When it comes to tax incentives, government policy today appears to be fewer but more generous.
This is because international standards distinguishing acceptable from harmful incentives have been clarified, and the stakes have been raised for noncompliance.
For example, the UK first introduced a tax incentive in 2013 that allowed companies to pay tax at a lower rate on income from intellectual property (IP) owned in the UK — even if researchers originally responsible for the innovation had done their work elsewhere.
“A general lowering of tax rates across major countries seems an inevitable consequence of the narrowing of the forms of acceptable tax competition.“
A year later, the UK announced it had agreed to modify the so-called patent box, supporting the base erosion and profit shifting (BEPS) initiative of the G20 and the Organisation for Economic Co-operation and Development (OECD). Being a key member of this initiative, the UK narrowed the design of such incentives so that future incentives would apply when the R&D spending for the innovation had taken place in the country granting the incentive.
Global shifts in tax policy
The UK’s changing incentive policy is just one example of the significant shifts in global tax policy this decade. Through their own efforts, along with collaboration with other jurisdictions via the OECD, EU, IMF etc, governments around the world are overhauling tax laws and processes created without globalization and digitization of the world’s economy in mind.
Countries still want to attract businesses with tax incentives, but they also want to make sure they create a more consistent and coherent framework of international tax law to prevent the loss of tax revenue through “tax tourism.” As part of this rewrite of the international tax law, they have agreed to forego certain types of tax incentives common in the past and to review and change others, such as patent or innovation box regimes.
While the final menu of options is still not fully clear, countries are likely to compete in the future using a narrower range of tax incentives, both for R&D and broader business investments. Those incentives area also generally becoming more favorable for businesses.
“The range of incentives is being reduced transformationally,” says Mat Mealey, EY EMEIA International Tax Services Leader.
Leveling the playing field
The tax incentives reform process will be guided by the G20 and OECD’s BEPS plan that is aimed at increasing transparency and safeguarding government tax revenue.
More than 111 countries representing more than 95% of the world’s economy have pledged to implement the BEPS plan, which was unveiled in 2013. The OECD delivered a detailed plan of updated and acceptable tax practices in 2015, and tax authorities around the world are now introducing the various initiatives. In addition, “harmful” forms of tax incentives are being identified and pressure brought to bear on countries that use harmful incentives to comply with the new international norms.
The BEPS plan has made it far more difficult to obtain the benefits of tax incentives without relocating substantive activity, such as in offices, or workers. This makes the cost to capture incentives higher (involving more business change); therefore, it will reduce the responsiveness of income flows to tax incentives.
Another key area targeted for change or elimination is the targeted use of exemptions for elements of corporate income. These forms of incentive are less visible than reductions in headline tax rates and were extremely important in the pre-BEPS era. Being less visible than tax rate-based incentives, they were harder for other countries to counteract.
On the other hand, tax rate incentives are considered acceptable post-BEPS provided that they apply to all companies, regardless of who owns them. However, tax rate incentives are very simple to understand. This may make it harder to implement politically, where voters are paying high rates of tax and are experiencing post-global financial crisis austerity policies.
These tax base incentives were more commonly used by midsized countries and won’t be completely eliminated as long as they apply to every taxpayer, according to Marlies de Ruiter, EY Global ITS Tax Policy Leader and former Head of the OECD’s Tax Treaty, Transfer Pricing and Financial Transactions Division.
In general, de Ruiter says she believes that all tax incentives in the future will come under the same kind of scrutiny as the patent and innovation box regimes.
“There’s going to be a more level playing field,” says de Ruiter.
As a result, she agrees that jurisdictions will use corporate tax rate reductions instead of tax base or targeted incentives to attract businesses. This trend is clearly visible in headline rate reductions recently announced or proposed in Hungary and Luxembourg as tax regimes evolve to a post-BEPS environment.
Acceptable tax competition
Indeed, survey data suggests the overall effect of BEPS is likely to be more countries offering the same smaller range of tax incentives. As a result of the BEPS guidance, countries now have a clearer idea of how to use patent and innovation box regimes. According to the publication Insights from the EY outlook for global tax policy in 2017: A rising tide for incentives that was based on surveys of 50 countries, nearly 20% of countries improved their R&D incentives between 2016 and 2017 and 14% improved other business incentives.
“These measures [innovation and patent boxes] are attractive to governments, and countries increasingly want them to continue to be available — perhaps as a more ‘acceptable face’ of tax competition,” Chris Sanger, EY’s Global Tax Policy Leader, wrote in the tax policy report
“For example, the patent box regimes give businesses a tax break only after they start deriving income from their IP. Countries may look to provide benefits earlier in the cycle by supporting R&D with subsidies,” says de Ruiter.
While it’s still too early to know exactly how tax incentives will change, Mealey says he expects that overall there will be fewer types of tax incentives for businesses with more focus on tax rates. Claiming the benefit of incentives will be harder given a greater need to relocate substantive activity to capture benefits, which makes the cost to realize the value of incentives more expensive.
On the positive side for business, the standardization of acceptable forms of incentive and the focus on the headline tax rate will tempt larger countries to engage in tax competition in a way that was unaffordable when tax incentives were offered by very small countries at effective rates at or close to zero.
Lower tax rates in the largest countries offer huge value for business and might outweigh the loss of very low tax rate incentives in smaller countries at a global level. France, the UK and the USA are all examples of larger economies that have adopted or very recently announced an intention to pursue policies with more competitive headline corporate income tax rates.
Preparing for change
While the tax incentives system is in transition, taxpayers in the short term will have to cope with annual changes to their compliance burden. Businesses will need to keep up with the fast pace of change, speaking up, where possible, to influence the process and planning long-term moves on the basis of what they think their operating environments will look like in the future. As many of the changes won’t take effect until the end of this decade or the beginning of the next decade, there’s time to take stock.
The good news is that there is now long-term clarity on how IP will be taxed and what types of IP incentives are sustainable. This means that business can make informed decisions about locations for their laboratories and researchers.
A general lowering of tax rates across major countries seems an inevitable consequence of the narrowing of the forms of acceptable tax competition. This will be broadly beneficial to business and is also likely to level the playing field in terms of the tax competitiveness of different countries.
“Elements like the availability of talent, livability, predictability, certainty and stability of a country will be proportionately even more important to future investment decisions,” says Mealey.
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