Refundability and the OECD's Tax Project's Unclear Impact on the Developing World

How the new 15% global minimum tax affects low-income, developing countries is a new hot topic of conversation. It’s not a question with a simple answer. According to non-governmental organizations, the deal is a sham, a rich countries’ racket to reapportion the tax revenue pie amongst themselves while leaving the others out entirely.

I think it’s more complicated than that.

But in one particular, subtle way, the specific interests of cash-strapped, poorer countries may have been overlooked, or at least not fully addressed. The rules behind the Organization for Economic Cooperation and Development’s global minimum tax agreement–Pillar Two of the “Two-Pillar Solution”--will restrict countries’ abilities to use tax incentives to boost their economies. And it could do so in a way that restricts poorer countries more than their Western counterparts.

The 15% global tax agreement, inked last summer after years of negotiations on how to shore up the international tax system, isn’t based simply on statutory tax rates. It looks to effective tax rates, based on its own formulas, to take into account the generous tax subsidies, exemptions and incentives that all countries use to attract business or alleviate poverty. Without taking them into account, a minimum tax pact would be little more than fanfare.

Of course, the OECD doesn’t have the power to literally forbid these incentives. What it can do is try to disincentivize them. Through Pillar Two, the OECD recommends that countries enact legislation which increases the tax costs for companies that take advantage of tax breaks–if those breaks lower the companies’ effective tax rate to below 15%. The company’s headquarter country can tax it on subsidiaries in other jurisdictions, if those jurisdictions tax the subsidiaries’ income below 15%, through Pillar Two’s primary rule, the income-inclusion rule. And the subsidiary countries can tax the company if the headquarter country isn’t taxing it enough, through the UTPR. (Which might stand for under-taxed profits rule, although that’s a bit unclear.)

This way, no matter where the company goes, Pillar Two applies, and the “race to the bottom” ends at 15%, according to Pillar Two supporters.

One of the challenges the OECD faced in designing this plan was devising a common definition of taxable income, that takes into account all the various ways a company’s tax liability could change. OECD officials said that listing particular tax incentives for each jurisdiction would be impossible–all would have to be included, based on some common parameters.

This is where things got a bit sticky, because everyone hates tax incentives in general, but loves theirs in particular.

Many in the U.S. balked when they learned that the UTPR could hit companies on their domestic income for using tax breaks like the research & development credit. (Not totally clear what was the surprise–that R&D was included or that the UTPR could apply to U.S. domestic income at all. Either way, many were shocked.)

Interest groups couldn’t believe that the OECD would dilute the value of tax breaks for worthy goals like green energy or low-income housing–aren’t those always exempted from projects like these?

There was one exception that the OECD managed to create wiggle room for–refundable tax credits could be considered a form of income, not a tax break. This still lowers a company’s effective tax rate. (Since its income is rising without a corresponding rise in taxes.) But not as much as if it were considered a reduction in tax, like most non-refundable tax breaks are.

Pushing the line even further, OECD officials have also stated that they may consider transferable tax credits to be refundable–being able to trade the credit is kind of like getting a refund, they reasoned. This will cover most of the green energy tax credits in the Inflation Reduction Act, for starters.

Refundability is the main way out, though. If the government is willing to offer the company immediate cash in lieu of the credit, then it’s not really a tax credit at all, it’s a subsidy.

“In this way, the government effectively pays for the activity or expenditure in a similar manner to a grant,” the OECD’s Pillar Two commentary stated. “The basic idea is that the incentive or grant is delivered by a tax reduction to the extent possible because it is more efficient than having checks from the government and taxpayer crossing in the mail.”

The problem is, not all governments are in a position to offer corporations immediate cash.

The OECD’s recent report on tax incentives, requested by Indonesia and released last week, acknowledges this deep into the text. It states something that is straightforward and somewhat obvious, but I haven’t heard anyone in authority say until now–that converting nonrefundable credits to refundable ones could lead to “substantial revenue losses” for some countries.

“This could be particularly damaging, especially for jurisdictions with limited fiscal space, as the credits would need to be paid-out to firms with insufficient tax liability,” the OECD added.

Indeed, refundability has been a problem in tax administration generally for many developing countries, especially when it comes to value-added taxes. I reported on this issue back in 2018–in Africa some companies wait years for refunds on VATs from countries which never put aside funds to pay them, jamming the system. Some countries, such as Zambia, considered scrapping the VAT altogether, to replace it with a sales tax that is simpler but more distortive. (Zambia ultimately changed course and kept its VAT.)

In some abstract, conceptual sense, there may be no economic difference between a tax expenditure and a grant. But when it’s uncertain whether the company will ever be able to recognize that tax incentive as a benefit, it makes a huge real-world difference.

You could argue this isn’t so much a bug of the OECD plan, as a feature. One of the goals of the project was allegedly to stop countries from competing against each other for investment with bigger and bigger tax goodies. To be blocked from using a tax incentive–but also know that neighbors are blocked as well–is what many developing countries want. But why should they be disadvantaged relative to Western nations that can afford to dole out generous government grants through their tax systems?

The primary justification for this treatment is formalistic–the overall income definition relies on accounting standards, and in this case accounting standards call for refundable credits to be seen as income. But OECD officials have argued it’s the correct policy as well–tax incentives are better when they provide “financial support up-front, and that is not somehow contingent on future profit returns,” said John Peterson, a senior OECD tax official, at a conference this spring.

It’s a good argument, but what about countries where this just isn’t an option? Or if offering potential future tax benefits down the line is a cost-effective way to support a new investment?

I also suspect that part of this is jurisdictional–the OECD has a mandate to update the global rules on taxes, not necessarily subsidies. That’s more of an issue of fair trade, edging onto the World Trade Organization’s turf. That tax policy is often siloed off as a separate policy discussion, distinct from other fiscal matters, can be a hindrance–the late Ed Kleinbard, tax expert at the University of Southern California, often railed against this, claiming it distorted the choices. Is this a prime example?

The OECD tax incentives report has more subtexts than a Stanley Kubrick movie. It also notes that expenditure-based tax incentives–read, the U.S. R&D credit–are less impacted by Pillar Two. This is because of the substance-based carveout, an exemption in the income definition for tangible assets and payroll. The carveout is meant to better focus the tax on intangible income and pure cash boxes in tax havens.

This could likely benefit developing countries as well. For the most part, they’re not the ones competing for income disconnected from any real activities. These countries want real boots and machines on the ground. But threading the needle on those tax policies may involve some tricky guesswork. How to guarantee that benefits are associated with substance? And what about activities that might not fit through the substance-based carveout? Some resource extraction or manufacturing operations may require less workers than you’d think.

Not to sound like a broken record on this point, but this comes down to the blurred, unclear goals of the OECD project. If it’s about stopping tax avoidance and income-shifting by huge corporations, then developing countries don’t have a reason to oppose it outright, even if they’re skeptical that they’ll see much of a benefit. If it’s about limiting all forms of tax competition, then it’s a harder choice–one that some of those countries may welcome, while others will question.

The developing world isn’t a monolith. Some of them would rather win the race to the bottom, than end it.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

Cryptocurrencies have flummoxed government rules of all types, and tax rules are no exception. The OECD negotiations on digital taxation have been difficult, but at least they're happening. There's nowhere near any consensus about how to deal with these nebulous, purported currencies, which technically don't really exist anywhere. The OECD is trying to take the first steps, though, and on Monday it released a framework for dealing with tax evasion through cryptos, at the behest of the G-20.

Remember Pillar One? Despite the public commentary that it's all but dead, the OECD is still moving ahead with implementation, announcing a new public consultation on tax certainty aspects. Stakeholders can submit public comments up until Nov. 11. As I said last week, it would be a mistake to ignore this entirely, even if it seems a tad theoretical at this point.

As the OECD looks to increase corporate taxation, most countries are going in the opposite direction, according to a new report from Oxfam International. The report claims that the COVID-19 fallout lead to a drop in government expenditures, even in the health space.

Headed to Texas? I'll be at the American Bar Association Tax Section's fall tax conference in Dallas tomorrow and Friday. If you're there, don't hesitate to give me a holler.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Airman, created by George Kapitan and Harry Sahle, debuting in Keen Detective Funnies #23 in 1940. The son of a renowned ornithologist dons these gas-powered, Icarus-style wings to avenge his father's senseless murder.