Will the interplay between the global minimum tax and ESG incentives impact business in Luxembourg?

ESG tax incentives have become a major tool in the drive to encourage sustainable business activity, with more than 1,850 incentives available globally. Yet, the effectiveness of incentives may soon be reduced, as countries adopt the global 15% minimum effective tax rate rules agreed in the OECD/G20 Inclusive Framework on base erosion and profit shifting (BEPS).

Assessing the impact of BEPS 2.0 Pillar Two on tax incentives and ESG strategies

With BEPS 2.0 Pillar Two implementation at various stages around the world, it is important for multinational companies and tax jurisdictions to fully appreciate the impact a global minimum 15% effective tax rate (ETR) will have on existing tax incentives.

Pillar Two has been specifically designed by the OECD/G20 Inclusive Framework to eliminate rate-based tax competition between jurisdictions, regardless of the objective and intent behind the tax incentives. The Global Anti-Base Erosion (GloBE) Rules provide for a coordinated system of taxation intended to ensure large multinational enterprise (MNE) groups pay a minimum level of tax on the income arising in each of the jurisdictions where they operate. The financial benefit of many tax incentives could be significantly diluted by a top-up tax should a tax incentive take a multinational’s ETR below 15% in that particular jurisdiction. This 15% global minimum tax is expected to impact MNEs with companies/business already close to, or below, this threshold. To calculate this ETR figure, companies need to generate and report on about 200 data points for each country, many of which involve information not typically included in financial reporting systems. These data are necessary to calculate what the OECD/G20 Inclusive Framework calls GloBE income or loss.

This creates a challenge for many jurisdictions and multinationals that – faced with a climate emergency and challenging emissions targets – have relied on cash and tax incentives to catalyze their ESG goals.

While tax incentives will not necessarily take a multinational below the 15% ETR, Pillar Two introduces a significant level of uncertainty and complexity that will force many companies and jurisdictions to rethink their tax and ESG strategies.

ESG tax incentives: understanding the impact on the status quo

To understand the Pillar Two challenge, it is first necessary to understand the status quo. Sustainability tax incentives can be categorized in three broad groups: those that encourage a reduction in natural resource consumption, those that encourage a switch to renewable or alternative energy sources, and those that encourage innovation of new low carbon products and manufacturing processes.

Sustainability tax incentives themselves also come in at least three forms: accelerated tax depreciation and additional tax allowances, concessionary tax rates and tax holidays (for large multi-faceted projects such as factory building), and research & development (R&D) super deductions and credits (which are used by many jurisdictions globally).

Regardless of category or form, all of these sustainability tax incentives will be affected by Pillar Two, subject to certain caveats set out in the GloBE rules. The OECD has identified one specific category of tax credits – Qualified Refundable Tax Credits (QRTCs) – which would be treated akin to a cash benefit and hence would not face the significant negative impact that other tax incentives face. Such QRTCs would need to be paid or be available as cash equivalents to the taxpayer within four years upon the taxpayers satisfying the conditions for the QRTC incentive.

The impact of Pillar Two will however not be uniform across the globe. It is likely to vary according to company, sector and jurisdiction and will lead to some companies reconsidering where they locate their business activity.

In EU countries such as France and Germany where the OECD states there is a composite effective average tax rate of 25% and 29% respectively and Africa, where the average corporate tax rate is 28%, tax incentives are less likely to take a multinational’s ETR below 15%, so Pillar Two may not have a significant impact.

How will Luxembourg-based MNEs be impacted?

In Luxembourg, the composite tax rate currently sits at 24.94% (applicable for the tax year 2023 for a company with a registered office in Luxembourg City), and tax incentives are unlikely to pull the effective tax rate down below 15%. Even so, it was highlighted by the Minister of Finance in her response to a parliamentary question earlier this year, that around 7,500 entities could possibly be affected by the new rules. And, as the Pillar Two must be implemented into domestic law by 31 December 2023, there is potential for a big impact on the tax landscape.

MNEs based outside of Luxembourg but with substantial activity in Luxembourg could still therefore benefit from financial modeling to assess the tax incentives used and whether these will bring them below the minimum. A core element of this is understanding the data points and reporting elements needed to calculate the firm’s tax rate according to BEPS 2.0 Pillar Two. Additionally, MNEs with limited/no presence in Luxembourg but looking to possibly expand could benefit from a review of Luxembourg’s alternative incentives to invest in an ESG-friendly way (e.g., grants) to evaluate whether they are more attractive than those offered in other competing business locations.

As a financial hub, sustainability incentives are well established in Luxembourg, and new sustainability taxes, exemption policies and incentives to reduce, switch or innovate continue to emerge. Some of these are outlined here. A national Emissions Trading System (ETS) enables emissions rights to be counted and the proper performance of operators' environmental obligations to be monitored. The EU Directive on the reduction of plastic products was implemented on 9 June 2022 into national legislation. All provisions will be enforceable at the latest on 31 December 2024.

Luxembourg introduced a carbon tax in 2021, which is set at €30 per ton of CO2 for 2023 and participates in the EU ETS.

Investments in assets purchased or constructed for the purposes of protecting the environment, reducing waste or saving energy may also qualify for a tax credit of 9% up to an investment amount of €150,000 and 4% for investments over that amount. A tax credit of 8% up to an investment amount of €150,000 and 2% for investments over that amount is also available under certain conditions and up to a determined amount for the acquisition of passenger cars with zero emissions, functioning exclusively on electricity or on hydrogen fuel cells.

Preparing for Pillar Two: next steps for MNEs and jurisdictions

With countries already beginning to take action now to implement BEPS 2.0 Pillar Two in 2023 to take effect in 2024, MNEs and jurisdictions should start reassessing their sustainability incentive strategy. Among other things:

• Financial modeling will be a powerful tool for MNEs, helping them conduct a full assessment of the tax incentives they use and calculate whether these incentives reduce their Pillar Two ETR below the 15% threshold
• Jurisdictions should assess what the GloBE rules mean for sustainability tax incentivization on a sector-by-sector, region-by-region and business-by-business perspective, investigating alternative ways to incentivize sustainability behaviors
• As a matter of urgency, MNEs should review what data points they need in order to calculate the specific Pillar Two ETR and set in place the reporting processes necessary for generating