A historic global statement has been signed by 132 members of the OECD Inclusion Framework (including Israel) which intends to bring fairness and stability to the international corporate tax framework and will lead to a complete reform of the international corporate tax system. The proposed reform is based on a Two Pillar Solution developed by the Inclusive Framework to address tax challenges arising from the digitalization of the economy. Pillar One of the proposal provides new nexus rules for the allocation of profits of a Multinational Enterprise (MNE) to countries where MNEs do business and where products and services are used and/ or consumed without having a physical presence. Pillar Two provides for a global minimum effective tax rate of at least 15 % for MNEs which will help to curb aggressive tax planning and stop the corporate tax “race to the bottom”.
Some key elements of the Two Pillar System and their possible impact on Israel.
- Pillar One: Allocation of profits to market jurisdiction
The Allocation of profits of the largest MNEs to market jurisdictions, where the consumer or users are located is a complete new concept. It reflects the changing nature of business models, including the ability of companies to do business without a physical presence.
Under the proposed rules a new nexus rule is adopted which will ensure that 20 % to 30 % of the residual profit defined as profit in excess of 10 % of revenue will be relocated to the market jurisdiction where the goods or services are used or consumed provided that the MNE derives at least EUR 1 million in revenue from the respective market jurisdiction (this threshold is lowered to EUR 250,000 for smaller markets).
This Re-allocation rule would only apply to the biggest MNEs in the world with global turnover of above EUR 20 billion (maybe reduced to EUR 10 billion) and a profitability rate of above 10 %.
Due to the threshold of 20 billion Euros the proposed new allocation rule would probably not have an impact on Israeli companies. The rule might have an impact in the futures if the threshold is to be lowered to EUR 10 billion.
However, for tax collection purposes the Pillar One Solution might have an effect. There is a likely chance that some profits of the biggest MNEs are reallocated to Israel if the MNE has Israeli users and consumers.
The Digital Service Tax Rules of various countries such as France and Turkey taken as a unilateral measure will most likely be removed and eliminated once the Pillar One Reallocation Rule is in place.
- Pillar Two: Global Minimum Tax
The member countries of the OECD Inclusive Framework (including Israel) also agreed on the implementation of a global minimum tax of at least 15 % on a country by country basis. For years countries are concerned with the competition between jurisdictions to drive the corporate tax rate down in order to create investment incentives. With the agreement of a global minimum tax of at least 15 % (e.g. Germany and France demand a higher rate) this race to the bottom should be back-stopped. The Minimum Tax has two parallel components: The “GLOBE-Rule” (Global Anti-Base Erosion) and the “STT-Rule” (Subject To Tax Rule).
- The Globe Anti Base Erosion Rule (GLOBE)
The GLOBE consists of an a) “Income inclusion Rule” (“IIR”) and b) “Undertaxed Payment Rule (“UTPR”). Under the IIR the home jurisdiction of a MNE would be allowed to tax the income of foreign controlled corporations of the group if the income would be taxed at an effective tax rate lower than the minimum tax rate of 15 %, meaning that the IIR would impose a top-up tax on a parent entity in respect to the low taxed income of a controlled foreign corporation. To the extent that the low tax income of a controlled foreign corporation is not subject to the IIR, the “Undertaxed Payment Rule will apply. Under the later deductions might be denied or adjustments might be required for certain payments made to related low-taxed foreign corporations. Thus, even if there is no Income Inclusion Rule in the jurisdiction of the parent company the UTPR will make sure that the effective tax rate is at least 15 % for low taxed entities.
The GLOBE Rule will apply to MNEs with global turnover above EUR 750 million, although countries are free to adopt lower thresholds.
The GLOBE Rule will have the status of a common approach, whereby countries of the Inclusive Framework (including Israel) are not required to adopt the rules, but are required to accept the application of GLOBE by other Inclusive Framework countries.
The Globe Rule might have a significant impact on MNEs with Israeli subsidiaries and on Israeli groups, especially if the Israeli entity is a so called “preferred technological enterprise” or a “special preferred technological enterprise” under the Law for Encouragement of Capital Investments and subject to low tax rates of 6 % or 12 % and thus, below the minimum rate of at least 15 %.
- Subject to Tax Rule (“STTR”)
The second component of the Pillar Two Solution is the STTR, which will be applicable parallel to Globe and which is a lot simpler. It is a treaty-based rule and will apply as a withholding tax on certain intercompany payments, such as interest, dividends and royalties in cases where the applicable nominal corporate tax rates in the recipient country is less than the minimum rate for STTR, which will be between 7.5 % – 9 %. The taxing right will be limited to the difference between the minimum rate (e.g. 8 % for STTR) and the corporate tax rate on these payments in the country where the recipient is located. If STTR applies, even reduced withholding tax rates under a Double Tax Treaty could be ignored. Therefore, a multilateral instrument will have to be adopted to facilitate the adoption of the STTR.
The STTR will have an impact on MNEs with Israeli Subsidiaries where the group might enjoy a reduced withholding tax rate for dividends of 6 % under the Law for Encouragement of Capital Investments.
Summary
The proposed Two Pillar System agreed by 132 members of the Inclusive Framework is a huge step that can lead to a complete global reform of the corporate tax system.
A detailed implementation plan is to be finalized by October 2021 and the rules could be effective in 2023 according to the ambitious timeline set by the Inclusive Framework.
For tax collection purposes Israel will mostly likely have a net benefit from the Pillar One Solution due to the allocation of taxing rights to market jurisdictions.
The Globe Rule under the Pillar Two Solution would enable countries to impose “top-up tax” on a parent entity with respect to income incurred by a subsidiary in a low-tax jurisdiction (income inclusion rule) or to deny associated deductions (undertaxed payments rule). As long as the Israeli subsidiary will pay the nominal corporate Israeli tax rate of 23 %, the proposed minimum tax regime will not have an impact on Israel. However, it will have an effect if the Israeli corporation is classified as a preferred technical enterprise and subject to the special tax rates of the Law for Encouragement of Investments with lower Israeli tax rates than the minimum tax rate of at least 15 %. In this regard, it is expected that Israel will make some adjustments to the “Encouragement Law” in order to avoid that benefits granted in Israel will be picked up by the taxation in foreign countries.
There are still a lot of questions open with respect to the implementation of the Two Pillar System. A question will also be how many countries will actually adhere to the rules and adopt or at least accept the final rules. MNEs with Israeli subsidiaries or Israeli based MNEs will analyze the impact of this global tax reform on their existing business and tax structure and eventually may consider a reconstruction at an early stage.