The future of tax incentives: are Qualified Refundable Tax Credits the answer?

Capital-importing countries must review their incentive toolkits with the impending introduction of a global minimum corporate income tax.

Introduction

The proposed global minimum tax is designed to address base erosion and profit shifting (BEPS) concerns and to prevent unhealthy tax competition. It seeks to ensure that large multinationals pay tax at a minimum effective rate of 15% in every jurisdiction where they have physical operations. This is achieved through a set of domestic tax mechanisms called the Global Anti-Base Erosion (GloBE) Model Rules (also known as Pillar Two Rules) endorsed by over 140 jurisdictions.

Multinationals enjoying tax holidays or concessionary tax rates are expected to pay additional taxes when the rules kick in. It does not matter if the preferential tax regime is harmful. It is also not relevant whether there is economic substance. While substance-based income exclusion is built into the GloBE rules, it is not likely to be meaningful for multinationals with entrepreneurial and principal hub models.

Countries in Southeast Asia have long been deploying tax incentives as one of the key policy tools to attract foreign direct investments. Such tax incentives typically provide for a lower corporate income tax (CIT) rate or tax holiday on qualifying income derived from the activities supported for a period of time. With the impending introduction of the GloBE rules, many of these tax incentives are no longer expected to be meaningful for companies that are within the scope of the GloBE rules since there is a requirement for the effective tax rate (ETR) to be at least 15% on a jurisdictional basis.

As countries come to terms with the need to shift away from reliance on traditional tax incentives in promoting investments, they (including Singapore) will be required to re-evaluate their existing incentive toolkits in a bid to ensure they remain attractive in drawing in investment dollars.

One of the likely directions we expect various governments to consider are measures that would not result in material fluctuations to the ETR calculation. In the design of such a measure, it is important to have an appreciation of the accounting treatment of the particular measure vis-à-vis the treatment under the GloBE rules as the computation of the ETR under the GloBE rules rely on financial accounting information.

In this article, we focus on the concept of Qualifying Refundable Tax Credits (QRTCs), which was discussed in fair detail in the report on the Pillar Two Blueprint (Blueprint) issued in October 2020 and also included in the GloBE rules.

Treatment of tax reliefs vis-à-vis government grants and QRTCs under GloBE rules

This is where matters get complex and several defined words that may not be familiar are introduced. First, we set out the principles and then explain through an illustration.

The ETR of an MNE Group for a jurisdiction is equals to the sum of the Adjusted Covered Taxes of each constituent entity located in the jurisdiction divided by the net GloBE income of the jurisdiction for the fiscal year. Whether a tax credit or grant is to be included in the net GloBE income (denominator) or as an adjustment to the covered taxes (numerator) would therefore influence the ETR for the jurisdiction.

Based on the Blueprint, the first point of reference in determining whether grants or tax credits should be recognised as income or reduction to tax liability is how they are recognised under financial accounting rules.

Grants are typically recognised as income and therefore should be included as part of GloBE income in determining the ETR. For tax credits, the accounting treatment is less clear as they are not specifically addressed in the financial accounting standards.

The OECD has however identified a specific category of tax credits - QRTCs, which should be treated as part of an item of GloBE income of the recipient entity in the year that such entitlement accrues for the purposes of the GloBE rules. On the other hand, a tax credit that does not meet the conditions for being a QRTC will be treated as an adjustment to the tax liability.

QRTCs is defined in the GloBE rules as “a refundable tax credit designed in a way such that it must be paid as cash or available as cash equivalents within four years from when a Constituent Entity satisfies the conditions for receiving the credit under the laws of the jurisdiction granting the credit”. This is further explained in the commentary to the GloBE rules as government incentives delivered via the tax system and incentives to engage in certain activities, whereby the government allows the company to offset its taxes on a dollar-for-dollar basis or via a refund of unused credit (where the company does not have tax liabilities).

At first glance, it may appear to be similar in substance to the granting of specific deductions or enhanced deductions on expenditure incurred in relation to activities that are encouraged by the government. However, there are slight differences in how they are to be administered and this distinction is important in the ETR calculation. An illustrative example is provided below. 

Given the above illustration, QRTCs and grants are generally expected to be more attractive to companies impacted by Pillar Two going forward, as compared to other tax incentive schemes such as tax holidays or concessionary tax rates, as well as non-refundable tax credits or additional tax deductions. Having said that, it should be noted that some uncertainty remains where it relates to QRTC associated with capital expenditure.

Do we expect a shift in the incentive landscape for the region?

Profits from international shipping operations are traditionally subjected to limited taxation under elected tonnage tax regimes or complete exemption under income tax regimes. Such profits will generally be excluded from the scope of GloBE rules.

Tax holidays and concessionary tax rate incentives will remain relevant in the startup ecosystem development and for multinationals with consolidated revenue below €750 million. In addition, as ETR is calculated on a jurisdictional basis, MNE Group companies that derive income subject to tax at concessionary rates below 15% due to tax incentives and yet also derive income subject to the local country’s headline tax rate, may not require top-up. In such situations, the tax incentives will continue to be relevant.

With the above, we expect that certain tax incentives and regimes such as tax holidays and concessionary tax rate programmes would continue to be retained in various jurisdictions for companies to access them to the extent that the GloBE rules do not apply. At the same time, high-tax capital-exporting countries may offer more 15% tax incentives to prevent outflow of value-added activities. Particularly for developing countries in the region that may have limited fiscal ability to offer non-tax incentives, such tax holidays and concessionary tax rate programmes oftentimes prove to be a practical investment tool.

For countries that employ tax incentives as a key investment strategy, we would expect them to consider and explore new ways in developing non-tax incentives schemes. Inferring from the current landscape of non-tax incentive tools, these could include cash grant or subsidies, interest-free loans, discounted or free land, and other non-fiscal incentives such as relaxing land or company ownership etc. Likewise, the use of refundable tax credits going forward would be an area of particular interest.

Today, there are a number of tax credits being utilised by countries, especially in the developed economies such as the US and Europe. By contrast, as depicted in the recent OECD report on reconsidering tax incentives after the GloBE rules released in October 2022, reduced tax rates or tax holidays that fully or partially exempt the obligation to pay corporate income tax are more common tax instruments than investment tax allowances or tax credits among developing countries.

In Asia-Pacific, New Zealand’s research and development (R&D) tax incentive is an example of a tax credit. With the objective to encourage investment in R&D, companies that undertake qualifying R&D activities are eligible to receive R&D credits based on a percentage of the eligible R&D expenditure. Where there are no or insufficient tax liability to utilise the tax credits, unutilised credits can be refunded, subject to caps.

With the OECD giving its blessing for QRTCs to be treated as income instead of a reduction in covered tax liability for purposes of the ETR computation under the GloBE rules, it is likely that countries would be reviewing their existing tax credit schemes to assess whether adjustments should be made to qualify them as QRTCs, so that companies impacted by Pillar Two could continue to avail of them.

While QRTCs and cash grants are treated in the same way for GloBE purposes, we expect that there may be a stronger impetus by governments to consider QRTCs compared to cash grants. One of the reasons is cash grants require upfront funds to be set aside while QRTCs can be used to offset against other forms of taxes such as property taxes and hence, may not represent as significant an upfront cost to the government.

Nevertheless, given that QRTCs still require an element of refund or cash outlay compared to non-refundable tax credits, it is reasonable to assume that developed economies like Australia, the US and Europe may be the frontrunners in incorporating QRTCs into its incentive toolkits. 

Due to the nature of tax credits, which are expenditure-based and more focused in scope, it is likely that we will see QRTCs more widely applied toward the encouragement of specific activities to be undertaken such as research and development and sustainability, etc. 

Considerations for businesses

In a global environment that is increasingly inflationary, securing first-mover advantage will be beneficial to companies looking to snap up global opportunities to optimise their return on investments.

With the forthcoming implementation of Pillar Two, companies are evaluating and forecasting the impact of Pillar Two on their financials and operations.

For companies that are currently enjoying tax incentives today, it is important to consider how existing incentives will be affected. Where the impact is significant, it may be worthwhile for companies to start engaging with governments early so as to contribute or influence the policy decision-making process as governments look at the redesign of their incentive toolkits.

With the increasing significance of non-tax schemes, which typically provide benefits above-the-line, it is vital to involve other key stakeholders, in addition to tax and finance. This will help to ensure that a holistic and optimal outcome for return on investments can be achieved through effective use of available incentive tools.

This article was co-authored by former EY partner Tan Bin Eng, Yeo Ying, Partner International Tax and Transaction Services from Ernst and Young Solutions LLP and Tracy Tham, Associate Partner, International Tax and Transaction Services — Business Incentives Advisory.