Expert Speak Digital Frontiers
Published on Jun 27, 2019
Enforcement of the G20 agreement shall see stringent rules in order to contain the situation of tax avoidance.
G20 countries’ agreement promises to trip the tech giants

The Group of 20 (G20) Finance Ministers and Central Bank Governors Meeting, in Fukuoka was held last week. Amidst the shift in focus from international tax, the debate now centers upon the tax challenges arising from the digitalisation of the economy. The international tax system, designed on traditional business models face challenges to adjust to this new digital world.

To tackle the new challenges, some jurisdictions are on their way which intend to introduce interim unilateral tax measures that could damage the integrity of the international tax system.

Back in 2012, when scandals related to tax avoidance by the digital multinationals unleashed public anger and forced the G20 to act, OECD was called on to reform the global corporate tax system. As a result, a package of reforms known as the “Base Erosion and Profit Shifting” project, or BEPS were initiated. This reform process, led by the OECD countries was opened to the developing countries only after this initial package was unveiled.

The recent Group of 20 finance ministers agreement promises to shake up cross-border tax as digital firms will now be forced to pay taxes regardless of their physical presence or their measured profits in a country.

With a strong G20 support, significant progress has been made in recent years in the BEPS package including the exchange of tax information and capacity building in developing countries. Amidst this backdrop, the recent Group of 20 finance ministers agreement promises to shake up cross-border tax as digital firms will now be forced to pay taxes regardless of their physical presence or their measured profits in a country.

For the longest period, digital firms have been using the existing rules to considerably reduce their corporate taxes in the countries where they do most of their businesses by continuing to cut their tax bills by booking profits in low-tax countries regardless of the end user’s location.

For example, Google, moved €19.9 billion ($22.7 billion) through a Dutch shell company to Bermuda in 2017, and in the same year Facebook paid just £7.4 million ($9.6 million) in corporation tax to the United Kingdom, despite generating £1.3 billion of profit in the form of revenue there.

Multinationals can do this legally by using the so-called transfer pricing: a parent company sets the prices of transactions among its subsidaries to guarantee that profits are registered in low-tax countries, rather than where the economic activity that generated the profits actually occurred. For example, Vodafone which is the first major multinational to publish country-by-country data voluntarily, revealed that nearly 40% of its profits for 2016-17 were allocated to tax havens, with €1.4 billion declared in Luxembourg, where the company is taxed at an effective rate of 0.3%.

The new rules mean a higher tax burden for large multinational firms thereby making it harder for countries like Ireland to attract foreign direct investment with a promise of ultra-low corporate taxes. The G20 ‘Finance Ministers and Central Bank Governors Meeting’ communique seem to be in the right direction. “We welcome the recent progress on addressing the tax challenges arising from digitalisation and endorse the ambitious work program that consists of a two-pillar approach,” said the final version of the communique. “We will redouble our efforts for a consensus-based solution with a final report by 2020”.

The new rules mean a higher tax burden for large multinational firms thereby making it harder for countries like Ireland to attract foreign direct investment with a promise of ultra-low corporate taxes. The G20 ‘Finance Ministers and Central Bank Governors Meeting’ communique seem to be in the right direction.

These comments come against a background where individual countries — especially the UK and France — have expressed their displeasure with the time taken to agree on a global approach to the digital taxation and have indicated their plan to go ahead with a new tax regime in their respective jurisdictions.

These two countries have been vocal proponents of the proposal to tax big tech firms that focus on making it more difficult to shift profits to low-tax jurisdictions and introduce a minimum corporate tax.This has put the two countries at loggerheads with the United States, which has already expressed concern that US internet companies have been unfairly targeted in a push to update the global tax code.

“The United States has significant concerns with the two corporate taxes proposed by France and the UK,” Steven Mnuchin the US treasury secretary said during the two-day meeting of G20 finance ministers in the Japanese city of Fukuoka. “It sounds like we have a strong consensus” about the goals of tax reform, Mnuchin later added. “So now we need to just take the consensus across here and deal with technicalities of how we turn this into an agreement.”

Big internet companies have continually maintained that they follow the rules but the reality is that they pay very little tax in Europe and typically channel their sales through countries that have light touch tax regimes such as Ireland and Luxemburg. Tax avoidance can be found in all economic sectors, but digital companies best demonstrate how outdated the current international tax system is. As the marginal cost of production of these companies is zero the revenue accruing to them is equal to a rent and it is therefore important to tax this rent effectively. Contrary to what these companies’ leaders claim, this taxation would not negatively affect the supply of digital services as per some analysts.

Tax avoidance can be found in all economic sectors, but digital companies best demonstrate how outdated the current international tax system is. As the marginal cost of production of these companies is zero the revenue accruing to them is equal to a rent and it is therefore important to tax this rent effectively.

The G20’s debate on changes to the tax code focussing on two pillars could be a double whammy for some companies. The first pillar divides the rights to tax a company where its goods or services are sold even if it does not have a physical presence in that country.If companies are still able to find a way to book profits in low tax or offshore havens, they could thereby apply a global minimum tax rate that is to be agreed under the second pillar.

The path to a final agreement is still fraught with difficulty because of disagreement on a common definition of a digital business and how to distribute tax authority among different countries. Earlier this year, many countries gave their agreement on a roadmap to overhaul international tax rules overtaken by the development of digital commerce. The 125 members of the OECD led inclusive framework agreed on some concrete proposals in the two pillars which could form the basis of a global, consensus-based approach. These pillars involve the re-allocation of taxing rights among jurisdictions along-with the need to address the remaining Base Erosion and Profit Shifting (BEPS) issues, with the OECD claiming these to be the basis for detailed analysis over the next 18 months as the inclusive framework works towards delivering a proposal to the G20 by the end of 2020.

The first pillar will focus on how the existing rules that divide up the right to tax the income of multinationals among jurisdictions, including traditional transfer-pricing rules and the arm’s length principle could be modified to take into account the changes that digitalisation has brought to the world economy.

This will require a re-examination of the nexus rules that govern the amount of profit allocation to the business conducted there. The inclusive framework will look at proposals based on the concepts of marketing intangibles, user contribution and significant economic presence. The second pillar aims to resolve remaining BEPS issues and will explore two sets of interlocking rules designed to give jurisdictions a remedy, in cases where income is subject to no or very low taxation. Moreover, the new system will also need to decide when a digital company involved in a national economy can generate content from a community of users who live there — rather than simply selling a product across borders.

The inclusive framework will look at proposals based on the concepts of marketing intangibles, user contribution and significant economic presence.

Even in India, a proposal by CBDT (Central Board of Direct Taxes) to tax digital tech giants is being deliberated. Under this proposal, foreign companies such as Apple, Google, Facebook, Twitter, and Amazon reportedly have to pay a 30-40% digital tax in India for the revenue they generate from the country. According to the draft, companies with more than 200k users will have to pay taxes on the basis of the revenue generated from India. It remains to be seen how feasible this proposal might be as companies might be forced to change their entire holding structure under the new tax regime.

One can safely assume that when the G20 agreement is enforced in 2020, the geographic allocation of the multinationals’ global profits and tax payments should reflect both supply and demand factors. This should consider both sales (revenues) and employees (as a proxy for production). Such a system would benefit both developing and developed countries alike and would also ensure easy implementation of the new digital tax regime. Ultimately, G20 can even facilitate multilateralism.


(The author would like to thank Abhijit Mukhopadhyay, Senior Fellow, ORF for his comments on an earlier draft of the article)
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