Base Erosion and Profit Shifting Initiative (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to locations with nil or low tax rates and no/little economic activity, resulting in immense loss of tax revenues across nations.
The OECD/G20 inclusive framework on BEPS started in 2015 to tackle global taxation challenges concertedly. The framework consists of 15 actions that equip countries to counter tax avoidance. The rapid digitalization of the global economy and its associated challenges resulted in the transition to a two-pillar approach.
The first pillar involves solutions for determining the allocation of taxing rights. This is applicable to large multinational enterprises (MNE) and countries are empowered to tax MNEs with profits exceeding 10 per cent of their sales at a proposed effective rate of 25 per cent. It focuses on reallocating taxing rights to market jurisdictions, where MNEs generate substantial profits irrespective of their physical presence.
The timeline for adopting and implementing Pillar One lacks clarity due to the need for greater acceptance among countries. Pillar Two is designed to ensure that MNEs pay a minimum level of tax on profits. The strategy allows other countries to impose a ‘top-up’ tax on an MNE operating in its jurisdiction if the effective tax rate in the source country is below the agreed minimum rate.
Landmark pact
The BEPS initiative witnessed nearly 140 countries agreeing to a global minimum tax (GMT) rate of 15 per cent in a landmark deal in October 2021. The GMT forms a crucial part of Pillar Two of the two-pillar solution to counter global taxation challenges. This ensures that a minimum tax of 15 per cent is imposed on MNEs with annual revenues exceeding €750 million.
The OECD expects the new tax regime to cover 90 per cent of the global economy with a contribution of $150 billion to the coffers. The adoption of GMT assumes importance, given the role of tax havens and offshore financial centres (OFCs) in profit shifting.
An estimate by the Tax Justice Network in 2021 suggested that governments worldwide lose around $483 billion to tax havens every year. The loss of tax revenue is not just restricted to governments of developed countries; developing countries also face leakages in tax revenues. According to the 2023 State of Tax Justice report, India faces an annual loss of around 1.2 per cent of its GDP due to corporate tax abuse. The loss considered as a share of GDP or tax revenue is more significant for emerging countries. A shocking revelation is that the tax losses faced by low-income countries are equivalent to half of their public health budgets.
Challenges ahead
The adoption of BEPS poses significant challenges for both developed and developing countries. One critical factor that hinder the adoption of Pillar One is that countries are hesitant to give up their tax sovereignty.
For example, countries like India, which imposes digital services tax, will be forced to withdraw it. Recent studies estimate that the potential revenue gains from the reallocation of taxing rights as a part of the implementation of Pillar One are expected to be less than the revenues gained from digital services tax.
Developing countries, including India, have highlighted that Pillar One measures are skewed in favour of developed countries, where most of the MNEs are headquartered. Future discussions on the BEPS measures must reformulate the tax reallocation principles to account for the contributions of markets to the global profits of MNEs.
The potential revenue gains for developed countries by adopting BEPS measures, including GMT, are likely to be significantly higher than for developing countries. Another significant issue associated with implementing Pillar Two measures is its potential conflict with the existing bilateral investment treaties, particularly in the case of low and lower-middle-income countries.
Bilateral investment treaties are often designed to attract foreign investments to developing economies by providing tax sops. In such instances, developed countries will be in a position of power to levy ‘top-up taxes’ as developing countries would want to avoid being investor-unfriendly.
Impact on flows
The uncertainties arising from such tax measures will likely place a wedge on the capital flows between nations. Implementing policy measures associated with the BEPS initiative can potentially put a downward pressure on new investments by MNEs.
Between 2015 and 2021, FDI by large MNEs (annual revenues exceeding €750 million) constituted more than 70 per cent of the greenfield investments in developing economies. Further, the global investment landscape will substantially change with the re-distribution of investments.
Although the competition to attract FDI based on attractive tax rates may ease, other factors, such as institutional setup, business environment, etc., will determine the FDI flows in the future. India may not witness a substantial fall in inward FDI because of GMT.
Outward investments from India aimed at shifting profits may witness a fall, as nearly 70 per cent of India’s outward FDI was directed to OFCs between 2008 and 2020.
The success of the BEPS initiative hinges on the political will of the nations, concerted and inclusive efforts, irrespective of the size of the country.
Krishnan is a research scholar and Padmaja is an assistant professor at the National Institute of Technology, Trichy. Gopalakrishnan is Fellow, NITI Aayog. Views expressed are personal