Friday, April 1, 2022
Lilian Faulhaber (Georgetown; Google Scholar) presents Pillar Two's Substance-Based Income Exclusion: The Culmination of Years of International Tax Developments at Florida today as part of its Tax Policy Colloquium hosted by David Hasen:
In October 2021, over 130 countries reached political agreement on a two-part international tax reform package. The second part of this package, known as Pillar Two, is a minimum tax that would ensure that certain companies in jurisdictions with low tax rates would pay an effective tax rate of at least 15%. This article focuses on one element of the Pillar Two minimum tax: substance-based income exclusion (or substance-based carve-out). For countries who choose to implement a minimum tax with this substance-based income exclusion, the only income that will be subject to the minimum tax is the amount that exceeds the sum of a fixed percentage of payroll expenses in the low-tax jurisdiction and a fixed percentage of the company’s basis in tangible assets in the low-tax jurisdiction.
This article argues that the substance-based income exclusion builds on three developments in international taxation. First, EU law has pushed countries both inside and outside the European Union to include a substantial activities requirement in any anti-tax-avoidance provision that applies to foreign entities. Second, the OECD’s Forum on Harmful Tax Practices has recently started requiring low- or no-tax jurisdictions to have an overall substantial activities requirement in order not to be found non-compliant by the FHTP. Third, the U.S. GILTI provision included a carve-out for normal returns, which was part of a larger movement of countries designing international tax provision to target only excess returns.
These three developments — and the substance-based income exclusion, which I argue represents their culmination — represent a larger trend of accepting tax competition when it is accompanied by competition over jobs and investments. This trend is important because the headlines at the time of the international agreement around Pillar Two suggested that this was the end of tax competition and the “race to the bottom.” But these three developments and the substance-based income exclusion tell a very different story, which is that the international community is in fact moving not to eliminate tax competition entirely but instead to recommend rules that allow multinationals to continue to pay low tax rates – but only if they employ foreign workers and otherwise invest in low-tax foreign jurisdictions. Even though both the Pillar Two minimum tax and the substance-based income exclusion are effectively optional right now, the substance-based income exclusion highlights this important trend in favor of competition over jobs and investment that has been occurring in the international tax space over the last decade, despite the political rhetoric suggesting that the international community is in the process of eliminating tax competition.
The commentator is Reuven Avi-Yonah (Michigan; Google Scholar)