Major reforms to the global tax system are anticipated by 2027, with the spotlight on addressing issues at the nexus of taxation and digitalization. At the heart of this renewed momentum lies a new intergovernmental process at the UN. In August 2024, after three weeks of intense negotiations, tradeoffs, and compromises, applause broke out at the UN Headquarters in New York, as the Terms of Reference (ToR) for a new UN Framework Convention on International Tax Cooperation was approved by an overwhelming majority of Member States. The ToR stipulates the objective of establishing “an inclusive, fair, transparent, efficient, equitable and effective international tax system for sustainable development,” and constitutes nothing short of a historic shift in global tax politics.

Taxation and the Digitalized Economy

In addition to the Framework Convention itself, the ToR also specifies that two so-called early protocols should be negotiated, and one of these protocols should “address taxation of income derived from the provision of cross-border services in an increasingly digitalized and globalized economy.” Protocols are legally binding agreements that supplement and support the implementation of the Framework Convention — similar to, for example, the UN Framework Convention on Climate Change and its Kyoto Protocol. The ToR specifies that both the Framework Convention itself and the two early protocols should be finalized before the end of 2027.

Digitalization plays a role in relation to one of the most central and political issues in the UN Tax Convention negotiations, i.e., the question of ‘taxing rights’ — which countries have the right to tax the profits of a multinational corporation.

The fact that the effects of the digitalized economy is included as a topic for an early protocol is no coincidence. On the contrary, it is widely recognized that digitalization on the one hand has a lot to offer to the mission of creating a fairer and more effective international tax system, including in relation to tax administration, transparency, and exchange of information. But on the other hand, digitalization has also exacerbated some of the most fundamental tax-related problems we face today.

Which Countries Get to Tax Multinational Corporations?

Digitalization plays a role in relation to one of the most central and political issues in the UN Tax Convention negotiations, i.e., the question of ‘taxing rights’ — which countries have the right to tax the profits of a multinational corporation. The current international tax system has been developed by the Organisation for Economic Co-operation and Development (OECD), also known as the ‘rich countries’ club,’ and largely favors the interests of the countries where corporations have their headquarters. Since corporate headquarters are predominantly located in richer countries, this system puts developing countries at a disadvantage. One of the key problems is that, in order to claim the right to tax a specific multinational corporation, so-called source countries, which host economic activity of the corporation but not the headquarters, usually need to show that the corporation has a so-called permanent establishment within the country. This concept dates over a century back in time and still largely reflects the old ‘brick-and-mortar’ understanding of the economy, i.e., the assumption that business activity is linked to buildings and physical presence.

This way of thinking has long been outdated, but digitalization and the rise of the online economy has greatly exacerbated the divide between the prevailing tax approaches and economic realities. In today’s world, numerous forms of economic activity by multinational corporations can be carried out online without any form of physical ‘establishment,’ and in fact, some of the world’s largest, wealthiest, and most powerful corporations now have digital platforms as their central way of doing business. The practical consequence is that source countries see multinational corporations carry out large amounts of economic activity in their countries, but struggle to tax the resulting profits.

Large-scale Corporate Tax Avoidance

The problems concerning taxing rights are linked to another major problem with the international tax system, i.e., the issue of large-scale corporate tax abuse. The Tax Justice Network estimates that this problem costs governments around the world over USD 300 billion  in lost tax income every year. In addition to the strong negative impacts on government revenues, and thus on the level of funding for public services, tax avoidance by large multinational corporations also contributes to an un-level playing field vis-à-vis small and medium enterprises at the national level, which are not able to use international tax structures to dodge taxes.

At the heart of this problem lies the phenomena of ‘profit shifting,’ whereby multinational corporations move their profits to tax havens. This problem has existed since before the age of the internet, but today, digitalization of the economy has worsened the situation.

The reason why profit shifting can happen in the first place relates to a fundamental misconstruction in the international tax system. At the moment, there is no truly global agreement on how to tax multinational corporations, but the dominant system is the so-called OECD Transfer Pricing System. Under this system, subsidiaries of multinational corporations are treated as independent entities, rather than as an overall multinational entity, and countries tax these entities on the basis of the amount of profit that the company reports in each jurisdiction. The rules focus heavily on regulating the ways in which the subsidiaries trade internally and the so-called arm’s length principle stipulates that prices of goods and services should be set as it would in a transaction between two independent entities. The aim of this principle is to avoid corporations using internal pricing mechanisms to shift their profits to low-tax jurisdictions. However, it has always been open to abuse, and with digitalized business models the system that was already struggling started facing even graver challenges.

At the heart of this problem lies the phenomena of ‘profit shifting,’ whereby multinational corporations move their profits to tax havens.

Given the shortcomings of the transfer pricing system, academics and civil society organizations, among others, have long called for it to be replaced by a system based on formulary apportionment. This concept refers to a taxation method whereby the global profits of corporations are allocated to countries on the basis of a formula reflecting the level of economic activity in each country. However, instead of replacing the transfer pricing system, the OECD has instead repeatedly taken the approach of trying to fix it.

Failed Fixes

When the OECD in 2013 embarked on an attempt to update its international tax rules, the digitalized economy was the first topic of a 15-point action plan. After the first review had been completed in 2015, there was soon a growing recognition that the problems still prevailed, and thus, already in 2019, the OECD initiated a second reform process where digitalization became an even more central focus, with the title of the initiative being ‘Tax challenges arising from digitalization.’ This initiative led to what is known as Pillar 1, which focuses on a reallocation of taxing rights, and Pillar 2, which centers around a minimum corporate tax rate.

However, both of the pillars showed great weaknesses in terms of fairness and efficiency. Firstly, Pillar 1 requires endorsement from the United States to take effect, and since that has not happened, the agreement has never come into force. But more importantly, it has a very limited scope and even if it were to take effect, it is estimated to apply to less than 100 corporations, and for these corporations it will only apply to a limited share of the profits. From a fairness perspective, it is also highly problematic that the proposed rules aim to reallocate profits to countries where corporations have consumers and users of their services, but overlooks countries where production takes place, which is a factor that is very important for developing countries. At the same time, Pillar 1 would ban countries from imposing digital services taxes, which is a type of tax that has become attractive for developing countries because it is relatively simple to administer and can generate much needed revenue.

In 2022, the Africa Group at the UN kickstarted a groundbreaking reform by tabling a resolution at the UN General Assembly which called for an intergovernmental UN tax negotiation to be set up.

As regards Pillar 2, which was presented as a minimum effective corporate tax rate of 15%, the first problem relates to loopholes in the rules, which allows corporations to continue paying significantly less than the minimum rate. It is, in other words, not effective. Secondly, the discussion about allocation of taxing rights ended in favor of the countries where corporations are headquartered  — at the expense of developing countries. And finally, a last-minute addition to the rules, known as the ‘domestic top-up tax,’ introduced a loophole that makes it easier for low-tax jurisdictions to shortcut the system — a factor which caused the Financial Times to highlight that the ‘Global minimum tax will boost revenues for tax havens.’ All of these shortcomings led civil society organizations to reject the OECD agreement as ‘The Deal of the Rich.‘

An Africa-led Global Tax Reform at the UN

The outcomes of the OECD tax negotiations reflect the fact that developing countries were never able to participate on a truly equal footing. Despite being called the Inclusive Framework, the forum where the latest OECD tax deal was negotiated was anything but inclusive. Over a third of the world’s countries were not even at the table, and when the OECD tax deal on the two pillars was adopted in October 2021, four of the developing countries that had participated in the negotiations, Kenya, Nigeria, Pakistan, and Sri Lanka, did not agree to the outcome.

But instead of accepting the unfairness and inefficiencies of the international tax system, developing countries initiated a truly historic shift in global tax governance. In 2022, the Africa Group at the UN kickstarted a groundbreaking reform by tabling a resolution at the UN General Assembly which called for an intergovernmental UN tax negotiation to be set up. In August 2024, this initiative led to the adoption of the ToR for a new Framework Convention on International Tax Cooperation and two early protocols. 110 UN Member States voted in favor, 44 abstained, and eight (the United States, Canada, Israel, Japan, South Korea, Australia, New Zealand and the United Kingdom) voted against. But even among the no-voters it is expected that most, if not all, will remain actively engaged in the process.

The objectives of the ToR (paragraph 7) make it clear that the Convention and its protocols should be designed to promote inclusivity, efficiency, fairness, transparency, and sustainable development. Furthermore, the ToR outlines very important key commitments (paragraph 10) that should be covered by the Convention, including “fair allocation of taxing rights” and “equitable taxation of multinational enterprises.” Additionally, paragraph 15 makes it clear that one of the early protocols will include the issue of the digitalized economy.

The negotiation of the Framework Convention and two early protocols is set to begin in early 2025 and finish by the end of 2027. That makes the coming years a crucial period for international taxation, and it is high time to create a modernized, fair, and effective global tax system. This includes addressing the new challenges that digitalization has created, while at the same time harnessing the opportunities it presents.