Technology is making the world smaller. More countries are linked and interconnected in trade relations, particularly in digital trade, which the Organisation for Economic Co-operation and Development (OECD) Global Trade Forum highlighted would continue to grow, representing around 25% of the total trade as of 2020. Likewise, the World Trade Statistical Review reported that digitally delivered services traded within Asia reached 43.2% of the continent’s total trade in 2021.
Understanding the fundamentals of BEPS
A global initiative, led by the OECD and the G20 countries, was formed in 2015 to address base erosion and profit shifting (BEPS). As defined by the OECD guidelines, BEPS refers to tax planning strategies used by multinational enterprises (MNEs) that potentially take advantage of gaps and mismatches in differing tax rules across countries, resulting in tax avoidance where tax bases are eroded through deductible disbursements or where profits are artificially shifted to low or zero-tax jurisdictions with little or no economic activity.
With the rise of digitalization in the economy, the BEPS framework has continuously evolved to address the corresponding rise of global tax challenges through the development of a two-pillar approach that aims to create coherence and transparency in the application of international tax rules.
In 2021, the two-pillar approach, known as BEPS 2.0, was created as an update to the BEPS framework, which focuses on ensuring that profits are taxed where economic activities take place and value is created, upholding fairer and more equitable taxing rights across countries.
Based on OECD guidelines, Pillar 1 has two main components, namely Amount A and Amount B. Amount A relates to the reallocation of portions of profits of the related parties of a MNE group, more than an agreed baseline, to market jurisdictions where the MNE group has customers, regardless of the taxable presence in that jurisdiction. Amount B, on the other hand, relates to the setting of a standardized basis of renumeration, aligned with the arm’s length principle, for in-country baseline marketing and distribution activities performed by related party distributors for the respective MNE group.
Pillar 2, similarly, has two main components, namely, the global anti-base erosion (GloBE) rules and the subject-to-tax rule (STTR). GloBE rules refer to the imposition of a global minimum tax of 15% on the income arising from each jurisdiction where the MNE group operates. STTR, on the other hand, refers to the imposition of a globally agreed minimum tax rate of 9% on certain related party payments, such as interest and royalties of an MNE group, under agreed tax treaty benefits.
Between the two pillars, Pillar 2 is in the process of being implemented by a number of countries. Under the GloBE rules, the OECD has recommended that the income inclusion rule (IIR) and qualified domestic minimum top-up tax (QDMTT) become effective in 2024, while the undertaxed profits rule (UTPR) becomes effective in 2025. Meanwhile, STTR, being a treaty-based rule, can only be implemented through bilateral negotiations and amendments to individual tax treaties or as part of a multilateral convention.
Understanding the fundamentals of Pillar 2
Following OECD guidelines, MNEs with consolidated group revenue exceeding €750 million (approximately P45 billion) in at least two out of the last four years are required to pay a top-up tax on excess profits in any jurisdiction in which the effective tax rate (ETR) for the jurisdiction is below a 15% minimum rate. Collectively, such entities are called in-scope MNEs. Government entities, international organizations, non-profit organizations, and entities operating in pension, investment, real estate fund, and international shipping activities of MNEs are excluded from the coverage for Pillar 2.
Applying the GloBE rules, the IIR will impose an additional tax on the ultimate parent company of an in-scope MNE group when a foreign subsidiary of an in-scope MNE group is effectively taxed at a rate lower than 15%. In cases where the ultimate parent of an in-scope MNE group is in a jurisdiction that has not yet implemented Pillar 2, the UTPR is applied, which allocates the right to impose a top-up tax from the ultimate parent to the subsidiaries of an in-scope MNE group, located in different jurisdictions that have implemented Pillar 2.
QDMTT, consequently, impacts where the top-up tax is to be paid, as it allows any top-up tax from Pillar 2 to be collected in the domestic jurisdiction of the subsidiary, whose income tax rate is lower than 15%, rather than another entity of an in-scope MNE group in a foreign jurisdiction.
STTR, on the other hand, is a tax treaty provision to be added in certain double tax treaties of countries that allows the payor, known as the Source State, to recapture some of the taxing rights on outbound related party income payments, where the income is taxed under the payee, known as the Residence State, at a rate less than 9%. The covered income of STTR includes income payments pertaining to business profits, interest, royalties, and other income, excluding income from international shipping and air transport.
Understanding the impact of Pillar 2 in the Philippines
The Philippines has yet to locally adopt the OECD guidelines for Pillar 2. On November 2023, it nevertheless took a major step in joining the OECD/G20 Inclusive Framework on BEPS with its current 145 member countries, affirming BEPS actions in addressing the challenges posed by the digital economy.
Several countries have begun enacting laws to implement Pillar 2 beginning in 2024. Per the Philippine Statics Authority, four of the top trading partners of the Philippines, namely Japan, South Korea, the Netherlands, and Germany, have already enforced laws effective 2024 and 2025, while the rest, such as Hong Kong, Singapore, and Thailand, have ongoing draft legislations.
Philippine entities of in-scope MNEs are either subject to the regular corporate income tax of 20% or 25%, depending on the level of net taxable income and total assets, or to the preferential income tax rates such as the income tax holiday or the 5% gross income tax. As such, under the GloBE rules, those subject to preferential income tax rates may lead to the lowering of the ETR of an in-scope MNE group. Since most of the ultimate parent companies of in-scope MNEs are located outside the Philippines, the collection of the top-up tax will be effectively earned by foreign tax jurisdictions. This means that the tax savings arising from the lower income tax rate of a subsidiary in the Philippines of an in-scope MNE group will be offset by the top-up tax, which will be paid by the ultimate parent company, located in a foreign tax jurisdiction. Further, for the Philippines to benefit from the GloBE rules, implementing the QDMTT, which allows the domestic tax authority to collect the top-up tax, will be an advantage to the BIR but will effectively offset any income tax benefits granted by existing domestic tax rules such as the CREATE Act.
Under the STTR, interest and royalties are often subject to withholding tax rates that are above 9%. For instance, under the Japan-Philippine tax treaty, income payments for interest are subject to 10%, while royalties are subject to 10% or 15%. As such, STTR might not be as widely applicable for income payments between related parties in an in-scope MNE group where the Philippines is the Source State.
Clearly, if the Philippines implements Pillar 2 in the coming years, there is a need to rethink the current Philippine tax laws to balance the inflow of foreign investments in the Philippines with the tax implications of Pillar 2. As of 2024, the Board of Investments targets foreign investment approvals of around P1.3 to P1.5 trillion, after achieving a target of roughly P1.2 trillion in 2023. To continue the momentum of achieving the target year on year, with an annual increase of 10%, creating well-thought-out domestic tax rules that maximize tax collection under Pillar 2 while boosting the attractiveness of the Philippines as a viable investment destination can be challenging for various stakeholders.
Considerations such as the following, as laid out in OECD reports, might need a systematic, comprehensive analysis in localizing the implementation of Pillar 2 in the Philippines:
Truly, the Philippine entities of in-scope MNEs are at the crossroads of the impact of Pillar 2, paving new interpretations to the current tax rules and new revenue sources for tax collection.
Let's Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 30 January 2024
