known as Google tax, to claw back some of the taxes due to it.

Why is the new tax deal significant?

It will disincentivise profit shifting as the deal requires large MNCs to pay a minimum of 15% tax on their profits. This will bring more transparency in the functioning of large companies that do business in multiple countries.

It is also expected that decades of the race to the bottom – rising competition among many nations to lower the rate of corporate tax and even drop it to the level of zero – will be limited. An OECD statement on the finalisation of the deal said that it did not seek to eliminate tax competition. However, many countries are expected to raise the minimum corporate tax rate to 15%.

Ireland has committed that it will increase the rate for multinational companies to 15% from the current 12.5%. Thus, the 56 Irish MNCs and 1,500 foreign-owned companies based in the country will pay tax at the rate of 15%. The lower 12.5% rate will continue for smaller Irish companies, which the country is allowed to under the tax deal.

Ireland had become popular with American tech companies for the tax planning opportunities it offered. Tax rates in the US were among the highest in the world till President Trump slashed it to 21% from 35% in 2017. Thus, Ireland’s joining was critical for the finalisation of the deal.

How is the new tax deal structured?

There are two parts or two pillars in the deal. Pillar One deals with the right to taxation and pillar Two, with the minimum tax rate. An FAQ published by the OECD states that each pillar addresses a different gap in the existing tax rules that allows MNCs to avoid paying taxes.

Pillar One will apply to about 100 biggest and most profitable MNCs and seeks to reallocate part of their profit to the countries where they sell their products and provide their services. These are companies with global sales revenue above EUR 20 billion and profitability of 10% will be covered by the new rules. This pillar ensures that companies pay taxes in economies where they earn profits, although only a portion of their profits above the 10% margin is to be allocated to market jurisdictions. The scope of this pillar is to be reviewed for expansion after seven years.

Pillar Two applies to all MNEs with annual revenue of EUR 750 million. The profits of these companies will be taxed at a minimum rate of 15%.

Will all countries gain from the tax deal?

The OECD, which steered the deal, believes that all nations will benefit from implementing the agreement. It estimates that taxing rights on more than $125 billion will be reallocated to market jurisdictions annually under Pillar One. The gains to developing countries are expected to be greater than those in the advanced economies, as a proportion of existing revenues. The OECD has also estimated that the global minimum tax of 15% may generate around $150 billion in additional global tax revenues annually.

Many in developing countries remain sceptical about the gains from the deal, particularly under Pillar One. They argue that the deal will mostly benefit the rich OECD nations that are home to most of the large MNCs. Kenya, Nigeria, Sri Lanka and Pakistan have not joined in the deal. There are fears that the 15% rate will start a race to the minimum, with a large number of nations dropping the corporate tax rate to 15%, leading to an erosion of tax revenues. The global average corporate tax rate is currently 24%. The tax rate in the African nations is between 25% and 35%.

One fallout of the deal is a possible contraction of the corporate tax revenues of governments from the lowering of rate to 15%. That will force governments to raise resources from other sources. Thus, a rise in personal income tax rates is feared.