By Thomas Kirchner, CFA
15% minimum corporate tax decided at G-7.
Subsidies to replace tax incentives.
Trade wars will intensify over subsidies.
Implementation in the U.S. is unlikely...
The introduction of a global minimum tax rate may sound like a really good idea if you are a head of a cash-strapped government at a G-7 meeting where everyone has been concerned about their eroding tax base. However, new tax rules can have unintended consequences. Their proponents often have no experience with business decisions and are more focused on vague notions of tax fairness rather than the hard practicalities of decision-making when facing conflicting international tax regimes. Of the seven core nations at the G-7, only one is represented by a leader with private sector experience worth mentioning: Italy's PM Mario Draghi spent three years at Goldman Sachs and a few years as a consultant at the World Bank. We put little value in terms of private sector business expertise on UK PM Boris Johnson's decade as a journalist, apparently without any management responsibilities, or President Biden's two years as a public defender in the 1960s. Therefore, a tax regime heavy on pathos and light on practicalities should be expected.
With the new U.S. Administration seeking to increase corporate taxes, the U.S. withdrew its long-lasting opposition to the OECD proposal for a global minimum tax, paving the way for its adoption by the G-7. In fact, Treasury Secretary Yellen has her own 15% minimum tax rate proposal, which could be even more draconian than the OECD one.
How the new minimum corporate tax works
The global minimum tax framework proposed by the OECD and adopted by the G-7 has two pillars [i]:
1. The first pillar seeks to reallocate profits to markets where the economic activity occurs. This seeks to eliminate the creation of intellectual property holding subsidiaries (aka “patent boxes”) in countries with low tax rates, and thereby reducing the profits in high-tax countries via license payments to the patent boxes.
2. The second pillar is the actual minimum tax. It acts as a tax equalization: if a company pays less than a 15% tax rate in its foreign subsidiaries, then the home country will charge an extra tax so that the total tax increases to 15%. This is meant to reduce the incentive for moving subsidiaries to low-tax jurisdictions.
The tax would apply only to the largest companies who have more than a 10% margin. “Large” appears to refer only to the largest 250 companies – at least for now, rules tend to expand once in place, after all.
What the margin is on is unclear – net margin on sales, EBITDA margin on sales, return on equity, return on invested capital? Whatever the metric, one company that has caused the ire of many politicians for its creative use of low-tax jurisdictions will not be included: Amazon.com does not make 10% on those metrics. The only way to have Amazon included would be to apply the minimum tax to each business segment. That is something under serious consideration and, if actually implemented, would make such a minimum tax a bureaucratic nightmare.
The main difference between the OECD and Secretary Yellen’s minimum taxes are their scope: Yellen's minimum would apply to all companies; the OECD proposal only to the world's largest companies, with a disproportionate, if not exclusive, burden borne by U.S. tech giants.
The devil is in the details
The tricky question is what taxes exactly count toward the minimum. After all, tax rates themselves are always secondary considerations, exemptions and calculation methods are the main drivers of the taxes effectively paid. And as one may expect, the minimum tax already has a number of pet peeves excluded.
Most notably, the Digital Services Tax (DST) that Europeans want to impose on U.S. tech giants would not count toward the 15% minimum. Therefore, the effective minimum for tech giants will be higher than 15%. Europeans propose to abandon the DST in exchange for the minimum tax but experience shows that a tax, once proposed, will eventually be implemented.
Other taxes, such as real estate taxes, labor-related taxes, business activity taxes, value-added taxes, franchise taxes and the like also would not count. This matters a lot, because by some estimates, profit taxes only represent one quarter of the total tax burden of large, global enterprises, with the rest coming from such other taxes that generally are ignored in the debate about “fair” tax burdens [ii]. Therefore, charts that have circulated recently showing a steady decline in corporate taxes over the last five decades are misleading because they ignore the simultaneous increase in other forms of taxation.
The second pillar in particular can have severe impacts depending on how poorly it is implemented. For example, does each foreign subsidiary have to pay a 15% minimum tax, or can losses in one country offset profits in another, so that foreign subsidiaries pay the 15% minimum in the aggregate? This is more than a technical detail – it can make the difference on whether or not entering a foreign market makes sense or not. If each subsidiary has to pay a 15% minimum tax, it could make more sense for companies to not enter markets through subsidiaries but to use foreign partners. Effectively, this rule alone can lead to a severe de-globalization of global enterprises.
The Biden Administration currently supports a country-by-country minimum tax calculation. We believe that one of the unintended consequences might be the further export of U.S. jobs. Long-term investments outside of the U.S. will become less attractive for U.S. firms compared to locally-based firms that can fully utilize the initial tax losses such investments entail. Therefore, crucial elements of the supply chain that are currently owned and controlled by U.S. firms will slowly fall under the control of foreign firms, with eventually entire supply chains being expatriated and U.S. firms becoming mere importers of finished goods.
Another uncertainty is the treatment of REITs and investment funds. Alone the suggestion that a fund-level corporate tax might be imposed shows how little economic sense is in the minds of policymakers. It is only a matter of time until someone discovers mortgage-backed securities, CLOs or other securitizations as potential targets for a corporate tax.
Tax incentives become pointless, shift revenue from one country to another
Tax incentives are a powerful instrument used by governments to attract business. A global minimum tax will negate any such incentives. For example, if the state of Georgia tried to attract investment by a foreign sports car manufacturer in Atlanta through tax abatement, any such benefit would be offset by the Federal government which would collect a higher tax. In fact, the tax revenue would simply shift from the State to the Federal government. A similar shift in tax revenue would also occur internationally should the Federal government offer similar incentives. The car company's home country would then increase its taxes to the minimum and collect the tax incentives offered by the U.S.
In particular, Biden's proposed 10% “Made in America” investment tax credit would end up in the coffers of foreign tax authorities if paid to a foreign company investing in a U.S. plant and if that company is then hit with the 15% minimum rate in its home country.
Rethinking subsidies
Such an international shift of tax revenues is probably not what the G-7 leaders have in mind, but it is an inevitable consequence of the proposed minimum tax regime. The implications are widespread, because tax incentives are used widely to support investment in favored areas: accelerated depreciation for energy investments in the U.S., tax support for renewables pretty much everywhere, favorable tax rates or exemptions for agriculture. Traditional tax incentives will become appealing only for domestic enterprises.
But governments are creative, too, and if they cannot attract foreign investment through the traditional tax incentive schemes, they will create new incentive schemes. The most obvious coming to mind would be subsidies masked as social spending: for example, rather than making employers pay for health care and other social taxes, the government might pick up the cost disguised under welfare programs. This will lead to a reduction in unit labor costs, which can then be used through the clever use of transfer pricing rules to shift profits elsewhere.
The possibilities are endless, and it is clear that the winners will be the lawyers and tax advisors, for whom a new era of record billings is likely to begin. Whether any country will be better off remains to be seen.
Why trade wars will escalate
With tax incentives gone and governments coming up with with new and inventive subsidies, others will push back over such “unfair” trade practices. Both the WTO and European Union have rules about state aid. In fact, it's ironic that the 40-year battle between the EU and U.S. over subsidies to Airbus and Boeing is winding down just as governments are creating a tax framework that would make such subsidies more appealing in the future. This war intensified after a 2019 WTO ruling that authorized the U.S. to levy tariffs on the EU and at the same time authorized the EU to levy tariffs on the U.S. The absurdity of this ruling appears to have been grasped even by policymakers, who are now ready to do a deal [iii]. We note that while the press pins the beginning of the dispute to 2004, when the current case at the WTO was filed, the disputed subsidies actually go back as far as the 1980s. Most of the key decision-takers from back then are not even alive any more, and none hold public office.
We believe that the Airbus/Boeing trade debacle is a template for what lies ahead. As governments slowly come to grasp what their minimum tax decision has done to their ability to incentivize investment, they expand the use of subsidies, many of which will run counter to WTO rules. But elected officials benefit from the immediate political support that such subsidies create, while the cost in the form of punitive tariffs will be borne by future administrations and taxpayers decades later. No mechanism exists to address this conflict of interest. Therefore, it will happen.
The result will be violations of WTO rules, retaliatory tariffs followed by more rule violations and compensatory tariffs. We may have changed the tone of international trade relations, but the substance is at risk of sliding into an escalating trade war.
Good news: it won't happen
The fanfare surrounding the announcement of the minimum corporate tax stands in sharp contrast to the low likelihood of its implementation. The City of London and Switzerland are already trying to find ways for an exemption or circumvention. Even in the U.S. it is far from certain that it will be implemented. The agreement might be considered an international treaty, which would be subject to two thirds approval by Congress, a near impossibility. If the U.S. does not participate, it is likely that many other countries will also refuse to implement it. While the EU is very likely to implement it, we expect that it will dilute the impact through rulemaking if the U.S. does not participate.
The main problem with the global minimum tax is that it is designed to target U.S. tech companies. The U.S. will lose tax revenue to other countries as a global minimum tax shifts tech giants' taxes to other countries, but it will not have the opportunity to recover the lost taxes from foreign companies operating in the U.S. because they shift profits less frequently to patent boxes. Congress is likely to recognize this asymmetry and reject the OECD proposal.
Things get really complicated if Congress passed Secretary Yellen's 15% minimum tax proposal but rejected the OECD’s. In that case, U.S. firms face a double disadvantage: companies of all sizes would be faced domestically with the Yellen minimum, and the tech giants would be hit internationally with the OECD minimum. Firms domiciled outside of the U.S. do not face such a double disadvantage. It would be unfortunate if the asymmetry that the U.S. faces in international trade would now be replicated in international taxation. It is clear that if a future administration took a similarly tough line on asymmetries as the previous one, the global minimum tax regime will make such a confrontation only worse.
[i] “KPMG report: Analysis and observations about tax measures in G7 communique.” KPMG, June 7, 2021.
[ii] Natalia Drozdiak, Alberto Nardelli, Bryce Baschuk: “U.S. and EU to End for Good Trump’s $18 Billion Tariff Fight.” Bloomberg News, June 8, 2021.
[iii] Andy Agg, Andrew Packman: “2020 Total Tax Contribution survey for the 100 Group.” pwc for The 100 Group, December 2020.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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