Next Steps from the OECD on BEPS 2.0
Today, the OECD released a new consultation document on a proposal to change how some multinational businesses are taxed. This proposal lays out a unified approach to addressing the tax challenges arising from the digitalization of the economy. In May, the OECD published a program of work laying out several approaches to changing where multinationals are taxed and a new anti-avoidance regime.
Multinational companies generally pay tax on their profits in locations around the world where they have operations. However, highly digitalized businesses and those that rely on revenues from intangible assets like patents can minimize their exposure to taxes in the countries where their products are sold simply because they do not need physical establishments to sell those products.
The OECD’s program of work laid out three competing proposals to address the challenge of taxing businesses where they do not have physical presence:
Give countries new taxing authority over some share of the profits from highly profitable businesses
Allocate taxing authority among countries based on where multinational businesses have sales, employees, physical assets, and users
Use a formula for allocating just a certain share of the taxable profits of highly profitable multinational firms
The new unified approach from the OECD is a compromise among those previous proposals.
The proposal is from the OECD Secretariat and has not yet been endorsed by its member countries. The OECD hopes to use the proposal to move toward consensus not only among its member countries but the group of more than 130 countries in the Inclusive Framework.
Though there are many details remaining to be worked out, the new approach would give countries new taxing authority over multinational businesses in certain circumstances. Those narrow circumstances depend on whether a company is a consumer-facing business, whether the company is a certain size (potentially defined as more than €750 million [$823 million] in global revenues), and whether it meets a threshold that would be “largely based on sales.”
The shift would be a departure from the arm’s length principle that is currently used to determine where multinational companies pay tax when selling products across national borders.
Today’s proposal specifically says that companies in extractive industries would be excluded from the scope of the proposal and suggests that the financial services sector could also be a candidate for exclusion.
With those specifications, this becomes a somewhat narrow proposal that will likely impact a set of companies that have high levels of profitability and are headquartered in just a handful of countries.
This is because the proposal envisions separating out taxable profits above a certain level of profitability from profits below that level. More specifically, it’s an approach to divide “normal” returns from so-called “super-normal” returns. Though the new OECD document does not specify a threshold above which returns would be considered super-normal, it is worth considering recent research by the IMF that uses a threshold of 7.5 percent return to assets.
First, the IMF analysis has found that a large portion of multinationals have returns that are lower than that 7.5 percent threshold, meaning they might not be exposed to the new OECD proposal (depending on the ultimate threshold). The proposal envisions a potentially similar calculation using a certain level of profitability beyond which would be the deemed residual profit.
Second, the analysis finds that companies with profit margins above the 7.5 percent return on assets are concentrated in a handful of countries. Profits above this threshold are so-called “residual profits,” and the table below shows that the U.S. has the largest share of these profits.
Changing where companies pay taxes will impact the tax revenues of countries around the world and the OECD is working with countries on analyzing the impact of that shift in tax payments. With so many details still to be determined, it is difficult to assess how much revenue would be shifted and what countries will benefit the most.
However, the U.S. is most exposed to changing where highly profitable businesses are taxed not only because residual profits are concentrated here, but also because the U.S. has a trade surplus in royalties (our trade balance in “Charges for the use of intellectual property” stood at $72.6 billion in 2018 according to BEA data).
Preliminary results from the OECD, which were summarized in a webcast this morning, point to significantly higher tax revenues for most countries due to the change in where companies pay tax and the impact of a global minimum tax proposal. Investment hubs will likely face a loss of tax revenues while countries where sales are made are likely to see higher revenues. As expected, multinational businesses in the digital sector will bear the brunt of the impact from the proposals.
Initial OECD analysis also points to a modest impact on forward-looking effective tax rates. It is possible that this is due to the narrow scope of the project. If many companies are not impacted by the proposal, then the overall impact on effective tax rates could be small.
However, for there to be significantly more tax revenue available to countries, those industries or businesses that are impacted would need to pay significantly higher tax rates.
Another takeaway from the summarized results of the initial analysis points to the risks of the failure of this effort. The current level of uncertainty in global tax policy, partially driven by unilateral measures like digital services taxes, makes investment decisions difficult for multinational businesses. However, a solution at the OECD that leads to the reversal of the unilateral measures could improve things for international investment.
Related to this analysis, it is important to recognize that individual country proposals to tamp down on tax avoidance have created negative impacts on real investment. This can be seen in research on Controlled-Foreign-Corporation Rules and Thin Capitalization Rules. It is important for policymakers to understand these effects and to analyze the new OECD proposals in light of these studies.
The OECD will be hosting a consultation on this new proposal on November 21-22 (perhaps there will need to be a mini-Tax Prom in Paris). The deadline for providing comments on this new proposal is November 12.
Additionally, the OECD is expected to release a new paper outlining the minimum tax proposal in November with a further consultation in December.
The continuation of this work is important, but the OECD and policymakers around the world should carefully consider whether these proposals will lead to more certainty, or if they will undermine that goal by simply be a step toward more unilateralism. The impact on cross-border investment will also be a critical issue to consider, and the ongoing impact assessment by the OECD is an important part of the work.