Impacts of tax framework changes

Robert King, EY Indochina tax leader (left), and Ly Vu Uyen Nguyen, tax director of EY Consulting Vietnam

For many years now there has been a growing concern that globalisation has allowed multinational enterprises (MNEs) to take advantage of low-taxed jurisdictions, and mismatches in tax rules, to legitimately reduce their overall tax liability in a way that would not have been possible prior to globalisation.

The dramatic expansion of the digital economy has caused even greater challenges. The traditional international tax model struggles to accommodate the world of e-commerce whereby goods and services can be delivered to customers without having any presence at all in the recipient country.

The Organisation for Economic Co-operation and Development (OECD) estimated in 2015 that the magnitude of corporate taxes that may be lost as a result of these issues could be up to $240 billion annually. This concern prompted the G20 leaders to endorse an action plan on this matter, referred to Base Erosion and Profit Shifting (BEPS). In 2015, the OECD in conjunction with the G20 released the final reports on BEPS, which contained 15 actions and involved over 60 countries.

BEPS action 1 addressed some of the challenges of the digital economy and introduced some recommendations. But it also promised to continue working on the specific issues raised by the digital economy.

Since then, a number of interim reports have been produced, and public consultations undertaken. In 2016, to ensure that any recommendations took into account both developed and developing nations, the OECD and G20 Inclusive Framework (IF) was established, involving 139 nations.

In July, a statement was released by the IF outlining the key elements of a two-pillar solution to address the tax challenges arising from the digitalisation of the economy. Over 132 IF member countries endorsed the policies and concepts set out in the statement, with Vietnam being one of them.

Reallocating portion of profits

Pillar one is essentially a mechanism to reallocate a portion of the profits to market jurisdictions where the goods or services were used or consumed. Pillar one is expected to impact only a small number (estimated to be around 100) of the largest global companies. Specifically, only MNEs with an annual global turnover above €20 billion ($23.3 billion) and a profitability above 10 per cent are in scope. Furthermore, extractive industries and regulated financial service companies are excluded. Interestingly, however, it is not limited to digital companies.

The final details need to be determined, but the July statement envisages that between 20-30 per cent of residual profit (meaning profit above 10 per cent of revenue) will be reallocated in this way. A credit or exemption mechanism will be used to avoid double taxation.

What does this mean for Vietnam? None of the Vietnamese-headquartered MNEs are expected to meet the global turnover threshold to be impacted by pillar one. However, when the threshold is reduced, seven years after the rules eventually become effective, to €10 billion ($11.64 billion), there may well be some directly impacted Vietnamese companies.

Vietnam, as a country, could potentially benefit from pillar one. To the extent that any in-scope multinational derives at least €1 million ($1.16 million) of revenue from Vietnamese customers, part of the residual profits would be allocated to Vietnam for taxation purposes.

The OECD has estimated that more than $100 billion of profits are expected to be reallocated to market jurisdictions each year. There are a number of details still to be worked out. October 2021 is the proposed date for finalising the details with an intended implementation date of 2023.

Preventing race to the bottom

With increased globalisation comes increased mobility, MNEs can make decisions on where to manufacture their product and where to set up their different support functions (procurement, IT, trading, research and development, treasury for example). Digital companies are even more mobile than traditional companies.

One of the factors taken into consideration about where a multinational decides to locate their functions is the tax outcome. There has been an increasing concern over recent years that, in order to attract foreign investment, countries are pressured to provide tax incentives and generally reduce the corporate tax rate to make their country more competitive. This has caused a trend of lowering corporate tax rates and what has been described as a race to the bottom.

Pillar two is designed to combat this trend. It is optional and has a series of measures that effectively set a minimum corporate tax rate of at least 15 per cent. This means that where a MNE has profits captured in zero-tax or low tax jurisdictions, pillar two will operate to ensure that such low-taxed profits will be subject to a minimum tax of at least 15 per cent by way of a top-up tax, denial of deduction, or withholding tax.

Certain aspects of pillar two will apply to multinationals that have an annual turnover in excess of €750 million ($873.6 million). A jurisdiction may, however, choose to apply the income inclusion rule to MNEs headquartered in their jurisdiction even if they do not meet the turnover threshold. The pillar will not apply to pension funds, investment funds, non-profit organisations or international shipping income. It is expected to generate $150 billion in additional global tax revenues.

It is anticipated that pillar two should be brought into law by 2022 and be effective by 2023, and it could impact Vietnam in a number of ways. Firstly, there will be some Vietnamese-headquartered companies who meet the threshold and are hence directly subject to these proposed new measures. Whether they would actually be impacted by these measures depends on whether these companies have subsidiaries being taxed at a rate of less than 15 per cent.

The second way Vietnam could be impacted is less direct. Vietnam has a generous tax incentive regime. Broadly speaking, tax incentives in Vietnam are based on location (industrial zone, economic zone, difficult socioeconomic areas); incentivised sector (such as high-tech, agribusiness, energy-saving products, socialisation activities, and many other things) and large-scale projects.

The exact incentives provided differ depending on the category, but generally consist of a tax-free period and a period of enjoying a reduced tax rate (which can be as low as 5 per cent). On top of the corporate tax incentives, there can be import duty exemptions and exemptions from the state land rental fee.

Increased emphasis

Once the new framework is in place, the attractiveness of the tax incentive regime will be diminished. Large MNEs that invest in Vietnam may be subject to some form of “top-up tax” in their home jurisdiction to the extent that the tax incentives reduce the tax in Vietnam below the 15 per cent rate. But what impact is that likely to have on investors?

Firstly, we may consider this from the point of view of new investors. From experience in advising many MNEs investing into Vietnam, few if any base their investment decision solely on the availability of tax incentives. The fact is that many competing countries in ASEAN and elsewhere also offer various forms of tax incentives. These other countries will also have their tax incentives neutralised by pillar two.

The new rules will put more emphasis on the fundamental business reasons for choosing an investment location. Factors that have made Vietnam an attractive location remain: a large, well-educated, inexpensive labour market, a stable political environment, excellent location and improving infrastructure, among other things. Furthermore, as more companies invest in Vietnam, the supporting industries and critical mass improve their attractiveness.

Vietnam now has an extensive network of free trade agreements (FTAs) that includes markets such as the European Union, the United Kingdom, Russia, South Korea, ASEAN, China, Japan, Canada, Australia, and more. The FTAs make Vietnam’s exports more competitive compared to other nations that do not have such an extensive network.

Apart from reduced duties on goods traded between the agreement parties, the FTAs also have additional commitments concerning employee rights, environmental matters, intellectual property protection, and other things that will continue to improve Vietnam’s attractiveness over time. Pillar two will not impact the benefit of these agreements.

So, while pillar two may reduce the benefits of the tax incentive regime for large MNEs, it does not necessarily follow that it will significantly detract from the attractiveness of Vietnam as an investment destination.

On the other hand, existing investors in Vietnam that have made decisions based on certain tax assumptions and have modelled return-on-investment outcomes based on these assumptions, may be very aggrieved by the proposals. While the two-pillar framework has been agreed in principle, the details of the design are still being considered. We anticipate that some multinationals who have recently invested in Vietnam and have real economic activities and substance in Vietnam may advocate for relief, which could be by way of specific carve-outs or grandfathering provisions.

Such advocacy may be supported by the words in the final paragraph in the OECD’s July statement, which states that “the agreement reached indicates the ambition of the IF members for a robust global minimum tax with a limited impact on MNEs carrying out real economic activities with substance”. The statement also discusses the introduction of “safe harbours” and other mechanisms to ensure the rules are as targeted as possible. Finally, the last sentence in the statement reads “excluding MNEs in the initial phase of their international activity from the application of the global minimum tax will also be explored”.

We should learn more about these proposed fundamental changes to the international tax framework soon, as the next report with further details, is due to be released in October.

* The views reflected in this article are those of the authors and do not necessarily reflect the views of the global EY organisation or its member firms.