1. Introduction
In an increasingly globalized economy, the issue of tax avoidance has taken center stage, with multinational enterprises (MNEs) leveraging tax havens to minimize their tax liabilities. Tax havens—jurisdictions offering low or no corporate tax rates—facilitate strategies like profit shifting and base erosion. These practices allow companies to report income in low-tax jurisdictions, even when profits are generated in high-tax regions.
For instance, an MNE might transfer intellectual property (IP) rights to a subsidiary in a tax haven and charge royalties to its operational entities in other countries. This strategy, commonly referred to as transfer pricing, results in inflated expenses in high-tax jurisdictions and disproportionately high profits in the tax haven. Similarly, mechanisms like intra-group loans and licensing agreements are employed to move earnings across borders without actual economic activity in the tax haven.
Another method involves thin capitalization, where companies use intra-group loans to create tax-deductible interest expenses in high-tax countries. For instance, consider a manufacturing firm headquartered in India. It sets up a subsidiary in Luxembourg, which lends money to the parent at a high interest rate. The interest payments are deductible in India, lowering taxable profits, while Luxembourg taxes the subsidiary’s income at near-zero rates.
Another mechanism involves profit shifting through contract manufacturing. For instance, a pharmaceutical MNE might outsource production to a low-tax jurisdiction, ensuring that profits from manufacturing accrue in the low-tax jurisdiction, while high-tax jurisdictions only see minimal profit margins from distribution activities.
A report by the International Tax Policy Forum indicates that a substantial portion of multinational profits, around 30%, is shifted to tax havens, resulting in an estimated $500 billion in annual profit shifting.
These practices not only undermine the tax bases of high-tax jurisdictions but also distort economic competition. Developing countries, including India, have been particularly vulnerable to such practices, losing significant tax revenues while bearing the brunt of MNE operations.
These aggressive tax planning techniques have led to significant revenue losses globally, prompting the OECD to act. India, a key emerging market, loses about $10 billion annually to tax avoidance schemes, particularly those involving low-tax jurisdictions like Mauritius, Singapore, and the UAE. These losses affect India’s ability to invest in essential services like education and healthcare.
The Organization for Economic Co-operation and Development (OECD) recognized these challenges and, through its Base Erosion and Profit Shifting (BEPS) initiative, introduced the Two-Pillar framework. This initiative addresses not only the loopholes in existing international tax systems but also the inequities caused by digitalization, where companies generate significant revenue in jurisdictions without a physical presence. The Two-Pillar Solution aims to curb these practices, ensuring profits are taxed where value is created. India, as a significant player in global trade with over 150 Indian-headquartered MNEs, stands at a pivotal moment to align with these reforms. The implications of these rules—both opportunities and challenges— are profound for Indian businesses operating across multiple jurisdictions.
2. OECD Two-Pillar Framework: An Overview
2.1 Pillar One: Reallocation of Taxing Rights
Pillar One targets MNEs with revenues exceeding €20 billion and profit margins above 10%. Its objectives include reallocating taxing rights from residence-based jurisdictions (where companies are headquartered) to source jurisdictions (where they derive significant revenue). This is achieved through two mechanisms:
- Amount A: Allocates a portion of residual profits—above a 10% return on revenue—to market This ensures that countries with substantial user bases or consumer markets gain taxing rights.
- Amount B: Provides a fixed return for baseline marketing and distribution activities to simplify compliance and reduce disputes.
For instance, consider a global e-commerce giant with €30 billion in revenues, earning substantial sales in India. Under Pillar One, a portion of its residual profits— calculated as profits exceeding 10% of revenue—would be allocated to India, even if the company has no physical presence here. If the company earns €5 billion in global residual profits, and India accounts for 20% of its user base, €1 billion could be subject to Indian taxes under Amount A.
This pillar primarily affects digital and consumer-facing businesses like e-commerce platforms, technology companies, and social media giants, which often generate revenue in markets without any physical presence.
2.2 Pillar Two: Global Minimum Tax
Pillar Two aims to establish a global minimum tax rate of 15% to deter profit shifting to tax havens. The OECD’s BEPS Action 4 report from 2024 suggests that the effective tax rates for MNEs utilizing tax havens can be as low as 3% to 5%, compared to the global average of 23.85%. This significant disparity emphasizes the need for the OECD’s introduction of a 15% minimum tax rate under Pillar Two.
It comprises three components:
1. Income Inclusion Rule (IIR): Ensures that income earned by subsidiaries in low-tax jurisdictions is taxed at the parent company level to the extent of the
2. Undertaxed Payments Rule (UTPR): Denies deductions for payments to entities in low-tax jurisdictions that do not meet the minimum effective tax
3. Qualified Domestic Minimum Top-Up Tax: Allows countries to implement domestic laws ensuring all income is taxed at the 15% rate.
The rule applies to MNEs with global revenues above €750 million. Companies must compute their Effective Tax Rate (ETR) for each jurisdiction and pay a top-up tax to meet the 15% benchmark.
3. Implications for Indian Multinational Enterprises
3.1 Positive Outcomes
Indian MNEs, particularly in the IT and pharmaceutical sectors, stand to benefit from the increased transparency and predictability offered by the OECD framework:
1. Fair Competition: The OECD framework levels the playing field for Indian companies, ensuring foreign competitors no longer benefit from disproportionate tax advantages.
2. Reduced Tax Disputes: With globally standardized rules, Indian MNEs can mitigate the risk of tax disputes in foreign jurisdictions, fostering stability in cross-border operations.
3. Global Credibility: Indian MNEs aligning with OECD standards will enhance their reputation, attracting investment and facilitating smoother entry into global markets.
For IT service firms like Infosys or Wipro, the reforms create a level playing field by reducing the tax advantages foreign competitors gain in tax havens. Additionally, industries reliant on intangible assets, such as pharmaceuticals, can leverage standardized rules for global tax planning, reducing the likelihood of tax audits or disputes in foreign jurisdictions.
3.2 Challenges
However, Indian MNEs face significant challenges, particularly in adjusting to the new regulatory landscape:
1. Increased Administrative Burden: Detailed reporting of jurisdictional ETRs and recalibration of tax structures will require substantial effort.
2. Higher Costs: The implementation of transfer pricing methodologies aligned with Pillar One and Pillar Two rules involves operational costs and may reduce profit margins. Large Indian conglomerates like Tata and Reliance, with diverse operations, must implement granular reporting systems to compute jurisdiction-specific ETRs.
3. Jurisdictional Complexities: Indian tech companies operating in markets like the US or Europe must navigate complex tax allocation systems under Pillar One.
4. Indian Government’s Policy Response
India is actively preparing for the implementation of the OECD framework:
- Legislative Alignment: Amendments to incorporate the Income Inclusion Rule and Undertaxed Payments Rule are underway.
- Withdrawal of Equalization Levy: As part of its commitment to the multilateral framework, India has committed to rolling back its digital services tax post-Pillar One implementation.
- Capacity Building: Training tax administrators to handle the complexities of the OECD rules and enhancing tax infrastructure are key priorities.
- Stakeholder Engagement: The government is conducting consultations with industry leaders to address sector-specific challenges and ensure balanced
5. Recommendations for Indian MNEs
To thrive under the OECD rules, Indian MNEs should:
1. Conduct Impact Assessments: Assess the effect of Pillar Two on subsidiaries operating in low-tax jurisdictions.
2. Invest in Technology: Automate reporting and compliance to streamline jurisdictional tax calculations.
3. Reassess Transfer Pricing Strategies: Align intra-group transactions with OECD guidelines to minimize disputes.
4. Engage with Policymakers: Provide industry-specific inputs during consultations to ensure practical and balanced regulations.
6. Conclusion
The OECD Two-Pillar Solution is a groundbreaking reform addressing global tax challenges, particularly the misuse of tax havens. For decades, the ability to shift profits to low-tax jurisdictions without corresponding economic activity created inefficiencies in the global tax landscape. By introducing a fair and equitable system, the Two-Pillar framework represents a paradigm shift in international taxation.
Pillar One ensures that large consumer markets like India receive their fair share of tax revenues, particularly from digital and e-commerce companies. This is a crucial step in aligning taxation with value creation. Meanwhile, Pillar Two curtails harmful tax competition by setting a global minimum corporate tax rate, closing loopholes exploited by MNEs to erode tax bases.
For Indian MNEs, the journey forward is both complex and promising. While the immediate challenges include increased compliance costs and potential erosion of profit margins, the long-term benefits—enhanced tax certainty, reduced disputes, and fair competition—cannot be overstated. Industries such as IT services, pharmaceuticals, and export-driven manufacturing must adapt by investing in robust tax systems and aligning business models with global norms.
The Indian government must also play an active role, ensuring the transition is smooth. Policymakers need to strike a balance between aligning with global rules and safeguarding domestic interests, such as retaining India’s appeal as an investment destination. The withdrawal of the Equalization Levy is a positive signal, but further reforms are required to streamline tax administration and enhance competitiveness.
In conclusion, the Two-Pillar Solution is not merely a tax reform; it is a step toward global economic justice. As India integrates these rules, it has the opportunity to lead by example, championing a fairer tax system that supports sustainable growth while ensuring equitable revenue sharing among nations. For Indian businesses, success will hinge on their ability to adapt, innovate, and collaborate within this new global tax landscape.
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Author: Anshi Bhatia
