October 13, 2022 OECD releases report on interaction of Tax Incentives and Pillar Two
Executive summary On 6 October 2022, the OECD released the report Tax Incentives and the Global Minimum Corporate Tax: Reconsidering Tax Incentives after the GloBE Rules (the Report). Prepared at the request of the Indonesian G20 Presidency, the Report identifies considerations for jurisdictions when preparing for the implementation of Pillar Two. In particular, it addresses the current use of tax incentives in developed and developing jurisdictions in the context of the GloBE Rules and describes how key provisions of these rules may impact diverse types of tax incentives differently. The Report suggests that the design of the GloBE Rules could provide new momentum for jurisdictions to engage in tax incentive reform. It recognizes that any such reforms require careful consideration in a Pillar Two environment, as the GloBE Rules would not affect all taxpayers or all tax incentives in the same ways and to the same extent. In particular, the OECD discourages the use of incentives that provide windfall gains to Multinational Enterprises (MNEs) without generating substantial tangible investment or jobs. The OECD expresses the view that expenditure-based tax incentives linked to payroll and/or tangible assets have proven to be most effective, while these would also be least affected by the GloBE rules due to the Substance Based Income Exclusion rule (SBIE). The Report suggests that tax incentives reform, with a focus on existing incentives that carry the greatest risk of resulting in MNEs being liable for Top-up Taxes under the GloBE Rules and that result in the largest revenue forgone for the jurisdiction, and the introduction of Qualified Domestic Minimum Taxes (QDMTs) may be the most important first steps that a jurisdiction can take in preparing for the implementation of Pillar Two, in particular in developing countries. Detailed discussion Background The OECD released Model Rules in December 2021 and related Commentary in March 2022, which are intended to provide a common framework to the more than 135 jurisdictions that have joined the agreement on Pillar Two for incorporating these minimum tax rules into their domestic tax legislation.1 The introduction of the GloBE Rules may limit the effectiveness of certain tax incentives where they reduce in-scope MNEs' effective tax rates (ETRs) below 15%. As tax incentives are commonly used instruments across both developed and developing economies in pursuit of a variety of goals, governments will need to consider the implications of the GloBE Rules for their domestic tax policies. The Report was prepared by the OECD at the request of the Indonesian G20 Presidency. Report overview On 6 October 2022, the OECD released the Report Tax Incentives and the Global Minimum Corporate Tax: Reconsidering Tax Incentives after the GloBE Rules. It is intended to support jurisdictions in evaluating their tax incentives in a post-GloBE environment and provides suggestions for jurisdictions to consider as they prepare for the implementation of Pillar Two. The Report is divided into seven sections and includes three annexes:
Section 2: Tax incentives use and design This section provides an overview of the use and design of tax incentives across the world, with a focus on developing jurisdictions. According to the OECD, tax incentives can be used to promote certain activities, sectors, investment in public goods or investment in specific geographic locations from a domestic policy perspective. The Report suggests that the proliferation of tax incentives over time may be linked to competition to attract and retain foreign direct investment, including mobile capital. According to the OECD, between 2009 and 2015, the introduction of new tax incentives and the amendment of existing incentives to make them more generous have surpassed the repeal of tax incentives and their amendment to make them less generous. The Report indicates that as a consequence, the increasing use of tax incentives has led to a global decline in statutory and effective corporate income tax rates. According to the OECD, an upper bound figure based on country-by-country report data suggests that 54% of total profits of MNEs above the €750 million threshold in 2018 were subject to an ETR below 10%. The Report notes that the design of tax instruments varies across regions, with broadly targeted income-based tax incentives being prominently used in developing jurisdictions. This includes reduced tax rates, tax holidays or other base-narrowing provisions (e.g., investment tax allowances). In this regard, the Report refers to economic studies that reach the conclusion that expenditure-based incentives are more effective to attract jobs and activities in a jurisdiction than income-based tax incentives. The GloBE Rules would impact the use of different tax incentives in different ways, with some incentives only being affected to a limited extent. According to the OECD, where tax incentives are successful in attracting tangible investment and jobs, the GloBE Rules would have more limited impact. Conversely, according to the OECD, a higher impact can be expected where tax incentives result in low-taxed profits in a jurisdiction without relevant substance. Section 3: Key aspects of GloBE Section 3 describes the general architecture of the GloBE Rules. It includes a summary of the general rules on the scope of the GloBE Rules, the determination of GloBE Income or Loss and Covered Taxes and the computation of ETR. It also provides an overview of the key steps in determining a Top-up Tax liability for MNEs. Section 4: The GloBE Rules and the use of tax incentives Section 4 describes the interaction of the GloBE Rules with different tax incentives. When jurisdictions are assessing the potential impact of the GloBE Rules, the OECD proposes a three-tiered framework to consider the interaction between the GloBE Rules and tax incentives: (i) at the jurisdiction level; (ii) at the entity level; and (iii) at the incentive level. At a jurisdiction-level, the Report indicates that the impact of the GloBE Rules on tax incentives depends on the jurisdiction's standard corporate income tax system, the definition of the tax base, the extent of base-narrowing provisions and the impact of other jurisdictions' tax provisions that may impose tax on the investor (e.g., controlled foreign company regimes). At the entity-level, the Report indicates that the extent to which the GloBE Rules may increase effective taxation depends on the characteristics of the investor and on the nature of the activities undertaken in that jurisdiction. For in-scope investors, there would be a greater likelihood of Top-up Taxes being payable when there is low relevant substance in the jurisdiction. Also, where an MNE has a mix of ETRs across different entities in a jurisdiction, it could be less impacted by the GloBE Rules. At the tax incentive-level, the Report indicates that the impact of the GloBE Rules greatly depends on the design of the tax incentives. First, tax incentives targeted to activities that are out-of-scope for GloBE (e.g., shipping or funds) are unaffected. Second, tax incentives that have substance requirements may encourage MNEs to carry out additional substantive activities in the jurisdiction that benefit from the SBIE. Third, tax incentives that are targeted to a specific category of income or expenditure (such as reduced tax rates for certain kinds of income) may be less affected than those tax incentives broadly applicable (such as a permanent reduced tax rate for certain companies) given the potential to blend with income from other activities that are more highly taxed. Fourth, where incentives can be combined, the accumulation of incentives may give rise to high levels of tax support that may in turn generate low ETRs. Finally, some tax incentives are less affected due to the way in which they are accounted for under Financial Accounting principles and the GloBE ETR calculation (e.g., Qualified Refundable Tax Credits). Section 5: GloBE and tax incentives design This section focuses on the analysis of the impact of different incentive types on ETRs over the life of an investment, using stylized examples. According to the OECD, this analysis is intended to help policymakers to better understand which incentives would be more strongly affected by GloBE and under which conditions, illustrating the jurisdiction and entity-level factors outlined in Section 4 of the Report. The Report indicates that three key elements of the GloBE Rules cause variation in the impact on tax incentives: (i) the scope of the rules; (ii) the calculation of the GloBE ETR; and (iii) the SBIE. The impact of the GloBE Rules on a given tax incentive instrument depends on the extent to which the instrument contributes to a reduction in the GloBE ETR. The extent of the impact of the GloBE Rules on tax incentives depends on whether the tax incentive: (i) reduces the numerator – Covered Taxes; (ii) increases the denominator – GloBE Income; or (iii) is adjusted to ensure a neutral effect on the GloBE ETR. The Report identifies tax incentive instruments most likely to be affected and tax instruments unaffected or less likely to be affected. The first group of tax incentives instruments includes those that are treated as reductions in Covered Taxes in the GloBE ETR calculation. In the second group, the Report includes certain refundable tax credits and tax incentives that defer tax payments into the future. The Report also includes examples illustrating the impact of different tax incentive instruments. The Report states that the SBIE also plays a key role in the effects that Pillar Two has on the use of tax incentives in a post-GloBE environment. With the application of the SBIE, the extent of any Top-Up Tax under GloBE depends on the degree of economic substance (payroll and tangible assets) that firms have in a given jurisdiction, which is linked to the nature of the entity's activities. The Report provides examples to illustrate the impact of economic substance on GloBE outcomes. Section 6: Options for policymakers This section provides an outline for jurisdictions wishing to reassess their tax incentives environment in light of GloBE implementation. According to the OECD, jurisdictions should recognize that under the GloBE Rules opportunities to continue to use tax incentives to attract investment would remain, but the incentives would need to be carefully designed. In this regard, the Report includes suggestions for developing and emerging economies to consider as they prepare for GloBE. According to the OECD, jurisdictions should reconsider and revisit their use of tax incentives. In the view of the OECD, Pillar Two and the GloBE Rules in particular should empower governments to pursue tax reform and remove tax incentives where the costs outweigh the benefits from such incentives. The Report stresses that given the global nature of Pillar Two, inaction by a jurisdiction could lead to forgone revenues. Furthermore, the Report indicates that there is no one-size-fits-all answer on how GloBE could affect tax incentive use. This is because the GloBE Rules could have less of an impact on certain taxpayers and certain incentive designs compared to others. According to the OECD, tax reform proposals should be considered carefully, as the potential impact of GloBE Rules varies from jurisdiction to jurisdiction and so would the appropriate policy response. The OECD expresses the view that tax reform should build on sound economic principles, be evidence-based and contribute to enhanced transparency of tax design. In addition, jurisdictions may wish to reconsider of the use of tax incentives beyond those directly affected by the GloBE Rules. The Report outlines potential steps for a first screening of GloBE impacts in a jurisdiction. The Report indicates that tax reform may take time, but there are actions that jurisdictions could take in the immediate term. According to the OECD, as a rapid response, jurisdictions should consider the introduction of a QDMT to ensure that they collect Top-up Taxes on low-taxed profit in their jurisdiction that could otherwise be collected by other jurisdictions. The Report further indicates that jurisdictions also need to consider whether other broader aspects of their tax policy landscape are in need of reform to prepare for the implementation of the GloBE Rules, including strengthening or streamlining their anti-avoidance rules where appropriate and continuing to invest in their tax capacity. Section 7: Conclusion The Report reiterates that not all jurisdictions, MNEs, and tax incentives are equally affected by the implementation of the GloBE Rules. Tax incentives may contain design features that make them less affected by the GloBE Rules. Consequently, when evaluating and potentially redesigning tax incentives, jurisdictions should consider the following: (i) elements in their domestic tax systems that cause MNEs to be subject to low tax rates; (ii) the nature of the entities operating in the jurisdiction; (iii) the activities undertaken by entities operating in the jurisdiction; and (iv) the tax incentives offered to such taxpayers and their particular design. According to the OECD, as a first step for implementation of the GloBE Rules, jurisdictions should consider the introduction a QDMT. In the OECD's view, introduction of a QDMT should have limited impact on competitiveness, as the income would otherwise be taxed by other jurisdictions under the GloBE Rules. In addition, the OECD cautions that when preparing for implementation of the GloBE Rules, jurisdictions should evaluate any potential introduction of new tax incentives, or entry into investment agreements or contracts, that include stabilization clauses and properly assess their implications in the context of the GloBE Rules. Finally, the Report indicates that the OECD expects to launch a program of technical assistance to help developing jurisdictions in their consideration of tax reform as they implement the GloBE Rules. Annexes The Report includes three supporting Annexes. Annex A of the Report describes the OECD Investment Tax Incentives Database which compiles quantitative and qualitative information on the design and targeting of corporate income tax incentives across developing and emerging economies, using a consistent data collection methodology. For each tax incentive, it includes information on three areas: (i) instrument-specific design features; (ii) eligibility conditions; and (iii) legal basis. As of July 2022, the database covers 48 developing and emerging economies in Eurasia, Latin America & the Caribbean, the Middle East, North Africa, Southeast Asia, and Sub-Saharan Africa. Annex B of the Report describes the methodology used in Section 5 of the Report. The methodology is based on a forward-looking ETR framework to analyze the impact of GloBE on firms' ETRs in the presence of tax incentives to flexibly capture time-varying tax incentive design features. Annex C includes a series of additional charts supporting the main results discussed in Section 5 of the Report. Implications The Report describes how the GloBE Rules would have a material impact on tax incentives worldwide, consequently affecting the taxation of in-scope MNEs and the operation of jurisdictions' tax policies. Jurisdictions need to prepare for the implementation of Pillar Two, including the potential redesign of their tax incentives policy. The Report encourages jurisdictions to look at their own tax incentives systems and to consider potential tax reforms. It is important for businesses to monitor the introduction of Pillar Two rules in jurisdictions of relevance and evaluate the potential impact on their tax positions of the interaction between the global minimum tax rules and existing tax incentives as well as any potential changes jurisdictions may make to those incentives. Moreover, businesses may also want to engage with policy makers to discuss the potential re-design of existing tax incentives in connection with the introduction of Pillar Two. _________________________________________ For additional information with respect to this Alert, please contact the following: Ernst & Young Belastingadviseurs LLP, Rotterdam
Ernst & Young SA (Portugal), Porto
Ernst & Young LLP (United States), Global Tax Desk Network, New York
Ernst & Young LLP (United States), Washington, DC
_________________________________________ ENDNOTE 1 See EY Global Tax Alerts, OECD releases Model Rules on Pillar Two Global Minimum Tax: Detailed review, dated 22 December 2021 and OECD releases Commentary and illustrative examples on Pillar Two Model Rules, dated 21 March 2022. | ||||
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