Tax and Non-Tax-Related Challenges of Pillar 2 for Non-Advanced Economies

This article identifies and suggests ways to overcome tax and non-tax-related challenges stemming from implementation and application of pillar 2 rules, paying special attention to non-advanced economies (NAEs). The analysis shows that many aspects of pillar 2 are the most challenging for NAEs for legal, social, and economic reasons. Accordingly, we recommend changes to pillar 2 rules and their interpretation to put NAEs on equal footing with advanced and emerging economies.

Introduction

The political agreement of the OECD/G-20 inclusive framework on a global minimum tax (pillar 2)¹ is a basis for implementation of the OECD pillar 2 model rules by more than 140 states and jurisdictions.² EU member states implemented (or will implement)³ pillar 2 via the EU pillar 2 directive,⁴ which, apart from small amendments, replicates the OECD pillar 2 model rules. Pillar 2 operates via an interlocking mechanism consisting of three rules:

• the qualified domestic minimum top-up tax (QDMTT);

• the income inclusion rule; and

• the undertaxed profits rule (formerly the undertaxed payments rule).⁵

The mechanism is interlocked via those rules and has been dubbed “devilish logic”⁶ because no state or multinational enterprise can escape its logic once a critical mass is achieved. This appears to be the case if the EU member states and some other jurisdictions implement pillar 2⁷ — if a QDMTT does not bring the tax up to a 15 percent effective tax rate, then IIR or UTPR will do so. That is to say:

1. If a state that can impose a minimum 15 percent global tax on in-scope MNEs fails to do so despite the fact that the effective tax rate (ETR)⁸ of that MNE is below 15 percent, then the state did not introduce a QDMTT.

2. Another state will apply an IIR to tax the MNE’s income up to 15 percent (in principle, a state in which the ultimate parent entity (UPE) has tax residence, or one in which the next intermediate parent entity in the ownership chain has tax residence), and if that state also fails to tax the MNE’s income up to 15 percent,

3. then another state (wherever there is any constituent entity (CE) in the MNE’s group) will do so via a UTPR in accordance with the politically agreed fixed formula based on the share of total employees and tangible assets.⁹

Notably, IIR and UTPR activate a pressure mechanism on states to implement QDMTTs to ensure that MNE groups in-scope of pillar 2 pay at least 15 percent of global minimum tax somewhere in the world (wherever CEs of MNE groups are located), under QDMTTs, IIRs, or UTPRs,¹⁰ irrespective of any risk of tax avoidance or harmful tax competition.¹¹ This appears to be in accordance with the purposes of pillar 2 that aim to create a double barrier against tax competition. One blocks tax planning (optimization) among MNEs by requiring them to pay at least 15 percent ETR under pillar 2 rules on their excess profits. This is the tax base for the top-up tax; that is, income or loss in scope of pillar 2 minus the substance-based income exclusion (SBIE).¹² The second barrier against tax competition is among source countries by pressuring them to levy at least 15 percent ETR on pillar 2 in-scope MNEs.¹³ Altogether, pillar 2 rules aim to reduce tax competition globally via the mechanism leading to a top-up to 15 percent ETR of MNEs’ excess profits via a set of coordinated domestic rules.¹⁴

This objective goes beyond the base erosion and profit-shifting project’s purpose: it aims to eliminate tax planning for MNEs (apart from that within the scope of SBIE) and tax competition among jurisdictions affected by pillar 2 rules “even if it is not associated with practices that artificially segregate taxable income from the activities that generate it.”¹⁵ Such a goal “reflects a remarkable departure from the long-standing policy that countries may compete over real economic activity (as opposed to ‘artificially’ shifted profits) without objection.”¹⁶ Still, a goal of pillar 2 appears to be ensuring a global level playing field in corporate income tax between the biggest and other corporate income tax payers.

The implementation and application of the very complex pillar 2 rules may be extremely burdensome, both financially and administratively.¹⁷ It will also heavily challenge the future of tax incentives, forcing states to shift toward nontax incentives (for example, subsidies) to attract foreign direct investment (FDI).¹⁸ This transition in international tax law is seen by many as a serious threat to attracting FDI and tax sovereignty, especially for low-income developing countries and emerging market and middle-income economies¹⁹ (less so for advanced economies).²⁰

However, other perspectives see pillar 2 as more than a potential risk to attracting real investment flows through tax incentives. It can be interpreted as an opportunity to establish a new equilibrium in global tax competition. This involves reassessing the extent to which a tax system can and should be used to attract investment. In any case, pillar 2 appears as an opportunity to evaluate tax incentives to understand whether they are still effective. In fact, regular systematic evaluation of tax incentives (tax expenditures)²¹ is commendable in general, irrespective of pillar 2. According to the IMF, “systematic evaluations, as opposed to ad hoc discussions, are needed to guide informed decision-making and to avoid a situation where the narrative on the benefits of TEs [tax expenditures] is primarily driven by profiting stakeholders.”²²

Still, opportunities and challenges stemming from pillar 2 do not seem to be distributed equally among stakeholders. The analysis in the next two sections identifies pillar 2’s most serious challenges to attracting and retaining FDI, and thus economic growth. In particular, the minimum effective tax rate of 15 percent imposed via domestic pillar 2 rules is expected to offset some of the intended advantages of tax incentives, thus requiring a fundamental reconsideration of how countries go about the promotion of economic growth and the attraction of cross-border real investment flows.

Following the introduction, the article zooms in on major challenges for retaining or introducing tax and nontax incentives, and then addresses legal certainty mainly through the prism of investment protection under international investment agreements (IIAs). In those three sections, the analysis verifies that these challenges are more difficult to face for low-income developing countries and emerging market and middle-income economies than advanced economies. The goal of sections 2-4 is to help all countries involved and affected by pillar 2 rules to prepare and adopt a high-level strategic plan regarding their tax and nontax incentives in light of pillar 2.²³ The last section includes conclusions and policy options mainly for policymakers.

Our main claim in this article is that some of the pillar 2 model rules and their interpretations, as provided by the OECD, may need to be reconsidered to ensure more equal treatment of NAEs²⁴ and advanced economies in facing pillar 2-related challenges. The latest report of the United Nations Conference on Trade and Development (UNCTAD) on global FDI demonstrates that FDI was on average globally weak, with lower flows to developing countries.²⁵ This finding further supports our focus on the need for ensuring a level playing field between NAEs and advanced economies regarding implementation and application of pillar 2 rules. Neglecting that issue may lead to a further decline of FDI flows to the countries that sorely need it.

Comparative Pillar 2 Challenges to NAEs

The future of tax incentives under pillar 2 appears to be challenging, especially for NAEs.²⁶

Effect of Pillar 2 on All Tax Incentives

Pillar 2 rules will affect all tax incentives, not only those that are inefficient. Some authors argue that the OECD assumes that without the pillar 2 rules, countries feel pressure to offer tax incentives.²⁷ As a result, the elimination of corporate income tax competition is a public policy justification for the 15 percent global minimum tax. The OECD implies that pillar 2 will negatively affect only poorly designed tax incentives,²⁸ while protecting the corporate tax base with well-designed tax incentives; that is, those “providing substantial tangible investment or jobs” because of the SBIE.²⁹ However, the SBIE can at maximum exclude from pillar 2 rules only up to 37 percent of in-scope profits in the first year of implementation, and 23 percent after 10 years.³⁰ Hence, the vast majority of profits subject to ETR below 15 percent because of well-designed tax incentives fully benefiting from the SBIE can still be negatively affected by pillar 2 rules. Attracting FDI through tax incentives will be more difficult and complex in NAEs, even if they have efficient tax incentives in force.

Research of the Central Bank of Malaysia on the six MNEs that invested in Malaysia (Belt and Road Initiative’s member state) in 2013-2015 in the electrical and electronics industry is illustrative. These investments were attracted by tax incentives (tax exemptions and allowances).³¹ Because of these, the MNEs enjoyed an average ETR of 7.4 percent, significantly lower than Malaysia’s 25 percent corporate tax rate in 2015 and two times lower than the global minimum tax under pillar 2 rules. The cost-benefit ratio for those tax incentives is positive because:

1. While these tax incentives cost the Malaysian budget MYR 600 million per year (about $126 million), it gained MYR 1.2 billion annually in FDI.

2. Investments generated average annual exports of MYR 46 billion.

3. The MNEs registered a trade surplus of MYR 16.5 billion.

4. They employed around 48,000 Malaysians with total annual wage earnings of MYR 3.3 billion, and collectively engaged about 5,700 local suppliers resulting in overall domestic spending on inputs and services of MYR 13.3 billion annually.³²

This example shows that tax incentives in NAEs can be efficient. Pillar 2 does not seem to properly take into consideration the fact that many NAEs lack the competitive advantages typical for advanced economies, like political stability, advanced infrastructure, enough skilled workers, or an abundance of natural resources with the necessary technology to exploit them.³³ NAEs use tax incentives to attract FDI to compensate for their structural disadvantages vis-à-vis advanced economies. The effectiveness of this strategy cannot be dismissed without a country-by-country analysis. The OECD, the main architect of pillar 2, 25 years ago acknowledged that:

countries with specific structural disadvantages, such as poor geographical location, lack of natural resources, etc., frequently consider that special tax incentives or tax regimes are necessary to offset non-tax disadvantages, including any additional cost from locating in such areas. Similarly, within countries, peripheral regions often experience difficulties in promoting their development and may, at certain stages in this development, benefit from more attractive tax regimes or tax incentives for certain activities.³⁴

The OECD has been well aware historically that tax systems can support and foster economic development in NAEs. With the advent of pillar 2, however, it is uncertain whether the OECD still subscribes to its previous views.

In this regard, the U.N. seems to more strongly support NAE tax incentives as tools for economic development. Notably, the UNCTAD observed that under pillar 2, low-tax countries may risk attracting fewer projects than higher-tax countries that will become relatively more attractive for investment. That is, pillar 2 may lead to “a reallocation of investment towards higher-tax countries.”³⁵

In a similar vein, Indonesia’s minister of investment, Bahlil Lahadalia, said in an August 2023 related statement on behalf of members of the Association of Southeast Asian Nations (ASEAN) that pillar 2 rules “don’t give equitable treatment to developed and developing countries,” and that “the former must leave room for the latter to attract investment.”³⁶ Lahadalia also said that “if the global minimum tax rules are implemented too early, then businesses will start investing in their own developed countries and disrupt downstream investments in ASEAN countries. The new rules would also force developing countries to send raw materials to developed countries.”³⁷

Special Economic Zones (SEZs) in NAEs

Statistics reveal that up to 70 percent of NAEs have at least one corporate income tax incentive offering long-term tax holidays (zero ETR) within a special economic zone (SEZ).³⁸ Attracting FDI via SEZs is more typical for NAEs than advanced economies.³⁹

An SEZ is defined as:

a limited geographic area within a country with a zone management providing infrastructure and services to tenant companies, where the rules for doing business are different — promoted by a set of policy instruments that are not generally applicable to the rest of the country [such as] customs regimes (efficient customs, duty, or value-added tax (VAT), free or deferred); regulatory regimes (efficient licensing, planning, flexibility), and fiscal regimes (capital freedoms, tax incentives, subsidies).⁴⁰

The main function of an SEZ is to generate positive economic growth in a country or its region. It does this through preferable tax and nontax incentives and FDI-friendly regulations.⁴¹

Typically, SEZ tax incentives depend on the firm and include predefined criteria foreign investors must meet. The criteria include significant economic activity, a minimum investment amount, and the creation of employment opportunities.⁴² Meeting these criteria usually coincides with meeting the BEPS action 5⁴³ substantial activity requirement for preferential tax regimes compatible with international standards. Hence, SEZ tax incentives will likely be accepted in the course of the peer review and monitoring process conducted by the Forum on Harmful Tax Practices.⁴⁴ By complying with substantial activity requirements, states offering SEZ tax incentives appear to align taxation of profits with the substantial activities that generate them.⁴⁵

Pillar 2 directly undermines SEZs and their attractiveness to pillar 2 in-scope MNEs. Pillar 2 deviates from the elimination of harmful tax practices and the realigning of profit taxation with the substantial activities that generate them.

For example, a recent study concludes that pillar 2 will have a negative effect on several tax incentive regimes in Uganda and Zambia, including their SEZs.⁴⁶ Further, the UNCTAD has been explicit that pillar 2 will have a negative effect on using SEZ-based tax incentives to attract FDI.⁴⁷ In a similar vein, pillar 2 may complicate the effectiveness of the regional headquarters program announced by Saudi Arabia. This program aims to offer a 30-year tax relief incentive, including 0 percent tax rate, for qualifying MNEs.⁴⁸

Accordingly, the OECD’s reassurance that pillar 2 will increase tax revenue in NAEs because more than half of taxpayers with ETRs below 15 percent are in advanced economies,⁴⁹ does not seem cogent. The claim’s lack of persuasiveness stems from the fact that it disregards the negative effect of pillar 2 on NAEs attracting FDI via tax incentives and, therefore, fails to carefully and inclusively consider the budgetary effect. Experts have found evidence that withdrawing tax incentives from middle-income jurisdictions like Puerto Rico can lead to negative consequences. The elimination of a U.S. corporate tax break in Puerto Rico resulted in a contraction of the economy, marked by an 18.7 percent decrease in the number of manufacturing establishments following the tax exemption repeal.⁵⁰ Other research found that U.S. firms affected by the Puerto Rico modification reduced their worldwide investment by 6.7 percent, cutting employment of U.S. nationals by 10 percent.⁵¹

Moreover, the OECD in its most recent pillar 2 revenue effect estimates observed that the global minimum tax “is more effective in lifting the level of taxation of all previously low-taxed profit, independent of the reason that resulted in low taxation.”⁵² This implies that OECD believes reduced profit shifting will be a relatively small outcome of pillar 2 and that a material share of profits will be relocated to jurisdictions in which MNEs are headquartered or other higher-tax jurisdictions, including investment hubs. In other words, there will be no positive pillar 2 indirect spillover effect on NAE revenue. These countries can benefit from pillar 2 only if they collect taxes through a QDMTT, a difficult and challenging new administrative burden.⁵³

Although hubs like Ireland and Singapore could lose investment as a result of pillar 2, unless they restructure their incentive system, it can be assumed that their capacity to successfully and swiftly make necessary and adequate restructurings is much bigger than that of NAEs. Pillar 2 therefore seems to benefit mostly advanced economies, making big winners of high-income jurisdictions in which MNEs are headquartered and with a high frequency of investment hubs.⁵⁴ In the medium and long term, pillar 2 winners may change. However, this should be measured by the criteria taken into account by MNEs when they consider new locations for investments. Some new criteria may appear in the wake of pillar 2, leading to the emergence of a new type of tax competition.

New Type of (Unintended) Tax Competition

Pillar 2 rules may lead to a new type of (unintended) tax competition. The primary example is maintaining or lowering corporate income tax rates in some jurisdictions to 15 percent, or even lowering those rates below 15 percent for entities outside the scope of these rules. This path might be followed by countries levying significant amounts of tax via the QDMTT; that is, those jurisdictions with a considerable presence of MNEs with local ETRs below 15 percent and a substantial pillar 2 in-scope income. They can simply offset low or zero tax on entities outside the scope through the QDMTT, thereby creating a new unintended tax competition.⁵⁵

The new tax policy option seems complicated for NAEs relative to advanced economies insofar as the former are three times more vulnerable to negative effects of other countries’ corporate income tax rules and practices.⁵⁶ In other words, if a group of advanced economies implements the QDMTT-based policy option, it may have a disproportionately large effect on some NAEs, pressuring the jurisdictions to reduce their tax rates on income of entities outside the scope of pillar 2. Failing to do so may cause mobile multinational income to relocate to advanced economies with lower tax rates.⁵⁷

Further, as practice has already shown, pillar 2 responses may include jurisdictions implementing a 15 percent ETR without the €750 million threshold (for example, Colombia),⁵⁸ or introducing a conditional QDMTT activated only if the UPE is in a jurisdiction that has implemented an IIR or the CEs are subject to an IIR or a UTPR (for example, Barbados until the end of 2024),⁵⁹ or to introduce only a QDMTT (for example, Switzerland, at least for the time being).⁶⁰ These solutions increase tax system complexity. Their fate also is uncertain during the OECD and the inclusive framework members’ peer review process. Hence, it is not clear whether these solutions will benefit NAEs in the long term and allow them to fairly compete with advanced economies in a pillar 2 era of new tax and nontax competition.

Qualified Refundable Tax Credit

The wording of a qualified refundable tax credit (QRTC) under pillar 2 model rules creates a challenge for both tax and nontax incentives because a QRTC is, in substance, a grant or subsidy.⁶¹ An analysis of QRTCs builds a bridge to pillar 2’s relationship to non-tax-related incentives.

Article 3.2.4 of the OECD pillar 2 model rules provides that QRTCs “be treated as income in the computation of [global anti-base-erosion (GLOBE)] Income or Loss of a Constituent Entity.” When a QRTC reduces tax payable in a tax year, it does not reduce the CE’s covered taxes. OECD pillar 2 model rules article 4.1.3(b) further provides that “any amount of credit or refund in respect of a Non-Qualified Refundable Tax Credit (Non-QRTC) that is not recorded as a reduction to the current tax expense” will be treated as a reduction to covered taxes of a CE. Pillar 2 treats refundable tax credits more favorably than nonrefundable tax credits insofar as only the former avoids a reduction of ETR for determining whether a CE is in scope of pillar 2 and the amount of undertaxed income applicable to the 15 percent ETR top-up tax.

Model rules article 10.1.1 defines a QRTC 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.” Paragraph 110 of the commentary on article 3.2.4 clarifies that by providing a QRTC, “government effectively pays for the activity or expenditure in a similar manner to a grant.”

Considering QRTCs’ wording, advanced economies will be in a better budgetary position than NAEs to pay investors for activities or expenditures. If non-QRTC tax credits had been treated equally beneficially under pillar 2 rules, NAEs would be less vulnerable in implementing and applying them.

However, it would be difficult to eliminate entirely the distinction between QRTCs and non-QRTCs under pillar 2. Accounting standards used for pillar 2 calculations treat refundable investment tax credits (ITCs) as income, while any nonrefundable ITCs are treated as reductions in tax liability.⁶²

This distinction is necessary because of differences between nonrefundable and refundable tax expenditures. Tax holidays and SEZs are typically nonrefundable tax expenditures. They arise from the geographic location of income-producing activities (also called spatial tax expenditures). Basically, they require that the government refrain from collecting tax revenue.

Refundable ITCs, on the other hand, address market failure⁶³ by actively involving the government, for example, by granting ITCs via cash or cash equivalent like green energy credits or chip manufacturing credits. The line between spatial and market failure tax expenditures seems to be the underlying reason for pillar 2’s distinction between QRTCs and non-QRTCs.⁶⁴

Still, most NAEs, especially low-income developing countries, cannot engage in refundable ITCs that can qualify as QRTCs under pillar 2 because they simply cannot afford refundability due to insufficient liquidity. By contrast, high-income advanced and emerging economies can afford refundability.⁶⁵ The distinction between QRTCs and non-QRTCs creates tax policy tensions between high- and low-income countries.

Major NAE Challenges — Collateral Benefits

The analysis above demonstrates that the future of tax incentives under pillar 2 could be challenging, notably for NAEs’ ability to attract FDI. States will be forced to replace tax incentives with nontax incentives like grants or subsidies.⁶⁶ Although it is possible to design nontax subsidies that are economically equivalent to tax incentives,⁶⁷ the ability of governments in some jurisdictions to replace tax benefits with equivalent subsidies may vary, depending on political, institutional, economic, or other constraints.⁶⁸ Moreover, the situation appears complicated and restricted by the concept of collateral benefits under the OECD pillar 2 model rules.

Article 10.1.1(c) of the model rules disregards a domestic 15 percent minimum tax QDMTT or IIR if a state provides “any benefits that are related to such rules.” In other words, even if a state effectively levies a 15 percent minimum tax via a QDMTT or an IIR on the income of the local CE, another state retains the right to top that tax wholly or partly on its local CEs in the same MNE group via an IIR or a UTPR, if the former state provides any nontax incentive, related to taxation under pillar 2 rules in whole or in part, to replace the tax incentive that originally brought the ETR below 15 percent. Thus, the concept of collateral benefits is important for states in the design and deployment of their tax and nontax strategies to attract FDI. Together with an IIR and an UTPR, it allows foreign states to soak up tax and nontax incentives of a state in which a CE is located. The concept permits one group of states to encroach into the tax and economic sovereignty of others. It is a concept that requires strong legitimization through a principled, clear-cut test to avoid uncertainty and disputes among states and between MNEs and states. However, as of now, this is not the case.⁶⁹

Paragraph 116 of the QDMTT commentary says:

The tax must be implemented and administered in a way that is consistent with the outcomes provided for under the GloBE Rules and their Commentary, including the prohibition against the implementing jurisdiction providing any collateral or other benefits that are related to such domestic tax as discussed further in the Commentary to the definition of a Qualified IIR. This limitation on collateral benefits is not intended to restrict the ability of a jurisdiction to make changes to the design of its corporate tax system in light of the new international tax architecture under the GloBE Rules. Such changes to the domestic corporate tax rules consequent on the introduction of a domestic minimum tax should not be considered a benefit provided that they do not result in MNE Groups achieving overall tax outcomes that are inconsistent with the outcomes provided for under the GloBE Rules and their Commentary. [Emphasis added.]

Neither the OECD pillar 2 model rules nor their commentary are clear as to what circumstances or parameters (legal, economic, factual, or the mix) will be determinative for a proper identification of collateral benefits. The example provided by the commentary (para. 124) is only relevant to the obvious situation in which a tax under the IIR (or QDMTT) is later neutralized via “a tax credit equivalent to a portion of the tax paid under the IIR to be used against other taxes.” In this case, the OECD is clear that the jurisdiction in question has not adopted a qualified IIR (or QDMTT). No other example is provided.

Treatment of grants or subsidies under the concept of collateral benefits remains prone to disparate, possibly even contradicting, interpretations and applications in the absence of a mechanism dispute resolution in this area. Moreover, the commentary on a qualified IIR (para. 123), which by analogy is relevant to a QDMTT, pulls toward a very broad understanding of the concept of collateral benefits:

The word “benefits” is comprehensive enough to cover any kind of advantage provided by a jurisdiction, including tax incentives, grants, and subsidies and the phrase “related to such rules” is intentionally drafted with broad language to take into account different mechanisms through which the benefit is provided. [Emphasis added.]

If the word “benefits” were subject to a narrow and precise legal analysis to determine whether a grant or subsidy is a collateral benefit, a much-needed legal certainty could be secured. For instance, this approach would mean that only subsidies limited to pillar 2 in-scope MNEs that are directly tied to the payment of a QDMTT or IIR would fall within the scope of collateral benefit. However, the commentary (para. 126) does not seem to take this approach:

A tax benefit or grant provided to all taxpayers is not related to the GloBE Rules. Facts that are relevant but not decisive include whether the tax benefit or grant benefits only taxpayers subject to the GloBE Rules, whether the benefit is marketed as part of the GloBE Rules and if the regime was introduced after the OECD/G20 Inclusive Framework started discussing the GloBE Rules. [Emphasis added.]

On the concept of collateral benefits, the commentary introduces a broad economic-factual, rather than a narrow legal, approach to determining pillar 2 compatibility with nontax incentives. This resembles the OECD economic-factual approach to the concept of beneficial ownership introduced in the 1977 OECD model tax convention. Its ambiguity has triggered disputes among taxpayers and tax authorities for many years, a situation detrimental to the stable and predictable functioning of tax treaties and EU secondary law.⁷⁰ A similar fate may await the concept of collateral benefits because of its ambiguity and a far-reaching penetration of tax and nontax incentives in relation to pillar 2. Accordingly, the UNCTAD warns that even incentives “that an outside observer might not be able to link to a QDMTT,” like refunds of customs duties, export taxes, sales taxes, renegotiated production sharing or royalty agreements, and public spending on infrastructure, may not be entirely safe during the pillar 2 anticipated peer review and ongoing monitoring process. These nontax incentives in certain circumstances will be seen as “artificial refunding of any QDMTT in this manner.”⁷¹

It is unclear how small but tax- and business-competitive jurisdictions like Hong Kong and Singapore will retain their competitiveness under pillar 2 and its push toward nontax incentives beyond collateral benefits.⁷² Can Hong Kong replace its reduced 8.25 percent rate for corporate treasury centers with subsidies and still pass the collateral benefits test? These nontax incentives could be offered to all taxpayers, not only those subject to taxation under pillar 2. Still, it will de facto benefit predominantly MNEs in scope of pillar 2 because small and medium-sized businesses are unlikely to set up corporate treasury centers in Hong Kong to carry out intragroup financing activities.⁷³

It will be introduced after the OECD/G-20 inclusive framework starts discussing pillar 2 rules. Following para. 126 of the commentary, these subsidies seem questionable under the concept of collateral benefits. Another example comes from Vietnam. The country announced the implementation of the domestic minimum additional tax (DMAT) framework. The money from DMAT will “assist enterprises with various expenses, such as research and development costs, investment in equipment, and high-tech production expenditures,” providing that they comply with the Vietnamese pillar 2 rules.⁷⁴ Will those subsidies pass muster under the concept of collateral benefits following the commentary to it and further developments during the peer review process? It remains unclear. But it is clear that many jurisdictions will struggle to remain, or become, competitive via their tax and nontax incentives after pillar 2 unfolds globally.

The biggest struggles to design and implement nontax incentives in the world of pillar 2 will most likely be faced by NAEs and advanced economies with small territories. Under pillar 2, attracting FDI will require these states to compete harder with large, advanced economies that have much more money to offer foreign investors through subsidy schemes.⁷⁵ Failing to keep up could mean losing FDI. Investors in the life sciences industry in Latin America, for instance, have made clear that a 15 percent ETR would significantly affect their future investment decisions.⁷⁶ They compare cost efficiencies in states in which they inevitably are subject to pillar 2 tax with other states in which they either can escape it or obtain nontax incentives to compensate them for the losses under pillar 2 taxation. Just as in the case of QRTCs analyzed above, NAEs without a strong enough budgetary position to provide investors with nontax incentives in the form of cash are more vulnerable to losing FDI than advanced economies with enough cash to do so.

Pillar 2 As a Threat to Legal Certainty

The analysis above shows that pillar 2 generally weakens the position of NAEs, already economically weak in comparison to advanced economies in attracting FDI. Further, pillar 2 may not only weaken NAEs economically, it may cause serious legal cross-border issues for NAEs vis-à-vis advanced economies.

For example, at least some subsidies offered by inclusive framework members in lieu of tax incentives may be at odds with WTO rules on subsidies and countervailing measures as well as others.⁷⁷ Considering that more than 160 states and jurisdictions are WTO members⁷⁸ with some tax-related disputes among them,⁷⁹ the possible tensions between tax and nontax incentives caused by pillar 2 will need close scrutiny.⁸⁰ Likewise, jurisdictions should carefully examine the compatibility of pillar 2 with their tax and investment treaties.⁸¹ Similar attention should be given to subsidies granted instead of tax incentives in light of the EU Foreign Subsidies Regulation.⁸²

It is worth a separate consideration that UNCTAD has recently released a policy note stating that pillar 2 may lead to issues with investment protection standards under the majority of IIAs, especially for countries with SEZs.⁸³ UNCTAD therefore urges governments to develop expertise on the interplay between pillar 2 and IIAs:

Expert knowledge of international legal obligations across different fields of specialization is necessary for governments to assess whether and how to engage in the renegotiation of incentives. [(. . .)] Most tax administrations could develop technical expertise with respect to IIA disciplines through closer interaction with government departments in charge of the negotiation of IIAs and the defence of ISDS [investor-state dispute settlement] cases and vice versa.⁸⁴

Interactions between pillar 2 and IIAs appear to be of major importance for NAEs that attract FDI using SEZs and other negotiated and contractually stabilized tax incentives.⁸⁵

Ensuring Tax Certainty for FDI

The principle of tax certainty arises out of the rule of law by way of the principle of legal certainty.⁸⁶ According to tax certainty, tax provisions must be clear, precise, accessible, and reasonably intelligible to all users, as well as amenable to dispute resolution in impartial courts and tribunals. This principle is one of the core elements of taxpayers’ fundamental rights.⁸⁷ It protects taxpayer expectations regarding their tax rights and obligations by restricting the discretion of tax authorities to determine a taxpayer’s tax liability arbitrarily.

The literature on tax certainty cites awareness, reliability, and calculability.⁸⁸ Its fulfilment is rewarding both for government (increasing attractiveness of the tax system for foreign investors) and for taxpayers (decreasing investment risk). Ensuring tax certainty is widely recognized by the OECD as bringing “benefits for taxpayers and tax administrations alike and is key in promoting investment, jobs and growth.”⁸⁹ Both the OECD and IMF underscore that for international trade, investment, and business location decisions, tax certainty is a key factor for taxpayers and has a pivotal effect on FDI.⁹⁰

Accordingly, it is of no surprise that foreign investors attach great value to tax system certainty, predictability, and stability. Tax systems that ensure tax certainty ensure great value to foreign investors, not only by securing stable and predictable return on investment, but also by reducing dispute risks with tax authorities.⁹¹

A major source to ensure a predictable and stable legal environment, including tax law, for foreign investments is IIAs. They constitute a global investment regime promoting investment.⁹² Under IIAs, the host state respects the protection standards that lead to a stable legal environment for FDI. The IIA’s most important and powerful enforcement tool is the right of individual investors to initiate arbitration against host states through investment treaty arbitration or an investor-state dispute settlement (ISDS) mechanism.⁹³ This tool ensures that host states respect IIA investment protection standards.⁹⁴ Failure to do so would lead to the significant costs of defending and potentially losing ISDSs. It would also negatively affect their investment climate.⁹⁵

China, Switzerland, and the United Kingdom, for example, have ratified IIAs with over 550 countries and jurisdictions,⁹⁶ strengthening their credibility to potential investors. A large IIA network offers investment security to FDI from all corners of the globe, reducing investment price and risks in those countries.⁹⁷ Evidence gathered and analyzed by World Bank Group (WBG) experts shows a correlation between states losing a high percentage of ISDS cases and negative rule of law ratings and high-risk grading by private political risk-rating companies.⁹⁸ Data also show actions leading to investment withdrawals and cancellations coincide with conduct that IIAs purport to prevent, including unfair and inequitable treatment.⁹⁹ States cannot overlook the fact that IIAs and ISDSs contribute to the development of a rule-oriented regime for cross-border investments,¹⁰⁰ by significantly decreasing FDI risk and cost.

UNCTAD recognizes fair and equitable treatment (FET) as the most important investment protection standard under IIAs for purposes of pillar 2 taxation.¹⁰¹ A FET breach is the most frequently invoked claim in ISDS cases, including tax-related cases.¹⁰² Among core FET elements recognized by IIA jurisprudence and in the literature, two of the most important to ensure tax certainty are the highly interrelated issues of:

• the requirement of stability, predictability, and consistency of the legal framework; and

• the protection of investor confidence and legitimate expectations.¹⁰³

The UNCTAD also considers these to be sources of a possible clash with pillar 2 rules.¹⁰⁴ This is because the biggest potential for IIA violations by pillar 2 rules lies with the lack of sufficient attention to tax certainty rules. When tax rates or tax incentives are subject to a significant change during the lifetime of the investments, or the effectiveness of tax incentives is hampered by the pillar 2 mechanism, it creates uncertainty that affects a country’s FDI attractiveness.

Once again, NAEs are more vulnerable than advanced economies to the effects of pillar 2 because the latter are in a better budgetary position to defend or negotiate any claims under IIAs raised by foreign investors. This is shown by statistics according to which big winners in terms of monetary awards in ISDS cases are participants from high-income developed countries (won by investors from advanced economies or lost by investors challenging advanced economies), while the big losers are investors from low- and middle-income developing countries and emerging economies.¹⁰⁵

The same pattern appears for the frequency and number of claims against host states: They typically originate in high-income developed countries, while low- and middle-income developing countries are usually host states against which investors initiate ISDS proceedings.¹⁰⁶ It is therefore worth looking a bit closer at the potential clash between pillar 2 and IIAs.

Potential Clash Between Pillar 2 and IIAs

Clashing Investment Protection Standards

UNCTAD and scholars observe that the four kinds of investment treaty protection most likely to cause tensions with pillar 2 are:

• the FET;

• the umbrella clause;

• nondiscrimination; and

• non-expropriation.¹⁰⁷

In the majority of IIAs, tax carveouts will be of no or little relevance to eliminating investment protection under pillar 2 rules.¹⁰⁸

In practice, the FET and the umbrella clause are of the highest importance in taxation challenges under pillar 2.¹⁰⁹ This typically takes the form of the premature revocation of promised tax incentives.¹¹⁰ The allegation’s best chance for success occurs when host states apply QDMTTs after promising tax incentives such as tax stabilization, investment, or similar agreements to investors (members of MNE groups), often constituting a part of the process of entering SEZs. This is much more likely to occur in NAEs.¹¹¹

In the above cases, irrespective of alleged FET violations, the state’s promises may be brought under IIA protection via so-called umbrella clauses that require host states “to comply with obligations the state has entered into with respect to investments protected by the treaty in which the umbrella clause is found.”¹¹² Typically, umbrella clauses extend investment treaty protection to all obligations arising under any investment contract between the host state and an investor (parties of the IIA with an umbrella clause).¹¹³ In the absence of an umbrella clause, a violation of contractual obligations by the host state would not be covered by the IIA, unless that violation is so severe that it violates any of the IIA’s standards of investment protection per se.¹¹⁴

An umbrella clause is important for investors aiming to challenge tax measures because it may open a separate door for IIA-based claims that are easier to win in ISDS proceedings than reliance on remaining standards of investment protection.¹¹⁵ That is why investors often want state promises to include specific IIA provisions such as tax stability, setoff clauses, adjustment clauses, advance tax rulings, or any other agreements that will protect investments against unforeseen tax measures.¹¹⁶ It is why in its guidance the OECD disregards “QDMTT payable” whenever an MNE group legally challenges a QDMTT based on “superior law or based on a specific agreement with the government of the QDMTT jurisdiction limiting the MNE Group’s tax liability, such as a tax stabilization agreement, investment agreement, or similar agreement.”¹¹⁷

As observed above, because of NAE characteristics, they often conclude tax stabilization agreements with investors within SEZs or beyond, giving investors the strongest claims under IIAs against pillar 2. This practice is not common for advanced economies. The highest risk of violating IIAs because of an FET or umbrella clause breach rests with NAEs. It is therefore complicated and unreasonable for NAEs to apply a broad interpretation of the concept of collateral benefits. In that regard, UNCTAD highlights that investors can rely on IIAs to convince countries to grant incentives that provide economically comparable benefits to corporate tax incentives, for example reduced customs duties or renegotiated production-sharing agreements.¹¹⁸

Given the design of the global minimum tax, investors are likely eager to obtain incentives that raise income instead of lowering the effective tax rate, while simultaneously avoiding the receipt of a collateral benefit. Why would governments agree to do so? The answer to this question is heavily country dependent and, in many ways, relates to the reasons why low corporate income taxes were granted in the first place. In the short- and medium term after the introduction of the global minimum tax, IIAs may constitute an additional factor that induces governments to agree to the (partial) replacement of incentives, even in situations where normally they would not want to do so.¹¹⁹

UNCTAD calls that approach “meeting in the middle” to avoid ISDS claims by host states. To this end, “expert knowledge of international legal obligations across different fields of specialization is necessary for governments to assess whether and how to engage in the renegotiation of incentives”; that is, to assess whether the MNE (investor) position is strong (thus requiring states to provide incentives compensating for IIA violations) or weak (leaving countries free to “safely omit doing so”).¹²⁰ A broad factual-economic approach will be applied over a narrow legal approach for collateral benefits, leaving a smaller chances to meet in the middle. In a similar vein, the less economic power and cash an FDI hosting country has, the less chance it has to avoid ISDS claims against it by providing MNEs non-pillar 2 related benefits, that is, a kind of compensation for IIA violation arising from the application of pillar 2 rules.

Tensions Between Pillar 2 and IIAs Spotted by the OECD

The OECD acknowledged potential tensions between pillar 2 rules and IIAs in its report on “Tax Incentives and the Global Minimum Corporate Tax” in October 2022¹²¹ without including any legal analysis or further follow-up. The report devoted only two paragraphs (paras 21-22) out of 120 to the topic. The OECD merely concludes that “more analysis of the interaction of these regimes is needed, taking account of investment treaties, ISDS interpretations and the implementation of Pillar Two.”¹²² Without further analysis, however, the OECD decided to discourage investors from making claims against host states under relevant IIAs in its administrative guidance on pillar 2 released in July 2023 — the part on QDMTT payable — without even identifying the problem.¹²³

The QDMTT payable guidance boils down to the conclusion that any direct or indirect challenge in a judicial or administrative proceeding to a QDMTT amount by an MNE group “based on constitutional grounds or other superior law or based on a specific agreement with the government of the QDMTT jurisdiction limiting the MNE Group’s tax liability, such as a tax stabilization agreement, investment agreement, or similar agreement” will not be treated as QDMTT payable under article 5.2.3 of the OECD pillar 2 model rules. The top-up tax payable under the QDMTT will not reduce the top-up tax to zero and thus may be collected by another jurisdiction under the IIR or UTPR. Also, the QDMTT safe harbor¹²⁴ will not apply when the QDMTT is not payable. The MNE group will instead be subject to the credit mechanism in article 5.2. and any QDMTT that was not included in QDMTT payable “shall be included in QDMTT payable for the Fiscal Year to which it relates when such amount is paid and no longer contested by the MNE Group.”¹²⁵

The OECD guidance on QDMTT payable aims to discourage MNE groups from legally challenging QDMTT via sources external to pillar 2 rules by making these challenges economically a waste of time: The challenge will simply lead to taxation under an IIR and UTPR. Although in that regard the OECD did not refer to IIAs explicitly, in practice challenges to QDMTT will arise mainly out of relevant IIAs¹²⁶ because of their scope of investment protection and international investment treaty arbitration case law.¹²⁷

This OECD approach will generally favor advanced economies because the majority of MNE UPEs in scope of pillar 2 come from these countries and, therefore, disregarding QDMTT payable will allow them to charge top-up tax via IIAs under the primary rule, by the UPE country.¹²⁸ In these circumstances, the imposition of a top-up tax via IIR would not be subject to an ISDS claim because investors cannot bring investment treaty claims against their home states (a UPE’s country).¹²⁹ Hence, the OECD guidance brings a double benefit to high-income developed countries:

• no room for ISDS claims against them under the IIR; and

• the right to collect top-up tax via an IIA.

But it presents a double loss to low- and middle-income developing countries:

• disregarding their QDMTTs whenever they violate IIAs and investors decide to exercise the rights under those IIAs; and

• decreasing legal certainty and access to justice in those countries for investors.

Of course, superficially the OECD guidance appears beneficial to all countries, including NAEs, because it discourages investors from challenging QDMTTs implemented by all countries. However, the major point on taxation under IIR and UTPR after challenging QDMTT via IIAs is neither certain nor conclusive for investors’ decisions and an ISDS tribunal’s reasoning.¹³⁰

Consequently, if followed by inclusive framework members, OECD guidance has the potential to significantly reduce protection of foreign investments globally with negative consequences for MNE investment tax certainty in NAEs. Because of widespread tax incentives in the form of SEZs and other state promises to investors, these countries are vulnerable to ISDS claims from violations of their IIAs by the implementation and application of QDMTTs and other pillar 2 rules. Therefore, mainly NAEs will suffer from a reduction of tax certainty toward foreign investors.

Conclusions and Policy Options

The challenges of pillar 2 rules show that the economic situations and resources of countries do not appear to have played a role in the design or interpretation of the rules. The pillar 2 model rules can potentially:

1. have a negative budgetary effect on NAEs attracting FDI via tax incentives, in particular via SEZs;

2. trigger a new, unintended tax competition in which NAEs will likely be in a relatively worse position than advanced economies because of NAEs’ lower administrative and financial capabilities;

3. distort the level playing field between advanced economies and NAEs because of:

1. 1. QRTC design, the implementation and application of which is much easier for advanced economies compared with NAEs because the former are often in much better budgetary position to provide cash back to investors in the form of QRTCs; and

   2. the design and interpretation of collateral benefits, which leave NAEs in a worse situation because of weaker budgetary positions than advanced economies on the implementation of nontax incentives beyond the definition of collateral benefits used to attract or retain FDI;

4. violate IIAs and WTO rules, leaving NAEs in a worse situation than advanced economies because of the far-reaching effect of pillar 2 rules on NAE tax promises to foreign investors and the pervasive presence of SEZs relative to advanced economies.

The following options could be considered by policymakers to establish a level playing field:

1. Tax incentives offered by NAEs, especially via SEZs approved by the OECD Forum on Harmful Tax Practices, that meet economic substance and nexus requirements, to increase economic growth (jobs, innovation, infrastructure improvement, etc.) should not be considered as reducing the ETR for pillar 2 purposes. Similar to the option in Annex V of the subject-to-tax rule multilateral instrument, this solution could be suspended when an NAE becomes an advanced economy (and vis-versa), emerging market, or middle-income economy, depending on the political consensus and the ambitions of the global tax policymakers;

2. All tax incentives that have been qualified as non-harmful by the OECD forum will be treated as QRTCs (at least in NAEs);

3. The concept of collateral benefits will be based on a precise, legal approach rather than a broad, economic-factual approach in determining whether grants or subsidies, other than those exempted from the scope of that concept indicated in policy options 1-2 above, were provided to circumvent the effect of pillar 2 rules (specific legal parameters to this end would be decided upon a political consensus);

4. All countries and jurisdictions, irrespective of their categorization as advanced economy, NAE, etc., can decide independently after a consultation within the inclusive framework forum on a case-by-case basis to not apply pillar 2 rules to the extent to which the application would lead to a violation of their IIAs, WTO rules, and other rules stemming from superior laws relative to pillar 2 domestic legislation, such as constitutional laws and EU law.

In addition to substantive policy options, it is worth considering a solution that will address prospective disputes between MNEs and countries and, perhaps, even between countries. We think that this kind of solution could lie in the establishment of an international body of experts with three core competencies related to pillar 2 disputes:

1. assisting domestic tax authorities in issuing rulings in cross-border tax cases;

2. acting as mediators between taxpayers (foreign investors and MNEs) and tax authorities (local governments); and

3. issuing expert opinions in cross-border tax and tax-related investment and WTO disputes — the expert opinions will be of persuasive authority only by default, but disputing parties can agree in advanced to treat them as legally binding.

Bearing in mind that one of the most important and most challenging aspects of tax certainty globally is raising tax certainty in cross-border disputes, establishing a body of experts may ensure that other recommendations become successful in the long term by securing a high level of tax certainty.

The design and process of implementing the recommendations could be initiated by the OECD within a broader forum such as the Platform for Collaboration on Tax, which is a joint effort launched in April 2016 by the IMF, the OECD, the U.N., and the WBG. This could increase the legitimacy and inclusivity of pillar 2, especially because the major goal of the recommendations is to align pillar 2 with the global policy priorities such as energy transition and the elimination of poverty. Implementation of these priorities go beyond the OECD’s authority and experience.

We humbly hope that the recommendations, once further designed and put forward by the OECD together with the Platform for Collaboration on Tax and followed by inclusive framework members, will eliminate NAEs’ competitive disadvantage, and contribute to the energy transition and elimination of poverty. The recommendations genuinely aim to serve as a resource for global tax policymakers and inclusive framework members when considering amendments to pillar 2 rules and their domestic incarnations.