Taxing MNCs: G-7 formula is flawed

The agreement reached by the finance ministers of the advanced economies at the G-7 meeting on taxing MNCs stands on two main pillars: one, a global minimum corporate tax (GMCT) rate of 15%, and two, “reaching an equitable solution on the allocation of taxing rights, with market countries awarded taxing rights on at least 20% of profit exceeding a 10% margin for the largest and most profitable multinational enterprises.” Concurrently, efforts are to be made for the removal of all Digital Services Taxes (DST) imposed on these companies by several countries.

The move is prompted by MNCs registering in low-tax jurisdictions such as the Netherlands, Ireland and Luxembourg, and showing all their revenues and profits in those jurisdictions regardless of where their sales are made. This way, they avoid paying higher taxes in the ‘source’ country and cause a corresponding loss of revenue to the latter— around $100 billion annually, according to the Tax Justice Network (TJN). 

India, too, is losing heavily— around $10 billion annually— according to TJN. The loss is mostly due to digital giants such as Google, Facebook and Amazon reporting the bulk of the revenues generated from Indian customers in the books of their investment arms/subsidiaries registered in tax havens such as Singapore, Mauritius and Ireland.

How does the G-7 address this? Under pillar I, by requiring every country to set a floor tax rate, it wants to kill the very urge that drives MNCs to register their subsidiaries in low-tax jurisdictions. Under pillar II, source countries get to tax a certain portion of the profits generated by such companies from the operations in their territories.

Far from helping, however, this prescription will only create more anomalies.

A globally determined minimum tax rate will interfere with the sovereign right of a country to galvanise its tax policy to achieve its objectives. For instance, on September 20, 2019, the Indian government brought about a steep reduction in the tax rate for new entities in the manufacturing sector from the then existing 25% to 15%. Under the GMCT regime, with the floor set at 15%, India will lose the freedom to lower its rate below this level if it wants to. Had an earlier US proposal to set GMCT at 21% gone through, India would then have been forced to raise its minimum tax rate from 15% to 21%.

That apart, a GMCT will do little to tackle tax evasion. For instance, think of a scenario wherein India levies tax at 21% against the current low of 15% (for new manufacturing units). This won’t result in additional tax collection to fully offset the loss resulting from profit-shifting. If out of Rs 100, only Rs 20 is recorded in India, the extra revenue from the higher rate will be only Rs 1.20 (20x.06) against a loss of Rs 12 due to profit-shifting (80×0.15).

The only logical way to prevent evasion is for the source country, where the profits are generated, to capture and tax them. This right should vest entirely with the source country. This stance is endorsed by the Organisation for Economic Cooperation and Development (OECD), which is coordinating the efforts of over 140 countries to arrive at the so-called BEPS (base erosion and profit-shifting) framework agreement to tax MNC profits.

Thus, in an October 2019 draft on “taxing digital companies,” the OECD had stated: “Profits of MNCs should be available for taxation in the country where their customers are, irrespective of any physical presence in that market, and a formula should be evolved for such taxation.” But the formula proposed by the G-7 under pillar II is flawed.

It gives to the source country taxing rights only to the extent of 20% of the profit (exceeding a 10% margin) and that too, for the largest and most profitable MNCs. Put simply, if the firm earns Rs 100 from its operation in India, then India gets to collect tax only on Rs 20. Who gets the right to tax the balance Rs 80? Will it be the tax haven or the home country of the MNC or both?

Clearly, the G-7 formula is erroneous. Neither the country of incorporation nor MNCs’ home country has any right to collect tax on profits made from its operations in the source country.

To conclude, India should not agree to the GMCT. However, it can take on board the G-7 proposal under pillar II, but with a clear stipulation that only the source country from where an offshore firm is deriving its income – irrespective of where it is recorded – has the sole right to collect tax on it. A consensus should be built around a criterion for arriving at the annual taxable profit. The source country should have the freedom to decide the tax rate it deems fit in line with its policy imperatives.

Until then, India should retain DST (or ‘equalisation levy’ introduced in 2016/2020, instead of tax on profits) on digital giants.

(The writer is a Delhi-based policy analyst)