There is significant disquiet over the impact, particularly on developing countries, of the OECD’s base erosion and profit shifting (BEPS) rules, which aim to introduce a minimum global corporation tax of 15%.

Opposition to the proposals was voiced by several panellists at AICE 2022, a World Free Zones Organization conference held in Jamaica at the end of June 2022. Many developing countries have historically relied on tax incentives to attract foreign direct investment (FDI), and there is a perception that poorer countries are being bullied into these reforms by the rich world.

“The argument of the people who support this is that it is going to happen, so you better start preparing for it. I find it a little repugnant,” says Juan Carlos Hidalgo, a public policy consultant based in Costa Rica, who participated in the conference. “Any policy should be discussed and debated on its merits. We are still a long way from knowing how this will take shape.”

Hidalgo says many countries, despite being signatories to the initiative, still do not fully comprehend the impact it will have. He points to the recent announcement of a new free zone in Jamaica offering 0% corporation tax for 50 years as evidence.

John Peterson, head of unit for GloBE (Pillar Two) at the OECD, disputes this and says developing countries participated in the discussions “on an equal footing” and the “rules acknowledge the calls from developing countries for more transparent, mechanical, predictable rules to level the playing field and reduce the incentive for multinational enterprises [MNEs] to shift profits out of developing countries.”

Criticisms of the new rules broadly fall into two camps: either their design means they will not work as intended, or that even if they achieve what they intend they will have significant negative consequences, particularly for developing countries.

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What are the OECD BEPS rules?

The OECD’s proposals are split into two ‘pillars’. The first will reallocate certain taxable income generated by MNEs from their home markets to the jurisdictions where they have business operations and earn profits, regardless of whether they have a physical presence there.

This is the least controversial part of the reforms. The UN Conference on Trade and Development (UNCTAD) has said that Pillar 1 will be substantially investment neutral.

Pillar 2, in contrast, is predicted by UNCTAD to have far-reaching consequences for FDI.

The Global Anti-Base Erosion (GloBE) rules under Pillar 2 set a global minimum corporation tax of 15% for MNEs with a turnover of more than €750m ($761.31m). The intention is to stop companies parking profits in tax havens where they pay no or very little tax and stop the race to the bottom of countries competing on tax rates to attract investment.

Yet some are concerned that increasing taxes on company profits will act as a drag on the global economy and foreign investment flows.

“Corporation tax hurts the tax base by creating a hurdle rate for any business investment decision, which otherwise would expand the tax base,” says Daniel Bunn, executive vice-president at US-based think tank the Tax Foundation.

This concern seems to be backed up by UNCTAD analysis. Although it says the impact on global FDI is hard to estimate due to the broad scope of the reform, its baseline scenario is for Pillar 2 to cause a 2% reduction in the global volume of FDI stock to developing countries.

“I think we are going to see a shifting towards fewer jurisdictions,” says Bunn. “It won’t be the retrenchment from globalisation as some people suggest. Just that if you have manufacturing here and service centres there, you may decide to combine some of those activities in the same jurisdiction to avoid having top-ups in some jurisdictions.”

Bunn says that existing investment in physical assets such as production, marketing and distribution centres will remain sticky, but new flows of FDI will be impacted. “If a jurisdiction is on the cusp of thinking through how to attract new types of investment, this deal puts you at a disadvantage,” he adds.

Will increased tax revenues be positive for international development?

There are parallels between efforts to tackle climate change and the new BEPS rules. Both ask the developing world to give up a tool of economic growth that helped to make the developed world rich, but for Hidalgo, the justification for phasing out fossil fuels is much stronger than the one for global tax reform.

“Taxes were low at the development stage of the world’s major economies, so how is it fair to ask developing economies to give up low tax strategies to attract investment?” Hidalgo asks. “With the climate emergency, there is a real emergency, and we have to bring down emissions. It is unfair [on developing countries], but we must do it. In the case of the tax system, there is no such urgency”.

According to UNCTAD, fewer than one-third of developing economies report an average effective tax rate below 15% and developing countries with average effective tax rates below 15% account for just 6% of total inward FDI stock to developing countries.

This suggests that even if corporate tax rates do influence FDI, the new rules would impact flows in only a small number of countries. Research by Investment Monitor shows there is no correlation between corporate tax rates and FDI flows in developing countries. India and Vietnam have the highest FDI volumes of all developing countries, yet divergent tax rates of 40% and 20%, respectively.  

Morocco’s corporate tax rate falls in the middle of the rates of these two countries, yet its FDI flows are much lower than both. Although they are outlying countries in the data, across all tax bands the volume of FDI projects differs greatly from country to country.

Yet headline tax rates and the tax collected from companies are not the same. Peterson says that according to OECD data, “in half the countries in Latin America and Asia-Pacific for which data is available, foreign affiliates of MNEs show effective tax rates [ETRs] that fall below 15%. In Africa, 25% of the countries for which data is available display average ETRs below 15%.”

Headline corporate tax rates in developing countries may not rise significantly due to the new rules, but countries should collect a lot more tax. Will higher tax revenues lead to greater development in those countries?

Research shows that global average corporate tax rates have declined from more than 45% in 1980 to below 25% in 2018, yet over the same period government revenues as a proportion of GDP have risen from 30% to 35%. A decline in corporate tax rates globally has not resulted in a decline in overall government revenues.

Hidalgo questions whether an increase in the tax revenues in certain governments is even desirable. “When you have governments that are extremely inefficient in public spending or, in some circumstances, have high levels of corruption, the more money you give to a government, the worse off society and the economy becomes.”

This trust in the markets rather than governments to deliver development is not shared by Peterson. He says the intention of the rules is to get governments to incentivise investment in their countries “rather than giving away the tax revenues of future generations, which current politicians don’t have to pay for, because it doesn’t show up in their budget expenditure”.

Research by Investment Monitor suggests corporate tax rates are not a good predictor of how good public services will be in any given jurisdiction, yet there is a statistically significant relationship between higher corporate tax rates and a higher public services index score.

Improving infrastructure, reducing corruption and red tape, and boosting the skills base of your domestic workforce should all incentivise FDI in the long-term, and a variety of tax incentives, including payroll taxes, and subsidies remain outside the scope of the BEPS rules. Peterson says that the use of these incentives, instead of low corporation tax, will increase government transparency.

“[Under the new rules] if you really want to incentivise companies, you have to do that through a cash incentive, rather than hide that in tax breaks that play out in the future,” Peterson adds. “You can offer exactly the same amount of value, but you have to be upfront about it. You have to write a cheque, and everyone can see that you are writing a cheque.”

Will BEPS reduce tax competition?

Pillar 2 is intended to stop the race to the bottom, and analysis by UNCTAD suggests that setting “a floor on effective tax rates on excess profits inherently limits the downward potential for international tax competition”.

Yet research produced by Michael Devereux, John Vella and Heydon Wardell-Burrus of Oxford University in January 2022 shows tax competition will not disappear. The devil is in the detail of how each company’s taxable excess profits are calculated under Pillar 2 rules.

If a company’s effective tax rate in any jurisdiction it operates in is under 15%, it must pay a top-up to bring its tax payments up to the floor rate. There is a carve out, however, called the substance-based income exclusion, which is taken off how much is paid after the effective tax rate is calculated.

The carve out is in reference to a fixed return on assets and payroll expenses in each jurisdiction. This provision essentially means that business activity linked to physical assets and employment has a lower tax burden. The carve out is 5% of the full payroll cost. If the top up is less than 5% of the payroll or asset value, the company doesn't owe a top up.

By leaning into these carve outs, countries can still reduce the tax paid by companies in their jurisdiction. The research by Oxford University shows that by introducing a qualified domestic minimum top-up tax under the new rules, countries will still be able to compete on corporate taxes, even down to zero.

The research paper states: “Following the introduction of Pillar 2, countries may have a stronger incentive to compete on corporation tax. Countries with MNEs with local effective tax rates below 15% and some excess profit (i.e. liable to a top-up) may have to reduce the corporation tax rate liability they impose on companies just to retain the same competitive position they currently enjoy relative to competitor countries.”

A scenario in the Oxford University paper shows how a country with an existing 13% corporate tax rate could give a company the same ultimate tax incentive under Pillar 2 by reducing its corporate tax rate to 11%.

The incentive will be even greater for countries to reduce corporation tax rates than under the current system because now they can offer a tax incentive at 0% while still claiming a top up. The qualified domestic minimum top-up tax moves source countries to the front of the queue for tax collection.   

“It is hard to say that countries aren’t going to compete over tax anymore,” says Bunn of Tax Foundation. “I think there is going to be a race to be the first person in line to collect the top-up, and there will be competition in other tax areas. The way these rules treat direct subsidies to business is an open door for countries.”

Peterson concedes that tax competition will not entirely disappear but says “where we were before was nowhere and this at least creates a measurable level playing field and a rule that discourages without eliminating profit sharing”.

Will BEPS spell the end for free zones?

While tax competition is unlikely to disappear completely, the rules changes will force free zones to modify their strategies for attracting investment. In 2019, UNCTAD estimated that there were 5,400 special economic zones globally, and that 75% of developing economies are home to some form of free zone.

Many of these zones offer low or no corporation tax rates as a cornerstone of their investment promotion offering. In many countries they are essential engines of economic growth.

“In Costa Rica… we have a dual economy,” says Hidalgo. “We have an external sector based on free zones, which is extremely competitive and is the only part of the economy growing. Then there is the rest of the economy, which is stagnant.”

Hidalgo says that in the five years to 2021, nine out of ten formal jobs created in the country were in free trade zones, despite representing only 8% of GDP.

Bunn of Tax Foundation says that renegotiating or unwinding tax holidays could be a long and painful process for some free zones located in countries that implement the new rules.

“For some jurisdictions it will mean trimming back on free zones or just leaning into the carve outs from the deal,” says Bunn. “So whatever investment you are attracting is tied to payroll in tangible investment, rather than services or intellectual property.”

Free zones, such as those in Costa Rica, that have created a lot of jobs will be able to lean into the carve out and remain somewhat protected.

“It is likely that many of the operations of an MNE group inside a free zone would have significant amounts of tangible assets and employees," says Peterson. "The exclusion offered by the substance carve out can be expected to reduce (and in some cases eliminate) the income that would otherwise be subject to top-up tax under the GloBE rules.”

However, Peterson adds that free zones based entirely on tax incentives will of course be impacted and must adapt, but that is a positive as it will tackle the political strategy of “mortgaging your children’s future in order to be able to win votes at the next election”.

Small island nations that have specialised as tax havens are also unlikely to see all inward investment cease, as the legal obscurity they offer companies will remain attractive to certain organisations.

Bunn says: “Some jurisdictions have legal protections for businesses and shareholders that will probably still provide value as a conduit jurisdiction for investment, even if the tax value is gone.”

Are the BEPS rules too complicated?

The level of complexity of the rules has also been criticised. The International Chamber of Commerce is supportive of the aims of BEPS, but Christian Kaeser, the chair of its commission on tax, claims some of the adjustments required to calculate effective tax rate under the proposals are “close to impossible to calculate”.

He gives an example of deferred tax liability, created by differences between book values and tax values. Pillar 2 requires an estimate on whether every deferred tax liability will be paid within three years, but some of these liabilities will never be paid, just reversed over time.

Kaeser says there are hundreds of thousands of assets on books that create those differences, which will require item-by-item analysis. “The systems are simply not built that way, and honestly, it doesn’t make sense to build them that way because nobody can explain why the three-year rule makes sense,” he adds.

Kaeser says these challenges will be overcome if you throw enough money and resources at the problem, but that is “wasted money”. “Why are we not just taking book value?” he asks. “Full stop. No adjustments. Once you start with the adjustments, the complexity kicks in.”

Peterson concedes that international tax is already complicated before you throw in a comprehensive and coordinated system incorporating every country’s tax rules and existing cross-border tax rules. “There are limits to the simplicity that we can achieve,” he says.

However, he argues that the challenges with complexity are front-loaded in the implementation phase. Once implemented as a single system that all countries adhere to, Peterson argues that “we can leverage that system to create quite a high level of administrative simplicity".

An alignment of global tax rules will create greater transparency, according to Peterson, and make it easier for tax authorities from different countries to work together to make sure they are paid what they are owed by MNEs.

Jurisdictional blending and threshold rates

Kaeser also argues that the BEPS rules could have been simplified by aligning tax rules recently introduced by the US.

Global Intangible Low-Taxed Income (GILTI) was introduced in 2017 by the US to impose a higher tax burden on foreign profits. Research by the Tax Foundation shows that since its introduction, FDI from the US into low-tax jurisdictions has fallen significantly.

Between 2017 and 2020, US FDI to Bermuda was -32%, to Switzerland -16% and Ireland -15%.

GILTI is based on the global blending principle, which sets a floor of 15% on a MNE’s global effective tax rate. If its rate is below that, it has to top up to its host country, in this case the US.

Adopting global blending for GloBE rules would allow for “super easy application because then you have consolidation, as it is already built into the system”, says Kaeser.

Yet the GloBE rules are based on jurisdictional blending, which requires MNEs to calculate their effective tax rate in every jurisdiction they operate in. Each jurisdiction can then claim any required top-up. This is intended to stop profit shifting while also allowing developing economies to benefit from the increase in taxation.

“Provided you don’t get an aggregate level of taxation that is below 15%, there is no GILTI charge,” says Peterson, explaining why jurisdictional blending has been favoured for the GloBE rules. “The US is protected because you can’t [benefit from low-tax jurisdictions] forever before you start having to pay US tax, but the underlying countries are not protected.”

Kaeser argues that the introduction of jurisdictional blending creates unwelcome added complexity, following 14 existing BEPS action items already introduced to stop aggressive tax planning.

Bunn agrees that “the timing is off. Not because of the war in Ukraine or inflation but because a lot of significant international tax rules were changed between the period of 2015 and 2020. There was not any sort of accounting for what is left of the problem that remains to be solved or whether the existing rules are contrary to the new solutions.”

Kaeser also argues that it would have been more beneficial for the company revenues threshold of €750m to be lowered to capture more companies. This would have forced more developing countries to be better prepared for the changes, as more of the companies operating in their jurisdictions would have been impacted.  

“The scope needs to be widened so developing countries can benefit more and the complexity of the rules needs to be reduced to lower the administrative burden,” says Kaeser.

“That number wasn’t plucked out of the air,” Peterson counters. “If you look at corporate revenues of all companies in the world, 90% are earned by companies that are in excess of €750m. We are targeting the smallest number of companies to collect the largest amount of corporate revenue possible.”

Peterson thinks it is unlikely that any country doesn’t have companies operating in its jurisdiction that don’t meet the threshold. “They may not know it, because the name of the company operating in their jurisdiction doesn’t look anything like a company that they would recognise," he says. "But it is owned and controlled by one of these companies.”

Will the GloBE rules be implemented?

When 136 countries signed up to the GloBE rules in October 2021, the OECD said that signatories would aim to implement them in 2023. Yet there has since been political opposition to the initiative in some countries.

There are doubts as to whether Pillar 2 could be passed into law in the US, given opposition from Republican lawmakers. Hungary, meanwhile, has stated its opposition to the rules, putting into doubt its implementation in the EU. These challenges not only question the timeline but also whether the rules are set in stone.  

“I don’t think the rules are settled until one of the G7 countries signs this into law,” says Bunn. “Once you get that, then there is a real legal basis for it.”

Peterson is unequivocal that the rules are settled and that the timetable will be met. He says the original plan was for countries to introduce the income inclusion rule (IIR) by 2023 and the undertaxed payments rule (UTPR) by 2024. Although some countries have said the IIR deadline is too optimistic, Peterson says they will be able to implement UTPR on time.

On the question of European disunity, Peterson points to media reports at the end of June 2022 that the EU is working on ways to implement the rules despite Hungarian opposition. French Finance Minister Bruno Le Maire was quoted as saying “minimum taxation will be implemented in the coming months without or with Hungary”.

Yet Kaeser is concerned that if the EU implements the rules but other major nations, including the US, don’t, it will distort competition at a time when internationalism is already under strain.

“It does not look like the world order is becoming more harmonised. It rather looks like the opposite,” Kaeser says.

As many as 27 African countries have not signed up to the inclusive agreement, including major regional economies such as Ethiopia, Ghana, Kenya, Mozambique and Nigeria. Hidalgo thinks “we may have a two-tier system, and pressure to eventually withdraw from the inclusive framework is going to be huge for some countries”.

Bunn worries that even if the rules are implemented widely, developed countries are not doing enough to help the developing world adapt to the consequences.

“If we are putting developed countries in a position where they are not able to compete on tax and instead have to build up their infrastructure and skilled workforce [to attract investment], but the US is not coming to the table to really support them in that effort, China stands ready to lend to them for large investment projects,” says Bunn.     

The impact of Pillar 2, if implemented as planned, will be far-reaching and hard to fully anticipate. The OECD wants to move on from debating the value of the initiative and instead focus on helping countries with the complex job of embedding these rules into their existing tax systems.

Whether the OECD likes it or not though, there are still plenty of people wanting to debate the necessity and structure of these rules. Until they become widely implemented, these debates are likely to continue.