Biden’s corporate tax reforms are welcome – but their impact remains uncertain

Rishi Sunak hailed a ‘historic agreement’ as G7 finance ministers agreed in principle to overhaul the way multinational companies are taxed. This was no overstatement from the chancellor: the communique could lead to the biggest reform of the international corporate tax system for a century.

The Cornwall summit saw agreement on a minimum tax rate of at least 15% and a new formula to allocate a portion of the profits of the largest and most profitable multinationals to the country where consumers and users are based. For regular watchers of the OECD Base Erosion and Profit Shifting (BEPS) process, which has been seeking international consensus on improving the international tax system since 2013, this agreement seemed impossible just a few months’ ago.

However, for all the new impetus provided by Joe Biden, who endorsed OECD proposals on which the reforms are modelled, this is not a final, detailed agreement.

The G7 agreement could be the biggest international corporate tax system reform since the 1920s

Experts have long recognised that the international tax system is not suitable in a world of complex multinationals. Originally conceived in the 1920s and little changed since then, the current international tax regime allows countries to tax multinationals’ profits based on where the value is created. That was relatively simple for a widget company – the profit will be allocated to where the widget is made. But modern companies and supply chains are complex, and there is no single ‘right’ answer to the question ‘where was the value created?’. With digital companies, where some contend much of the value is generated by users who neither pay nor are paid, the problem is even harder. This creates scope for companies to record profits in lower tax countries to reduce their overall bill.

As well as the problem of identifying where profit should be taxed, this source-based system of taxation encourages countries to compete, via lower tax rates, for activity. This has been an accepted international practice, including the UK reducing its rates in the 2010s and Ireland having a very low 12.5% corporate tax rate.

The two pillars of the G7 agreement propose solutions to both problems. The minimum tax (pillar two) would limit tax competition by disincentivising countries from having a tax rate below the minimum: if the tax rate is too low, other countries could then claim additional tax from the company. The agreement to allow some of the profits of the biggest and most profitable businesses to be taxed based on the location of consumers (pillar one) is an attempt to limit the problems that arise from identifying where value is created, at least in the most problematic cases like digital companies.

The agreement will likely mean some more revenue for the UK

The agreement is likely to be beneficial for the UK. The UK’s corporation tax rate is set to increase to 25% in 2023, far above the proposed minimum. The UK undoubtedly loses some corporation tax revenue via profit shifting activities of multinationals, although it is difficult to put a precise number on this and some of the larger estimates should be treated with scepticism.

The UK is also a big consumer market, especially of the content of large US-based digital companies, and so the pillar one proposals should also benefit the UK. This has been a focus of UK policy for some time, and the Digital Services Tax (DST) was introduced to capture companies that the government felt should be paying more corporation tax in the UK. As part of any final agreement, the UK would likely abolish the DST, with any new revenue from corporate taxes partially offset by the loss of DST revenues, which are projected to be £700m a year by 2024/25.

While the agreement will mostly benefit the UK, it will also make it harder for the UK to engage in tax competition, which it did openly during the 2010s. It may also threaten the 10% ‘patent box’ rate – a lower rate of corporation tax charged on income arising from intellectual property – introduced in the 2010s.

Whether the deal will raise a large amount of revenue for the UK depends on the details

The G7 reached an agreement on principles, but crucial details are yet to be decided. What is the minimum tax rate of 15% actually taxing? Different countries have different definitions of taxable profit. Will the minimum tax rate apply at a country level, or will a multinational need to pay at least 15% tax overall? If the latter, the proposals would raise much less revenue overall. The details on pillar one profit allocation will matter too. Which companies will it affect? Will there be opt-outs for certain industries? All these questions remain unresolved.  

The answers will determine revenue implications for the UK. While large profits reported in tax havens is evidence of profit shifting, it is hard to know where the profit is being shifted from. Should that profit be UK profit, French profit, or US profit? A change this radical would lead to changes in patterns of multinational activity too, again with uncertain consequences for the UK. The Treasury would should not bank on the multi-billion sums that some have estimated a deal could raise.

So while this agreement is welcome news, just how radical it turns out to be, and what it means for the UK, will depend on how these proposals are fleshed out at the upcoming G20 meeting and beyond.