Authored by Bryan Soepardi, R&D Tax Specialist at RSM Australia

Years of intense work and negotiations has led to a revolution of international tax rules, helping to bring them into the 21st century. This saw members of the OECD and G20 Inclusive Framework on Base erosion and profit shifting (BEPS) come together to agree on a Two-Pillar Solution on 8 October to address the tax challenges arising from the digitalisation of the economy. As of 30 October, the kinks have been ironed out and the new reform has been set in motion.

The progress so far

Today, 136 countries and jurisdictions, representing more than 90% of global gross domestic product (GDP), have joined the Two-Pillar Solution establishing a new framework for international tax and a detailed implementation plan that envisages implementation of the new rules by 2023.

So, what does the OECD’s two-pillar solution to international profit shifting promise to do?

Firstly, it will generate USD $150bn of additional tax revenues through the imposition of a 15% global minimum tax rate.

Secondly, it will redistribute taxing rights on an estimated USD $100bn of company profits to the countries in which the sale of goods and delivery of services takes place.

The global competition for economic growth and innovation has seen countries long turn to concessional tax programs, patent box regimes, and tax incentives to fuel research and development (R&D) efforts. So, what impact will the OECD’s proposed reforms have on the location and intensity of innovation?

Implications on the global competition for innovation

In theory, a tax incentive provides governments with a simple tool for incentivizing multi-national enterprises (MNEs) to bring their R&D operations into their country.

Whilst other factors such as access to labour, capital, customers, and favourable regulation should drive the location of business investment, there is a widely held view that tax incentives are an effective tool both in attracting inward investment and increasing the demand for domestic R&D work.

When paired with a well-constructed patent box regime, countries can incentivize MNEs to generate, retain, and commercialize valuable intellectual property (IP) within their country.

In its current form, the OECD’s international tax reform package may have unintended effects on the effectiveness of these tax incentives, for example:

  1. Imagine an MNE which has R&D and sales operations in one country. The MNE invests heavily in profitable R&D activities, such that it enjoys a concessional patent box tax rate on most of its profits, and further benefits from a sizeable tax credit on its R&D expenditures.
  2. Under Pillar 2 of the OECD’s reform package, a top-up tax will be levied in the MNE’s parent country to bring its global tax rate to a 15% minimum.
  3. From the MNE’s perspective, the country’s R&D tax incentive no longer subsidizes the cost of its R&D activities in that country. Nor does the country’s patent box regime provide a monetary incentive to generate, retain, and commercialize valuable IP in that particular country.

By removing its R&D tax incentive and patent box regime, that country can recoup some of the tax revenues that would otherwise be exported to the MNE’s parent jurisdiction. However, the country now faces a different dilemma.

If it believes in the effectiveness of its tax incentives in stimulating business entity research and development (BERD) and economic growth, the removal of this incentive will result in a fall in both metrics. If the country previously relied on a lower tax rate to stimulate inward investment, it may now need to explore other methods of maintaining the same level of BERD and associated economic growth in an increasingly mobile and competitive global environment.

From a global perspective, an effective increase in the cost of innovation may hamper business investment in R&D activities which are inherently risky and have an uncertain return.

On the other hand, an increased focus on non-tax considerations such as the quality of labour, household wealth and consumption, and other country-specific benefits may drive more efficient global investment decisions. An increase in the cost of R&D may drive both MNEs and governments to consider more efficient means of supporting and encouraging innovation.

On example of this was the announcement by the Irish Government in October 2021 of its willingness to accept the global minimum tax rate of 15% (albeit with a carve out for smaller domestic businesses). This was a clear indication that Ireland recognises it will need to rely on factors beyond the tax concession to maintain its position as an attractive destination for the innovative businesses of the future.