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In the context of the G20/OECD Base Erosion and Profit Shifting (BEPS) project, an inclusive framework involving 141 jurisdictions was agreed in principle on a global minimum tax for multinationals. The reform, known as the second pillar of BEPS, would introduce a 15 percent minimum tax on the foreign profits of large multinational companies with revenues of more than 750 million euros. A surcharge is added to domestic taxation through a complex mechanism that ensures that in each country the multinational company pays a tax equal to at least 15 percent of the “excess” profits of the foreign affiliate; amounts related to actual economic activity (assets and employees) (called spin-offs). Implementation of the second pillar is planned for 2023, although this timetable is widely considered ambitious.
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The second pillar of BEPS aims to prevent multinational companies from shifting profits to low-tax countries and to reduce tax competition between countries. Further goals are to stabilize international tax rules and reduce tax uncertainty, create a more level playing field for companies and prevent the spread of unilateral measures that worsen the investment climate. In addition, the tax increase would support the mobilization of domestic resources to achieve sustainable development goals.
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The minimum tax on the profits of multinational corporations has a major impact on international investment and investment policy. Taxes are an important factor in FDI, tax rates enter the calculations of MNEs’ investment decisions, and differences between countries affect MNEs’ location choices. Therefore, tax rates and incentive programs (fiscal incentives) are important components of the investment policy toolkit.
The effective effective tax rate on foreign direct investment is much lower than the general tax rate and has minimal impact
In order to attract international investment, the statutory corporate tax rate has been reduced over the past three decades. Currently, this share is around 25 percent in both developed and developing countries. The effective tax rate (ETR) on reported profits of foreign affiliates tends to be low, averaging less than 20%, mainly due to fiscal incentives provided by the host country.
However, MNCs often pay much less tax on their foreign earnings than a standard ETR because they can shift some of their profits to low-tax jurisdictions. As a result, multinational companies have an average effective tax rate of around 15% on their foreign earnings, which is well below the general tax rate. This is reflected in the new FDI level ETR indicator introduced in this report, which captures the average tax paid by MNCs on all their FDI earnings, including repatriated profits.
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The second pillar would increase the corporate income tax levied by multinationals on their foreign profits. The game has two different mechanics. First, MNCs reduce profit shifting because they receive less income from it and pay host country tax rates. Second, foreign affiliates that pay ETRs below the host country’s minimum reported profits are subject to an additional tax. The expected increase in ETR (at FDI level) faced by MNEs is conservatively estimated at 2 percentage points and varies by region (Figure 12). This equates to a roughly 15 percent increase in taxes paid by multinationals to host countries – more for large multinationals directly affected by the reforms.
An ETR analysis of the level of foreign direct investment before and after Pillar II shows that the reforms are mainly aimed at reducing the shift of profits from the application of minimum rates to offshore financial centers (OFCs) rather than through the application of minimum rates elsewhere. This is especially true for developing countries, which on average have higher ETRs and a higher risk of profit shifting.
Both developed and developing economies are expected to benefit greatly from the tax hike. Offshore financial centers would lose a significant portion of the corporate income tax collected from foreign subsidiaries of multinational corporations. For smaller developing countries, where ETRs tend to be lower, the imposition of additional taxes can have a significant tax impact.
The other side of the increase in tax revenue is the potential pressure on the volume of investment, i.e. the increase in corporate income tax on foreign direct investment activities causes a potential pressure on the decrease in the volume of investment. The potential negative impact on global FDI is around -2% under the baseline scenario. This estimate seems modest, referring only to productive investment, and cannot be directly compared to historical trends in standard FDI flows, which are characterized by large changes due to the financial component of FDI.
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At the same time, narrowing tax rate differentials lead to a shift in investment from low-tax jurisdictions to high-tax jurisdictions, with developing countries benefiting relatively more due to their higher corporate tax rates. The directional effect can compensate for the investment loss caused by the quantitative effect. However, this does not happen automatically. In a world with lower tax rates, countries would benefit more from improvements in other investment determinants, including infrastructure and the regulatory and institutional environment.
The mechanisms put in place to implement the second pillar are sufficient for a relatively limited number of investor home countries (e.g. G20 and OECD members) to implement the premium, so the effect is almost universal. Host countries, including many developing countries, can impose additional taxes to protect tax revenues – before home countries can. However, the effectiveness of competitive tax rates or traditional tax incentives in attracting FDI is reduced.
As such, the Pillar II reforms will have a significant impact on national investment policy makers and agencies and their standard toolkits. Worryingly, awareness of the reforms among entrepreneurs in Investment Promotion Agencies (IPAs) and Special Economic Zones (SEZs) remains low. More than a third of respondents to UNCTAD’s annual IPA survey said they were not yet aware of the reforms, and only about a quarter had begun to assess their impact. They need to act fast. At a minimum, they should review the current use of incentives, assess the impact on existing investor portfolios, and determine the best ways to retain and promote investment.
Fiscal incentives are widely used to promote investment, including as part of the value proposition of most SEZs. Looking specifically at the most commonly used incentives to attract FDI:
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Some pro-investment fiscal policy options remain, including extending the benefits of so-called substance-based divestments to investors, shifting to incentives less affected by Pillar II, or reducing taxes not covered by Pillar II as long as they contribute to important investment decisions. The report provides detailed guidance on the impact of the second pillar on the most common types of investment financial incentives (Table 2).
The need to review the mix of incentives offered to foreign investors provides an opportunity to rethink them. In recent years, UNCTAD has called on countries to carry out such assessments in order to redirect incentives to investments that perform better in terms of sustainable development – in particular by linking incentives to the SDGs. The move away from lower interest rate incentives and waivers to incentives linked to real capital expenditure – less affected by the second pillar – is well suited to this objective, as investments in SDG sectors tend to be capital intensive.
Tax reform also has an important impact on international investment policy makers and IIA negotiators. They must take into account the possible limitations that the obligations of the Interinstitutional Agreement may impose on the implementation of the main provisions of the second pillar. When inter-institutional agreements and their ISDS provisions prevent host countries from imposing additional taxes or removing benefits, tax increases go to the home country at the lowest level globally. Without compensating for the increase in investment attractiveness, host countries lose tax revenues. The existing older generation inter-institutional agreements, which exist mainly in many developing countries, can be particularly problematic.
The strategic consequences of investment policy reform are also important. The global minimum tax will initially apply only to international companies with consolidated revenues exceeding 750 million euros. This appears to exclude a large portion of potential investors for whom countries can continue to compete with fiscal measures independent of the new rules. However, this threshold covers more than two-thirds of new investment projects made in the last five years, with a greater share in developing regions (Figure 13). Moreover, while many companies will remain outside the scope initially, the largest MNEs are making increasingly large FDI (SME investment abroad is declining), which, together with the expected gradual lowering of the threshold, means that over time almost all FDI will be subject to minimal restrictions.
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Less competition from low-tax jurisdictions could benefit developing economies. Still competitive
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