The EU has a new deal deal to achieve ‘tax fairness’. This is how it will work.

The European Union is one step closer to achieving what it calls “tax fairness.”

After more than a year of political wrangling and veto threats, the 27 member states agreed to endorse a long-stalled deal to establish a minimum level of corporate tax, which will be set at 15% for all large companies.

The reform, opposed at different points in time by the likes of Ireland, Hungary, Estonia and Poland, has been hailed as a major step to put the brakes on a long-running race to the bottom that has seen countries around the world gradually reduce their corporate taxes in order to lure multinationals.

Many governments now believe these years of intense tax competition have done more harm than good, leaving their public coffers unfit to cope with ballooning climate, energy and welfare expenses.

“Minimum taxation is key to addressing the challenges a globalised economy creates,” said Paolo Gentiloni, the European Commissioner for the economy who for months led the negotiations.

“The EU has proven that it is truly committed to tackling the injustices that characterise the global economic system and to ensure that everyone pays their fair share.”

The 15% minimum corporate tax, however, is not the bloc’s exclusive brainchild.

The ground-breaking deal builds upon an international agreement brokered by the Organisation for Economic Co-operation and Development (OECD) and endorsed by 137 countries representing more than 90% of the global GDP, including the United States, China, India and Russia.

Seizing the momentum of the COVID-19 pandemic, when governments were forced to issue huge levels of debt to sustain their economies through lockdowns, the OECD managed to conclude years of work to reform the global tax system and address the new challenges arising from the digital economy.

The Paris-based organisation designed a two-pillar reform, with Pillar One centred on the reallocation of taxable profits and Pillar Two focused on establishing the 15% minimum corporate tax. 

Pillar One is seen as the most complex element because it aims to shift a share of taxing rights from the country in which a company is physically based (for example, Google’s EU headquarters in Ireland) to the country in which the profits are earned (for example, Google’s profits earned in France). 

Over $125 billion (€118 billion) in profits are expected to be re-distributed annually under Pillar One. Technical discussions to define the formula and conditions are still ongoing at OECD-level.

Work on Pillar Two is, however, much more advanced.

The European Commission proposed in December 2021 a directive to bring Pillar Two into EU law, making the minimum tax a legally binding obligation for all 27 member states. 

Taxation is one of the few fields at the EU level in which unanimity is required, something that allowed Hungary, and later Poland, to delay the approval of the directive and create an unofficial link to other unrelated files.

After the hard-fought agreement, member states will have one year to transpose the rules before they become totally enforceable.

At a global level, Pillar Two could generate about $150 billion (€141 billion) in additional tax revenues every year, the OECD estimates.

A top-up tax

As of today, four EU member states have corporate tax rates below the 15% goal: Hungary (9%), Bulgaria (10%), Ireland (12.5%) and Cyprus (12.5%), while others, like Estonia, offer discounts that can bring the rate under 15% in certain circumstances.

The 15% minimum corporate tax will apply to large companies that make combined financial revenues of more than €750 million a year, gained through their domestic and international operations.

Government entities, NGOs, pension and investment funds, and income from international shipping will be exempted.

The reform’s main element will be the so-called top-up tax: if an EU-based parent company has subsidiaries located in jurisdictions that offer a corporate tax rate below the 15% threshold, that parent company will be obliged to pay the difference between the lesser tax rate and the 15% minimum rate.

This top-up tax will be collected by the EU country in which the parent company is ultimately located.

For example: if a Berlin-based parent company has a subsidiary in Andorra that is subject to a 10% corporate tax, the German government will be allowed to slap a 5% top-up tax on the parent company’s eligible profits to make up for the difference.

Additionally, EU governments will be able to increase taxes on subsidiaries in their territory if these subsidiaries belong to a foreign company that pays less than a 15% corporate tax rate in its home country.

The combination of the two rules is designed to mitigate tax erosion and profit shifting, as big companies will have fewer incentives to move their commercial operations to low-tax jurisdictions.

Importantly, the rules will apply regardless if other countries join the OECD deal or not.

“This is truly a major step forward for all those who care, as we do, about tax justice and our ability to tax any economic player at least 15%, where, as you know, many groups were not taxed on our soil,” said President Emmanuel Macron of France, one of the reform’s most vocal defenders.

Following OECD guidelines, the EU deal introduces a “substance carve-out” that will initially exclude 8% of the company’s tangible assets, like buildings, and 10% of payroll costs from the calculation of the top-up tax.

These derogations will be gradually reduced until reaching 5% on both accounts.

According to the EU Tax Observatory, this carve-out can be useful to discourage companies from moving to tax-free jurisdictions like Bermuda and the Cayman Islands, despite not having any physical presence in them.

Under the new deal, these subsidiaries will not benefit from the carve-out and will be subject to the full force of the 15% minimum tax rate.

But, the observatory warns, the derogation may dent the reform’s economic impact and trigger a “new form of competition” between countries, as large companies will be enticed to transfer their offices and jobs to tax havens with the aim of protecting a share of their coveted profits.

“From an economic point of view,” the observatory said in a 2021 study, “carve-outs are justified by the desire to combat artificial transfers of profits as a priority – and almost exclusively that.”