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The global tax revolution

More fairness and a minimum corporation tax rate

  • A decades-long race to the bottom in the world of corporation tax is coming to an end

  • Focus on redistribution and harmonised tax rules

  • Impact on companies relatively limited, but significant shifts at country level

End of the race to the bottom

More than 60 per cent – that was the rate of tax that companies had to pay on their profits in Germany in the 1980s. The US charged less than 50 per cent corporation tax at the time, while Switzerland’s rate was just under 30 per cent. For decades, local corporation tax rates have been a significant factor for companies when choosing where to base their headquarters. The multinational oil company Royal Dutch Shell, for example, is planning to give up its second headquarters in The Hague, meaning that it will be (tax) resident in London going forward. It will even remove the designation ‘Royal Dutch’ from its company name. Officially, Shell has cited the structural complexities arising from being listed on two stock exchanges (e.g. in connection with share repurchases) as the driver for the move. In addition, higher emissions reduction thresholds apply in the Netherlands. But it seems safe to assume that the UK’s corporation tax rate being 6 percentage points lower makes the farewell less painful for Shell.

Over the last few decades, many countries became sucked into a veritable race to the bottom in their bid to attract large multinationals (see chart 1). The formation of huge digital corporations whose business models no longer required a physical presence made this approach even more appealing. If, for example, a big US tech company chose a particular country as the base for its European headquarters, it would typically pay corporation tax on all of its European profits in that country. But such practices may soon be a thing of the past. A new international agreement seeks to stop countries from undercutting each other and to stop companies from transferring profits to tax havens. What does this mean for the affected countries and companies?

Chart 1: Decades-long race to the bottom to come to an end

Corporation tax rates* (%)

Chart 1: Decades-long race to the bottom to come to an end
Source: OECD, as at 23 November 2021. *Combined tax rate (e.g. national and federal state level).

In 2012, the G20 nations, the OECD member states and a number of emerging markets came together to combat the tax avoidance practices of multinational corporations. The aim of this initiative was to find specific ways to tackle tax avoidance strategies such as base erosion and profit shifting. Even back then, the spotlight was on the digital economy. However, it soon became clear that the measures adopted in 2015 did not go far enough. This prompted spirited solo efforts from various governments: In 2019, France introduced a digital services tax that applied to revenue as well as advertising income and proceeds from the sale of personal data; however, this tax was later suspended. Similar rules were introduced in Italy, Spain and the UK.

As the debate on this issue intensified, the G20 and OECD states also decided to revisit the subject. The aim of the new project launched in 2019 was to develop a harmonised global taxation concept that would provide solutions for two key challenges:

  • What kind of taxation concept is needed to address the rapidly advancing digitalisation of business models innovatively and effectively?

  • How can the tax avoidance strategies that remain in use be tackled at the root and stopped for good in order to make taxation fairer at a global level?

The outcome of the project was announced in October and ratified by the G20 nations and a further 136 countries. The newly agreed rules are divided into two pillars: The first pillar aims to distribute corporation tax revenue more fairly, while the objective of the second pillar is to generate more corporation tax revenue overall.

Initially, the measures under the first pillar were meant to apply to digital businesses only, but the US successfully pushed for the scope to be expanded. Now, around 100 of the biggest and most profitable multinationals in the world will be targeted. The measures will shift the entitlement to levy taxes on corporate profits of around US$ 125 billion annually from the current place of tax residence of affected companies to the countries in which the taxable revenue and profits are actually generated (the ‘market states’).

The focus is on companies with annual revenue of more than €20 billion and a profit margin of more than 10 per cent. In future, market states will be entitled to tax 25 per cent of any profit above the 10 per cent profit margin at their local rate.

From a regional perspective, US corporations make up the majority (around 60 per cent) of the companies affected by the new rules. In terms of sectors, technology and pharmaceutical companies are most heavily represented in the target pool. These two sectors also account for the largest absolute share of profits to be redistributed. Among the companies likely to fall under the new rules are also a number of German enterprises. Based on the latest data, Bayer, Fresenius, SAP, Adidas, Deutsche Telekom, Henkel and Siemens all meet the defined criteria. By contrast, Germany’s big car manufacturers are likely to slip through the net as they typically do not break the 10 per cent profit margin threshold. Certain businesses, for example mining companies and regulated financial services providers, are exempt from the rules either because they have close physical ties to specific locations by virtue of their business model (mine operators) or because they are already subject to a dedicated taxation framework (financial services).

It is important to bear in mind that the primary aim of the first pillar is not to generate more tax revenue but rather to distribute tax revenue more fairly by strengthening the entitlement of the places where taxable profits are actually earned. The net impact on affected companies should consequently be limited. At country level, however, there will be a very tangible shift in tax revenue streams away from low-tax economies, such as Ireland and Luxembourg, towards countries such as the US and large European economies.

Minimum tax rate will generate additional revenue

The second pillar will have noticeable effects for companies. For some corporations, the implementation of a 15 per cent minimum tax rate will lead to a (modest) rise in their overall tax rate. The OECD projects an increase in annual tax revenue of more than €130 billion. But comparing this figure to, say, total annual US corporation tax revenue (approx. €320 billion in the 2021 fiscal year) or Apple’s profit (more than €80 billion) provides a clue as to why the capital markets have more or less taken this news in their stride.

The rules under pillar two generally apply to companies that generate annual revenue of at least €750 million. This alone would affect almost 8,000 companies globally, including several hundred German businesses. However, governments have the right to also apply this 15 per cent tax rate to multinational companies headquartered in their country, even if these do not reach the revenue threshold. At the same time, governments are not obliged to raise their tax rates for all companies to this level. Where revenue or profit is taxed at a lower rate in another country, the country in which a company has its headquarters may apply subsequent taxation. The difference between the actual tax paid in the other country and the agreed minimum tax rate determines how much subsequent tax can be levied.

The countries that stand to benefit from the new rules are primarily those with a relatively high tax rate, e.g. France, Germany and the US. According to analyses by the Conseil d’analyse économique, an institution that also advises the French government, these countries will probably see a significant increase in tax revenue, especially in the short term (see chart 2). Over time, however, this added revenue will decrease as low-tax economies will likely raise their tax rates. Ireland, for example, has already decided to raise its tax rate for companies with revenue of more than €750 million from 12.5 per cent to 15 per cent.

Chart 2: Beneficiaries of the minimum tax rate

Potential increase in tax revenue per year as a result of the minimum tax rate (€ billion)

Chart 2: Beneficiaries of the minimum tax rate
Sources: Conseil d'analyse économique, Union Investment, as at June 2021.

This means that any national digital tax projects are off the table for the time being. All signatory countries have agreed on a moratorium. In return, the US announced that it would not impose retaliatory tariffs against France, for example. Once the international taxation arrangements have been implemented, Austria, Italy, Spain and the UK will also abolish their digital taxes. The implementation schedule is ambitious, aiming for the new rules to come into effect in 2023. But given the enormous complexity of the undertaking and the remaining political hurdles, for example in the US, it seems likely that the implementation will take longer.

Rules will bring more fairness

Fundamentally, the two pillars of the new regime address exactly those issues that have led to the prevailing imbalance in taxation over the course of decades of changing economic structures: Ever more complex supply chains have paved the way for base erosion, and the growing significance of intangible assets has made it easier to shift profits. Last but not least, digital business models that do not require any physical presence have often escaped the grasp of the global taxation system. Profits have become more movable and countries compete for them by undercutting each other with ever lower tax rates. However, this race to the bottom runs counter to one of the fundamental principles of good tax policy: fairness. At the same time, the transition to a greener economy poses huge challenges for governments that will need to be tackled with extensive public investment. Implementing a long-term solution at international level that prevents extreme forms of competition in the global tax arena is therefore a sensible and necessary step.

The new regime does offer benefits for the affected companies. Firstly, it provides them with a reliable basis for planning. The existing patchwork of rules will disappear along with the threat of potential new digital taxes or retaliatory tariffs. And secondly, it will create a level playing field for all competitors, at least with regard to taxes. This is undoubtedly one of the reasons why companies have reacted relatively positively to the new rules and why the announcement of the new arrangement did not trigger a setback for affected stocks and bonds in the capital markets. Some companies will see their overall tax rate go up slightly, but compared to their (in some cases very substantial) margins, this increase should be negligible.

However, this does not spell the end of the competition between countries. Instead, it merely shifts the focus away from taxation and towards investment incentives, such as financial support for companies seeking to set up new premises or reductions in ancillary wage costs. Countries such as the US and Germany are also likely to make greater use of these instruments again going forward. As part of efforts to bring strategically important supply chains back closer to home, e.g. as a strategic move in the competition with China, a more proactive industrial policy approach will be indispensable.


Authors:

Janis Blaum and Sandra Ebner

As at: 3 December 2021