By Smarak Swain, Shilpa Goel and Ashish Goel
The COVID-19 pandemic has severely affected national economies and the global economy. The world is experiencing an economic slowdown and is possibly staring at a prolonged recession. This is bound to have a significant impact on tax policy and decision making at the domestic and international levels.
At the behest of the Group of Twenty (G-20) nations, the Organisation for Economic Co-operation and Development (OECD) is working on an ambitious project (with strict timelines) to revise how nations have historically applied and interpreted some of the core international tax principles with respect to tax challenges facing the digital economy.
The OECD’s Programme of Work, which is being supported by 135+ countries and jurisdictions that are part of the Inclusive Framework, comprises a two-pillar (Pillar One and Pillar Two) approach to address the tax challenges of digitalisation.
While the OECD’s work on Pillar One started off by trying to find solutions to the challenges in taxing the digital economy, it has ended up in effectively re-writing transfer pricing rules. Pillar Two aims at enforcing a global minimum rate of tax to curb a race to the bottom on corporate taxes by certain countries and jurisdictions. The OECD is eyeing a deadline of December 2020 to implement the proposed reforms.
The Inclusive Framework was working full throttle to meet the already rigorous December 2020 deadline and then the pandemic hit planet Earth. Countries badly hit by the pandemic (which includes all major economies of the world) are already experiencing a contraction in aggregate demand. Lower aggregate demand will increase unemployment, which in turn will further lower aggregate demand. National governments will have to step in and spend to create demand and stimulate the economy. They will desperately seek additional revenues without raising burden on domestic business.
Pillar One, which proposes to give new taxing rights to market jurisdictions, means additional revenues for governments. No doubt, there would be an increased political manoeuvre to make it a reality. It would not, therefore, be an exaggeration to suggest that Pillar One would likely meet its intended deadline.
This is more so given that no extensions have come from the G-20 nations, at whose behest the OECD is working on the reform process. Quite on the contrary, the OECD, in a recent note to the G-20, has itself suggested that the work on digital economy taxation is important and is progressing well despite limitations posed by COVID-19 (virtual meetings are being held).
The case with Pillar Two, however, is likely going to be exactly the opposite. Pillar Two is a peculiar reform, in the sense that it imposes a global minimum tax rate irrespective of whether or not a State seeks to attract footloose businesses or encourage BEPS practices.
Clearly, this seeks to force tax policy on all sovereign powers all over the world: a developing country that wishes to incentivise foreign investment cannot provide tax exemptions. Many countries will be up in arms against this proposal in a post-COVID-19 world. Keynes’ solution against economic slowdown was government spending and a low tax rate. There is no doubt that many more countries will be rolling out tax incentives as part of their COVID-19 economic stimulus package.
Take, for instance, the immediate response some governments to the pandemic. Singapore’s immediate response was a 25 percent rebate on tax liability of businesses. South Korea has reduced the corporate income tax of small and medium enterprises. South Korea is also offering its companies a tax deduction of 100% for at least three years if they downsize their overseas operations and expand domestic operations. And this is just the beginning.
The idea of a global minimum tax rate will not go down well with major world economies. At the same time, major economies will not be fine with allowing so-called tax havens to engage in harmful tax practices.
Tax havens have thrived in times of economic crisis. Switzerland grew in the years after the two world wars, partly because High Net-worth Individuals escaping high tax rates in their residence countries shifted base to this low tax jurisdiction. Similarly, Dubai’s business spiked in the aftermath of the Iranian Revolution of 1979. Its business spiked again when civil war in Syria led to the country’s economic ruin.
Hence, international efforts will focus on enforcing ‘economic substance requirements’ in low tax jurisdictions. OECD’s Forum on Harmful Tax Practices will undoubtedly play an important role in identifying regimes that allow multinationals to book profits without having substantial economic activity in the jurisdiction.
The pandemic’s after-effects will be more severe on developing countries than developed countries. These countries will seek cheap foreign capital to boost economic activity, leading to proliferation of exemptions and deductions. Countries will reward Special Economic Zones and Export Oriented Units attractive tax incentives to pull capital into the country.
However, incentives for foreign investment will be provided strategically. For instance, many countries that distrust China want to control and monitor Chinese capital in their territories, rather than award them with exemptions. Tax incentives will be targeted and provided through specific amendments to tax treaties. This will ultimately be a result of negotiations between capital exporting and capital importing countries.
States will be more dependent on multinationals to jumpstart their economy. In order to attract more multinationals, they will proactively provide tax certainty. This will likely see a spike in advance pricing agreements. Safe harbour regimes will be further liberalised to account for the changed circumstances.
We are writing this piece amid a pandemic. The discussion in this piece speculates about a post-COVID-19 world, implying the underlying optimism in the authors: that the world will soon overcome the pandemic. But what if this becomes the new norm? What if the pandemic stretches for a year or two?
In such a situation, work-from-home will become a new normal. Professionals and skilled labour around the world are already becoming accustomed to web conferences and have moved from desks to desktops. This will require a relook into the definitions of permanent establishment and place of effective management and would trigger a renegotiation of tax treaties.
The views expressed herein are personal to the authors.