The FDI angle:
- The implementation of the 15% global minimum tax on corporate income starts in 2024.
- About 55 countries are taking steps to implement it, including Japan, South Korea, the UK and EU member countries.
- The US and China are notable holdouts, but the OECD believes only a critical mass of countries is needed to set the reform in motion.
- Why does this matter? Countries around have widely used tax holidays and incentives to attract foreign investment. The reform is expected to increase their fiscal revenues, but also reduce global FDI by 2%, Unctad estimates.
“The time of tax planning has come to an end,” declared Pascal Saint-Amans, the OECD’s former tax chief, in an interview with fDi in June.
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He was reflecting on the landmark 15% global corporate minimum tax whose negotiations he spearheaded from 2013 to 2022, and which is now finally reaching fruition as countries are expected to start implementing it from the fiscal year starting on January 1, 2024.
More than 140 jurisdictions have signed up to the plan, which was first unveiled in 2021 and requires multinational enterprises (MNEs) with annual revenues of more than €750m to pay an effective tax rate (ETR) of at least 15% in each jurisdiction where they operate. This is the most significant international tax reform for MNEs in recent years, and arguably a rare success of multilateralism these days – provided it pans out as planned.
The uptake we are seeing makes us confident that over the next year or so, we’re going to get to a place where we have that critical mass and the minimum tax has the desired global impact.
The lofty goal is to curtail harmful tax competition. The so-called ‘race to the bottom’ has seen countries compete for investment by slashing statutory corporate tax rates and widening their offer of tax holidays, preferential rates and other deductions. In 1980, statutory corporate tax rates around the world averaged 40.11%; in 2022, the average was 23.37%, according to OECD estimates based on rates in 180 jurisdictions. This has prompted MNEs to shift operations and taxable profits accordingly.
The reform ultimately aims to put an end to this downward spiral and, in doing so, recover billions of dollars in additional tax revenues that governments can channel into tackling climate change, poverty, infrastructure shortages and other obstacles to improving their country’s economic development. Proponents also argue it will help level the global playing field for foreign direct investment (FDI), forcing countries to compete on merit and stopping the race to the bottom. However, uncertainties abound.
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Implementation depends on a complicated set of rules that remain a head-scratcher for many policymakers, governments and MNEs. Besides, the world’s biggest economy and the country that first sponsored the initiative at an OECD-level, the US, is not currently planning to implement the reform — and neither is China, for that matter.
Even in the developing world, scepticism abounds, with a group of low-to-middle-income countries pushing through a counter-initiative at the UN that will give the body a bigger say in international tax reforms.
Top-up tax pecking order
The global minimum tax is part of a wider initiative championed by the OECD to fight base erosion and profit shifting (BEPS) by MNEs — in other words, their efforts to exploit the plurality of fiscal arrangements offered by countries the world over to minimise their final tax bill.
The OECD estimates that these practices cost fiscal authorities annual revenue losses of $100bn to $240bn, or the equivalent of 4% to 10% of global corporate income tax revenue. It and the G20 first developed an action plan to address these challenges in September 2013. That bloomed into the OECD/G20 Inclusive Framework on BEPS, which counted 145 participating jurisdictions in November 2023. At its heart is a two-pillar approach to dealing with BEPS. Pillar one refers to where big MNEs pay taxes, with a particular emphasis on tech companies providing digital services; pillar two is the global minimum tax leg of the initiative.
While a consensus on pillar one has yet to emerge — in fact, several countries have already broken the ranks with their own digital service tax frameworks — implementation of pillar two seems to be around the corner, with a cohort of advanced countries introducing the rules from 2024.
Notwithstanding its complexity, the 15% reform boils down to three cascading rules that create a pecking order of tax collection rights between the countries where a company operates (see diagram above). The idea is that the rules work together to ensure that, at the end of the day, each MNE subsidiary will pay the minimum corporate tax rate.
Domino effect or wait and see?
The OECD expects signatories to introduce the reform starting in 2024, although it set no official deadline and implementation is not mandatory.
However, the cascading mechanism is designed in a way that forces countries to voluntarily introduce the reform or risk losing potential tax revenues to other countries further down the pecking order.
The premise — and certainly hope — is that implementation by a couple of large economies, which capture a significant chunk of MNE activities, will spark a domino effect. This is about to be put to the test.
“The uptake we are seeing makes us confident that over the next year or so, we’re going to get to a place where we have that critical mass and the minimum tax has the desired global impact,” Manal Corwin, director of the OECD centre for tax policy and administration, tells fDi.
As of November, three of the signatories — the UK, South Korea and Japan — have finalised national laws that will commence next year. Germany is set to join this list in December, when the upper house of its legislature is expected to sign off on the bill approved by the Bundestag. Under an EU directive passed in 2022, all the bloc’s 27 member states are required to adopt local rules before January 2024, although none have yet made it past legislative proposals. At least 27 other jurisdictions have taken steps towards implementation, according to fDi calculations based on research by consultancies PwC and EY.
We are already seeing both a bit of a ‘domino effect.
Mbakiso Magwape, a lawyer and research fellow at the International Centre for Tax and Development, says the steady progress being made in Europe has “triggered a call to action” by regional tax bodies which want developing countries to stop dragging their feet. This includes the African Tax Administration Forum which, in 2023, released model rules for the continent, where it says many countries’ fiscal incentives bring MNEs’ ETR to below 15%.
But progress is being made in other low- and no-tax jurisdictions. In November, Bermuda released draft legislation for its first ever corporate income tax set at 15%. All the while, more countries continue to sign the global pact, with Kuwait and the Philippines joining in October 2023.
“We are already seeing both a bit of a ‘domino effect’, and a bit of ‘wait and see’,” says Daniel Bunn, president and CEO of think tank Tax Foundation.
He notes that some jurisdictions, such as Singapore, have confirmed they will not have their rules in place until 2025. “I see that as a cautious approach, waiting for those jurisdictions that are ahead of the game to test things out before they follow suit.”
Eroding consensus
Tax experts support the OECD’s claim that its three-tiered system will allow the 15% tax to operate as a global reform, even without all signatories implementing it. What’s needed is a critical mass of jurisdictions where MNEs are either headquartered or have subsidiaries.
According to OECD estimates based on the countries taking steps towards implementation as of October 2023, almost 90% of in-scope MNEs will be caught by one of the three rules by 2025.
However, the consensus that the OECD reached in 2021, when 136 jurisdictions out of the 140 then participating in the OECD/G20 Inclusive Framework signed up to the reform, has been eroding.
Among the holdouts are the world’s two biggest economies.
Since signing the global pact in 2021, China has made no public statements about adopting the 15% reform.
Meanwhile in the US — where Treasury secretary Janet Yellen was a leading figure in winning international support for the OECD pact in 2021 — the reform has been blocked by fierce pushback from Republicans who claim it threatens the country’s tax sovereignty, would hit US competitiveness and even breaches the US constitution. They also contend that the US already taxes its MNE’s foreign profits at 10–15% under its existing tax regimes.
Right now the US is not involved, for example, so that really changes the outcome for countries like us.
Even without the US taking part, Mr Bunn notes that as its MNEs have subsidiaries in countries implementing the rules, the assumption is that the three-tiered mechanism “will essentially fold in all the in-scope US corporates”.
But the country’s international clout has sparked queries over whether its standing on the sidelines of the OECD reform outweighs any domino effect triggered by the prospect of losing potential tax revenues. This is particularly true in Latin America, where the US holds significant sway and no country has yet publicly taken steps towards implementing the OECD rules.
“[Latin America is] still doing the homework as to what our options are and what other countries — especially the bigger economies — are doing,” says Claudia Pellerano, president of the Free Trade Zone Association of the Americas and chairwoman of the Las Americas free zone in the Dominican Republic, a country that offers 0% corporate tax rate under its free zone regime. “Right now the US is not involved, for example, so that really changes the outcome for countries like us.”
UN alternative
Consensus for the reform has been eroding rapidly among developing economies, too. These countries, particularly in Latin America and Africa, typically offer higher statutory corporate tax rates than their developed counterparts. However, they make extensive use of tax holidays and other incentives to lure investors, which has a heavy impact on the final ETR they levy on MNEs.
The OECD estimates that, between 2017 and 2020, $2.14tn in profits generated by large MNEs were taxed at rates below 15% each year. More than half (53.2%) of those profits were reported in jurisdictions with high headline tax rates. On the other hand, tax havens, or low tax jurisdictions, accounted for 18.7% of those profits.
The organisation therefore argues that the 15% minimum tax rate will increase fiscal revenues in developing countries. However, that would come at the cost of limiting their room to pull the fiscal levers to compete for investment.
Cesare Zingone, CEO of Zeta Group Real Estate, a developer of free zones in Central America, argues that the reform’s rationale of levelling the playing field rests on the “flawed assumption” that all countries are equal.
“The minimum global tax unfairly impacts developing economies that typically lack the resources and infrastructure to compete with industrialised nations,” he says. “Tax incentives serve as a necessary tool to mitigate this inherent disparity.”
The minimum global tax unfairly impacts developing economies that typically lack the resources and infrastructure to compete with industrialised nations.
But others claim it is not realistic to compare the FDI prospects of large, advanced economies with deep talent pools and strong market access with smaller, less-developed markets that lack these features. “Ultimately, I don’t think they’re competing for the same types of FDI,” says Ricky Shah, head of Middle East consulting at OCO Global. The 15% minimum tax means the latter need to “think more carefully about how they differentiate themselves within their regional sphere”, he adds.
These countries have also complained that they have been corralled into a global reform led by advanced countries in the form of the OECD. This issue hit a flashpoint in November at the UN, when 125 countries including China, India and Brazil pushed through a resolution brought by a group of African countries to give the New York-headquartered body a bigger role in global tax negotiations.
This would go some way in addressing the developing world’s concern that OECD countries are leading global tax reforms without obtaining sufficient input from them.
“There is a feeling that the interests and priorities of... developing countries have not been taken into account well enough by the OECD — particularly with respect to pillar one, which has led to growing frustration,” says Mr Saint-Amans, who led the OECD Centre for Tax Policy and Administration until 2022 and is now a partner with advisory firm Brunswick. “But those promoting this latest initiative at the UN seem to be willing to undermine the whole work done by the OECD to make the case for an alternative.”
The UN now has a mandate to develop a framework convention on international tax co-operation, which may end up challenging the OECD leadership in this field.
Read more about the global minimum tax reform:
Changing the FDI calculus
One of the OECD reform’s biggest unanswered questions is how it will impact MNEs’ investment decisions.
Countries around the world, particularly developing economies, have used corporate tax breaks to attract FDI from big and small firms alike. Unctad estimates that the 15% minimum tax will reduce global FDI by around 2%. Based on the $1.3tn in total FDI — consisting of greenfield investment, project finance and mergers and acquisitions — that Unctad tracked in 2022, this amounts to $26bn.
At the same time, the OECD argues that this will be compensated by up to $200bn in extra tax revenues generated each year. The idea is for these funds to be channelled into areas such as infrastructure, education, urban regeneration and logistics which foster economic development and, in turn, create more attractive FDI destinations.
Tax incentives’ diminishing in value is “inherently a good thing [as it] refocuses countries on upping their game in more valuable areas” rather than using incentives to deflect from the market’s structural deficiencies, says Mr Shah. “Tax incentives minimise some of FDI’s positive spillovers because, ultimately, the government is foregoing what can be fairly sizeable [tax] revenues”.
Ghada Adel, head of tax for the Middle East and Africa at ABB, the Swedish-Swiss supplier of electric equipment with operations in more than 100 countries, seems to agree.
“Our global ETR stands between 25% and 27%,” she says “We don’t think too much about tax incentives, but rather focus on whether the economy itself is an attractive place to invest.”
However others warn that the 15% reform will not prompt a clean switch from tax breaks to tax revenues. “A lot of smaller or developing jurisdictions that are sensitive to FDI will have to compete even harder on non-tax measures to remain an attractive jurisdiction,” says Mr Bunn.
Free zones’ conundrum
Some of the OECD reform’s biggest ramifications for FDI will play out in special economic zones (SEZs), which have traditionally offered corporate tax breaks.
OECD research shows that up to 70% of developing countries have at least one corporate income tax incentive targeting SEZs. Yet the tax holidays and rock bottom corporate tax rates that SEZs have been providing MNE tenants must come to end if their government implements the global corporate minimum tax.
In recent years, free zones around the world have been taking strides to make infrastructure, streamlined regulations and market access their most important drawcards.
But Mr Zingone says: “The reality is that tax policies remain the primary criterion for international investors considering [free zone] investments in developing countries.”
Operators in Latin America are considering which fiscal incentives they can leverage that would not be impacted by the OECD’s rules.
Gustavo Gonzalez de la Vega, the Canary Islands’ vice-minister of economy and internationalisation, says the local government is looking at ways to reduce labour costs in its free zones. Others are considering how carbon credits can help cut tenants’ costs.
While these changes may help SEZs maintain their competitiveness in the long term, their most immediate problem could be a legal one.
Tenants’ corporate tax breaks are often protected by investor-state contracts or bilateral investment treaties. Mr Magwape says that reneging on promised tax benefits by implementing the OECD reform would likely breach these agreements.
A recent Unctad note concludes that this will lead to investor-state conflicts, but it does not expect a wave of arbitration claims. Instead, it expects MNEs to use the change as a bargaining chip in asking for other benefits.
This uncertainty is prompting some tough questions. Mr Zingone says several of Zeta Group’s North American MNE clients in the life sciences industry have made clear that a 15% tax would significantly impact their future investment decisions. “In the case of a tax rate increase, they would be comparing Costa Rica’s cost efficiencies with other locations such as Puerto Rico,” he says.
With any progress under a UN framework likely some way off, policy-makers and MNEs heading into the pivotal year of 2024 must remain firmly focused on the OECD-led reform. There will be a long transition period, with implementation over many years. But at the outset, there are doubts as to whether it will meet its goal of levelling the playing field. “It’s not a zero sum game,” quips a regional tax head at a global consultancy. “There will be winners and losers.”
Seth O’Farrell and Alex Irwin-Hunt contributed reporting.
This article first appeared in the December 2023/January 2024 print edition of fDi Intelligence
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