The OECD Tax Agreement: A Global Shift, or a Shifty Promise?

Nine years ago, former United Nations Secretary-General Kofi Annan penned a New York Times editorial, with the headline “Stop the Plunder of Africa.”

Aside from illicit finance and tax evasion, Annan fingered transfer pricing and tax avoidance as a major source of this “plunder,” siphoning billions of dollars that could help struggling African nations build up infrastructure and alleviate poverty.

“It is all but impossible for Africa’s understaffed and poorly resourced revenue authorities to track real profits through the maze of shell companies, holding companies and offshore entities used by investors,” Annan wrote.

The Group of 20 nations and the Organization for Economic Cooperation and Development finalized in 2021 an agreement for a major global tax overhaul, the Two-Pillar solution, which is meant to address many of these very issues.

Yet, based on the public discussion, developing nations in Africa and around the world missed out again.

The agreement was designed by the OECD, a coalition of mostly Western countries. Despite the involvement of the larger “Inclusive Framework,” a group comprising most of the countries in the world, the Two-Pillar solution fundamentally favored the interests of wealthier nations, critics allege. The rules are complex and will be a major burden for cash-strapped poorer tax authorities, and the 15% global minimum tax is too low to really stop the tax competition which further puts developing countries at a disadvantage.

“The complexity of the administration, lack of data, lack of administration and information systems and competent human resources are also challenges that have to be faced by developing countries,” said Melani Astuti, an official at the Indonesia Ministry of Finance, said recently.

Global nonprofit Oxfam International was less subtle, calling the agreement a “mockery of fairness” when it was finalized in October 2021.

“This deal is a shameful and dangerous capitulation to the low-tax model of nations like Ireland,” Susana Ruiz of Oxfam said.

All of this may be true. Yet, it may also miss some important ways that the agreement, if fully implemented, could be a major benefit to low-income countries struggling with tax enforcement. It could do this by reducing the very tax avoidance that Annan pinpointed.

For the most part, the tax avoidance issues plaguing the “global South” aren’t in the sexy digital/high-tech IP area. But they’re no less pernicious. In a 2021 report, the International Monetary Fund identified related-party debt, mispricing of minerals or services such as marketing or management as major sources of tax avoidance in the sub-Saharan African mining industry. For instance, a mining company might charge its African subsidiary an exorbitant management fee for operating a mine, reducing taxable income in that jurisdiction while increasing income for the subsidiary receiving the fee–likely in a low-tax jurisdiction. Based on transfer pricing principles, those prices must be within the range of what independent parties would pay. But imagine how subjective “management fees” are to correctly price, especially for less sophisticated tax administrations.

Many developing countries’ economies are based on natural resources or commodities–the one thing you’d think would be relatively easy to price. They’re traded every day on open markets transparent spot prices, after all. But it’s a lot trickier than that in practice, since independent parties don’t always use the spot price. The issue became so difficult, South American countries developed the “Sixth Method” for commodities, essentially mandating that the spot price on the day of shipment is the correct transfer price.

While these may all look different from the kind of IP-based cost-sharing arrangements you hear about, they end up in basically the same place. Income is earned in low-tax jurisdictions with little in economic substance or workforce to justify it. Mauritius, the tiny island nation off Africa in the Indian Ocean, has been accused of acting as a deposit box for European countries looking to move taxable income away from the African nations where they exploit resources for profit.

This is where the OECD’s Pillar Two proposal comes in. It’s part of an overall project to deal with the “digitalization” of the economy, and ostensibly the global minimum tax is meant to target complex tax structures based on valuable intangibles. But it doesn’t target those transactions in particular–it looks for the havens where they’re likely to end up. Which could be the same low-tax jurisdictions where profits from developing countries are making their way to.

Under Pillar Two, a country can implement an “income inclusion rule,” and tax the foreign income of its taxpayers, if that income is not taxed by a foreign jurisdiction above the 15% rate. The formula also includes a carveout for tangible property and payroll, to better target the jurisdictions involved in avoidance or profit-shifting.

This is where the disagreement about whether Pillar Two will help developing countries comes in, I think. It’s not the developing countries who will be collecting revenue directly from IIRs, as they normally aren’t the residence of large global multinationals. So it’s easy to conclude that developing countries are missing out on potential gains from this new tax regime.

But Pillar Two is ultimately supposed to change taxpayer behavior. Without low-tax jurisdictions to put income in, corporations will have much less of an incentive to shift income in the first place. (The costs of income-shifting to the taxpayer are often underappreciated by commentators–companies can’t afford to do it if there isn’t a clear, substantial tax benefit at the end.) And without shifting, that income is more likely to remain where it was originally earned, including those poorer countries. In theory.

The indirect nature of this may be a factor in developing countries’ favor. They don’t have to be the ones dealing with these complex new rules in order to benefit. The rules give an incentive for Western nations to do the enforcement for them.

This still may not be the ideal fix, from the point of view of developing nations. They’d probably rather see a system which affirmatively reallocates more income to jurisdictions with workforces or natural resources. Or one which targets transactions like marketing or management fees directly–which the OECD’s Pillar One, Amount B does try to do, although critics claim it’s not enough.

But given the political realities of what is possible, and how intractable the income-shifting problem has been for the developing world, it’s a change that shouldn’t be casually dismissed.

The politics of developing nations and the OECD are complex and multifaceted. Part of this has to do with the blurring of the project’s goals, including to supposedly “end the race to the bottom” in tax competition. Maybe the 15% rate is too low to really help countries which feel forced to sacrifice their tax base in order to attract investments or jobs. And the substance-based carveout reduces it further.

But this is partially a reflection of the lack of a consensus on this issue, even within the developing world. Some countries would rather win the race to the bottom, than end it.

Many of the criticisms of the OECD process are coming from those who advocate shifting global tax policy to the United Nations, or to some other coalition which would supposedly offer better representation to the whole world. I’m skeptical that a forum shift would really change the underlying power dynamics which shape these negotiations. You can’t take the politics out of politics, or diplomacy.

As I said earlier, this is ultimately about changing the behavior of global multinationals, which makes it inherently unpredictable. There's precious little in hard data or analysis about how much developing countries may stand to benefit. It will also likely be many years before we have a clear idea how this upheaval has ultimately re-settled taxable income.

But when it's all over, countries may be surprised at who gains the most from this process.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

NEWS OF THE WEEK

France, Germany, Italy, the Netherlands and Spain issued a joint statement Sept. 9 claiming they were ready to move ahead on Pillar Two themselves, if the European Union fails to move forward due to Hungary’s veto. It’s not 100% clear if they can actually do this under EU’s common market rules, and this is likely more of a negotiating ploy. Nevertheless, it indicates continued momentum for the global minimum tax and could put more pressure on the EU to figure out a way forward.

The OECD held a public consultation for Pillar One on Sept. 12, to discuss implementation issues. Pillar One will require a multilateral treaty which many expect to take years to finalize and approve, so the issues now feel a tad academic. Business representatives are still concerned about how complex and administratively burdensome the new rules could be. A replay of the consultation is available on the above link, as well as written comments.

Caterpillar Inc. announced in an SEC filing that it had reached a settlement, without penalties, with the Internal Revenue Service for its 2007-2016 tax years. This apparently ends the 14-year saga which began in 2008 with a whistleblower complaint and included not only an IRS audit but a Senate hearing, a Department of Justice investigation, a raid of the company’s Peoria, Ill. office and a shareholder lawsuit. This case always fascinated me, and not only because it involved a century-old manufacturing behemoth, the polar opposite of the Silicon Valley tech giants which normally get into international tax trouble. It came down to what it always does–valuable intangible assets, and the difficulty the tax system sometimes has with modern business structures, including the “razor and blades” model that Caterpillar uses to earn income from replacement machine parts over decades.

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