A Solution for R&D and Pillar Two?

How to treat incentives like the U.S. tax credit for research and development remains one of the biggest political landmines as implementation of the Organization for Economic Cooperation and Development’s Pillar Two 15% global minimum tax continues.

The nonrefundable credit offers a dollar-for-dollar match for qualifying R&D spending, and it’s one of the most popular (and politically supported) incentives in the U.S. tax code. But it could be targeted by the minimum tax’s under-taxed profits rule, the enforcement mechanism to target companies based in countries (like the U.S.) that neglect to implement the new OECD rules. Under that regime, U.S. companies may see increased foreign taxes if the R&D credit brings their effective domestic tax rate below 15%.

Countries may be eager to take a pound of flesh from large, profitable U.S. companies through this new, internationally-sanctioned rule. Congress is unlikely to make changes to the credit, including through a qualified domestic minimum top-up tax, the policy to enact Pillar Two at the local country level. And other OECD members would reject any compromise plan which would treat the R&D credit differently. (Their patience with U.S. demands, as the country refuses to make any moves to honor the agreement itself, is probably at an end anyway.)

There is an intriguing possible solution that has been floated by tax practitioners and may be in the mix at Paris negotiations, however.

The idea is to treat any expenditure-based incentive (e.g. the R&D credit) like a subsidy, rather than a reduction in taxes. Similar special treatment already exists for refundable and transferable credits, lessening (though not eliminating) the UTPR impact. For those credits, the logic is that they’re really more akin to subsidies than a tax break, and thus are less harmful to the Pillar Two goal of eliminating base erosion and tax competition. They count as additional income, but not a reduction in taxes. Maybe a tax benefit which is limited by the amount a taxpayer actually spends in a jurisdiction should follow the same principle.

And tying tax incentives to expenditures is also in keeping with prior OECD work to distinguish between legitimate and “harmful” tax benefits. When in doubt, follow what you already know.

“I'm very sympathetic to the idea that an expenditure-based in the location would be a path to look at,” said Robert Stack, a managing director at Deloitte Tax LLP and the former deputy assistant secretary for international tax affairs at the U.S. Department of the Treasury. “I think it's a path, I think it's a path being looked at.”

Stack said this during a tax conference at the Georgetown University Law Center in Washington, D.C. on April 5.

Speaking at the same panel, Danielle Rolfes, a partner at KPMG LLP who worked with Stack at Treasury during the OECD negotiations over the 2015 Base Erosion and Profit Shifting project, elaborated a bit on the logic behind this idea.

“An expenditure-based incentive, for in-country incentives, that doesn't exceed the amount of the expenditure is a subsidy of that expenditure,” she said. “The government is saying, I'll go in with you on that expense.”

And testifying last month before the Senate Finance Committee, Secretary of the Treasury Janet Yellen said the administration believed it had “an opening” to negotiate a favorable resolution of the issue at the OECD–is this what she meant?

The alternative to an expenditure-based incentive is one that is tied to profits–its value increases the more income a corporation can report in that jurisdiction. Those include patent boxes, which in their purest form give a low tax rate to income from intellectual property or intangible assets. Or it could be a low tax rate generally–the more income you have in the jurisdiction, the better for the taxpayer, especially if it means they pay less somewhere else. (Technically, the U.S. R&D credit is tied to profits too, since it’s non-refundable and can’t be claimed unless there’s income to claim it against. But that’s less dramatic than some of the other examples.)

The OECD has been dealing with patent boxes since 1998, when it first created the Forum on Harmful Tax Practices. As part of the BEPS project, it codified the “modified nexus standard,” based on an agreement between Germany and the United Kingdom over the latter country’s patent box, as the basis for whether a tax regime could be considered harmful.

“The nexus approach uses expenditure as a proxy for activity and builds on the principle that, because IP regimes are designed to encourage R&D activities and to foster growth and employment, a substantial activity requirement should ensure that taxpayers benefiting from these regimes did in fact engage in such activities and did incur actual expenditures on such activities,” the 2015 Action 5 BEPS report stated.

This standard doesn’t even say that an incentive can’t be profits-based. It just says that, for incentives that apply to income from IP, there needs to be some connection to real R&D activities. Otherwise, it’s just an invitation to engage in profit-shifting through intangibles.

In a sense, the OECD Pillar Two project already followed this logic, through the economic substance carveout. It grants an exemption based on tangible assets and payroll, so the minimum tax focuses on intangible income that’s likelier to be involved in profit-shifting. In theory, this gives countries some room to still use incentives to attract investment, although how exactly they would design policies to do that is still a bit of an unanswered question.

In fact, the OECD has already said that an expenditure-based incentive is the best way for countries to offer incentives while also complying with Pillar Two. Guidance issued in 2022 on tax credits noted that, because of the economic substance carveout, expenditure-based incentives are "likely to be comparatively less affected by the introduction of" Pillar Two than other types of tax breaks.

But it wouldn’t be perfect–there are still times when a company uses the R&D credit and has a low tax rate, but doesn’t have enough assets or employees to cover their excess profit. Given that limitation, why not just take this logic to its conclusion and give the expenditure-based incentive full favorable treatment?

Here, the OECD wouldn't need to delve into where the spending goes, and distinguishing good and bad policies, something it has been very reluctant to do. (I think it's a little weird for the OECD to disincentivize incentives for decarbonization while it starts its own climate change/decarbonization initiative, but that's another discussion.) And there's an additional political appeal–it wouldn’t only benefit the United States. Many countries have expenditure-based incentives and would like to see them protected, and others may like to have the option to enact one to as it replaces credits now negated by Pillar Two.

But as a solution, it does face some hurdles. It’s harder to view this as an administrative or implementation issue, as the OECD characterized the prior guidance exempting transferable credits such as the Inflation Reduction Act’s green energy incentives. Everybody’s reluctant to re-open policy discussions as laws are being enacted, a recipe for a messy situation.

There’s also the question that seems to lurk around the corner of every Pillar Two debate–what is the policy’s goal? If it’s to end base erosion and profit-shifting, then it’s hard to see how the R&D credit and other incentives tied to real spending could be a part of that. There's not a separation between real activities and the reported profits.

But if Pillar Two's goal is to stop tax competition and end the “race to the bottom,” that’s a different story. The R&D credit may be an example of better tax competition, but it is still unquestionably a lure for investment. That makes it harder to carve out of this framework.

Under President Biden, the U.S. has been pushing for this larger goal of the global minimum tax, to end the “race to the bottom” and reduce the pressure that developing countries face to offer better and better tax credits to attract foreign investment. But the U.S. has also been reluctant to see its own policies be put under the same microscope.

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

• Today, the House Ways and Means Committee will be "marking up" (adding amendments and then voting up or down on approval) two bills that relate to the implementation of the Inflation Reduction Act’s green energy credits. Both bills–"Stop Executive Overreach on Trade Agreements" and “End Chinese Dominance of Electric Vehicles in America Act of 2024”–ultimately come down to complaints from lawmakers in both parties that the Biden Administration isn’t doing enough to enforce the “Made in America” requirements in the IRA, and to exclude countries like China from benefiting from its funding. It’s unlikely that these bills would become law as they’re currently written, but the fact that they’re out there shows how this backlash continues to grow. The twin goals of the IRA–to speed up decarbonization of the economy and to boost manufacturing in America–are coming into conflict and that’s going to become a bigger and bigger issue as the money starts to flow. Add to that concern from foreign countries and the European Union that these subsidies are a discriminatory attack on their industries. This is an interesting area to watch as climate change and carbon pricing/decarbonization may supplant international tax avoidance as the primary issue in global tax debates.
• Speaking of decarbonization, France announced last week that it would be joining Canada’s “Global Carbon Pricing Challenge,” a coalition of nations aiming to cover 60% of global emissions with carbon pricing by 2030. Most of Europe is now participating, as well as the EU and other countries around the world–but not the United States, which has yet to enact any type of major tax on carbon. This is another indication that the major economies are getting serious about increasing the cost of carbon emissions, although it’s still in the starting-up phase. Meanwhile, the U.S. just passed its first major climate change legislation, but it’s entirely with a carrots, no sticks approach. The OECD has begun its effort to help coordinate the different approaches countries are taking to address these problems. As I said above, this is set to become the major issue in global taxes.
• Extra-legal standards set by non-profits are becoming a bigger and bigger factor in global tax policy, especially as governments are increasingly relying on them to set their own laws. Public country-by-country reporting has been a part of the Global Reporting Initiative, a model for transparency in corporate governance, for several years now. The Financial Accounting Standards Board, which sets generally accepted accounting principles (GAAP) in the U.S., recently enacted its own version of CBC reporting, despite a backlash from taxpayers. And on April 15 (perhaps not coincidentally, tax day in the U.S.), the The International Ethics Standards Board for Accountants announced new ethical standards in tax planning for tax practitioners. The IESBA said this would be “principles-based framework and a global ethical benchmark” for accountants as they advise clients about international tax structures. It will no doubt be examined closely by practitioners as they come under stronger scrutiny by governments and the public for participating in what are alleged to be abusive schemes.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Black Cat, first appearing in Pocket Comics #1 in 1941. A movie star bored with the life of glitz and glamor, Linda Turner became a vigilante to repel Nazi and Japanese plots to take over Hollywood during World War II. She used her acrobatic and fighting skills (her mother was a stuntwoman) to become a formidable threat to America's enemies. Pretty awesome, but we must deduct points for coming out a year after Catwoman.

Contact the author at amparkerdc@gmail.com.