Ideal Tax Credits Under the Global Minimum Tax

Despite some over-enthusiastic promises made during the process, no one thinks that the Organization for Economic Cooperation and Development’s 15% global minimum tax will end tax competition as we know it.

For starters, there’s plenty of competing to be done above the 15% rate. But also, the minimum tax includes many carveouts and exceptions, which could theoretically allow countries to continue to offer well-designed tax credits to potential investors.

The project has reached a sort of twilight in-between phase, as the OECD continues to issue new guidance throughout the year, and countries begin to implement legislation of their own to participate. Last month the organization issued an “Implementation Handbook,” which included some guidelines on how countries should approach meshing the minimum tax (a.k.a. Pillar Two) with their existing tax regimes.

One thing that the new handbook touches on but doesn’t go into detail about is existing tax incentives. There have been other reports in the past, both from the OECD and other organizations, looking at this issue. If countries want to comply with Pillar Two, while also attracting businesses through any means they can, how should they go about it? What does an “ideal” tax credit look like in the post-min tax world?

Ironically, it could look a bit like the incentives in the U.S.--even though many U.S. lawmakers and critics of the OECD view the whole thing as an attack on Congressionally-authorized credits.

Once it’s up and running, the global minimum tax is enforced through national laws, a sort of self-policing system. When companies have income that is taxed at below a 15% effective tax rate, someone picks up the difference–ideally the company’s home country, if not another subsidiary jurisdiction. The system uses its own measurement for taxable income, based on financial accounting.

Tax credits can reduce the ETR, in some cases quite drastically. The exception is refundable tax credits, which are considered new income rather than a reduction in taxes, and thus affect the measurement less. While the OECD steadfastly refused to draw up a list of favored or exempted tax credits–even for seemingly noble causes such as anti-poverty initiatives or green energy production–it did ultimately allow for some wrinkles. Credits which can be transferred to a third party, including many in the Inflation Reduction Act, are considered the same as refundable, according to guidance from earlier this year. And credits for low-income housing were ultimately treated in a similar way. In both cases the OECD said this was simply following financial accounting rules, albeit for unique situations.

So, refundability may be the best way to protect your tax credits. But not every country is in a position to offer refundable tax credits. (And some, like the United States, just don’t want to.) What are other options?

There’s also the substance-based carveout, which exempts income from Pillar Two based on 5% of depreciable tangible property and 5% of payroll costs. The exemption is meant to ensure that the minimum tax is focused on intangible income, such as income from copyrights or patents. Many left-leaning critics of the project claim this will allow tax competition to continue, squeezing countries for desperately-needed revenue.

The problem is that while the substance-based carveout creates a window for new tax benefits, the size of that window is going to vary in every individual case. That’s going to be a challenge for policymakers trying to craft a consistent new tax rule.

An OECD report on tax incentives and Pillar Two, issued last year, lays out the pros and cons of several different tax incentive structures under the new regime. It notes that tax breaks based on expenditures, instead of income, are less likely to be affected since those expenditures are probably tied to workforce and assets. Which are the very things that reduce the incidence of the global minimum tax.

An example of an expenditure-based credit is the U.S. R&D credit, officially known as the credit for increasing research activities. It provides a direct reduction in taxes for some research expenses on a dollar-for-dollar basis. This is also a credit which the OECD has declined, so far, to provide any further protection for, despite persistent pressure from the U.S. Treasury Department–leaving many taxpayers worried that this lucrative tax credit could be dampened.

That’s despite the fact that in many cases, the R&D credit could be covered by the substance-based carveout. The Tax Foundation, in a general analysis of tax credits and Pillar Two, noted that most U.S. taxpayers are unlikely to be affected by Pillar Two for their domestic credits “under most circumstances.”

That’s the rub–most companies will probably be OK, but there’s no guarantee. The specter of Pillar Two will remain, causing increased risk and potential compliance costs, even if the ultimate average tax liability is negligible.

Another available tax incentive is a patent or IP box, despite its long history as one of the most abusive tax policies, at least according to critics. It may seem nonsensical, since Pillar Two is specifically designed to target IP profits, which IP boxes grant a special tax rate for. But the OECD previously created requirements for these policies, the “modified nexus approach,” requiring the benefit to be paired with real R&D activities. This grew out of a dispute between Germany and the U.K. over the latter’s IP box, and eventually became part of the guidance for the 2015 Base Erosion and Profit Shifting project.

(I’ve wondered why the OECD didn’t lean harder on the modified nexus rules to create leeway for the global minimum tax. I guess the policymakers were committed to sticking with Pillar Two’s formulaic definition of substance, wary of adding any potentially subjective determinations into the mix.)

Ireland recently announced it was raising the rate on its “knowledge development box” to 10%, to be Pillar Two-compliant. The rate is still below the official 15% minimum, but the Irish government apparently believes the substance-based carveout will cover the difference.

There still will be some risk with IP boxes–potentially even more than with an R&D credit, since the boxes grant special rates to profits, which don’t have the limit that expenditures-based credits do.

But, both will have some amount of risk. Just like, conceivably, any tax credit.

The substance-based carveout is theoretically the great dividing line for Pillar Two, separating on-paper profits from real, brick-and-mortar activities. But, in some cases it seems less like a clear bright line than a gray zone.

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.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• Back in May, the OECD released a draft “toolkit” to aid developing countries assess risks for base erosion related to the pricing of minerals, as well as a more specific report on the pricing of bauxite. After receiving comments to these initial drafts, the organization released a new report on the pricing of lithium earlier this week. The pricing of commodities is a more interesting issue than it might seem, and it’s been a persistent problem in Latin America and other areas with natural resource-rich but struggling economies. And given the surge of interest in certain minerals used for electric batteries and clean energy use, expect this to become more and more important in the years ahead.
• The Senate Finance Committee is holding a hearing today on “How the Tax Code Affects High-Income Individuals and Tax Planning Strategies”--or, in the punchier language of Chairman Ron Wyden’s announcement, “the schemes the ultra-wealthy rely on to legally get away without paying their fair share in taxes.” Based on a report prepared for the hearing by the Joint Committee on Taxation, the hearing is likely to focus on issues in individual taxation like capital gains, trusts and inheritance, and carried interest. But there still will be some topics relevant to international taxes, such as the taxation of passive foreign investment companies (PFICs). With the IRS continuing its crackdown on wealthy tax filers, both the hearing or the JCT report could be worth a look.
• The OECD also released this week eight peer review reports for countries’ compliance with the organization’s information exchange system. (Part of the paradigm-shifting new regime of tax transparency.) According to the organization, more than half of the involved countries have now received a second review, with 88% rated as either “compliant” or “largely compliant.”

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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The Magician from Mars, appearing first in Amazing Man Comics #7. This half-human, half-Martian woman possesses seemingly God-like powers which were actually the result of radiation exposure as a child. She escaped captivity on Mars and came to Earth to help those in need. This character is thought to be the first super-powered heroine in comics.

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