An OECD-led global agreement with provisions set to take effect on Jan. 1 continues to send ripples through the tax world. Among the many changes under the agreement lies Pillar Two—a set of rules designed to ensure multinational corporations pay a minimum level of tax.
One aspect of Pillar Two revolves around the treatment of tax credits. The distinction between the tax treatment of refundable versus non-refundable credits shines a light on what may be a loophole that consumes the foundational principles of equitable taxation.
Allowing refundable credits to be treated as income rather than a reduction in taxes paid effectively allows a backdoor for state-sponsored tax avoidance strategies that the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting project intended to eliminate.
The policy solution is to move one level of abstraction up and look at total state fiscal concessions to a given multinational taxpayer—a necessary, albeit much larger, undertaking.
Tax Credits Under Pillar Two
Tax credits help states seeking to attract foreign investment through their tax code. Value transfers handled through a tax credit system can help offset a nominally higher tax rate—a tax credit keyed to 10% of profits functionally cuts a 20% tax on profits in half.
The tax credit system is already in place, so there’s substantial administrative overhead saved by simply using the credit system to provide a competitive effective tax rate for would-be foreign investors.
Pillar Two places pressure on low-tax countries to properly tax multinationals seeking a landing pad for their wealth. At a high level, if enough countries sign on to a global minimum tax and are given the ability to tax multinationals that are undertaxed by another country, there will be a disaggregated enforcement effect.
The comparative tax advantage one country can offer to a multinational is blunted if another country with which the multinational does business can swoop in and collect the difference. This necessitates a granular policy for credits, depending on their refundability.
Dichotomy of Credits
As such, Pillar Two treats refundable and non-refundable tax credits differently. A refundable tax credit can be thought of as a cash return, absent the taxpayer having taxes owed, which is more likely the case in a tax shelter country.
Under Pillar Two, a qualified refundable tax credit is considered income, not a reduction in taxes paid. A non-refundable tax credit is treated as a reduction in taxes paid.
When attempting to ascertain if a given multinational is meeting the global minimum tax threshold of 15%, one essentially considers a question of ratio. The ratio is determined by comparing covered taxes paid and global income. A tax credit can either be thought of as adding to the denominator (global income) or subtracting from the numerator (covered taxes).
A credit for the same amount results in a higher effective tax rate if applied as an addition to income as against a subtraction from taxes paid—with no other difference in economic outcome for the taxpayer. If, under the new global minimum tax rules, a taxpayer is asked whether they would prefer a new credit be classified as income to them or a reduction in taxes paid, they would opt for the former.
This means the most competitive states seeking foreign income and leveraging their tax code to attract it will need to find a way to make their tax credits refundable, which may hurt them from a revenue perspective.
Implications for Tax Shelter Countries
The incentive for countries seeking to attract foreign income through operation as a tax shelter is clear—wherever possible, seek methods of maintaining a high nominal tax rate and reimbursing investors through other means.
The first and most administratively simple method is the preference for QRTCs over nonrefundable credits. This doesn’t eliminate the race to the bottom Pillar Two seemed aimed at discouraging, but instead gives preferential treatment to those countries most able to pivot.
That said, the QRTC plan has laid breadcrumbs on the path forward for states seeking to continue to leverage their tax code to attract investment: value transfers from the state to the taxpayer. Cash grants can maintain a high covered tax rate, leaving no tax revenue on the table for other countries to pounce on, while nonetheless keeping the effective tax rate of the taxpayer as low as possible.
Broader Solution Needed
The policy solution is suggested by the problem, but it’s a massive undertaking. There must be a reconceptualization of what is being disincentivized.
There isn’t something particularly nefarious about a given multinational taxpayer paying a low covered tax rate sui generis—the issue is with the multinational failing to pay its fair share to contribute to the economies where it does business.
A taxpayer that pays a low tax rate and one that pays a high tax rate but is reimbursed through other value transfers are economic equivalents—they are each falling short of carrying their share.
Comprehensive Reforms
The competitive landscape was, for many years, the tax rate—countries with lower rates received more foreign income. The states hoped to make up in fees and tax base what they left on the table in terms of rate. Pillar Two largely closes that route off.
The next path of least resistance is to leverage the tax code to achieve a lower effective tax rate, and Pillar Two similarly closes routes, leaving open only tax credits that are the near equivalent to cash grants in terms of upfront costs for the state—with minimal deferral and offset possibilities.
From there, the cycle will continue. If tax credit distinctions are given equal tax treatment, the race among would-be tax shelter states will move to cash transfers or other methods of returning value to a taxpayer aimed at reducing their effective tax rate.
This necessitates a universal approach to value transfers when calculating covered tax rates and compliance with the global minimum tax. The tax code is merely one aspect. Tax shelter states have traditionally made use of the tax code to reduce a nominal tax rate to a more competitive effective tax rate, but only out of convenience and expedience.
Pillar Two illustrates the need to reconsider how value can be transferred to a taxpayer to reduce their contributions back to the societies where they do business. These state fiscal concessions are what should be considered in ratio with global income to determine the extent to which a multinational taxpayer is paying their fair share, globally.
Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social
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