BEPS Pillar II will fundamentally change the international tax architecture

Within the context of the G20/OECD Base Erosion and Profit Shifting (BEPS) project and through discussions in its Inclusive Framework with the participation of 141 jurisdictions, agreement has been reached in principle on the introduction of a global minimum tax for MNEs. The reform, known as BEPS Pillar II, will introduce a minimum tax of 15 per cent on the foreign profits of large MNEs – those with revenues above €750 million. Through a set of complex mechanisms, top-up taxes will be added to domestic taxes to ensure that, in each country, MNEs pay taxes equal to at least 15 per cent of “excess” profits of foreign affiliates; that is, profits that exceed an amount – known as the carve-out – that is related to real economic activity in the host country (assets and employees). The implementation of Pillar II is planned for 2023, although the timeframe is widely seen as ambitious.

BEPS Pillar II aims to discourage MNEs from shifting profits to low-tax countries and to reduce tax competition between countries. Further objectives are to stabilize international tax rules and reduce tax uncertainty, to create a more level playing field for companies, and to prevent the proliferation of unilateral measures that would lead to a deterioration of the investment climate. In addition, increased tax revenues will support domestic resource mobilization for the SDGs.

The introduction of a minimum tax on MNE profits has major implications for international investment and investment policies. Tax is an important determinant of FDI; tax rates enter the calculation of MNE investment decisions, and differences between countries affect MNE locational choices. Therefore, tax rates and preferential schemes (fiscal incentives) are an important part of the investment policy toolkit.

Real effective tax rates on FDI are well below headline rates and will be affected by the minimum

Statutory rates of CIT have declined over the last three decades in a race to the bottom to attract international investment. They now hover at about 25 per cent in both developed and developing countries. Effective tax rates (ETRs) on the reported profits of foreign affiliates tend to be lower, less than 20 per cent on average, mainly because of fiscal incentives offered by host countries.

However, MNEs often pay significantly less than the standard ETRs on their foreign income because they can shift part of their profits to low-tax jurisdictions. As a result, the actual tax rates faced by MNEs on their foreign income are about 15 per cent on average, significantly lower than the headline rate. This is captured by a new metric introduced in this report, the FDI-level ETR, reflecting the average taxes paid by MNEs on their entire FDI income, including shifted profits.

Pillar II will increase the corporate income tax faced by MNEs on their foreign profits. Two distinct mechanisms are at play. First, MNEs will reduce profit shifting, as they will have less to gain from it, and will pay host-country tax rates. Second, foreign affiliates that pay an ETR below the minimum on profits reported in host countries will be subject to a top-up tax. The expected rise in the (FDI-level) ETR faced by MNEs is conservatively estimated at 2 percentage points, with some variations by region (figure 12). This corresponds to an increase in tax revenues paid by MNEs to host countries of about 15 per cent – more for large MNEs that are directly affected by the reform.

The analysis of the FDI-level ETR pre- and post-Pillar II shows that the reforms work mainly through the reduction in profit shifting caused by the application of the minimum rate to offshore financial centres (OFCs), rather than through the application of the minimum elsewhere. This is particularly true for developing countries which, on average, have higher ETRs and a greater exposure to profit shifting.

Both developed economies and developing economies are expected to benefit substantially from increased revenue collection. Offshore financial centres stand to lose a substantial part of CIT revenues collected from MNE foreign affiliates. For smaller developing countries – which generally have lower ETRs – the application of the top-up tax could make a major difference in revenue collection.

Increased taxes could have a volume and a distribution effect on FDI

The flipside of increased tax revenues is the potential downward pressure on the volume of investment that the increase in CIT on FDI activities will exert. The baseline scenario places the potential downward effect on global FDI at about -2 per cent. This estimate, which appears moderate, refers to productive investment only; it cannot be directly compared with historical trends in standard FDI flows, which are characterized by large variations caused by the financial component of FDI.

At the same time, the reduction in tax rate differentials will result in the diversion of investment from low- to higher-tax jurisdictions, with developing countries benefiting relatively more because of their higher corporate tax rates. The diversion effect could counterbalance investment losses caused by the volume effect. However, this will not occur automatically. In a world of smaller tax rate differentials, countries stand to gain more from improvements in other investment determinants – including those related to infrastructure and the regulatory and institutional environment.

No country can afford to ignore the reforms

The mechanism that has been devised for the implementation of Pillar II is such that it is sufficient for a relatively limited number of investor home countries (e.g. G20 and OECD members) to apply the top-up tax for the effects to become almost universal. Host countries, including many developing economies, then have the option to apply the top-up tax first – before home countries can do so – to protect tax revenues. But the effectiveness of competitive tax rates or traditional tax incentives to attract FDI will be diminished.

IPAs and SEZs should urgently review investment incentives

The Pillar II reforms will thus have major implications for national investment policymakers and institutions, and for their standard toolkits. Worryingly, the current awareness of the reforms among investment promotion agencies (IPAs) and operators of special economic zones (SEZs) is still very low. More than one third of respondents to UNCTAD’s annual IPA survey indicated they were not yet aware of the reforms, and only about a quarter had begun an assessment of the implications. They will need to act soon. At a minimum, they should review their current use of incentives, evaluate the implications for their portfolio of existing investors and identify the best approach for both investment retention and promotion.

Fiscal incentives are widely used for investment promotion, including as part of the value proposition of most special economic zones. Looking specifically at the incentives most used to attract FDI:

• Accelerated depreciation and loss carry-forward provisions will remain effective.
• Tax holidays and exemptions will lose all or most of their attraction for investors.
• A range of other incentives will be affected to various degrees depending on their design.

Some fiscal policy options to promote investment remain, including amplifying the benefit to investors of the so-called substance-based carve-out; shifting to incentives that are less affected by Pillar II; or reducing taxes that are not covered by Pillar II, to the extent that they have a bearing on investment decisions. The report provides a detailed guide on the implications of Pillar II for the most common types of fiscal incentives for investment (table 2).

The need to review the portfolio of incentives on offer to foreign investors provides an opportunity to rethink them wholesale. In recent years, UNCTAD has urged countries to engage in such an evaluation, with a view to shifting incentives towards the promotion of investments with better performance in terms of sustainable development – specifically linking incentives to the SDGs. The shift from reduced-rate incentives and exemptions towards incentives linked to real capital expenditures – which are affected less by Pillar II – fits well with this objective, because investment in SDG sectors is often capital intensive.

IIA negotiators should be aware of increased risks

The tax reforms also have important implications for international investment policymakers and negotiators of IIAs. They need to consider the potential constraints that IIA commitments may place on the implementation of key provisions of Pillar II. If host countries are prevented by IIAs and their ISDS provisions from applying top-up taxes or removing incentives, the tax increase to the global minimum will accrue to home countries. Host countries would lose out on tax revenues without the compensating investment-attraction benefit. Existing old-generation IIAs, of the type predominantly in force in many developing countries, are likely to be particularly problematic.

More than two thirds of new investments are “in scope”of the reforms

The strategic implications of the reforms for investment policy are also important. The global minimum tax will initially apply only to MNEs with consolidated revenues over €750 million. It may appear that this leaves out a substantial part of potential investors for which countries can continue to compete through fiscal measures, unaffected by the new rules. However, the threshold captures more than two thirds of new investment projects carried out over the past five years, with even higher shares in developing regions (figure 13). Moreover, even if initially many firms will remain out of scope, the fact that more and more FDI is carried out by the largest MNEs (overseas investment by SMEs is in decline), combined with the expected gradual reduction of the threshold, will mean that over time almost all FDI will be subject to the minimum.

Reduced competition from low-tax locations could benefit developing economies. Nevertheless, as competition shifts from tax levers to alternative investment determinants, and from fiscal incentives to financial incentives, many could still find themselves at a disadvantage because they are unable to afford the substantial upfront financial commitments associated with infrastructure provision or subsidies.

There is no time to waste

Looking ahead, many important details of Pillar II still need to be defined. Moreover, significant political hurdles to final adoption remain. Many countries may therefore be inclined to take a “wait and see” approach. However, the potential impact of the reforms is so great that it would be prudent not to delay in reviewing the proposals, evaluating policy options, and preparing responses. For developing countries, it is important to strengthen cooperation and technical capabilities to ensure effective participation in the process of negotiating the final shape of the reforms.

Early engagement and preparedness for the reforms will also help reduce tax uncertainty for MNEs, which can act as a barrier to investment. Furthermore, in this period of adjustment, it is important for policymakers to avoid extending long-lasting legal commitments to provide advantageous tax treatment or incentives.

Developing countries need support: 3 key actions

Finally, the implementation of BEPS Pillar II by tax authorities will be highly complex, and so will the translation of the reforms into investment policies, incentives regimes, and the value propositions of investment promotion agencies and special economic zones. Moreover, the tax revenue implications for developing countries of constraints posed by IIAs are a major cause for concern. The international community, in parallel with or as part of the Inclusive Framework discussions, should alleviate the constraints that are placing developing countries, and especially LDCs, at a disadvantage:

• Vastly scale up technical assistance to developing countries to support BEPS implementation and investment policy adjustment.
• Adopt a multilateral solution to remove implementation constraints posed by IIAs and mitigate ISDS risks.
• As a stopgap measure, establish a mechanism to return any top-up revenues raised by developed home countries that should have accrued to developing host countries, but that they were unable to raise because of capacity or treaty constraints.