The long and winding road to global corporate tax justice

In theory, the Biden administration and the EU can collaborate to end multinational tax abuse. In practice, it’s not that simple.

More than 130 countries and jurisdictions have now signed up in principle to outline proposals to reform international corporate tax rules. These proposals—and in particular, the global minimum corporate-tax rate envisaged—would represent the biggest change for a century. But the reforms, now driven by the United States under Joe Biden, are also proving highly divisive, globally and within the European Union. That has potentially important implications for the tax rules and EU-US relations.

Donald Trump was a bad US president and an easy one for the EU to oppose. That’s part of the reason the tax negotiations, under the auspices of the Organisation for Economic Co-operation and Development’s ‘inclusive framework’, had largely ground to a halt by the November 2020 presidential election. Biden looks a better ally and the Treasury under Janet Yellen certainly knows on which side tax justice lies. But while the ‘America First’ agenda has gone, the new administration doesn’t seem likely to put anyone else first instead.

Although the new ambition is to make sure all multinationals pay a fairer share of tax everywhere, the old desire—to keep the taxable profits of US multinationals largely out of other countries’ hands—remains. Squaring the two is not unproblematic for the Biden administration. For the EU, it exposes three serious issues: the EU’s own ambition, whether its internal decision-making is fit for purpose and how it relates to the US.

Problem clear

In the wake of the 2008 global financial crisis, the richer countries that make up the membership of the OECD found common cause, for the first time, with lower-income countries which had long objected to the scale of corporate tax abuse—largely perpetrated by multinationals from OECD countries, using ‘tax havens’ which are OECD member states or dependent territories of them. And so it was that the larger and more diverse G20 group of countries—rather than the narrow G7/G8 constellation—became the leading forum for international tax reform.

The problem was clear. The shifting of taxable global profits had exploded since the early 1990s, when US multinationals transferred 5 per cent from the location of the underlying economic activity. By the early 2010s this ratio exceeded 25 per cent and was growing steadily.

The G20 gave the mandate to the OECD in 2012 and the Base Erosion and Profit Shifting (BEPS) initiative ran from 2013 to 2015. It aimed to bring the taxable profits of multinationals more in line with the location of their real economic activity. But the process was hampered by the refusal of the US and others to go beyond the ‘arm’s length principle’, which underpins the separate-entity accounting approach and dates to decisions taken by the League of Nations (faced with much smaller imperial companies) in the 1920s and 30s.

This principle treats each subsidiary within a multinational as distinct for tax purposes. To ensure taxable profits are declared in the correct entity (and so jurisdiction), it requires that intra-group transactions are carried out at ‘arm’s length’ prices—the prices that would in theory apply if the same transaction occurred between unrelated entities in an open market.

The principle is however economically incoherent, since the raison d’être of multinationals is that they can do business more efficiently than separate entities conducting the same transactions—and so arm’s-length prices cannot be appropriate by definition. In practice, it has stimulated vast intra-group transactions where there is no open-market equivalent—loans, charges for ‘management services’, intellectual-property payments—and tax authorities are then unable to challenge a pricing arrangement which happens to strip profits out to a low- or no-tax jurisdiction.

‘BEPS 2.0’

BEPS could thus only put the most partial of sticking plasters on a by now gaping wound and a new process, ‘BEPS 2.0’,  began almost before all the action points arising had been transposed into legislation. It took at its starting-point the need to go beyond the arm’s-length principle. This was the focus of ‘pillar one’ of the reforms, designed to make profit shifting harder or impossible. ‘Pillar two’ meanwhile would introduce a global minimum tax rate, providing a floor to make profit shifting also much less profitable.

The ambition of pillar one was wide. An original proposal from the intergovernmental group of 24 lower-income countries (the G-24) in January 2019 would have ended use of arm’s-length pricing and apportioned all the global profits of multinationals as the basis for taxation according to where their real activity took place. The OECD secretariat swiftly eliminated this from consideration—despite the ‘inclusive framework’ having set its evaluation as part of the secretariat’s workplan—once it became clear that the US and France were negotiating bilaterally on a far narrower scope.

The G-24 version of pillar one would have covered the 8,000 or so largest multinationals across all sectors. The secretariat proposal focused on 2,300 multinationals in consumer-facing businesses and automated digital services. The US proposal, now the basis for agreement, covers only around the 100 largest and most profitable, excluding financial services and the extractives sector, with global annual revenues of over $20 billion and a margin on sales above 10 per cent. Only 20-30 per cent of the profits above that very high margin would be apportioned to the jurisdiction where final sales occurred.

In this sense, the US position is unchanged in principle—‘we won’t let you target our tech multinationals’—but more extreme in practice. The G-24 proposal would not have targeted US technology companies, covering all multinationals, but there seems no appetite in the current process to reopen the struggle to fix the arm’s-length principle.

On pillar two, however, the Biden administration position has been far more ambitious than anything the previous administration would accept. It sought to set the minimum rate at 21 per cent, rather than the feeble 12.5 per cent the OECD had been promoting. Even the rate of 15 per cent or above endorsed by the G7 and the G20 finance ministers at their recent summits would be a meaningful improvement and imply substantially greater revenues—since so much profit is currently taxed at a much lower rate.

Topping up

Less obviously, but more importantly, the Biden administration took an early decision to accept proposals to assess the effective rate on a jurisdiction-by-jurisdiction basis. This entails that tax at below the minimum rate on any profits in any jurisdiction would be ‘topped up’ to the minimum. The previous position had been one of ‘global blending’: there would be no topping up as long as the aggregate rate paid worldwide reached the agreed minimum. That would have rewarded profit shifting up to the point where taxes paid below the minimum rate (on profits shifted out of the EU, for example) could be offset by taxes above the minimum rate (paid in the US, for instance).

Now any taxes on profits declared in a haven such as Ireland or the Netherlands, taxed there at a near-zero effective rate, will face being topped up to the minimum somewhere—regardless of whether the profits were shifted in and of how the multinational’s tax position looks elsewhere. The minimum rate is intended to be the minimum in every jurisdiction where a multinational operates, which dramatically improves its impact—while posing the most serious threat tax havens have ever faced to their business model.

But on one crucial aspect, the Biden administration is very much in line with Trump’s. As with the OECD proposal, the first right to top up tax is given to the headquarters country. For instance, a US multinational achieving a near-zero effective rate by a secret ruling in Luxembourg on profits shifted out of Spain would see its tax topped up by the US—not Spain.

A version of pillar two later proposed by tax-justice researchers, the minimum effective tax rate (METR), would apportion the undertaxed profits to the countries of real activity, allowing them to top up the tax instead—not at the minimum rate but at their prevailing statutory rate. This would raise an estimated $460 billion worldwide at a 15 per cent minimum, compared with $275 billion under the OECD proposal.

Almost every country would do better under the METR, including in the EU, and the incentive for profit shifting would be much more sharply reduced. The proposal is also significantly simpler than that of the OECD and is not expected to require global treaty change—allowing progress via ‘a coalition of the willing’, without havens or others able to block adoption. But while this alternative has been discussed widely, the OECD remains committed to privileging headquarters countries.

This poses a further problem. If the incentive to shift profits into the traditional havens is eliminated, an incentive remains to shift profits into the headquarters country and there to pay the minimum tax rate (rather than the statutory rate). At least one major US multinational has taken this approach to the minimum-tax provision in the Trump reforms, ending its use of Bermuda and instead directing profits to the US—with no evident reduction in profit shifting, or increase in tax paid, in the rest of the world.

A global equivalent of this would leave headquarters countries with substantial additional revenues but all others equally exposed to corporate tax abuse. While the US is primarily a headquarters country, most EU members (and all lower-income countries) are more likely to play host to the biggest multinationals.

Significant challenges

The EU therefore faces three significant challenges. First, will the reforms deliver on the public demand to see fair treatment of the major tax avoiders, including US technology companies? The tight limits on the redrawn pillar one and the absolute requirement to give up digital sales taxes in exchange make that highly unlikely. The European Commission’s proposed digital levy may address the problem but US opposition has led to work on this being suspended to allow the OECD negotiations to move ahead.

Secondly, will the reforms deliver substantial additional revenues, to support the pandemic response and economic recovery? Pillar two should do so but the distribution of benefits is likely to be heavily stacked towards those bigger EU members that are more often headquarters countries for the biggest multinationals. That may well create tensions, even among the various ‘winners’. The EU’s self-image of supporting international development will also be difficult to square with the bloc’s support for a measure that denies most benefits to lower-income countries.

Thirdly, will the reforms allow the EU to move ahead as one? Open opposition has thus far come only from two groups: on the one hand, the few lower-income countries, including Nigeria and Kenya, that have braved the wrath of the OECD and the threat of US trade sanctions by opposing the unfairness of the deal and, on the other, the low-tax states that have sought to defend their right to promote tax abuse at others’ expense. The second group includes Ireland, Hungary and Estonia, making the intra-EU split the most significant by far among OECD members.

The EU has faced a swift shift—from a broadly united, somewhat progressive voice in international tax talks to a divided, potentially regressive set of actors in a world where the US has claimed the mantle of fairness, leading the end of the ‘race to the bottom’. That characterisation overlooks the pronounced emphasis of US diplomacy on US revenues over all others but it captures a key element of the public discourse.

Ireland and others may soon abandon outright opposition, recognising that the minimum-tax element can and will proceed as a coalition of the willing, requiring them to rework their business models. But the EU may still struggle to achieve unanimity—and that could result in the biggest divergence of member-state corporate-tax rules for decades.

Lower-income countries

At the same time, forcing the deal through over the growing objections of many lower-income countries could result in it remaining on paper only. For example, it would be unrealistic to expect India to give up the substantial revenues of its ‘equalisation levy’ on technology companies in exchange for uncertain benefits from a narrow pillar one, which in any case would only materialise after global treaty change. India and others might well choose however not to risk outright opposition to the US and instead agree a deal that might be highly unlikely even to issue in treaty change—nor, therefore, the need to enact policy change.

In this scenario, pillar two would proceed as a coalition of the willing. The Biden administration could demonstrate the global participation that would ensure support in Congress and the minimum tax would become law in the US and many other G20 countries from 2023. That in turn would put a line through the business model of Ireland and the other most important profit-shifting jurisdictions—which could end their resistance, eventually perhaps allowing a subsequent EU directive to align member states fully again.

Globally, unilateral measures could continue to spread in the vacuum which would be created by a pillar-one agreement that failed to result in treaty change. At the same time, pressure to shift from the OECD to a genuinely inclusive setting at the United Nations would likely also grow. Both the high-level UN FACTI Panel addressing financial accountability, transparency and integrity and the secretary-general’s initiative on financing for development beyond the pandemic have recommended a UN tax convention, which could create the basis for intergovernmental tax negotiations under the organisation’s auspices.

Long proposed by the G77 group of countries, such proposals have previously been defeated by the common opposition of OECD members—in particular, the EU and US acting together to retain power. A divided EU, combined with EU-US tensions and widespread international dissatisfaction at the openly unfair distribution of benefits in the OECD proposals, could however provide the basis for an important shift in the global architecture.

This is part of a series on the transatlantic relationship supported by the Friedrich Ebert Stiftung