The side-by-side package released by the OECD in early January was welcomed by the international tax community and heralded as demonstrating renewed commitment to international tax cooperation. While getting the agreement over the line was a triumph for international cooperation, that narrative misses what the side-by-side package means for international tax.
In our view, the side-by-side package concedes to tax competition (even if that concession is currently limited) and puts the global minimum tax framework under strain.
We see the potential for strain on the Pillar Two framework in two features. First, the side-by-side package dilutes the primary enforcement mechanism under the original framework, namely the undertaxed profits rule (the “UTPR”). That dilution means countries may revisit how they have implemented the global minimum tax. Second, the side-by-side package actively revives tax competition by adopting a new permissive treatment for qualified tax incentives (“QTIs”), albeit the level of tax competition that is permissible may be limited.
Dilution of UTPR and why it matters
Under the side-by-side safe harbour, MNE groups that are headquartered in the United States are excluded from top-up taxes under both the main Pillar Two top-up tax (the income inclusion rule or “IIR”), and also the UTPR. While that appears to be a reasonable outcome for US headquartered groups, it changes the options available to countries that compete for US foreign direct investment.
Under the original Pillar Two framework, if a country imposed tax on an entity at an effective rate that was below 15%, a top-up tax would inevitably be applied somewhere else in the group. The IIR would apply if the entity had a parent entity resident in a jurisdiction that had implemented Pillar Two. If not, the failsafe would kick in and a top-up tax would be applied under the UTPR by any Pillar Two jurisdiction in which group entities were located.
That design meant that profits that were taxed below an effective tax rate of 15% in any jurisdiction would inevitably be subject to a top-up tax elsewhere. Given low-taxed income was going to be taxed somewhere under Pillar Two, many low-tax jurisdictions took the decision to introduce a local Pillar Two top-up tax of their own (called a “qualified domestic minimum top up tax” or “QDMTT”) – presumably on the basis that if a top-up tax was going to be applied, they may as well collect it.
The exclusion of US headquartered groups from the UTPR is a change to the fundamental assumptions upon which low-taxed jurisdictions would have based their decision to introduce a QDMTT, particularly for those jurisdictions that compete for US foreign direct investment. Under the US tax system (in particular GILTI / NCTI) the effective tax rate on non-US profits is generally measured on a blended basis, rather than on a jurisdiction-by-jurisdiction basis. For US headquartered groups, it may be possible to have profits taxed at a low effective rate in one jurisdiction without triggering any additional taxes under the US system, provided other non-US profits of the group are taxed at a higher rate in other jurisdictions, with the resulting blended rate being above the US minimum threshold.
Jurisdictions that previously had been low-tax but implemented a QDMTT on the understanding that the UTPR meant low-taxed profits would always be subject to a top-up tax somewhere may now have a new decision to make: do they (i) retain their QDMTT and continue to collect top-up taxes locally or (ii) remove or reduce their QDMTT with a view to attracting more US foreign direct investment and accept that other jurisdictions will apply top-up taxes to non-US headquartered groups operating in that low-tax jurisdiction. In other words, is it worthwhile to forsake extra tax revenue on local profits of non-US multinationals to attract more investment from US multinationals?
While the documentation outlining the side-by-side package includes a full section on ‘Reinforcing the effectiveness of QDMTTs’ and there is a strong desire amongst those involved in the negotiation of the package for jurisdictions to retain QDMTTs, there is no mechanism to ensure QDMTTs are retained either under the OECD framework or under the EU Pillar Two Directive. QDMTTs are, and will remain, optional. Any effort to make them mandatory would surely be regarded as too great an encroachment on the sovereignty of jurisdictions. While no jurisdiction has so far suggested removing their QDMTT, once one jurisdiction makes such a move, it will force others to reassess their position. In that respect, the exclusion from the UTPR, even it is only for US headquartered MNEs, has re-opened the door to tax competition.
New tax treatment of QTIs: a concession to tax competition
The concession to tax competition is more overt in the new treatment of “qualified tax incentives” or QTIs. Broadly, a tax incentive is typically a tax credit that governments offer taxpayers to encourage investment by reducing the overall tax liability of taxpayers. Under the original Pillar Two framework, tax credits and other tax reliefs were treated rather punitively, unless the tax credit was a qualified refundable tax credit (“QRTC”). In order to qualify as a ‘qualified refundable’ tax credit, the tax credit has to be refundable in cash within a four year period. These ‘qualified refundable’ tax credits are treated as equivalent to government grants or subsidies. This gives a better Pillar Two result, allowing taxpayers to reduce their tax burden below 15%.
The side-by-side package maintains this favourable treatment for QRTCs and introduces a new treatment for ‘qualified tax incentives’. To qualify as a QTI, a tax credit or tax relief must be calculated based on expenditure incurred or the amount of tangible property produced by a taxpayer. The value of the tax benefit realised under a QTI is treated as a paid tax for the purpose of calculating the Pillar Two effective tax rate of an MNE in a jurisdiction. While the QTI treatment is subject to a substance cap, (see below) it gives a much better result than even ‘qualified refundable’ tax credits because the tax credit – if it qualifies as a qualified tax incentive – is effectively ignored when calculating a taxpayer’s effective tax rate. Put simply, it allows governments give tax back to taxpayers, whilst still deeming such tax to have been paid when calculating the taxpayer’s Pillar Two effective rate.
The QTI treatment is subject to a substance cap in each jurisdiction (5.5% of payroll costs or depreciation of tangible assets in the jurisdiction), so there are limits on how much ‘tax back’ a government can offer. But the new treatment will encourage jurisdictions to offer tax reliefs that satisfy the QTI criteria – opening the door to tax competition.
Where to next?
Pillar Two is an extremely ambitious project, an idea that most would have thought impossible to agree less than a decade ago. Just over two years into its implementation some cracks are starting to show with jurisdictions looking for more exclusions and safe harbours. Some types of tax competition are now acceptable that were not two years ago. The responses of other jurisdictions over the next few years and the impact of Pillar Two on tax revenues internationally will be key factors that will be taken into account in the OECD stocktake of Pillar Two in 2029.
It strikes us that the direction of travel on Pillar Two will be towards a diluted version of what was originally envisaged. We hope that policymakers will reflect on whether the compliance burden associated with Pillar Two is justified by the revised policy goal.
Should you have any comments or questions on the side-by-side package or how it applies to your business, please speak to your usual Matheson contact or to any of our Tax partners.