Base erosion and profit-shifting refers to strategies developed by large multinationals to shift profits from high-tax to low-tax countries or tax havens. Companies use deductible payments such as royalties or interest to reduce the tax base in the high-tax location and record profit in lower tax jurisdictions.

After years of development, the OECD released the BEPS 2.0 agreement in December 2021, accompanied by model rules to help countries implement new international tax rules.

The current international taxing system assigns profits of multinationals to the country where the profits are earned. With the growth of intangible assets, which are easier to shift among jurisdictions, this “source-based” system of allocating profits has become increasingly difficult to sustain.

BEPS 1 aimed to buttress the source-based system by limiting various forms of “abusive” transactions designed to shift reported income to low-tax countries. But it otherwise left the fundamental system for allocating income among countries unchanged.

BEPS 2, in contrast, would modify the fundamental rules for allocating multinational profits among countries. It consists of two main “pillars.” Pillar 1 would re-allocate part of the profits of the largest and most profitable multinationals from where they earn income to where they sell products and services. Pillar 2 would impose a 15 percent minimum tax on global corporate profits, based on the residence of the corporation.

What is an example of corporate tax avoidance?

Corporation Orange develops a new software in its headquarters in California. The company then sells it at a low price to its affiliate in Ireland. Accounting rules require that such transactions are priced at arm’s length. Arm’s length pricing is the price at which a fair transaction would occur between two unrelated parties (i.e., not between two subsidiaries of the same company). However, patents and other intangible property are often unique and lack a market to identify the “correct” arm’s length price.

As the owner of the software patent, Orange Ireland earns royalties by licensing the right to sell the software to other affiliates of the company that use the software in production. Every time Orange US or another affiliate buys the software, it must pay royalties to its Irish subsidiary. This lowers profits recorded by Orange US or affiliates in other high-tax countries, and increases profits recorded in Ireland.

How does Pillar One work?

Pillar 1 would affect only large companies with global revenues above €20 billion (about $22 billion in early 2023) and profitability above 10 percent of revenues. It starts with the company’s financial statement income and applies a limited amount of tax adjustments to compute the Adjusted Profit Before Tax amount. Then, 25 percent of all profits above 10 percent of revenues are allocated to eligible jurisdictions in proportion to the amount of revenues generated in each jurisdiction.

For example, a Swedish company has sales affiliates in Germany, France, and the United Kingdom, and an affiliate in Bermuda that owns the patents for a drug the company developed. The company sells the drug in Sweden, Germany, France, and the UK. The sales affiliates pay royalties to the Bermuda affiliate for the right to sell the drug. The Bermuda affiliate records most of the company’s profit, as a result of the royalties paid by sales affiliates. In this case, Pillar 1 would reallocate some of the profit from Bermuda to the countries where sales occur, based on how much each affiliate sells in their country.

Pillar 1 includes rules designed to eliminate double taxation. Several countries have started implementing digital taxes, with the goal to limit base erosion and tax avoidance of digital companies. A digital tax is a tax on sales receipts of digital transactions in the country where they occur. They typically apply only to large multinational corporations. For example, Google’s advertising revenue in France is taxed at a 3 percent rate. When implemented, Pillar 1 would replace most current unilateral efforts to tax large multinationals, including digital taxes.

How does Pillar Two work?

Pillar 2 model rules are designed to ensure that large multinational companies pay a minimum tax of 15 percent on taxable profit in each jurisdiction where they operate. To the extent the countries where they operate impose a tax rate of less than 15 percent, companies would pay a top-up tax to the country in which they are resident.

Pillar 2 would apply to groups with at least €750 million in revenues globally. And, it would be implemented with two main mechanisms: the income inclusion rule (IIR) and the undertaxed profits rule (UTPR).

The income inclusion rule is a top-up minimum tax applied to the parent company where it is incorporated. The tax is paid on its proportion of ownership interests in all entities it owns, such that each entity would pay a minimum tax of 15 percent. For example, the US government would estimate the tax liability of a US corporation in all its foreign affiliates separately. For each affiliate with an effective tax rate of less than 15 percent, the US would apply a top-up tax to raise the rate to 15 percent.

The undertaxed profits rule is a backdrop to the income inclusion rule. It allows a country to increase taxes paid by a multinational company if it pays less than the minimum tax of 15 percent in another jurisdiction. This typically works by disallowing deductions to increase overall tax liability. For example, the US could disallow deductions for interest payments by the US affiliate of a German company, if that German company pays an effective rate lower than 15 percent in some jurisdictions.

How do the US international tax rules align with the BEPS project?

The United States participated in the development of the BEPS 1 project from 2013 through 2015. Following the change in administration in 2017, the US refused to join the multilateral efforts to implement BEPS in tax treaties. Although the US adopted some BEPS provisions in its model treaties, they have not been implemented in any actual US treaty.

However, the Tax Cuts and Jobs Act (TCJA) international tax reforms relied on several principles that were ultimately included in the Pillar 2 reform in BEPS 2. The global intangible low-taxed income (GILTI) provision is a minimum tax on foreign income, but it does not satisfy all the Pillar 2 requirements.

Among other differences, the GILTI tax rate is currently 10.5 percent (and set to increase to 13.125 percent in 2026), which is less than Pillar 2’s 15 percent global minimum tax rate, and GILTI liability is calculated using “global averaging” rather than on a country-by-country basis. Global averaging allows US multinationals to pay less taxes on their activity in low-tax countries and tax havens by using credits from taxes paid to high-tax countries to offset GILTI liability.

Although GILTI falls short in some respects of Pillar 2 requirements, it imposed much higher taxation of foreign-source income of US multinationals than other countries had imposed on their own multinational companies. Thus, Pillar 2 creates a more level playing field between US and foreign-based multinational companies.

TCJA also implemented the base erosion and anti-abuse tax (BEAT), which limits profit shifting by taxing many payments to foreign affiliates. The current BEAT rate is 10 percent, and it will increase to 12.5 percent in 2026.

More recently, international tax reform proposals by the House Ways and Means committee and the Biden administration would align the United States more closely with Pillar 2. President Biden’s proposed changes include moving the application of GILTI to a country-by-country system (following the income inclusion rule), an increase in the GILTI tax rate, and the implementation of an undertaxed profits rule.

Updated January 2024