Researching the R&D Options

In this partisan, polarized age, anyone in government has to watch their words closely if they want to avoid becoming political fodder.

Scott Levine, newly appointed to be acting deputy assistant secretary for international tax affairs at the U.S. Treasury Department, got a quick lesson on this earlier in 2024.

Speaking at a tax conference–where tax experts can normally be a little more free-flowing with their thoughts–Levine mentioned in March that Treasury would have to turn to “Plan B” if they fail to negotiate for favorable treatment of the U.S. research & development tax credit under the Organization for Economic Cooperation and Development’s 15% global minimum tax. Under the current rules, the credit lowers a company’s effective tax rate to measure compliance with the tax, and if it brings a company under 15% foreign countries can enact taxes on that company under this new regime.

Levine explained later at the conference that by “Plan B,” he meant asking Congress to change the R&D credit into a refundable tax credit, which reduces the effect under the minimum tax. (In that case it counts as increased income, not a reduction in taxes.) That’s hardly a secret–it’s been Treasury’s position that Congress should do this, ever since the OECD guidance laid out the differing treatments for refundable and nonrefundable credits.

Nevertheless, Republican critics seized on the comment.

Sen. Todd Young, R-Ind., demanded to know more about this “Plan B,” especially if it involves legislation, when Treasury Secretary Janet Yellen testified before the Senate Finance Committee later that month.

“This was the first that I had heard of the need for legislation to address the administration's failure to secure U.S. interests in the Pillar Two model rules,” Young said. “This committee needs to know what to expect and what sort of Plan B to prepare.”

Yellen assured Young and the committee that there was no “Plan B,” other than the proposed R&D change that it had already laid out. Nevertheless, to the critics, this was Treasury yet again failing to keep Congress in the loop of these negotiations, and only revealing legislation to pass after it’s too late to make changes.

In this case, it does seem to be just an unfortunate turn of phrase.

In a sense, though, it doesn’t really matter. When Yellen said there was no Plan B, she was probably more right than she meant to be. Not only has Treasury not yet drawn up a detailed proposal for this, but everyone in Congress knows that a change to a refundable tax credit isn’t likely to happen. If this is truly the Plan B, then it’s back to Plan A.

“I think it's really important that we not let European countries and the OECD think that is a realistic option in the United States,” said Danielle Rolfes, a former Treasury official and partner in charge of KPMG LLP’s Washington National Tax Practice, said during an April tax conference at Georgetown Law.

There are a variety of reasons why it’s hard to imagine. The cost could be as much as hundreds of billions of dollars over 10 years, and there’s not much of a constituency to push for it. (Unprofitable companies don’t have a lot of pull on Capitol Hill, as you might expect.) There are fears that it could lead to fraud, or investments of taxpayer dollars in questionable ventures that will never become profitable. With a nonrefundable tax credit, you at least know that the taxpayer is successful enough to have once had taxable income.

The expiration of many provisions in the 2017 Tax Cuts and Jobs Act next year will create a “Tax Cliff” that could force both parties to agree to a major overhaul of the tax code. In theory, that could be a vehicle for a change in the R&D credit. But with so many different issues in play, and with the parties scrambling for revenue to cover their priorities, it’s even less likely that something like this could make it through. When push comes to shove, only things that are absolutely necessary end up surviving tough political negotiations like this.

Many other countries did change their credits to become refundable, and they may be skeptical about these political obstacles. But the U.S. is different–we just do things our own way. Other participants in the OECD project will have to decide if they want years of tension around this issue, or if they’re willing to accept a fix.

There may be a fix in the works–an “opening,” according to Yellen–that would resolve, at least partially, the problem. This may or may not be to treat expenditure-based credits, like the U.S. R&D credit, as income. This would give them the same reduced impact as refundable credits.

The idea here is that expenditures are evidence of economic substance, just like Pillar Two’s substance-based income exclusion. In fact, because of that carveout, which is based on payroll and tangible assets, expenditure-based incentives are already favored. This could be seen as building on that principle–or, as a redundant double benefit.

One of the challenges with this concept is figuring out how to define qualifying expenditures. One can imagine creative lawmakers hoping to lure investment by drawing up credits with loose expenditure requirements that companies would be able to use against spending they were already doing. But, at the same time, the OECD would have to give countries leeway for their own rules. And they don't want to favor particular activities or incentives over others. That's a tricky needle to thread.

There is a precedent for a similar concept, however. In the OECD’s 2015 Base Erosion and Profit Shifting project report on Harmful Tax Practices, the organization laid out the “modified nexus” standard for determining whether regimes that grant special tax treatment to profits from intellectual property are considered harmful. In this case, the regimes are based on the amount of income earned in the jurisdiction. But the OECD standard looks at whether the amount of expenditures related to research and development are proportionate to the income and tax benefits. To determine which expenditures qualify, the report leans on existing national R&D laws, stating that expenditures “would include the types of expenditures that currently qualify for R&D credits under the tax laws of multiple jurisdictions.”

Those would include “salary and wages, direct costs, overhead costs directly associated with R&D facilities, and cost of supplies so long as all of these costs arise out of activities undertaken to advance the understanding of scientific relations or technologies, address known scientific or technological obstacles, or otherwise increase knowledge or develop new applications,” the report states. Of course, this is specific to R&D because it's about tying those activities to the favored IP.

For non-IP regimes, the OECD said it should follow a similar principle, based on whatever the favored activity is.

"The effect of this approach is therefore to link income and activities," the OECD states. "When applied to other regimes, the substantial activity requirement should also establish a link between the income qualifying for benefits and the core activities necessary to earn the income."

Pillar Two is already making some of these determinations for the substance-based carveout. As with the modified nexus standard, it’s leaning on existing law–there’s a lot of prior history to use with defining payroll and tangible assets. It’s a lot easier to look at that, than to start over from scratch.

Nevertheless, if the OECD pursues this route there are political challenges as difficult as the policy ones. Many countries are probably fed up with accommodating the U.S., no matter the logic. And some will see it as further diminishing the Pillar Two goal to stop tax competition–something that all of the participants have never seen quite eye-to-eye on.

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

• This isn’t technically tax news, but it’s big enough news to touch everything–the Biden Administration announced Tuesday it was hiking existing tariffs against China in retaliation for what it claims are unfair trade practices that harm American workers and businesses, especially in the electric vehicle area. Through the presidential authority under Section 301 of the Trade Act of 1974, which grants the president wide latitude to determine responses to actions it deems discriminatory, the U.S. is hiking tariffs against an array of products, from battery parts and EVs to semiconductors. (As well as some old-economy ones like steel and aluminum.) This generated praise from Democratic supporters and backlash from business groups, but it also marks a significant shift in how Democratic officials view protectionism and free trade. And if the Biden Administration is comfortable using aggressive Section 301 authority on China, does that indicate it would also use it against digital services taxes? Or even the enforcement provisions of Pillar Two?
• The Australian Treasury announced Tuesday that this year’s annual budget legislation would include a new penalty “for multinationals that attempt to avoid Australian royalty withholding tax by understating royalty payments or seeking to disguise them as something else, to ensure they pay their fair share of tax.” The bill will also include increased transparency measures to enforce the new penalty. These kinds of anti-abuse penalties aren’t uncommon, but it’s interesting to see that the Australian government remains vigilant about perceived tax avoidance by foreign companies–and it increasing relies on subjective determinations of intent.
• Lael Brainard, director of the National Economic Council–the top economic advisor to the president–gave a speech at the Hamilton Project Friday in which she outlined the administration’s priorities in the upcoming 2025 tax showdown. All of the themes were familiar, but it does help in seeing what Biden sees as the key priorities both in 2025 as well as this year’s election. Brainard expressed the White House’s commitment to enacting the global minimum tax agreement it forged in 2021, which she said “will finally address the race to the bottom in corporate taxes, while enabling businesses to compete and allocate capital based on workforce talent and market factors instead of tax minimization strategies.” Not that it was really needed, but the speech confirmed that President Biden is still committed to the agreement, despite the backlash it has provoked. And it also showed how his team views the OECD deal as part of the overall objective of ensuring that large corporations “pay what they owe” and pay their “fair share,” something that they likely view as a political winner in this year’s tough election climate.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Magno the Magnetic Man, first appearing in Super-Mystery Comics #1 in 1940. A WWII-era superhero who can fly and perform other super-human feats through never-explained (at least here) magnetism. His arch-nemesis is a Nazi stooge called "The Clown," who's pretty much what you're thinking.

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