India and the two-pillar solution: the road ahead

The global tax landscape is undergoing a seismic shift, with the OECD's BEPS initiatives at the forefront of the changes. The rules governing the taxation of international business income have long been susceptible to exploitation, allowing multinational enterprises (MNEs) to shift profits to low-tax jurisdictions. The OECD’s BEPS 1.0, introduced in 2015, aimed to address this issue through 15 actions focusing on transparency, preventing treaty abuse, and aligning taxation with economic substance. India's proactive measures – such as an equalisation levy, significant economic presence rules, and country-by-country reporting – were pivotal in capturing tax revenues from the digital economy and curbing profit shifting.

However, BEPS 1.0 left unresolved challenges, particularly in taxing the digital economy. This gap led to the development of the pillar one proposal, targeting MNEs with significant consumer bases in jurisdictions where they lack a physical presence. The expansion of pillar one to include all MNEs meeting a global turnover threshold underscored the need for a comprehensive framework. Concurrently, pillar two emerged to tackle profit shifting by imposing a global minimum tax rate of 15%, ensuring MNEs pay a minimum effective tax rate (ETR) in every jurisdiction in which they operate.

A critical precondition for a country to have tax revenue under pillar one is the abolition of any kind of digital services tax and similar measures, as well as a commitment to not introduce such measures in the future. India introduced an equalisation levy in 2016, initially targeting online advertising services, and expanded it in 2020 to include non-resident e-commerce operators. The levy aimed to level the playing field for Indian digital businesses. However, it also became a point of contention, especially with the US, which argued that the levy unfairly targeted American companies.

The Union Budget 2024–25, presented on July 23 2024, proposed the withdrawal of the 2% equalisation levy, effective August 1 2024. Finance Minister Nirmala Sitharaman highlighted that this move was crucial for India to align itself with the OECD’s pillar one and pillar two solutions. She emphasised that removing the levy was necessary for India to integrate itself into the global tax framework without the equalisation levy being a hindrance.

At a post-budget press conference, the finance minister reiterated the government's commitment to the OECD tax deal, specifically emphasising that the Indian government intends to adopt the OECD’s two-pillar solution. The scrapping of the 2% equalisation levy on non-resident e-commerce operators was a precursor to India’s adoption of the pillar one proposals, as was evident from the finance minister’s speech, in which she highlighted that “it was necessary for us, through the Parliament, to take steps to ensure that we are entering into that scheme of things [pillar one and pillar two] without this equalisation levy hanging on us”. Furthermore, the finance minister affirmed that the government is taking a “positive approach” towards the OECD tax deal and that it intends to adopt the two-pillar solution soon.

Adding weight to the finance minister’s statements, Revenue Secretary Sanjay Malhotra underlined India's active participation in the OECD negotiations. The revenue secretary highlighted that India would not come to an agreement at the cost of its own interests and would agree to the pillar one formulation only if it gets a “reasonable solution which is acceptable” to the dynamics of the Indian economy. He emphasised that India’s concerns about dispute resolution and withholding tax treatment must be addressed, but that these do not detract from the broader commitment to the OECD tax reforms. Speaking to Reuters, Malhotra highlighted that while India is committed to pillar one, it is also preparing to adopt pillar two.

In July 2024, the G20 meeting of finance ministers in Rio de Janeiro, of which India was a part, underscored the global consensus on implementing pillar two. The G20 finance ministers applauded the “resounding success of international taxation cooperation” in the form of significant progress on global minimum tax rules and urged all jurisdictions to implement the reforms swiftly.

More than 140 countries across the world, forming part of the OECD/G20 Inclusive Framework on BEPS, have come together to endorse the two-pillar solution. Of these, 27 countries – including major economies such as France, Germany, Italy, Luxembourg, the Netherlands, Switzerland, Sweden, the UK, Japan, South Korea, Vietnam, and Canada – have formally legislated the GloBE rules from 2024. Twenty-five other leading economies – including Australia, South Africa, Singapore, Thailand, Bermuda, and New Zealand – are at varying stages of implementation.

The GloBE rules have been framed as a ‘common approach’, with agreement reached in this regard. This means that jurisdictions are not required to formally adopt the GloBE rules, but if they choose to do so, they agree to implement and administer them in a way that is consistent with the agreed outcomes set out under those rules. Even if a jurisdiction does not implement the rules, agreement on a common approach means that one jurisdiction accepts the application of the GloBE rules by another in respect of MNEs operating in its jurisdiction. This implies that Indian-headquartered MNEs with a presence in jurisdictions that have already adopted the GloBE rules from 2024 need to gear up for, and be prepared to comply with, the legislative provisions of the rules from 2024.

A number of India’s leading conglomerates, pharmaceutical companies, automobile manufacturers, information technology companies, and fast-moving consumer goods companies have significant operations outside India in Europe, where the rules have largely been formally legislated from 2024. Such groups would be required to comply with the rules from as soon as 2024–25, even if India does not legislate in the near future.

The tax collection mechanism under the GloBE framework offers the source country (where a low-taxed constituent entity resides) the option to collect the top-up tax through the application of the qualified domestic minimum top-up tax (QDMTT) rule. Any shortfall in such taxes is then collected by the parent’s jurisdiction through the application of the income inclusion rule (IIR) and, lastly, by jurisdictions of other entities in the group, through the application of the undertaxed profits rule (UTPR; formerly known as the undertaxed payments rule).

Developing economies, which are heavily dependent on injections of capital from advanced economies, have raised concerns about losing competitiveness and attractiveness to investors following the implementation of the global minimum taxation rules. The GloBE rules pose a significant challenge for non-advanced economies that traditionally rely on tax incentives, such as tax holidays and reduced tax rates, to attract foreign direct investment. Given the constraints imposed by pillar two, developing economies will need to pivot towards expenditure-based tax incentives that could be more resilient under the new rules. Expenditure-based incentives provide tax relief based on the amount of investment made, regardless of profitability, thus aligning better with the GloBE rules.

Even with respect to tax incentives, jurisdictions could design refundable tax credits in such a way that they meet the criteria for qualified refundable tax credits (QRTCs). QRTCs are treated as income rather than as a reduction of taxes and therefore have a less adverse impact on the ETR than other types of tax credits.

To illustrate, say an MNE group has 1,000 of GloBE income and receives a refundable tax credit of 100 in a jurisdiction, assuming that the group has 170 of taxes (before adjusting the tax credit), there could be two scenarios under the GloBE rules, depending on whether the tax credit is treated as a QRTC or a non-qualified refundable tax credit (NQRTC).

Beyond tax incentives, developing economies can explore direct subsidies and other forms of financial support that do not affect the ETR calculation. Subsidies for infrastructure development, grants for R&D, and financial support for sustainable development projects can be effective in attracting investments without triggering GloBE top-up taxes. Additionally, developing countries might advocate for safe harbour provisions or transitional arrangements within the OECD framework to mitigate the immediate impact of pillar two. Such provisions could allow for a gradual adjustment period, giving countries time to realign their tax incentive structures without losing their attractiveness to foreign investors.

By transitioning towards expenditure-based incentives, leveraging QRTCs, and exploring alternative financial supports, developing economies can continue to attract and retain foreign investment. This approach not only aligns with the new international tax norms but also supports sustainable economic development, ensuring that such economies remain a competitive and attractive destination for global businesses.

India is already in an indifferent position given that the majority of tax holiday schemes and beneficial tax treatment schemes – such as an income exemption for setting up manufacturing units in underdeveloped regions, additional depreciation schemes, accelerated depreciation schemes, and sector-specific tax exemptions that would have qualified as NQRTCs – have already been phased out in recent years.

Over the past decade, India has instead focused on production-linked incentive schemes across various sectors – including electronics manufacturing, pharmaceuticals, automotive, textiles, and renewable energy – aimed at boosting domestic manufacturing and attracting foreign investment. Such incentives promote investments in tangible assets and labour, which have twin benefits under the GloBE rules: qualifying for a substance-based income exclusion that reduces GloBE income, and having no direct impact on the ETR.

According to corporate tax statistics from the OECD, based on 2018 country-by-country reporting data, about 150 MNEs headquartered in India could be affected by the GloBE rules. Furthermore, based on publicly available information for the fiscal year 2022–23, it is estimated that the number of in-scope Indian-headquartered MNEs would be around 200. India may not generate significant revenue from a QDMTT due to corporate tax rates in the country already exceeding 15%, with the exception of entities in Gujarat International Finance Tec-City (GIFT City) that enjoy lower tax incentives.

It will be interesting to see how the Indian government balances promised tax incentives with the new global tax standards in GIFT City. India could take its cue from economies with corporate tax rates above 15%, such as Japan, to introduce an IIR, which would allow the collection of top-up taxes from constituent entities of Indian MNEs in low-tax jurisdictions.

A study of the financial matrices of 120 major in-scope Indian-headquartered MNEs, based on publicly available information, gives a fair estimate of the profits earned by such MNEs across different jurisdictions and the amount of taxes paid on such profits, providing a book ETR. A high-level analysis conducted by comparing the book ETR with the global minimum tax rate of 15% under the GloBE rules indicates that the overall top-up tax liability of Indian MNEs would be in the range of $0.5 to $1 billion (assuming that none of the local jurisdictions have legislated a law that would trigger the collection of taxes under a QDMTT). This number, when compared with the overall expected additional revenue under the GloBE rules at a global level of about $200 billion, seems insignificant. However, this analysis does not factor in the potential revenue gains from the operation of a UTPR.

While it is true that India does not stand to gain much from the implementation of a QDMTT, it is also undeniable that introducing an IIR would bolster the tax collections of the Indian Revenue Service without creating significant administrative complications for the industry at large, given that the applicability of the GloBE rules is restricted to approximately 180 Indian-headquartered MNE groups.

India could still retain its competitiveness by channelling the increase in tax collected through the IIR to issue non-tax incentives to affected MNEs in the form of R&D credits, employment-related credits, and incentives linked to investments in tangible assets in India. It will be interesting to see how the Indian government will manage industry expectations given its commitment to complying with the principle of international tax cooperation.