More on Pillar 2 and Tax Competition

A few weeks ago, we wrote a Policy Brief1 examining the likely impact of the Pillar 2 minimum global tax on tax competition. At the time, this was uncertain because the precise rules had not been formulated. But with the publication of the “Model Rules” by the OECD on Monday, and the draft Directive by the EU Commission on Wednesday, of this week things have become clearer. 

Broadly, there are two steps in the calculation of the Pillar 2 top-up tax. The first is to calculate the effective tax rate (ETR) of a multinational company in a specific jurisdiction. If that ETR is less than 15%, then a top-up tax will be levied equal to the difference between the ETR and 15%, applied to “Excess Profit”2.  Excess Profit is defined as “Net GloBE Income” (from financial accounts) less a “Substance-Based Income Exclusion”. 

Our Policy Brief analysed two possible cases – essentially whether the denominator of the ETR would be based on “Net GloBE Income”, or “Excess Profit”. That has now been clearly resolved: it will be Net GloBE Income.

However, one additional and important factor has been added: the domestic government is invited to introduce a domestic top-up tax, through the somewhat cumbersomely named “Qualified Domestic Minimum Top-Up Tax” (QDMTT). Essentially this puts the domestic government at the head of the queue for collecting the top-up tax. 

This is a key change. It has always been expected that domestic governments may raise their taxes to avoid other countries introducing a top-up. Their incentives to do so was the subject of a recent blog by Shafik Hebous and Michael Keen. But now these incentives are subtly changed because there are important differences in the treatment between the “normal” covered tax (primarily – and henceforth for simplicity - the corporate income tax), and the top-up tax. 

So what will be the incentives to engage in tax competition? Note first that there is no change in the position of multinationals who are not within scope of Pillar 2, or which have an ETR in excess of 15%. 

The overall tax liability3 of a multinational subject to Pillar 2 which has an ETR of less than 15% turns out to be:

15% E + T * C / P


E = Excess Profit =  P – C
P = Net GloBE Income
C = Substance Based Income Exclusion
T = Covered Tax Liability

This puts a floor on the overall tax payment of 15% of Excess Profit, although not on the domestic tax. In the extreme, if domestic corporate income taxes were reduced to (or remain at) zero, then the top-up tax would apply, imposing a 15% tax charge on Excess Profit.

Had the QDMTT not been introduced in the Model Rules, the top up would be collected by other countries. In this case, if the domestic country reduced its corporate income tax by $1, the overall multinational tax liability would only fall by $C/P (i.e. less than $1). The remainder would be collected by other countries. As we argued in the Policy Brief, relative to a world without the minimum tax, this would weaken the incentive for countries to reduce their corporate income taxes (to be clear, this is because this reduction would improve their competitive position by less than it would in a world without Pillar 2); but it would not eliminate it altogether. It might still be the case that countries would compete away their right to tax, possibly all the way to zero.4

In a response to our Policy Brief, Johannes Becker and Joachim Englisch seemed to take issue with the view that countries’ incentives to change local tax rates was a very relevant issue for tax competition. They argued that the more relevant issue is the level of overall ETR paid by a multinational. That is, if Country A and Country B compete with one another by lowering their tax rate all the way to zero, that is less relevant for tax competition if Country C collects a top-up tax. We do not find that argument persuasive. A country that is compelled to give up taxing profit due to competition with its neighbours might be expected to consider that highly relevant.

In any case, the new provision makes that debate hypothetical. That is because reducing corporate income taxes to zero does not mean that the domestic government cannot raise any tax revenue from the multinational. It simply means it has to do it through the QDMTT. Assuming that domestic governments take advantage of this opportunity – and it is hard to see why they would not - the QDMTT really will be a floor to overall tax competition (albeit not for competition over the corporate income tax). 

Indeed, there are three reasons why competition over the corporate income tax might be more intense following the addition of the QDMTT. First, with the QDMTT, the incentive at the margin to reduce the corporate income tax is actually stronger than it would have been under Pillar 2 had the QDMTT not been introduced. Since no other country levies a tax on the profit, then a $1 reduction in the corporate income tax does reduce the tax liability of the multinational by $1 (recall that without the QDMTT it would be less than $1). That gives a stronger incentive to compete (though no more than a system without the minimum tax). Second, given the opportunity to raise revenue through the QDMTT, the government may feel less need to rely on revenue from the corporate income tax. Third, there remain many companies out of scope of Pillar 2. The government can compete for inward investment from those companies, safe in the knowledge that at least the QDMTTT can be levied from those subject to Pillar 2. 

But if countries come to rely more heavily on the QDMTT, this would represent a really very significant change in how the largest multinationals are taxed. The tax base would then be Excess Profit, defined as financial accounting net income, less a rather arbitrary substance-based income exclusion. That raises issues of significant consequence. For example, it would ultimately remove opportunities for governments to define the tax base in a manner of their own choosing. These issues and the general points made in this blog will be explored in greater detail in a forthcoming article. 


Jointly written with Martin Simmler. There was also an accompanying blog.
I’m leaving aside a number of other issues here to focus on the key factors for tax competition.
This is set out in the Policy Brief. 
If the other option had been chosen – i.e.  the denominator of the ETR would be based on Excess Profit - Pillar 2 would have had a different impact on tax competition. As we explained in our Policy Brief, the incentive to compete down to 15% of Excess Profit would not have been weakened, but the incentive to compete beyond this point would have been effectively removed.

Relevant research from the Centre for Business Taxation

Does the Substance‐Based Carve‐Out under Pillar 2? And How Will It Affect Tax Competition?”, Michael P. Devereux, Martin Simmler, John Vella and Heydon Wardell‐Burrus, EconPol Policy Brief 39, 2021.

Taxing Profit in a Global Economy, Michael P. Devereux, Alan J. Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella, Oxford University Press, 2021.

The OECD Global Anti-Base Erosion Proposal, Michael P. Devereux, François Bares, Sarah Clifford, Judith Freedman, İrem Güçeri, Martin McCarthy, Martin Simmler and John Vella, Oxford University Centre for Business Taxation Report, 2020.