International Tax Reform the C-Suite Can’t Ignore

By the end of this year, the global tax system will experience a historic shift that will have implications for multinational enterprises (MNEs) that go far beyond their tax departments. The upcoming regulatory changes will impose significant compliance burdens on MNEs and should prompt C-suites to reconsider whether their global operating models remain fit for purpose.

For decades, countries have competed intensely to attract MNEs’ operations by cutting their corporate tax rates and narrowing their tax base. But this competition is about to change significantly, now that 138 jurisdictions, representing nearly 95% of the global gross domestic product, have reached an agreement to put a floor on global tax competition. The agreement — part of an initiative led by G-20 countries and the Organization for Economic Cooperation and Development (OECD) — requires that all large MNEs be subject to a minimum tax of 15% in each foreign country in which they operate. Key jurisdictions, including all members of the European Union, are expected to apply the new rules in 2024.

A Brief History of Global Corporate Taxation

The new tax agreement represents a watershed moment for global business regulation. To understand how we got here, consider that the average corporate income tax rate among the high-income countries that the OECD comprised in 1980 was 47%, and that average had declined to 23% in 2021. The Obama and Biden administrations, among other governments around the world, have referred to this decline as a “race to the bottom,” whereas other policy experts assert that the decrease is the result of healthy competition fueled by tax policy.

In addition to the downward trend in corporate tax rates, the complexity of taxing cross-border income, combined with some countries’ intentional efforts to attract mobile income (meaning income that can easily be shifted to low-tax jurisdictions, such as the returns on intangible property and intercompany financing), have long meant that some MNEs’ profits could legally escape taxation altogether or be taxed only very lightly. Companies have long used complex tax structures with funny names, such as the “double Irish” and the “Dutch sandwich,” to exploit differences in countries’ characterizations of payments and entities to create stateless income. This has fed a perception among some lawmakers and the public, especially in Europe, that MNEs have been gaming the system to avoid paying their fair share. This sentiment, and many countries’ need for revenue following the global financial crisis of 2008-09, resulted in significant political momentum to reach a deal to address the ability of MNEs to engage in tax-base erosion and profit shifting (BEPS).

The G-20/OECD BEPS project was born from this movement. Its first action plan emerged in 2015: BEPS 1.0 was aimed at the specific techniques that MNEs were using to shift profits to low-tax countries. It largely blocked MNEs from using hybrid entities and payments to create stateless income. In addition, the rules governing the pricing of related party transactions were revised to make it more difficult to separate an MNE’s profits from its underlying value-creating activities. Although this latter change was intended to make companies report larger profits in the high-tax countries where their workers and headquarters were located, some MNEs responded by moving more value-creating activities into low-tax jurisdictions. Thus, BEPS 1.0 did not end the benefits of strategic tax planning, but it did require more operational considerations, such that minimizing a company’s effective tax rate generally required its tax department to insert itself into decisions about where the company located key decision makers and functions. This meant that tax savings often came at the cost of operational efficiency.

Given that companies were still able to maintain relatively low levels of taxation via their business models and low-tax jurisdictions, a new G-20 mandate arose in 2017 for the OECD to address remaining BEPS issues. Termed BEPS 2.0, this new phase includes a Pillar One plan, which aims to reallocate a portion of an MNE’s profits to the market jurisdictions where its customers are located, and a Pillar Two plan that sets a global minimum level of tax on an MNE’s income arising in each jurisdiction where it operates.

Pillar Two takes direct aim at the so-called race to the bottom in corporate tax rates, with detailed rules that lay out a coordinated system of global taxation. The rules require MNEs with revenues above 750 million euros ($815 million) to pay a corporate income tax of at least 15% in every country in which they operate. Compliance is ensured by granting other countries the right to impose a “top-up” tax on an MNE’s profits in any country with an effective tax rate below 15%. These rules enable countries to impose a top-up tax on a group entity located in one jurisdiction by reference to the group’s low-taxed earnings in other jurisdictions. This can occur even if that first group entity is already taxed at 15% or higher on its own earnings and has no direct shareholding relationship or intragroup business transactions with the entities generating the low-taxed earnings.

Consider an MNE operating in several countries, including a country with a 10% tax rate. Who gets the extra 5% top-up tax? First priority goes to the jurisdiction of the MNE’s ultimate parent company. If that jurisdiction does not adopt the rules, top-up priority next goes to the jurisdiction(s) in which the MNE’s intermediate holding companies are located. If the MNE is not owned directly or indirectly by a company located in a jurisdiction that has implemented the rules, the top-up tax is split among all jurisdictions where the MNE operates that have implemented the rules, based on each jurisdiction’s share of the MNE’s global assets and payroll. Thus, by design, an MNE cannot avoid the rules by being headquartered in a country that does not implement them. Because of the rules’ strict global design, the OECD expects them to increase global tax revenue from corporate income taxes by $220 billion per year.

In December 2022, the EU reached an agreement to make the minimum tax rules effective in all 27 member states by Jan. 1, 2024. South Korea also recently passed similar legislation, and Australia, Canada, Hong Kong, Japan, New Zealand, Singapore, Switzerland, the U.K., and others have publicly indicated that they will start the process to implement the rules. A divided U.S. Congress means that the United States will likely be an outlier and not implement the new rules anytime soon. However, as mentioned, that inaction will not stop other countries from imposing top-up taxes on a U.S.-based MNE’s low-taxed operations wherever they are located. This will potentially undercut the effectiveness of many existing U.S. tax breaks, such as the R&D tax credit, unless they are restructured.

How Corporations Should Prepare

C-suites should respond to this new global tax landscape in four ways, starting with understanding how much more in taxes their company will pay and managing investor relations accordingly. For some MNEs, the greatest costs will primarily come from the added administrative burdens of compliance. Other MNEs, however, might also see their effective tax rates increase significantly and will need to carefully manage investor expectations.

Second, the C-suite should reconsider existing supply chains and global organizational structures that were originally designed to minimize taxes. A 15% floor on the tax rate substantially reduces the returns on cross-border tax planning. That planning often required MNEs to adopt complex legal structures and product flows to locate profits in low-tax jurisdictions, even though their key value drivers and customers were located elsewhere. For example, tax planning that requires the title to tangible goods to be sold through a chain of multiple legal entities can add significant complexity to an organization’s enterprise resource planning (ERP) systems, as well as value-added taxes and customs compliance. Top managers will also want to look closely at unwinding inefficiencies that may have arisen when tax considerations, including those spurred by the changes made in BEPS 1.0, created pressure to locate value-creating activities in low-tax jurisdictions.

When the global minimum tax is fully implemented, these types of complex organizational structures may no longer be justified. Of course, some structures will still be advantageous: Effective tax rates in many countries significantly exceed 15%, leaving room for arbitrage. The point is that MNEs should reevaluate whether their prior tax-oriented organizational choices are still worth their operational complexity and inefficiency, considering that the tax benefits likely will be reduced. This exercise may be particularly salient to MNEs that are already undergoing transformation, including those aiming to simplify their supply chains and other operations.

Management should consider: How would the MNE have organized itself without regard to taxes? What are the real costs of these existing structures — not just in terms of maintaining additional legal entities, but in terms of complexity and operational inefficiency, reputational risk, and the risk that they will be challenged by tax authorities?

The third way C-suites should respond to these tax changes is to consider how to ease the compliance burden that may overwhelm their tax and accounting departments. Many tax departments, including those in MNEs that primarily operate in high-tax jurisdictions, have bemoaned the difficulty of accessing the internal data that will be required for compliance with the new global rules. They don’t see how they will be able to comply with their current staffing. Companies overhauling their ERP systems should consider bolt-on projects to automate some of the compliance. Getting this done quickly will require buy-in from top management.

Lastly, companies should consider ramping up their lobbying efforts. We doubt that global tax competition is truly behind us. We anticipate a new “race to the bottom” in other types of government incentives to attract business activity to jurisdictions that will not trigger the top-up tax under the new OECD rules. MNEs can seize this moment to lobby for other supportive policies to partially offset the tax changes. For example, governments are already mulling redesigning the type and size of direct grants and subsidies, guarantee mechanisms, and risk capital support measures that they offer for local research and development activities. They are also redesigning their tax incentives for commercializing locally conducted research. An extra push from MNEs now can mean the difference between the rollout of favorable policies or limited or no policies in this space.