The world is undergoing a major transformation in the international tax landscape, informed by, among others, changes in business models and globalisation.
These changes are expected to have a major impact on the standard fiscal toolkits for national investment policymakers and investment promotion institutions.
The revised tax rules were partly informed by what was termed the race to the bottom. This was characterised by countries reducing their corporate income tax rates or even eliminating them altogether in a bid to attract and retain foreign direct investment (FDI). This created tax competition as countries outdid each other in lowering their tax rates.
In 2020, member jurisdictions of the Inclusive Framework on Base Erosion and Profit Shifting (BEPS) agreed to introduce a global minimum tax. This is meant to ensure that multinational enterprises (MNEs) pay at least a minimum level of tax on their profit in the various countries that they have set up operations. The minimum tax rate was set at 15 percent of their profit as determined based on a set of defined rules.
This will either be paid in their country of operation or other countries where they have presence will be empowered to collect the same where the respective country of operation does not collect the tax.
The application of rule will imply that a top-up tax will be applied in each jurisdiction where a multinational operates and has an effective tax rate that is below the minimum tax.
The top-up tax will be collected by the country where the headquarters of the MNE (ultimate parent entity) is located through what is being referred to as the Income Inclusion Rule (IIR). Where the IIR does not apply an intermediate country will be empowered to collect the same through a different set of rules.
The primary countries where MNEs operate, however, have the option of applying a top-up tax first where their corporate income tax rate leads to a lower effective tax rate, through what is being referred to as a Qualified Domestic Minimum Top-Up Tax (QDMTT).
This priority ranking gives these countries the chance to protect their tax revenues which would otherwise be collected in the country where the parent company is located or other countries.
It is notable that the rules have been devised in such a way that their adoption by predominantly home countries for investors will indirectly lead to their application almost worldwide. Notably, most members of the OECD have already implemented or are in the process of domesticating these rules into their local laws.
This implies that they will have the right to impose top-up tax where the countries in which such investors operate have effective tax rates that are lower than the global minimum tax. It would largely affect developing countries which tend to be the host for investments from MNE’s that are headquartered elsewhere.
Preferential tax regimes
It is expected that the reduction in the difference between income tax rates between different countries will lead to tax being a less important driver of choice of investment location by MNEs. Many developing countries across the world have historically been introducing a wide array of tax incentives in a bid to attract FDI. This led to creation of preferential tax regimes such as Export Processing Zones (EPZ’s), free trade zones, Special Economic Zones (SEZ’s), among others.
These zones tend to enjoy a preferential tax regime which include tax incentives such as exemptions or reductions of the corporate income tax. These could include taxes on profits, capital gains and withholding taxes on various qualifying payments.
The imposition of a global minimum tax will reduce or eliminate the benefit of such incentives since a top-up tax will likely be imposed in the home country if the tax paid in the host country does not meet the set threshold. This is subject to certain substance requirements.
The imposition of corporate income tax below the global minimum tax or granting of an income tax holiday may prove ineffective in promoting FDI. Policymakers will therefore need to re-look at their investment promotion toolkit and rejig it to ensure that they have other value propositions that will attract foreign investors.
By and large, policymakers should review the tax incentives and preferential tax regimes to ensure that they meet the intended objective. Additionally, they should ensure that they revise where need be to safeguard potential involuntary forfeiture of tax revenue to other countries.
Robert Maina is an Associate Director at Ernst & Young LLP (EY). The views expressed herein are not necessarily those of EY.
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