Episode Transcript
[00:00:00] Speaker A: Foreign.
[00:00:05] Speaker B: This is Matt Andrew. I'm the global tax policy and controversy leader for A and M.
You're listening to A and M's podcast series in relation to the pillar 2 side by side and Safe harbor developments today. I'm here with Rory Lamb who is part of our Pillar 2 global network and also as a senior advisor director in our Hong Kong office.
So for the purposes of this particular web podcast, Rory will be hosting us through this. And Rory and I will now begin our conversation on the substance based tax incentive Safe Harbor.
[00:00:48] Speaker A: Rory.
Well, thank you very much Matt and hello everyone, my name is Ruri Lam from A and M Hong Kong office.
So Matt, this sounds like it's a safe harbor designed to protect certain tax incentives. What's the basic goal here?
[00:01:03] Speaker B: Yeah, thanks Rory.
I mean to me the fundamental goal is to prevent a globe top up tax from applying to benefits a company gets from qualified tax incentives, or what I'll now refer to as a qti, which is provided that this incentive is linked to real economic activity. And that's really the important point here.
A QTI will always be linked to a real economic activity or activity. So we're talking about genuine policy tools like R and D credits, super deductions for capital investment or credit based, or credits based on production volumes. And the idea is to, to preserve incentives that drive tangible business growth. And that's really what certain inclusive framework members want, particularly those in developing countries that rely on tax incentives to bring foreign direct investment.
[00:02:01] Speaker A: So in that case, Matt, is it true that not every tax break will qualify and if so, what will filter an incentive into that qualified category?
[00:02:11] Speaker B: Yeah, that's exactly right, Warrior. It's a specific filter. So there are two main criteria. The first, the incentive must be generally available in that jurisdiction. Not a one off deal, not a negotiation, but generally available with public criteria. Second, and this is key, it must be linked to real substantive activity happening locally.
And so that is real people doing real things in that location, not an outsourced location. So the rules really focus on two types.
Expenditure based incentives like credits for costs you incur on R D or research and development or assets.
And then there's the production based incentives which are tied to the volume of tangible goods you physically manufacture there. And that means. So that's important. It's not the value of the tangible goods, Rory, it's the volume of tangible goods. So it's really output focused on the, on the physical manufacturing output.
[00:03:14] Speaker A: I see. And how does the mechanism actually work then to protect this kind of incentive?
[00:03:21] Speaker B: Yeah, it Works by letting you treat the value of the QTI or the qualified tax incentive as if it were an increase to your covered taxes for globe calculation.
So if you remember, we had the qualified refundable tax credit which was an expansion of your denominator, your globe income. This is different.
This is different. QTI is increasing your covered taxes for the calculation, which is a significant benefit, but there are limits to that benefit and that's what's referred to as the substance cap. And you can only recognise the benefit up to the level of your substance based economic footprint in that jurisdiction and you can't use it to create a negative effective tax rate.
[00:04:07] Speaker A: Okay, and so how is that footprint or that cap calculated? Man.
[00:04:12] Speaker B: Yeah, there seem to be a couple of two calculation options or.
Yeah, optionality here. So there is an optionality. The first is, is probably the default method which uses a formula based on 5.5% of eligible payroll plus 5.5% of the depreciation on eligible tangible assets.
And so the second is an elective method which can sometimes be more beneficial. It uses 1% of the carrying value of eligible tangible assets, but you have to lock, lock into using the method for a five year period.
And so I think some multinationals are going to have a, have to do some math here. So what works best for you? And you could sort of see if it's 1% of the carrying value of eligible tangible assets that might be very beneficial where you've got significant manufacturing or multiple manufacturing production entities and facilities in one in one jurisdiction, whereas if you're more headcount heavy, labor intensive, then you might use the first, the first one focused on eligible payroll and depreciation instead. So it's a math exercise, Rory, and multinationals will need to make a decision on that.
[00:05:35] Speaker A: Okay. And Mats, we've also seen, you know, kind of talk of, you know, special election for refundable credits. How does this work?
[00:05:43] Speaker B: Yeah, it's really important nuance, I think. So for certain refundable or transferable tax credits.
So think credits like the US Qualified refundable tax credits or the, or the marketable transferable tax credit, there's an additional elective path. If you take it, you handle the credit differently, you exclude its value from your globe income entirely and then treat it as a reduction to your covered taxes, but still subject to that same substance cap that I just mentioned, Rory. So it's a different route to the same goal for these specific monetizable credits.
[00:06:24] Speaker A: I mean, thanks, Matt. There's a, you know, a lot to take in there.
Given all these conditions, what's the big picture takeaway for companies?
[00:06:34] Speaker B: Yeah, I think the key takeaway is that this is a narrow conditional framework. It's not a blanket protection. It's more designed to recognize only those incentives that as I've mentioned now three or four times, demonstratively linked to economic substance or sustained economic sum. So it's payroll, it's tangible assets on the ground, it's people, it's it's assets doing things and will.
[00:07:04] Speaker A: The design of this framework inherently favors certain types of businesses over others.
[00:07:10] Speaker B: Yeah, I think it's, as I mentioned, it feels to me in discussions with, with, in consultation with multinationals and governments, it does seem to tilt the field.
I mean to me the substance cap calculation is heavily geared towards capital expenditure and payroll and that's going to naturally benefit manufacturing and other asset intensive brick and mortar industries.
So the more service orientated IP heavy or asset light sectors may find it much harder to fully utilize this QTI safe harbor as their substance isn't as easily, easily captured by the payroll and tangible asset metrics. And that says to me, Rory, we're still going to have QRTCs, QTIs and other types of income tax incentives available.
And again, I think it's a math exercise lining up all those different types of incentive treatments under pillar two and then making an assessment about what's best for your business.
[00:08:14] Speaker A: So with that in mind, Matt, do you think this is going to influence how companies model their taxes and where they might invest?
[00:08:23] Speaker B: Yeah, I think that's without a doubt. I mean I think it's already starting to happen. It makes ongoing effective tax rate modeling around incentives absolutely essential.
But I think it's more than that. I think from my perspective it's looking at how pillar two treatment of incentives, it's transfer pricing, it's tariffs, it's cost management, all the things that are impacting multinationals is really important to factor all those different types of tax policy changes and impacts into this calculation. So not looking at it in isolation but I think this will be a catalyst for, for multinationals to really rethink about their ETR footprint under the new side by side permanent safe harbour rules with their substance based tax incentive as well. And that's from a multinational perspective and obviously governments are looking at this very closely now. They'll want their tax incentives to remain attractive and be globe compliant. So it's not a static picture, it's something that will require continuous monitoring from both the government perspective and the multinational perspective.
[00:09:34] Speaker A: Wow. There's a lot there for businesses to watch out for. Matt, thank you so much for unpacking that with us.
[00:09:40] Speaker B: Thanks very much.
[00:09:41] Speaker A: Rock.
