This is a chapter from the book: "Taxes Crossing Borders (and Tax Professors Too) - Liber Amicorum Prof Dr R.G. Prokisch".
Prof. Dr. R.H.C. Luja1
In 2022, the regulation of subsidies - including tax incentives - is no longer just a matter of national law, EU state aid law or international trade law. The academic year 2022/2023, in which Prof. Prokisch retires, is also the year in which new tax phenomena start casting their shadow over genuine national incentives, be it tax incentives or otherwise. This contribution will focus on how plans for an EU-wide corporate tax base (‘BEFIT’) and international agreement to secure a minimum level of taxation (‘Pillar Two’) might directly affect the granting of subsidies and tax incentives by EU Member States.
This contribution will focus on how to prevent parallel efforts to make the world more sustainable from colliding. Various efforts have been made to raise tax revenue and stop tax avoidance even to a point where such rules may hinder the pursuit of other sustainable development goals (SDGs) such as greening the economy.
Paragraph 2 will give two examples of subsidies that might be at stake: green incentives and emergency aid such as COVID-19 aid, as a stand-in for many other types of permissible subsidies governments might want to provide. Subsequently, paragraph 3 will address how Pillar Two may interact with subsidies enacted by national legislators or the EU itself and even lead to such subsidies being taxed by third countries. Paragraph 4 will focus on how a proposal for a European corporate tax might result in subsidies from one EU Member State being taxed by others as a result of formulary apportionment. It will also deal with the possible conflict between an equity allowance and Pillar Two. Paragraph 5 will address some possible answers to the problems mentioned, both unilateral (a claw-back mechanism) and multilateral (exclusive taxing rights for government subsidies). Some final remarks then follow in paragraph 6.
In recent international tax debates, discussions on tax incentives in the EU often focused on whether such incentives would violate the EU provisions on state aid as set forth in Article 107ff TFEU. In this contribution I will focus on the opposite, i.e. on generic incentives that stay outside the scope of state aid scrutiny and on selective subsidies and on tax incentives that would be tolerated in an EU state aid context (‘compatible aid’).
As part of the European Green Deal, the European Commission launched a programme called Fit for 55, which aims at reducing CO2 emissions by 55% (down from 2005 levels) before 2030.2 In the pursuit of many of these goals governments may well aid to stimulate various kinds of investments that may contribute to becoming green and carbon-neutral. Whatever the form of these investments may be, we should be aware that any corporate tax incentive will often result in some sort of tax reduction, either permanent (a superdeduction) or temporary (accelerated depreciation of green assets).3
In a non-tax context, one could consider the example of government subsidies in support of dealing with the consequences of COVID-19. The European Commission allowed Member States quite some leeway in this respect under the ‘Temporary Framework for State Aid Measures To Support the Economy in the Current COVID-19 Outbreak’. We will come back to this in paragraph 3.2. Without addressing the large variety in subsidies and tax incentives under this framework, for now we should focus on what might happen with this kind of government support in the near future taxwise.
Pillar Two intends to safeguard a minimum level of taxation across the globe with regard to multinational groups with a consolidated turnover of at least € 750 million. Without going into the details of Pillar Two, one of its elements is the introduction of an income-inclusion rule (IIR) that would allow a state to impose a top-up tax on a parent entity to ensure that any profit of its subsidiaries subject to an effective tax rate of less than 15% would still be subject to a tax equal to that minimum.4 Should the parent company not be subject to such IIR as it may be located in a country that did not sign up to Pillar Two, there is a fallback option to levy such tax at the level of one or more of its subsidiaries (i.e., the undertaxed payment rule or UTPR). Bottom line is that effective taxation below 15% of overall profit (meeting a particular definition) would trigger actions by other jurisdictions. Within the EU, these Pillar Two rules are likely to end up in a Directive to ensure their application.5
In the OECD’s 2020 Blueprint on Pillar Two there was an extensive discussion on how to treat subsidies (other than corporate tax incentives) under the new regime.6 The OECD since published extensive commentary on the new tax base, which will be used to measure a minimum effective tax level. Without entering into the details of these Global Anti-Base Erosion (GloBE) Model Rules, what we do know is that the GloBE tax base will be based on financial accounting rules. Traditional government grants in general will be included in the tax base as reflected in IAS 20, as would be most (refundable) tax credits.7
Emergency government assistance is at a limbo, as exempting it may lead to a lower effective tax rate.8 The Blueprint indicated that further attention would be given to exempting such assistance from GloBE rules, where government aid would be limited in time and targeted to those affected by an external shock. The Blueprint also announced that the issue of government grants and tax incentives might be revisited after a few years, should the proposed treatment turn out to have unintended outcomes.9 No further attention was given to government grants and emergency assistance in the 2021 Pillar Two model rules, so it seems the Inclusive Framework seems to be willing to take a wait-and-see approach before any measures are to be expected.10 But, can we afford to wait?
What to think of a situation where emergency aid, for instance to compensate for COVID-19, would have been tax exempt. From a theoretical point of view one could argue that instead of granting an a-typical exemption the initial amount of subsidy should have included the tax due if one would like to compensate for it. From a practical point of view one might argue that if one provides a non-refundable grant to deal with an emergency, one would not expect the same government to come in later and tax part of it away. Here, tax principles may be at odds with political and social reality, especially in the midst of a crisis.
Essentially, governments that would exempt any financial assistance offered by them to those affected might face issues later under the new Pillar Two rules. The expedient solution of exempting subsidies and grants may backfire in such a case.
Issues like these are not new. They were raised, for instance, in the context of the first proposal to come to a sharing mechanism for corporate taxation in Europe. As Freedman and Macdonald phrased it back in 2008: “Would governments wish to make grants if a percentage of them was effectively to raise tax revenue for another [Member State]?”. They also point out that it is questionable who would bear the effective tax burden if the grantor would have to raise the level of the grant to maintain the same post-tax benefit as intended. If the government issuing the grant or subsidy is also the taxing authority, then one might even question the usefulness and consistency of such approach, although admittedly taxing grants as such would initially fall within the concept of taxable profit as both authors stress.11 Now, nearly 15 years later, these questions play exactly the same role in regard to Pillar Two.
With a strict implementation of Pillar Two, small and medium-sized enterprises are out of scope, so the issue is limited to the largest multinational groups which, at least in the preceding year, had a turnover of more than € 750 million. But even here we might see a situation where a major multinational may see revenue drop suddenly and turn into a loss, while still meeting Pillar Two thresholds that look back at meeting the threshold in two of the four preceding fiscal years.12
If Pillar Two is indeed implemented as strict as it is first proposed, i.e. limited to the largest companies in the world based on a turnover threshold, the actual impact of all of the above might be rather limited. Most subsidies that aim at providing income support or disaster compensation are often limited in size or focused on small and medium-sized enterprises. But this is not the case necessarily in respect to investment incentives at large.
In this context one should think of special tax treatment for royalties, often sold as an R&D-stimulus. Such special regimes are not necessarily limited to maximum amounts of qualifying income or to smaller companies. Here the question is whether countries should reconsider their current offering once Pillar Two is in place.
For example, a special tax rate for royalty income to stimulate R&D to be carried out by the company concerned may fall within the debatable limits of what is still regarded as acceptable tax competition if one meets the modified nexus requirement.13 Views on whether regimes like patent boxes actually have the intended effect vary, but what we do know is that any tax incentive related to royalties received will effectively benefit those whose R&D has been successful. One might prefer incentives for R&D expenditure instead, as they will also benefit those that invest in R&D and fail, whose efforts may be essential to future successes and who equally create high-tech jobs and investment during the R&D period.
Whatever opinion one may hold towards patent boxes, what will countries with such boxes do once Pillar Two is introduced if they choose to hold on to them? Would one raise the effective tax rate of patent boxes to 15%? Or just for companies with a turnover of at least € 750 Million? Or, if qualifying royalties are only a part of the taxable income of such companies, should they include a claw-back provision that guarantees patent boxes not reducing the effective tax rate below 15% overall? If governments do not act at all, we are bound to see other countries stepping in with a compensatory tax.
In the EU, considerations like these may raise new issues. Applying a higher tax rate only to the largest companies from the onset may ironically result in state aid for small and medium sized enterprises, although one might argue that the introduction of Pillar Two could warrant a claw-back mechanism with the explicit and only aim to avoid compensatory taxation abroad. It would not be the Pillar Two Directive itself that would contain a legal basis for the clawback, but EU Member States may use the Directive’s existence as a justification for pre-emptive intervention with respect to companies covered by it.
In 2011, the European Commission attempted to introduce an EU-wide corporation tax base for larger enterprises, whose tax base would be determined on a consolidated basis and then be apportioned amongst EU Member States on the basis of a formula. This was the Common Consolidated Corporate Tax Base (CCCTB).14 The proposal never made it. In October 2016, the European Commission made an renewed attempt to introduce an EU-wide corporation tax base (the Common Corporate Tax Base, CCTB), now with the possibility of consolidation and apportionment in a separate proposal for a Directive.15 Also these proposals will be withdrawn and replaced by the so-called BEFIT proposal (Business in Europe: Framework for Income Taxation).16 Even though a BEFIT text has not been published to date, there are some observations here that can be made based on the earlier proposals if we assume that despite the name change BEFIT will copy many of the elements of the CCTB. For this we will use the Council’s latest Presidency compromise text from 2019 (hereinafter: CCTB proposal).17
Article 4(5) CCTB proposal included subsidies and grants in the definition of ‘revenues’ and hence made them part of taxable profit. To the extent they are linked to the acquisition, construction or improvement of depreciable fixed assets, the subsidies and grants would be excluded from the tax base based on Article 8(1)(A) CCTB proposal. Those subsidies would instead be taxed during the useful lifetime of the asset as depreciation would be lower due to the effect of the subsidy or grant on the initial book value.
The CCTB proposal included two extraordinary incentives. Article 9(3) CCTB proposal included a superdeduction of R&D costs up to 50% and up to 25% for the amount exceeding € 20 million. Article 11 introduced an Allowance for growth and investment (‘AGI’), effectively allowing for the deduction of a defined yield on a qualifying equity base. Both provisions met resistance from the European Parliament in 2018 (proposing to cap the superdeduction at € 20 million and exchanging the AGI for more limiting interest deductions), but the two of them were still included in the latest compromise proposal that never made it to the end.
The new BEFIT proposal is meant to include a debt-equity bias reduction allowance, better known by its acronym DEBRA, something of a substitute for the AGI. A final proposal for a stand-alone DEBRA is to be expected in 2022, to be introduced by Member States even if a later BEFIT proposal would not make it.18 Whatever format DEBRA takes, it may have Pillar Two implications as any allowance for equity will lower the taxable profit but leave accounting profits untouched. For those Member States that hover around the 15% tax rate, any allowance creating a difference between accounting and taxing profit might already tip the scale towards triggering Pillar Two sanctioned interventions by other jurisdictions. This not only affects DEBRA but also other targeted incentives reducing the tax base, like superdeductions related to environmental-friendly investments or R&D.
So, if the DEBRA proposal would result in Member States offering a mandatory allowance, Member States whose only or lowest tax rate is already around 15% may need to consider building in a safeguard in order not to trigger Pillar Two and allow other countries to tax away its allowance. Within the EU this could be regulated by making a corresponding adjustment to the Pillar Two Directive for allowances similar to DEBRA, but third countries that apply the ‘original’ Pillar Two proposal are unlikely to follow suit.
While there are still no clear details about BEFIT, what we do know is that the European Commission intends to apply a uniform corporate tax base and then will use formulary allocation rules to divide the taxable income amongst the EU Member States where the company is active.19 Without addressing what those allocation rules should look like, we must realize that the allocation of profits via a formula means that there will no longer be a direct link between the EU Member State granting a subsidy that contributes to such profit and the EU Member State to which part of that taxable profit will be allocated.
Not only does BEFIT take the option off the table to leave subsidies untaxed for reasons of administrative expediency or societal acceptance, it also breaks the link between the State issuing the subsidy and the one taxing its proceeds. This as such is not new when it comes to subsidizing activities outside of one’s jurisdiction, but it is rather new for the large majority of subsidies and grants that aim to stimulate certain activities at home or that compensate for local disasters, for instance.
With Pillar Two on the rise, governments may see their fiscal sovereignty restricted, even in cases of subsidies or tax incentives that may serve an agreeable purpose. What Pillar Two essentially calls for is a domestic backstop, i.e., a clawback mechanism resulting in meeting a 15% minimum tax level to ensure that special tax treatment will not lead to a top-up tax abroad. This ensures that governments still have some control of their domestic tax expenditure. But such a unilateral solution would not suffice for EU Member States faced with DEBRA or BEFIT as they may prevent an effective clawback.
In terms of solutions one might consider alternative options. The first would be to exclude government subsidies and grants from taxable profit for the purpose of Pillar Two and BEFIT altogether and leave their taxation to the granting state, which may well decide to include them in the domestic tax base or not to tax them at all.
Secondly, a future multilateral instrument (MLI) - or future bilateral tax treaties for that matter - should assign exclusive taxing rights over government subsidies and grants to the contracting state whose (national or local) authorities issued them. ‘Exclusive rights’ would refer to the traditional concept and not to situations where countries would reason that a treaty-override might be warranted if income is not effectively subject to tax, especially given this particular source of income. Needless to say that corresponding EU Directives would need to include a similar carve-out, as bilateral treaties or an MLI may be of limited use amongst EU Member States. Any of these legal instruments would have to clearly delineate what qualifies as a subsidy or grant, as to avoid regular government payments for services rendered or goods bought from being included. Whether or not to allow an equity allowance to fit in might take a long time to debate.
From a political point of view awarding exclusive rights might have another advantage. Under Pillar Two States might be brought in a position where they would have to levy a top-up tax at parent level because of a subsidiary abroad whose profits stem from tax-exempt government grants. Governments might like to avoid doing so if the nature of the foreign grant calls for it. Consider subsidiaries receiving research grants to find a cure for a particular disease, for instance.
There is far more to be said about exclusive taxing rights for subsidies and proper implementation might add quite some explanatory notes to a future Model Tax Convention; this contribution just serves to get the ball rolling again and to not let the discussion being parked as happened with Pillar Two. We just do not have the luxury to wait and see.
Whether it is the prospect of a 2030 Green deadline, a next pandemic or government action to deal with massive inflation or raised energy prices due to a war nearby, the last thing we need is governments being faced with other countries taxing away the financial interventions they deem necessary to deal with such challenges. Neither Pillar Two nor BEFIT deal with the fact that government expenditure and taxation should go hand in hand. We should reopen the debate and ensure that governments have exclusive taxing rights with respect to subsidies and grants they issue, whether they decide to tax them or not. This includes tax incentives meant as a stimulus for particular behavior, such as green investments. Going green at home should not raise an additional tax burden abroad. While a sustainable economy needs sufficient tax revenue, one SDG should not hinder another unnecessarily.
Pillar Two intends to have a limited scope and only affect the largest companies around the globe. For this reason one could take the view that the risk of subsidies being taxed abroad is a relatively minor issue, for now. The problem is that within the EU BEFIT will also bring smaller businesses into scope, thereby increasing the urgency to deal with this matter. Also, if DEBRA is to survive Pillar II scrutiny, further action may be necessary depending on its final design. Whether or not DEBRA will be adopted at all is still to be seen. And, obviously, while increasing corporate tax rates would reduce the likelihood of triggering IIR or UTPR top-up taxes even when granting generic or targeted incentives, it is no systemic solution to the matter at hand.