International trade has always been back bone of humanity for ages. Humans started to trade via sea thousands of years back in history. But, in recent times, enhanced technology and digitalization have speed up the process. Countries have come closer through increasing communication, contacts, ease of funds transfer, and increased awareness of the products/services available overseas.
However, expanding international trade has raised massive competition between tax jurisdictions of the world as each of the countries wants to attract more and more foreign investment for the prosperity of their nation. Some countries like Cayman Island, Bermuda, and Netherland have a very low tax rate and are called the tax heavens of the world.
So, the global giants registered their companies in the tax heavens and transfer their operating profit to be taxed there. However, this profit transfer in the tax heaven led to a loss for the jurisdiction in which profit was genuinely earned. It resulted in very low tax/no tax expense for the companies as tax heaven countries have very low or zero percent tax rates.
How companies can transfer their funds to tax heaven jurisdictions
Following are some ways the companies can shift their profit from higher tax jurisdiction to tax heavens.
1- Intellectual property restructuring
IP restructuring is when the parent company shows a patent/trademark under the company’s ownership registered in the tax heaven. The company in the higher jurisdiction uses the patent and pays royalties to a company registered in the tax heaven. Hence, profit for the company in higher jurisdiction decreases, and profit for the company in tax heaven increases (both companies have the same parent company).
So, the overall tax expense of the parent company decreases because tax heaven countries have very low tax rates or even zero rates of tax.
2- Thin capitalization
Thin capitalization is when the parent company registers a new company in the tax heaven country and injects massive capital. Then, another company of the parent registered in high tax jurisdiction raises debt and pays the interest expenses.
Hence, the profit of the company registered in the high tax jurisdiction decreases, and the company’s profit in tax heaven increases.
Again, the overall tax of the parent company decreases as there is a very low tax rate in the tax heavens.
Although, regulators are actively monitoring if companies are still shifting their profit to tax heavens. However, that’s not always possible to spot if trading is being done with the tax heaven country to evade the tax. So, to avoid tax evasion, there has been a proposal for global tax reforms. Let’s discuss what that tax reform is and how it intends to help in controlling tax avoidance.
Global tax reforms
The global tax reform project intends to address tax challenges brought with the digitalization of international trade. The project has gained significant momentum after rich and powerful countries like G7, G20, and 130 countries have agreed to implement global reforms in the international taxation rules. These countries represent 90% of the global GDP. So, the acceptance comes from giant jurisdictions, and there seem to be higher chances of implementation.
As per a report from Paris based Organization for Economic Co-operation and Development – OECD, implementing the 15% corporate income tax is expected to yield an additional USD 150 billion per annum in the global tax collection. It’s important to note that the 15% tax rate is the minimum rate of the corporate tax, although legal jurisdictions can exceed this tax rate depending on their will. %.
The new framework is designed to improve key elements of the tax system introduced 100 years back when technology and digitalization were not much permanent. So, as per OECD, there is a genuine need to implement two pillars of tax reforms to strengthen the taxation system and fill the gaps responsible for tax evasion.
Two pillars of the tax reforms
OECD/G20 framework on profit shifting has agreed following two pillars for improving tax structure on international trade and filling the gaps. OECD intends to issue a detailed plan with the remaining issues by October 2021.
Let’s discuss two pillars of the tax reforms.
1- Pillar one
There are three important components of pillar one that includes following,
- Amount-A – It’s a new right created for the market jurisdiction; it means jurisdiction/country where product/services are sold can charge tax to the company over a share of the residual profit calculated at multinational. The amount A is expected to increase the tax base for the companies as sales is distributed throughout the world for giant multinationals.
- Amount-B– It’s a fixed return for the certain baseline marketing and distribution activities that take place in the jurisdiction of sales. In simple words, the product/service price will be valued at market rate/arm’s length irrespective of the price charged by the company in a foreign jurisdiction. Valuation of the profit at arm’s length helps the tax jurisdiction to charge fair tax.
- Improvement in tax certainty on the profit earned by the company – it’s about innovative dispute prevention and the introduction of the enhanced dispute resolution mechanisms related to the country of jurisdictions and valuation of the company’s profitability.
These are the main components of pillar one in tax reforms and are based on the concept for determining tax jurisdiction and calculating the tax liability and related administrative procedures.
Scope and application of pillar -1
Pillar-1 is to be applied to the companies that generate global revenue of more than 20 billion euros with 10% profitability.
2- Pillar 2
Following four rules have been proposed in pillar 2 of the OECD’s global tax reform.
Income inclusion rule – IIR – It imposes a top-up tax on the parent company’s profits if they have any income from low tax constituents.
Under tax payment rule – UTPR – It’s only applicable on the income of the low tax constituent when it’s not subject to IRR. It’s designed to reduce the incentives-driven inversions by providing a base for the adjustment of top-up tax.
The minimum tax rate for IIR and UTPR will be at least 15%.
It’s important to note that rules have not been yet implemented in the world, and concerns are under consideration. However, OECD is committed to implementing this global tax reform by 2023.
Scope and application of pillar -2
Pillar 2 is applicable to companies with a global revenue above 750 million Euros.
Impact of the reforms on the economy of Singapore
The current rate of corporate tax in Singapore is 17% which is lower than other countries of the world like the USA, UK, and Australia, which state at 21%, 19%, and 30% respectively. The rate of corporate tax is lowered to attract foreign investment from all over the world, and a large part of their earnings remain in their pocket.
However, Global tax reform seems to impact the smaller economies like Singapore with a lower rate of corporation tax in the following ways.
Pillar 1 reform is designed to transfer the profit from the base country to the sales tax jurisdiction. Suppose if there is MNE in Singapore falling in the scope of pillar-1. It has to shift the profit to be taxed in other countries, and Singapore will not be able to tax on the income which has been taxed in the country of sales. So, small economies like Singapore seem to lose the tax collection.
On the other hand, pillar two reform intends to end the competition by decreasing the corporate tax rate to attract investment. Pillar 2 reform imposes an additional tax on the parent company if their foreign income is taxed below 15%. So, if some multinational pays 10% tax on the earning in Singapore, its home jurisdiction will be able to collect an additional 5%. Hence, the attraction of the MNEs towards low corporate tax jurisdiction is expected to decrease.
Further, there are 1800 MNEs in Singapore that are expected to fall in the scope of pillar 2. Although the current tax rate in Singapore is 17%, different allowances and incentives for research & development, capital investment, charitable actions, etc., can lead to a reduction in the effective rate of tax. However, if tax reform is implemented, the MNEs will not be able to enjoy tax incentives, etc., as they’ll have to pay the differential taxes in the house’s jurisdiction.
Impacts of the MNEs for tax reforms
MNEs are expected to have increased tax expenses if they fall within the scope of pillar-1 and pillar-2. However, the impacts of the tax reforms on different businesses are different. For instance, some companies have sales and production in a single country. They are not expected to have such impacts of global tax reform as their revenue is generated in the country of production. However, if the business has production one jurisdiction and sales in another jurisdiction, there can be following impacts,
- If the business falls in the scope of pillar one, a certain tax will be payable in the jurisdiction of sales. Although, MNE will not be required to pay the tax in the home country as the tax reform aims to increase tax certainty and not double taxation.
On the other hand, if the business has a profit center in a jurisdiction other than home, its foreign income in the home country is to be taxed at the differential of 15%. For instance, if the business has paid 5% tax in the foreign jurisdiction, it has to pay 10%in the home jurisdiction under the income inclusion rule of pillar 2 (However, only applicable if MNE fall in the scope of pillar-2 of global tax reforms).
So, global tax reforms seem to be impending and adversely impact profitability. Hence, the MNEs must consider aligning their documentation in line with the requirements of the procedures. Else, they have to face problems once global tax reform is implemented.