India, along with 135 other countries, reached an agreement to update international rules that aim to limit tax avoidance by transnational companies, on 8 October 2021. The agreement, which is a result of long-standing discussions at the Organisation for Economic Cooperation and Development, or OECD, endorsed a two-pronged solution to address tax challenges emerging out of digitalisation.
The solution is to amend profit allocation and nexus rules and expand the taxation rights of countries where businesses operate. The agreement also sets a global minimum rate of 15 per cent. In essence, the proposed changes, to which countries have agreed, will affect not just how much corporate tax transnational companies (TNCs) pay but also where they pay it.
The multilateral agreement has come against the backdrop of visible populist angst against large TNCs across the world. Global public finance experts attribute a worrying and real rise in economic inequity between and within nations, to exploitative behaviour by TNCs. For instance, a UK-based advocacy group called the Tax Justice Network estimates that India loses approximately $10 billion every year on account of international corporate tax abuse.
The use of tax havens
Public policy on corporate taxes has long struggled to find the optimal mix of tax rates and a taxable base. Lowering rates, as tax havens like Ireland and Netherlands have done, have two effects – an ‘income effect’ that depresses tax revenue due to the lower rate, and a ‘substitution effect’ that improves competitiveness in attracting capital flows. Take, for example, Ireland, which was the biggest recipient of foreign direct investment (FDI) in the world in the first half of 2020. The inflow of $75 billion into the country was higher than investments in the United States and China.
A key reason for Ireland’s growth is its favourable system for TNCs. Tax rates across the country have witnessed a consistent decline from about 50 per cent in the 1980s to 12.5 per cent today. Besides, other mechanisms allow TNCs to leverage innovative tax engineering techniques to shift profits into low-tax territories like Bermuda or the Cayman Islands. While companies across sectors exploit tax havens in an effort to minimise their tax liabilities, technology sector giants have come under particular scrutiny. For instance, Microsoft’s Irish subsidiary, which posted a profit of $315 billion in 2020 paid zero corporate tax on it, according to a report in The Guardian. While the strategy to establish itself as a tax-friendly jurisdiction has helped Ireland generate revenue and employment, it erodes tax bases of other countries like India, denying them valuable resources to reduce economic imbalances.
More importantly, countries around the world look to undercut the tax rates in other countries in their effort to attract investments, which has started a race to the bottom in taxation. To wit, corporate taxes have fallen from an average of 50 per cent in 1980 to around 24 per cent in 2020. The race to the bottom in corporate taxation exists because of a ‘prisoners’ dilemma’ game across countries. The gameplay is: countries will consider their best response imagining what other countries will do. If all other countries keep their corporate tax rates high, reducing corporate tax rates will ease capital inflows at the cost of other economies. Conversely, if others reduce their corporate tax rates, it is important to slash rates to remain competitive. With every country basing its strategy on this game, a secular and spiralling fall in the global corporate tax rate is inevitable.
Countries are aware of the limits posed by such a race. Their recipe for coordination, a theoretical solution to the prisoners’ dilemma, has predominantly hinged on bilateral treaties intended to create a stable and attractive tax environment. This coordinated approach also encourages capital inflows while ensuring mutual assistance and dispute resolution (for example, avoiding double taxation). There are over 3,000 such bilateral tax treaties. However, in attempting to solve this coordination problem bilaterally, countries have inadvertently incentivised ‘treaty shopping’. That is, when TNCs artificially shift profits to benefit from tax arbitrage between treaty jurisdictions
The OECD Solution
The integration of economies with global markets has increased with the growth of digitalisation, and tax rules framed in the 20th century fail to reflect this reality. Existing norms assume that businesses are physically present in countries where they have to operate. This is, of course, not the case for digital businesses. Consequently, there is much friction between sovereigns looking for an optimal mix of tax rates and a taxable base, and the TNCs that constantly seek opportunities to reduce their burden through base erosion and profit shifting.
The multilateral agreement addresses such concerns. First, it allows countries like India to expand their taxable base without resorting to unilateral actions like the introduction of new levies. This can deter inbound investments and increase the cost of doing business for Indian start-ups. Second, a global minimum tax rate means that the TNCs would have to pay at least 15 per cent on their taxable profits regardless of where they are headquartered or where they operate. This is expected to lead to additional global tax revenues of approximately $275 billion.
One outstanding academic concern is that high-income countries are expected to account for approximately 61 per cent of concomitant global tax revenue gains while developing countries are likely to earn a lower share. However, this short-term asymmetry of relative gains should not deter India from staying the course on a multilateral tax solution. In Koan Advisory’s recent report on ‘Redistributing Gains from Digitalisation’, we highlight that commentators and experts must instead pay attention to two structural features that point towards net long-term gains.
First, technology adoption follows an “S-shaped” curve — low growth at initial and saturation stages, and high growth at the intermediate stage. India is on the high growth part of this technology curve, while higher-income countries are on its saturation part. This implies that the quantum of tax revenue under the new regime is likely to grow at a higher rate for India than developed countries. Second, India’s transition from a technology imitator to an innovator will foster market expansion. The fact that 28 start-ups have achieved unicorn status just this year is a proxy indicator of this. India’s tax base will also grow faster than in the developed world. Thus, the country’s continued alignment with the global tax framework is a win-win scenario.
Mohit Kalawatia works at Koan Advisory Group, a technology policy consulting firm. He tweets @MohitKalawatia. Views are personal.
This article is part of ThePrint-Koan Advisory series that analyses emerging policies, laws and regulations in India’s technology sector. Read all the articles here.
(Edited by Srinjoy Dey)