There has been some confusion over how parts of the recent G7 agreement on new tax rules for multinational companies might work. The new policies would target the largest and most profitable multinationals and introduce a global minimum tax.
The G7 deal is the subject of subsequent debate and agreement in the G20 and in more than 130 countries around the world. As the debates continue, it is important to understand the nuances of what is being discussed.
First of all, a question on the income and profitability thresholds: which companies are present and which are not? Will some large companies be cut regardless of their profitability? Second, some question the exclusions and whether countries will continue to grant tax preferences such as patent boxes under the global minimum tax or whether some countries would be excluded altogether.
On both issues, there are a lot of unanswered questions, but it’s worth exploring what has been discussed so far and how these issues might be resolved.
Part of the debate over global tax reform, “pillar 1,” would change the rules about where the biggest and most profitable companies pay taxes. the G7 press release said the targeted companies would pay taxes in countries where they make sales on at least 20 percent of profits exceeding a 10 percent profit margin.
For this to work, you need a definition of “the biggest” and “the most profitable”. If a business is “big” but does not have a very high profit margin, it may not have to comply with the new system. There are big companies (one in particular) that politicians have identified as one of those who must comply with the new rules.
It comes down to the question of how a business that might not meet the “profitable” metric would be held to the new rules. This is where what is called “segmentation” comes in.
For example, if you have a large multinational company that is a conglomerate with several lines of business, then perhaps the most profitable lines of business would be grouped into pillar 1. Part of the company could be piloted. by valuable software and have a 20 percent profit margin while other parts of the business are in manufacturing and distribution and only earn a 5 percent profit margin.
If, by itself, the software business met both the “big” and “profitable” thresholds for Pillar 1, then the software part of the business might have to adhere to the new rules while the less profitable parts of the business. manufacturing and distribution of the business would not.
The challenge for policy makers is how to define the dividing lines between industries. It is not too hard to imagine the tax authorities gerrymanding companies in the most beneficial way under the rules of the first pillar.
But there’s probably an easier (and less political) way to do it. Large corporations already provide their audited financial statements to shareholders. These statements are issued in accordance with multiple rules and regulations and are intended to reflect the business and economic realities of a large multinational corporation. Companies with multiple lines of business are already reporting profits by segment, so decision makers wouldn’t necessarily need to design something from scratch.
While it does not make sense for a policy to be designed with one (or more) specific companies in mind, segmentation based on financial statements makes sense in a Pillar 1 proposal that is already complex.
Without segmentation, a company with high profit margins could be incentivized to dilute its profitability by acquiring less profitable businesses. Segmentation offers a way to prevent this type of merger activity to avoid pillar 1.
Segmentation is not a new idea. Several pages have been devoted to segmentation in a policy plan published last fall. However, the overall approach to this plan was incredibly complex, and a lot likely changed as policymakers worked on a deal.
Basing carve-ins on something like financial reporting to shareholders should avoid some of the more difficult political and complex questions. It might not be a perfect solution, but like Richard Collier (one of the designers of Pillar 1) recently declared, “In pillar 1, nothing is ever easy.
The other big question that has received a lot of attention is whether there will be any exceptions to the global minimum tax, or “pillar 2”. As with the focus on a business for pillar 1, questions were asked about A country on the overall minimum tax.
Like Pillar 1 and segmentation, the idea of waiving the global minimum tax is nothing new. that of last October global minimum tax blueprint is considering an option for a deduction for property, plant and equipment and labor costs when calculating the application of minimum tax. In the plan, this is a substance-based exclusion.
The idea behind such an exclusion is that if you have actual activities (called “substances”) even in a low tax jurisdiction, the minimum tax should not be so severe.
The question in the current negotiations is whether a deduction for assets and payroll will be sufficient for world leaders. In recent years, countries with preferential tax policies like patent boxes have adopted rules that require some economic substance for companies to benefit from lower tax rates.
Let’s say a reasonable amount of economic substance disables the global minimum tax in a low tax jurisdiction. This would mean that policies such as patent boxes, special economic zones and related tax preferences would continue to exist as long as companies do not artificially manipulate their profits to benefit from these preferences.
This would be the most generous form of substance exclusion, and would likely benefit many countries that have preferential tax policies.
The least generous form of substance exemption is having none at all, which the Biden administration proposed for the US version of the minimum tax.
Between the US position and the other end of the spectrum there are many alternatives, including my own recommendation for the design of the minimum tax base.
Whether businesses are excluded based on their industries, or operations in low-tax jurisdictions are excluded due to the presence of economic substance, time will tell. There is still a lot of work to be done, but these political questions must be resolved taking into account the need for simplicity and neutrality and an awareness of trade-offs rather than the politics surrounding certain companies or countries.
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