At the same time our everyday lives are affected by globalisation and digitalisation in ways we are not aware of. The internet, our ways of transportation, the way we communicate and the way we learn are all products of an increasingly digitalised and globalised world.
In the past decade, as digitalisation and globalisation of the world rapidly increased, the way of doing business evolved. The digital transformation of doing business has had far-reaching economic and social impacts resulting in significant changes. In today’s digitalised world, multinational companies are able to conduct business on a large scale in a jurisdiction with little or no physical presence there. This international development has sparked global debates in many legal and regulatory domains as well as in the field of international tax. International tax rules are based on agreements made in the 1920s when business revolved around brick and mortar factories and the only products sold were physical. Back then, the fundamentals of the international tax rules for determining where and how much tax should be paid were based on physical presence and the arm’s length principle. These fundamentals greatly aligned with the economic environment of that day. However, it has become more and more apparent that these fundamentals fall short in the modern day.
Through technological development, physical presence in a jurisdiction has become less essential for large multinationals. Factors induced by globalisation and digitalisation – such as the growth of intangible assets and companies’ ability to shift profits to low or no tax jurisdictions – pose a serious threat to the fundamentals of the international tax rules. Under the current international tax rules, profits from cross-border activities of a foreign company can only be taxed in another jurisdiction if that foreign company has a physical presence in that jurisdiction. In addition, technological advancement has made it simpler for large multinational companies to shift their profits to low or no tax jurisdictions. This tension created by the decreasing extent to which physical presence is required for (multinational) companies and their ability to shift profits to low- or no-tax jurisdictions imposes constant challenges to the effectiveness of the existing rules to distribute taxing rights between countries from cross-border activities.
During the financial crisis of 2008, most countries saw their tax revenues drop in cash terms due to declining economic activity and tax cuts aimed at softening the effects of the recession that followed. During these turbulent times in which job uncertainty grew and government expenditures increased at a rapid pace, the public debate about the status of our global tax system ignited. In this time of financial insecurity it became more and more important that multinational companies pay their fair share of taxes. The debate reached a peak when Mrs Hodge spoke the famous words ‘’we are not accusing you of being illegal, we are accusing you of being immoral’’. Following the financial crisis, the G20 countries put tax at the top of their agenda with the Organization for Economic Co-operation and Development (OECD) as intergovernmental organisation to lead the way. In 2013, the OECD committed to address the growing public and political concerns with the Base Erosion Profit Shifting project (BEPS) consisting of 15 measures set out to equip governments with domestic and international tax rules. The first spear-point of the BEPS project was addressing the tax challenges arising from digitalisation.
Out of the 15 measures of the BEPS project, addressing the tax challenges arising from digitalisation turned out to be the most difficult. However, on 8 October 2021, more than 135 counties and jurisdictions committed to the Two-Pillar Solution to reform international tax rules and ensure that multinational companies pay their fair share of tax wherever they operate. The Two-Pillar Solution consists of Pillar One and Pillar Two. By re-allocating some of the taxing rights over the largest and most profitable multinational companies to the markets where they have their business activities and earn profits, Pillar One seeks a fairer distribution of profits and taxing rights regardless of physical presence. Pillar Two on the other hand provides for a global minimum effective tax rate of 15% for multinational companies with a consolidated group revenue of at least €750 million. With the global minimum effective tax rate, Pillar Two intends to put a floor on tax competition between jurisdictions and eliminate the effects of low or no tax jurisdictions.
The OECD expects that under Pillar One, taxing rights on more than USD $125 billion of profits will be reallocated to market jurisdictions each year. As to Pillar Two, the minimum tax rate of 15% is estimated to generate around $150 billion in additional global tax revenues per year. Initially it was envisaged for both Pillar One and Pillar Two to take effect in 2023. However, this initial target date turned out to be too ambitious. On 11 July 2022, the OECD published a progress report on Pillar One in which it is recognised that the implementation timeline will be delayed until 2024. Also, with respect to Pillar Two, the implementation process has not been straightforward and might end in a fragmented approach.
During the course of 2022, various countries have taken their own steps towards the implementation of Pillar Two. Whereas some countries are leading the pack, other countries are holding off and taking a back seat. The implementation of Pillar Two in the United States remains stalled, as proposed changes to the current U.S. global minimum tax — the tax on global intangible low-taxed income (GILTI) — were left out of the recently enacted tax reconciliation bill, the “Inflation Reduction Act.” On the other hand, the government of the United Kingdom has published its first draft legislation with respect to Pillar Two with an intended implementation date of 31 December 2023.
As for the European Union, the European Commission proposed to implement Pillar Two by ways of an EU directive. Without coordinated implementation of an EU directive, the commission fears that the scale, detail and technicalities of the Pillar Two rules could fragment the internal market of the EU, creating mismatches and distorting the fair market competition between EU Member States. On 22 December 2021, the European Commission published the first draft EU Directive on the Pillar Two rules. However, up until today the EU Member States did not reach unanimous consensus on the proposed directive. All the while in anticipation of the Pillar Two Solution, obligations arise for companies such as describing the possible impact of Pillar Two in the financial statements. During this process, Hungary took up the role of the black sheep amidst the EU Member States. Apart from Hungary, all Member States are aligned on the implementation of the Pillar Two directive. As EU directives on taxation require unanimous consent of all the Member States, the implementation of Pillar Two by ways of an EU directive might take a little longer. It does not come as a surprise that France, Germany, Italy, The Netherlands and Spain released a joint statement on 9 September 2022, expressing their commitment to implementing the Pillar Two rules in 2023 – albeit on a standalone basis.
Only time will tell whether the international tax rules will catch up with the digital transformation of the global economy in the coming years. It appears unlikely that all jurisdictions will enact and implement Pillar Two measures within the ambitious 2023 target. Nevertheless, there is still a commitment by more than 135 jurisdictions to introduce the rules. As such, companies should be thinking ahead of time how Pillar Two could impact their business in order to be ready ahead of implementation.