In the last month, on October 8 to be specific, 136 countries agreed to a proposal to set a minimum global corporate tax rate at 15 per cent, starting in 2023. The proposal was developed by the Organization for Economic Co-operation and Development (OECD). The 15 per cent floor agreed is well below a corporate tax rate which averages around 23.5 per cent in industrialised countries. Many hope that the proposal heralds an important step forward on the road to international corporate tax reform.
The proposal was designed to help reverse nearly four decades of falling global corporate tax rates and to reduce the incentives for large multinational corporations (MNCs) to shift profits to low-tax jurisdictions to reduce their worldwide tax liability. Countries could still set their own local corporate tax rates. The idea is that if a MNC paid less than the global minimum rate in another country, that company's home jurisdiction could supplement its tax liability to ensure it paid the minimum. In this way, the incentives to shift profits to a low tax jurisdiction would be reduced.
The agreement stipulates a "two pillar" solution to address the issue of base erosion and profit shifting (BEPS), a strategy MNCs use to exploit gaps and differences between tax rules of different tax jurisdictions internationally. This is done to artificially shift profits to low or no-tax jurisdictions where there is little or no economic activity. BEPS result in tax not being paid in the jurisdiction where economic activity occurs - eroding revenue bases of countries and undermining the fairness and integrity of their tax systems. Although some schemes are legal, most are not.
The OECD's agreement's Pillar One stipulates a fairer distribution of profits and taxing rights among countries with respect to the most profitable MNCs. It will allow taxing rights to the countries over MNCs where they (MNCs) have business activities and earn profits, regardless of whether the firm has a physical presence there or not. This will apply to both products and services, particularly intellectual property and digital services.
The Pillar Two imposes a global corporate minimum tax at 15 per cent. This global minimum tax rate will apply to MNCs with revenues above US$870 million. This tax rule takes into account the relationship between MNCs and their subsidiaries. Parent MNCs whose subsidiaries have low-taxed foreign income must pay a "top-up" tax to increase the tax rate with respect to such income to 15 per cent.
The agreement on global corporate minimum tax does not seek to eliminate tax competition, but puts a multilaterally agreed limitation on it. Also, this minimum tax rule would not be self implementing. Each country will have to incorporate the rate and rules into its own tax system. For example, in the United States, the global corporate minimum tax would have to be passed by Congress and signed into law by the president. Furthermore, all international and bilateral tax treaties would require amendment.
While the global corporate minimum tax would apply to a specific minimum rate, its design in a particular country may take a different form. The most important issue is how the appropriate tax base is defined and implemented. In theory, an income tax should apply to a taxpayer's net income. But what constitute a taxable income has been always a problematic issue due to what is called the "inversion" tax loophole. Therefore, it remains to be seen how the OECD comes up with the definition of tax base for the effective implementation of its minimum tax agreement in 2023.
MNCs, in particular, deriving their income from intangible property such as royalties from trademark, patent and software licences have used subsidiaries in lower tax jurisdictions to avoid paying higher taxes in their home countries as well as in the countries where their income is earned. The agreement's overall objective is to ensure that MNCs pay at least some tax where they do business rather than where they choose to have their headquarters.
For example, Amazon, Facebook and Google have established their operations in Ireland where top corporate tax is 12.5 per cent far below the same in the US or in a large number of other countries they earn their incomes. In fact, they make nothing in Ireland. Due to the use of this inversion tax loophole, these companies effective tax rate becomes 2-3 per cent instead of 12.5 per cent in Ireland.
Ireland is not the only back door out of domestic corporate taxes. There are other countries in Europe like Luxembourg, Netherland, Poland and Estonia and host of other countries around the world. Tax competition fosters "race to the bottom" to attract investment into low tax jurisdictions from higher tax countries. This causes substantial loss of tax revenue and creating difficulties for financing public functions in higher tax countries.
The mainstream media has been very supportive of the agreement. The New York Times agreed that the minimum tax agreement could "end a decades-long race to the bottom on corporate taxation that has allowed tax havens to flourish and has drained countries of revenue". But that view is not correct rather creates confusion about the term a "tax haven" which has nothing to do with corporate taxation.
Though the mainstream media in the US is supportive of the global corporate minimum tax as well as domestic tax cuts, it refuses to say how it always stands by the corporate establishment in supporting domestic tax cuts in the country at a time of rising income inequality. The corporate tax rate in the US declined from 52.8 per cent in the late 1960s to 21 per cent in 2020.
The inversion loophole which is a tax avoidance method used by MNCs to shift their profits from high to low tax countries is not the only tax avoidance method they use. Another favourite method is what is called transfer pricing which is the manipulation internal intra-firm pricing mechanism to reduce tax liabilities in high tax countries, thus reducing net global tax payment.
For decades firms were involved in what is called the "shell-game", trading off corporate tax rates for loopholes and then loop-holes for rates. This, in fact, a tax evasion scheme (tax evasion is illegal while tax avoidance is legal) where income is concealed through complex legal structures and financial transactions facilitated by lawyers, accountants and financial institutions.
The global corporate minimum tax attempts to put a floor under both tax avoidance and tax competition. But that does not stop a country to provide subsidies rather than taxes to attract foreign investment. There is no difference between a subsidy and a tax cut. Both cost government tax revenue and benefit corporations.
Even if subsidies are targeted by the OECD, there may be other methods that can be used to incentivise foreign investment. Even if the 15 per cent tax legislation goes through legislatures in the 136 countries who signed on to the agreement, nothing can prevent each of them also passing more tax loopholes to the 15 per cent with accompanying exemptions, exceptions, offsetting tax credits and a whole lot more.
Most developing countries are likely to gain next to nothing in direct tax revenue from the minimum tax itself. But these countries eventually are likely to see some rise in their corporate tax revenue largely due to the expected global decline in both tax avoidance and tax competition.
Argentinian economy minister Martin Guzman said that the proposal would do little to help developing countries. Despite agreeing to the agreement, he had argued for a tax rate of at least 21 per cent. It is also to be noted that Kenya, Nigeria, Pakistan and Sri-Lanka have not signed up the agreement.
Oxfam also considers the 15 per cent rate as too low. In view of the corporate tax rate in industrialised countries averages at 23.5 per cent, well above the agreed 15 per cent floor, Susan Ruiz, Oxfam's tax policy head said, "The world is experiencing the largest increase in poverty in decades and massive explosion in inequality but this deal will do little or nothing to halt either. Instead, it is already being seen by some wealthy nations as an excuse to cut domestic corporate tax rates, risking a new race to the bottom".
It appears that the global corporate minimum tax rate is good news for tax havens and bad news for everyone else. The scandals unearthed in the Pandora Papers have nothing to do with corporate taxation but with individuals. Furthermore, the agreement has done nothing to address tax evasion by individuals using shell companies in tax havens. Interestingly enough, the Pandora Papers also highlighted that the US has become a prime tax haven along with others for rich foreigners cheating their own tax authorities.
The corporate minimum tax agreement envisions implementation of the rules in 2023. Given that 136 countries are involved in amending their tax laws, the timing looks too optimistic giving rise to uncertainty about timely implementation of the agreement.
The corporate minimum tax agreement is canvassed as an instrument to end a costly race to the bottom in the global economy. It is a hyped-up assertion. It possibly will change the type of race that countries play. Also, tax competition to lure foreign investment by lowering corporate tax rates or giving tax exemptions has been shown to be largely ineffective like low wages. In fact, low tax or low wage countries can turn out to be in most instances very high cost countries to do business. A low corporate tax regime only shifts tax burden onto workers, consumers and domestic small businesses.
Muhammad Mahmood is an independent
economic and political analyst.