Racing to the Top

The Organization for Economic Cooperation and Development’s 15% global minimum tax–a.k.a. Pillar Two–is being implemented around the world. None of the legislation has taken effect, yet, but it’s fair to say that the model is no longer theoretical.

But have there been second-order effects yet–reactions, changes in behavior, ancillary benefits or costs? 

One anecdote suggests that there have been. Speaking at a recent conference in D.C., Rafic Barrage, partner at Baker & McKenzie LLP, said that Singapore’s Economic Development Board told him that the country is looking at other ways to attract investment, now that its various tax incentives and benefits won’t be as effective as they have in the past, due to the minimum tax.

“One of the things they said to us was, they were trying to liberalize their immigration programs and attract more talent into Singapore,” Barrage said. “Historically, they've been rather stingy…But they realize that now there's more of a leveling of the playing field on the tax front, and they need to find other ways to incentivize.”

This is a fascinating tidbit which, if true, would be greeted with cheers by the officials at the U.S. Treasury Department. It’s exactly what they said they wanted–to end the “race to the bottom” in taxes, encouraging countries to compete through improvements to their workforce or infrastructure. Rather than ever-decreasing tax rates that drain resources, these are things that not only help developing countries continue to develop but can even be net positives for the overall global economy.

Not all of the reactions to Pillar Two may be like that, however. 

Many countries have responded by converting non-refundable tax credits into refundable ones, which protects them somewhat against the global minimum tax.

To review, Pillar Two is enforced by individual countries–they’re encouraged to enact taxes like the income inclusion rule, which targets the low-taxed foreign income of taxpayers based in their jurisdictions, or the under-taxed profits rule, which is applied by the subsidiary country based on the same metric, if the headquarters country declines to participate. Measurement of the income, to determine whether it’s taxed at below 15%, is based on financial accounting information, including adjustments such as a carveout for workforce costs and tangible assets. The combination of these laws would lessen or negate the benefits of a tax regime that provides taxation at below 15% for virtually any multinational taxpayer.

Ostensibly to track how financial accounting treats them, the OECD’s income measurement treats non-refundable credits as a reduction in taxes, while refundable taxes are treated as an increase in income, with a smaller impact on the effective tax rates. While it does match accounting standards, OECD officials have also stated that they believe refundability is a better policy on its own. It ensures transparency and more productive use of resources.

But providing cash benefits up-front can also require a lot of financial stability, which may be beyond many of the developing countries hoping to benefit from this project. That could be one way that the new race to the top still leaves some jurisdictions behind.

And for successful companies, refundable and non-refundable credits can be economically similar, if not identical. For them, despite all of this movement, not that much may have really changed.

Refundable credits are also more akin to direct subsidies, which are another way that countries can respond to these new tax restrictions. With lower tax rates off the table, jurisdictions–especially richer ones more flush with cash–may be more eager to provide up-front funding to new investors. Not everyone would agree that this is an improvement over tax competition, either.

Technically, Pillar Two isn’t even supposed to stop tax competition entirely. That’s likely an impossible goal, anyways–but the policy includes carve-outs that can still give taxpayers very low effective tax rates in some situations. 

The substance-based exemption, for instance, is based on 5% of a company’s tangible assets and 5% of its payroll costs. (Costs which can include not only salaries but everything from stock-based compensation to payroll taxes.) Because this exemption will grow depending on how much a company spends, the OECD has recommended that countries consider expenditure-based credits, rather than those based on the size of profits. (Although many U.S. multinationals seem very concerned that the minimum tax will dilute the value of the research & development credit, even though it’s also an expenditure-based tax.) 

Tax competition is usually seen as a resource allocation issue, a deadweight loss that is robbing jurisdictions from money they’d have at some theoretical “correct” tax rate. A recent working paper from the National Bureau of Economic Research estimated that tax competition reduces the welfare of poorer citizens around the world by 10-20%. 

But one could also view the issue as one of opportunity cost–what else could countries be focusing on, rather than ways to offer companies better and better tax benefits? Corporations have always claimed that, all things equal, they’d rather be in a jurisdiction with a strong infrastructure, rule of law, and educated workforce than one with a lower rate–but there’s a lot packed into “all things equal.”

Many, though, are skeptical that the OECD plan will have a significant impact on tax competition. It’s a little unclear if that was ever really the goal. Gabriel Zucman, professor at the University of California at Berkeley and author of “The Hidden Wealth of Nations: The Scourge of Tax Havens” said at the Davos forum a year ago that the OECD plan was “philosophically and conceptually” flawed because the substance-based carveout will still allow companies to chase lower rates for investment.

I question whether stopping tax competition is possible in a world with sovereign nations with the right to set their own tax rates. Maybe it would be a great thing for everyone to come together and agree on an acceptable range for corporate tax rates, but if they don’t want to, the amount of diplomatic pressure it would take to compel them would be enormous. (Though some, like Zucman, argue that the U.S. could impose this on multinationals unilaterally.) 

Given all of these dynamics, the responses to the global minimum tax implementation by individual jurisdictions is going to be very interesting to watch.

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

• The OECD released some long-awaited Pillar Two guidance on Monday, touching on issues such as the treatment of "blended" controlled foreign corporation rules and the rules for a transitional safe harbor based on country-by-country reporting. Many issues were unaddressed, however, such as the promised clarifications on the treatment of mobile assets in shipping for the substance-based carveout. The organization is likely to continue issuing new guidance in early 2024 and beyond. The big news in this package is the CBCR rules, which will likely be widely used for the few years it's available. The guidance includes some new anti-abuse rules for "hybrid mismatch arrangements," but officials say they're still wary that this framework could be stable long-term, as many taxpayers are hoping. (Also, to no one's surprise, the OECD's Inclusive Framework announced that it's delaying the deadline to finalize the Pillar One treaty text until March 2024. In the meantime, Treasury released all of its treaty comments for some Christmas break reading.)
• The Financial Accounting Standards Bureau, the U.S. rules-setter for financial accounting reporting standards used by the Securities and Exchange Commission, finalized controversial new income tax disclosures on Dec. 14. The new requirements include reporting of jurisdictional effective tax rates as well as details like "effects of cross-border tax laws" and tax credits. This is a huge step towards public country-by-country reporting, although it's still not quite there. (Employee head count is one major missing piece.) As with most accounting rules, the scheme also gives the reporter some discretion about what is significant enough to require disclosure. The standard has been criticized as being driven more by activism than shareholder concerns; it'll be interesting to see what kind of info this ends up revealing about the biggest companies' tax structures.
• Michael Plowgian, the deputy assistant Treasury secretary for international tax affairs, announced at the George Washington University Law School's annual tax conference in D.C. that he would be leaving the department at the end of the year. Plowgian was essentially the face of Treasury's OECD team over the past year, which includes being the target of harsh questioning from Republican critics of the agreement in Congress. He noted that his predecessor, Georgetown Law professor Itai Grinberg, also announced his departure at the GW conference a year earlier. Even in the tax world, where job-switching between the private and public sectors is common, this amount of turnover in a project like this is concerning. In his farewell speech Plowgian praised Treasury's staff and gave an impassioned case for public service, which he said often didn't get the recognition it deserves, especially in this heated partisan age.

NOTE: This newsletter will be off next week for the holidays. Happy Holidays to all of my readers and thanks for another amazing year at Things of Caesar! The next email will be sent during the week of Jan. 1.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Impossible Man, premiering in Red Band Comics #3 in 1945. He's actually the polar opposite of a superhero--not only is he a mere mortal human, but he crash-landed on a planet where everyone else is superpowered. Despite his severe vulnerabilities there, he uses his wits to outsmart super-villains, earning the name Impossible Man because he accomplishes feats that seem impossible to these non-Earthlings.

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