Refundability and Transferability

The Inflation Reduction Act’s green energy provisions have faced a barrage of attacks lately.

The House of Representatives yesterday passed a Republican bill to raise the statutory debt limit, and rescind most of the IRA’s incentives for renewable or clean technology development. The same day that bill was first introduced, the House Ways and Means Committee held a hearing allegedly concerning “the U.S. Tax Code Subsidizing Green Corporate Handouts and the Chinese Communist Party.” Chairman Jason Smith, R-Mo., excoriated what he claimed were “corporate welfare subsidies” that would pay “big dividends to big business and China.”

The law will likely survive this onslaught. Presidents don’t cede ground on their signature accomplishments lightly, and with current power dynamics the GOP doesn’t have the leverage to force him too. In all likelihood, companies can count on these credits sticking around for years to come.

But the biggest threat to their viability may come from within–a potential self-inflicted wound from the Biden administration, which could open the door for foreign jurisdictions to sap the value of these credits through increased taxation on U.S. companies.

I’m talking about the 15% global minimum tax, reached at the G-20 and the Organization for Economic Cooperation and Development and touted by President Biden and Democrats as one of its first major accomplishments in the first half of 2021.

As I’ve discussed in other newsletters, the OECD rules include retaliatory taxes which jurisdictions can enact when other countries neglect to follow the new rules. And since Congress wouldn’t sign on to legal changes to comply with the OECD and the min tax, also known as Pillar Two, those supposed scofflaw countries could include the U.S. If generous tax credits cause a company’s effective tax rate to dip below 15%, even on domestic income, U.S. companies could face higher taxes abroad.

Despite confident and apparently mistaken proclamations by the U.S. Treasury Department that the IRA’s credits would be covered by the OECD’s administrative guidance, the IRA green tax credits are among those that could set off the OECD’s global min tax apparatus. Even as the OECD prepares a new climate change initiative, green energy incentives aren’t considered exempt from Pillar Two.

But it’s far from finalized. Some still hope that with a little finagling, the OECD’s rules on income definition can be made to cover the IRA without sacrificing its overall principles. For the Biden administration, there’s cause for hope–but it will require answering some complicated technical and political questions.

Pillar Two is designed to recognize that low tax payments aren’t just caused by low tax rates. Jurisdictions can achieve them through a variety of methods–lax enforcement of transfer pricing rules, individual agreements with companies, or very generous tax credits and incentives. The OECD’s definition of income recognizes the latter as a reduction in overall tax payments when calculating a company’s effective tax rate in a particular jurisdiction. If it lowers the rate to below 15%, Pillar Two kicks in–the parent country applies the primary income inclusion rule to the company’s low-taxed subsidiaries, or if it declines to then the subsidiary countries apply the UTPR and then divide up the extra income among themselves. This happens even if the jurisdiction in question is the company’s home jurisdiction, as would be the case in some examples of U.S. companies using domestic tax incentives.

One exception is when a tax credit is refundable. If a company can immediately capitalize on the credit regardless of whether or not it can be matched with tax payments, the OECD rules treat it as an increase in taxable income, not a decrease in taxes. That still lowers the effective tax rate, but not by nearly as much.

The OECD has mostly said it’s following global accounting standards with this rule. One intuitive way to think about it is that a refundable tax credit is more akin to a direct subsidy than a tax credit, and thus is treated that way. (In the U.S., they’re even called “direct pay” credits.) International Accounting Standard 20, “for Government Grants and Disclosure of Government Assistance” of the International Financial Reporting Standards puts it this way, noting that an argument in favor of this approach is that “because government grants are receipts from a source other than shareholders, they should not be recognized directly in equity but should be recognized in profit or loss in appropriate periods.” (It should be noted, this isn’t the only way that the IFRS allows such credits to be recorded.)

Of course, refundable tax credits are much less common than nonrefundable ones. They’re more expensive, since they require the government to pay up-front and more often. They also could subsidize questionable ventures–those that haven’t seen a profit since their founding, and maybe never will.

Even before passage of the IRA, some OECD officials hinted that they may consider whether transferability would be treated the same as refundability. If an entity with a nonrefundable credit can sell it for cash to an entity that can use that payment to reduce its tax liability, then maybe that’s a type of refund. This became all the more pertinent after the IRA, which leans heavily into the transferability concept in its host of green energy incentives.

Everyone was pretty sure that the OECD was ready to confirm the transferability approach in its package of administrative guidance earlier this year. But when it was finally released, that concept was nowhere to be seen. Treasury even released a statement claiming that the guidance ensured that “green tax credits, including those that were included in the Inflation Reduction Act” would be protected, leading to a lot of questions about what they meant. (It’s possible that the department was referring to a smaller number of IRA credits that could be covered under the “equity method,” which was laid out in the guidance. But that won’t affect most of the IRA.)

Three months later, the OECD still hasn’t addressed the topic. This may have something to do with the brewing conflict between the European Union and the U.S. over the IRA’s many requirements for domestic manufacturing, which have ticked off many competitors. As the administration hopes to smooth over this conflict through some creative interpretations of the rules, it’s provoked another backlash from Congressional Republicans and some Democrats, apoplectic that Biden would seek to loosen made-in-America requirements.

But even if this is worked out, it still leaves the central policy question–is transferability the same as refundability? It hardly seems like a sure thing. The IFRS guidance doesn’t mention anything about transfers of this kind. The OECD rules seem to have been carefully written in passive voice to avoid specifying who exactly is doing the refunding, or whether it can be a private entity. It states that a qualified refundable tax credit is “a refundable tax credit designed in a way such that it must be paid as cash or available as cash equivalents” if the conditions have been satisfied, within four years after it is granted.

Note the word “must”--one aspect of a transferable credit is that it’s only convertible into cash if another party agrees. No one is obligated to do it. Unlike a traditional refundable credit, in which the recipient is legally entitled to the income so long as the government is able to provide it. Perhaps the “must” would mean that the government is required to respect the transfer in the case of a transferable credit, but that could be debatable.

Given the nature of the OECD’s process, to produce rules and standards by consensus, it can be tough to come up with a tweak like this if there isn’t an underlying principle. Many members don’t feel like giving the U.S. much charity. On the other hand, no one’s really sure what lies down the road of a global minimum tax without these exceptions–could it provoke retaliatory actions and potential trade conflicts?

It makes me wonder if maybe we have the wrong focus. Rather than trying to fine-tune these rules to cover every conceivable instance, the OECD should look more towards safe harbors and soft enforcement agreements to reflect the basic overall fact that these green energy credits are unlikely to be used in classic tax avoidance structures. By their very definition, they require a degree of economic activity, which the OECD rules exempt through the substance-based income exclusion. This is partly why I think the controversy seemed to catch many off-guard–these just aren’t the situations you think of when you consider the complex tax structures used in profit-shifting.

But that runs into the expanded goals of the OECD project, the commitment some have expressed to end the “race to the bottom” with generous tax benefits in the competition for investment. Which likewise raises questions about how the world will collectively approach the shift away from fossil fuels, and who will pay. If what lies at “the bottom” is a vigorous green energy industry, should we want to 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

• As OECD and Treasury officials work to hammer out Pillar Two's final details, the project still faces an onslaught from Republican opponents. According to a Roll Call piece, Congressional Republicans may include "some form of retaliation against countries that tax U.S.-based global companies" as part of the agreement, in a package of tax changes being drawn up at House Ways & Means. There are already many tools available for the executive branch to apply economic tariffs or other responses should it determine that countries are discriminating against U.S. firms, with a lot of flexibility to determine what "discrimination" means. So it's not totally clear what else Republicans might push for, but they seem more and more committed to pushing back against the OECD. Stay tuned for more fireworks.
• I've written about how information exchange between countries has led to a revolution in enforcement of anti-tax evasion measures. Often these issues are blurred with programs to tackle criminal money-laundering and other financial crimes. This report from the International Monetary Fund claims that these efforts should work hand-in-hand, as often the crimes can be hard to disentangle and better coordination could reduce redundancies and missed opportunities.
• Speaking of information exchange, the OECD released a study on Thursday reporting that Asian countries have made progress in tax transparency, as part of the organization's overall initiative.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Mr. Muscles, premiering in Mr. Muscles #22 in 1956. A wrestler who also fights crime without a secret identity, there isn't a lot of other information, except that he's apparently the "World's Most Perfect Man." He recalls Hugo Hercules, who many allege was the first comic superhero. Co-created by Jerry Siegel, who also co-created Superman and spent the rest of his career fruitlessly trying to craft another mega-star that he could own and profit from.

Contact the author at amparkerdc@gmail.com.