Leaders from G20 countries recently agreed to take the first step toward a global minimum tax (GMT) that would tax companies where they make money instead of where they're headquartered.
At their July meeting, the informal group of 20 of the world's advanced economies—backed a proposal to create a global minimum tax rate of at least 15%.
"After many years of discussions and building on the progress made last year, we have achieved a historic agreement on a more stable and fairer international tax architecture," the G20 finance ministers said in a joint statement at the conclusion of the meetings.
Many of the existing tax rules were designed over a century ago—and each country has its own. They're called Digital Services Taxes, or DSTs, and they impose taxes on multinational firms based on digital activities in a specific geographic region.
The proposed plan eliminates the DSTs and replaces them with the global minimum tax based on all the revenue a multinational company generates in a specific country.
Much of the groundwork for this effort has been laid by the Organization for Economic Cooperation and Development (OECD), which reports that the change could yield an additional $150 billion in global tax revenue annually. Earlier this year, U.S. Treasury Secretary Janet Yellen pledged to support the tax, which she said could "help end a 30-year race to the bottom on corporate tax rates."
Yellen and other supporters say the plan will discourage global companies from shifting profits—and therefore tax revenues—to countries with lower tax rates. This has become a frequent practice among companies producing intangible services such as ownership of intellectual property.
"Over the past few years, as some companies have grown exponentially, technology companies in particular, countries have become wary of the fact that business is being done in their country, but possibly not being taxed 'fairly,'" said Kendall Toyne, senior equity research analyst at Cavanal Hill Investment Management, Inc., a subsidiary of BOK Financial®.
How it works
The proposal sounds complicated, but it essentially has two pillars.
Pillar One includes countries that tax multinational corporations based on the share of the company's profits derived from that country's consumers. When those profits exceed 10%, the proposal allows countries to tax the remainder at 20%.
Example: Let's say a tech company generated $1 million in a country with profits of 15%, or $150,000. Under the plan, the country would tax the company at its regular rate on 10% (or $100,000) and then tax 20% on the remaining $50,000.
Pillar Two is the global minimum tax, which is proposed at 15% and would apply even when tax rates in a particular country are lower.
Example: A U.S. company generates revenues in a country with a tax rate below the 15% minimum tax rate. The U.S. would be able to impose an additional tax to ensure that the company paid the minimum of 15%.
Companies currently have to manage a variety of tax rates and Digital Services Taxes by country, all of which can change with little notice.
"Most of the large tech companies are on board with the concept of a minimum tax and a broader agreement," Toyne said. "The companies are willing to pay their fair share in exchange for a more predictable tax environment."
The agreement followed a joint statement by 130 countries (representing more than 90% of the global GDP), which included agreement on the OECD Framework on Base Erosion and Profit Shifting. Each country must then ratify the details through their respective legislative bodies. That may be a tall order, especially in the U.S.
"It's a pretty complicated process," Toyne said. "While there's quite a bit of skepticism that each country will be able to ratify the agreement, there's also clearly a lot of enthusiasm from world leaders to try. This initiative has some pretty healthy momentum behind it, and leaders and politicians seem to agree that something needs to be done."
If the effort can stay on track, the minimum tax would likely roll out in 2023. While the viability of this proposal moving forward is still in question, investors may be keeping an eye on the situation.
"Each of these large, global companies operates in a rapidly expanding footprint with tremendous incentive for them to continue to invest and grow," Toyne said. "While a change in tax structure would impact profitability, it is unlikely to be enough to dissuade them from making investments around the world."
Fundamentally, he said, countries have searched for an agreement for years on a unified way to tax highly profitably multinational companies and regulate market power.
"This move is something that will take investors and companies a while to wrap their heads around, and in the short term, it creates a little more noise in the market."