Revisiting Tax Incentives as an Investment Promotion Tool – Investment Treaty News (2024)

Analysis|January 13, 2024|Kudzai Mataba & Alexandra Readhead

Revisiting Tax Incentives as an Investment Promotion Tool – Investment Treaty News (1)

Introduction

In January 2024, a new system of international tax rules—the global minimum tax—will come into effect. These rules will impact the continued utility of some tax incentives as investment promotion tools by ensuring that large multinational companies pay a minimum effective tax rate of at least 15% no matter where they operate.

The effectiveness of tax incentives as an investment promotion tool has, however, been in question since the early 2000s, with some institutions that once championed their use calling for more cautionary application. Governments have, nonetheless, continued to extend tax incentives to investors, sometimes shortening their duration or imposing performance requirements on investors in efforts to ensure more direct benefits.

The stricter governance of tax incentives is indeed one way to minimize the unnecessary revenue losses that they may result in. However, it is important for governments to rethink their broader policies surrounding investment promotion and the use of tax incentives, reconciling these with changes in the broader investment landscape, including emerging international taxation rules, changing global value chains, and shifts to more sustainable production processes.

Recently, the International Institute for Sustainable Development (IISD) published a intended to update the investment community on the evolution of tax incentives as an investment promotion tool. It revisits the foundational premises surrounding the use of tax incentives and builds on an earlier policy brief titled Rethinking Tax Incentives, as well as IISD’s more recent work on the interaction between tax incentives and the Organisation for Economic Co-operation and Development [OECD]/G20 global minimum tax. This brief will highlight the five core questions posed in the Q&A.

How do tax incentives differ from other investment incentives?

Tax incentives are fiscal terms designed to reduce the cost of investment by lowering an investor’s tax liability. They have direct and quantifiable monetary benefits for investors. They can be divided into two broad categories based on their nature, namely profit-based and cost-based incentives.

  1. Profit-based tax incentives reduce the amount of tax payable by an investor—for example, by granting investors tax holidays or reducing the applicable tax rate.
  2. Cost-based tax incentives defer the payment of tax due to the government through, for example, the extension of extended loss carry-forward periods or accelerated depreciation.

Tax incentives are, however, not the only investment promotion tool at the disposal of governments. Non-tax incentives are measures put in place to make it easier for investors to do business in a specific jurisdiction or provide investors with financial support to carry out their business. They are commonly known as investment facilitation measures and can include making administrative procedures more effective and efficient or using cash grants and subsidies.

Are tax incentives an effective investment promotion tool?

It is difficult to answer this question definitively because to do so would require a determination of whether specific investments would have taken place in the absence of an incentive. This challenge is further complicated by the fact that tax incentives are often introduced in conjunction with other ease-of-doing-business reforms, which may exaggerate the impact of tax incentives on investment decisions. Various empirical studies, including the 2015 Report to the G-20 by the Platform for Collaboration on Tax, have, however, found that most investments would have taken place even in the absence of a tax incentive.

Even where an investment has been enabled by the provision of an incentive, the effectiveness of tax incentives has been found to vary depending on the type of investment and the sector it is in. Investment in primary sectors, such as agriculture and mining, has largely not been driven by tax incentives, ostensibly due to the location-specific sector of these investments. Investments that depend on agglomeration effects and investments in local markets that are less mobile in nature are less responsive to incentives. Although these broad categorizations are now significantly better understood, there remains a need for fine-grained research on how different types of incentives impact sectors differently.

Tax policy and the specific use of incentives are, however, only one factor that investors consider when making investment decisions. Investors are concerned about a country’s overall investment climate, including political and macroeconomic stability, the availability of a skilled labour force, the ease of repatriation of funds, and many other factors. The importance of tax settings should thus not be overemphasized. Tax settings alone cannot compensate an investor for an overall unfavourable investment climate that will make it difficult for them to conduct their business. In fact, tax incentives can withhold government revenues that could be used to improve investment-related infrastructure.

How will the global minimum tax impact the continued use of tax incentives?

In 2021, 137 members of the OECD/G20 Inclusive Framework agreed to a two-pillar solution to address tax base erosion and profit shifting by multinationals. Pillar 2 of this proposal establishes a global minimum tax of 15% that will apply to all multinational companies with an annual turnover of EUR 750 million or more. The aim of this initiative is to curb the proliferation of harmful tax competition that has led to the so-called “race to the bottom.” Under these rules, the tax benefit that a multinational receives in one jurisdiction will remain payable in another implementing jurisdiction, to the extent that the tax benefit reduces the effective tax rate of that multinational below 15%. Figure 1 presents a simple illustration of the global minimum tax’s primary rule.

Figure 1. The basic operation of the income inclusion rule under the Global Anti-Base Erosion System

Revisiting Tax Incentives as an Investment Promotion Tool – Investment Treaty News (2)Source: IISD-ISLP Guide.

In order to retain primary taxing rights and to ensure that no other country has a right to collect revenue made within its jurisdiction, countries should consider unwinding the most harmful types of tax incentives, which are broadly profit-based tax incentives. Table 1 provides a categorization of the types of tax incentives most likely to result in revenue losses under the global minimum tax regime.

Revisiting Tax Incentives as an Investment Promotion Tool – Investment Treaty News (3)

Table 1. Impact of the global minimum tax on types of tax incentives

Source IISD-ISLP Guide.

Factors to keep in mind when unwinding tax incentive regimes

Tax incentive reform can be a long and daunting exercise, which could explain why many ineffective incentive regimes persist. This is because tax incentives do not exist in vacuums. They are often embedded and reinforced in several domestic and international legal sources, including corporate income laws, investment laws, bilateral and regional treaties, and trade agreements. To coherently unwind a tax incentive regime, a government will need to establish where and how to make the necessary changes. This includes first mapping out all the sources of incentives and then investigating any barriers to reform, most notably the potential impact of legal guarantees of fiscal stabilization, which is addressed in the Q&A. The overall benefits of conducting such a review far outweigh the risks of sustaining an ineffective tax incentive regime.

What is the future of tax incentives?

It is not the intention of the global minimum tax to bring an end to the use of all tax incentives. The rules target only the most harmful types of tax incentives, which are broadly profit-based incentives. Developing countries will most likely continue to use tax incentives as an investment promotion tool for the foreseeable future. These incentives must, however, be designed and administered in a sustainable and responsible manner. Specifically, governments should

  • ensure that any use of tax incentives is underpinned by sound economic rationale. Companies requesting tax incentives should for example be mandated to prove the commercial need for an incentive through financial models that simulate the investment circ*mstances, including the impact of incentives on investor returns and government revenues.
  • make use of targeted incentives that have been proven to stimulate investment in specific sectors, limiting their reliance on profit-based incentives that are more susceptible to abuse but also less effective at encouraging investment in comparison to cost-based incentives.
  • monitor incentives carefully to measure if they are achieving their intended results, discarding those that do not perform.
  • foster transparency and inter-agency coordination, which will be critical to the effective administration of tax incentives. Ensuring accountability in the way incentives are granted and monitored significantly reduces opportunities for rent-seeking and corruption.

The continued use of incentives should be carefully considered in light of global changes that are altering investment patterns beyond the global minimum tax. Countries may, in some sectors, be better served by investing in other determinants of capital location decisions, including physical infrastructure, human capital, and the rule of law.

Conclusion

Countries that continue to use tax incentives as an investment promotion tool should be aware of the increased revenue loss risks that these fiscal tools will pose in light of the global minimum tax. The IISD Q&A aims to aid investment practitioners consolidate the wealth of knowledge on the utility of tax incentives so as to help them reconsider their continued effectiveness within their jurisdictions. It builds on previous IISD knowledge products on the impact of the global minimum tax on investment tax incentives including a blog article, an insights piece, and a Guide for Developing Countries on How to Understand and Adapt to the Global Minimum Tax. The recently established IISD Centre of Excellence on Tax Incentives has begun offering technical assistance to countries embarking on review processes of their use of tax incentives both in light of the global minimum tax and more broadly. Countries are welcome to channel requests of this nature to either the IISD Investment or tax teams.

Authors

Kudzai Mataba is a Policy Analyst at IISD, Investment and Tax.

Alexandra Readhead is the Lead of Tax and Extractives at IISD.

As an expert in international taxation and investment promotion, I bring a wealth of knowledge to the table. My experience includes a deep understanding of the evolving landscape of tax rules, particularly the global minimum tax set to take effect in January 2024. This system is designed to ensure that large multinational companies pay a minimum effective tax rate of at least 15% regardless of their operating location.

Now, delving into the concepts presented in the provided article:

  1. Tax Incentives as Investment Promotion Tools: The article discusses the use of tax incentives as tools for promoting investment. Tax incentives can be profit-based or cost-based. Profit-based incentives, such as tax holidays, reduce the amount of tax payable by investors. Cost-based incentives, like extended loss carry-forward periods, defer the payment of tax. Non-tax incentives, known as investment facilitation measures, are also highlighted, encompassing measures beyond fiscal terms to make business operations smoother.

  2. Effectiveness of Tax Incentives: The effectiveness of tax incentives as investment promotion tools is a debated topic. The article mentions the difficulty in definitively answering whether specific investments would have occurred without incentives. Empirical studies, including the 2015 Report to the G-20, suggest that most investments would have taken place even without tax incentives. The effectiveness varies across sectors, with primary sectors like agriculture and mining being less influenced by tax incentives.

  3. Global Minimum Tax Impact: The global minimum tax, established by the OECD/G20 Inclusive Framework, is set at 15%. The aim is to address tax base erosion and profit shifting. The article emphasizes that countries should consider unwinding the most harmful types of tax incentives, particularly profit-based ones, to retain primary taxing rights. Table 1 categorizes types of tax incentives likely to result in revenue losses under the global minimum tax regime.

  4. Unwinding Tax Incentive Regimes: Unwinding tax incentive regimes is presented as a challenging and lengthy process. Tax incentives are deeply embedded in domestic and international legal sources. Governments need to map out all sources of incentives and address potential barriers to reform. The article stresses the importance of conducting a comprehensive review to outweigh the risks of sustaining ineffective tax incentive regimes.

  5. Future of Tax Incentives: The article concludes by discussing the future of tax incentives. The global minimum tax is not intended to eliminate all tax incentives but targets the most harmful profit-based ones. Developing countries are likely to continue using tax incentives, but the emphasis is on designing and administering them responsibly. The article suggests criteria for responsible use, including sound economic rationale, targeted incentives, careful monitoring, and transparency.

In conclusion, the article provides a comprehensive overview of tax incentives as an investment promotion tool, their effectiveness, the impact of the global minimum tax, considerations for unwinding incentive regimes, and recommendations for the future use of tax incentives. This analysis is crucial for policymakers and investment practitioners navigating the evolving landscape of international taxation.

Revisiting Tax Incentives as an Investment Promotion Tool – Investment Treaty News (2024)

FAQs

What are incentives to invest? ›

They are widely used by developing countries to attract investments. The incentives take form of "direct subsidies (investment grants) or corporate income tax credits (investment credit) that compensates the investors for their capital costs".

What are the incentives for FDI in Nigeria? ›

They include positive incentives such as tax holiday, import duty relief, accelerated write-off of capital assets, tariff barriers to protect the investment from foreign competition, industrial estates and freedom of transfer of profits and capital.

Why do governments give tax incentives to foreign companies to invest in their countries? ›

The motive for public subsidies to foreign investors is to bridge the gap between the private and social returns, thus promoting larger inflows of FDI.

What is the investment tax allowance? ›

The investment tax allowance is given once only in respect of a promoted activity or promoted product. It is given during the approved tax incentive period at the rate of 60% or other rate of the QE incurred in the basis period for a year of assessment.

What is the most common incentive? ›

Employees are incentivized by different things, however the most common employee incentives include: Monetary bonuses. Salary raises. Additional vacation days.

What are the 3 R incentives? ›

Recruitment, relocation, and retention incentives (3Rs) are compensation flexibilities available to help Federal agencies recruit and retain a world-class workforce.

What are the incentives for FDI? ›

FDI incentives are commonly divided into three categories, namely fiscal, financial, and regulatory incentives, all of which are financed (or, in the case of regulatory incentives, offered) by authorities in the host area.

Who benefits from FDI? ›

Foreign direct investment offers advantages to both the investor and the foreign host country. These incentives encourage both parties to engage in and allow FDI.

What are incentives to attract foreign investors? ›

Governments can offer a range of incentives and tax breaks to attract foreign investment. These can include tax holidays, reduced tariffs, and exemptions from certain taxes. Incentives can also include grants and subsidies to support investment in specific industries or regions.

Do foreign investors pay taxes in the US? ›

U.S. Tax for Foreign Investors

As a general rule, foreign investors (i.e. non-U.S. citizens and residents) with no U.S. business are typically not obligated to file a U.S. tax return, including on income generated from U.S. capital gains on U.S. securities trades.

How does the investment tax credit work? ›

They let individuals or businesses deduct a certain percentage of investment costs from their taxes. These credits are in addition to normal allowances for depreciation. Investment tax credits differ from accelerated depreciation in that they offer a percentage deduction at the time an asset is purchased.

What countries have tax incentives? ›

Eight countries offering tax holidays for new foreign residents in 2023
COUNTRYBENEFIT DURATION
5. SwitzerlandUnlimited/ Indefinite Validity
6. Uruguay11 years for Option 1/ unlimited for Option 2
7. Israel10 years
8. Chile3 years
8 more rows

How much investment income is tax free? ›

Here are the MAGI thresholds for net investment income tax:
Filing statusMAGI threshold
Single$200,000
Married filing jointly$250,000
Married filing separately$125,000

How do I avoid 3.8% investment tax? ›

Sell investments at a loss to offset investment gains. Defer capital gain, such as selling the investment in the future instead of selling it now. Use Section 1031 like-kind exchange which is selling an investment property and using that money to buy another investment property.

Who pays the 3.8 investment tax? ›

As an investor, you may owe an additional 3.8% tax called net investment income tax (NIIT). But you'll only owe it if you have investment income and your modified adjusted gross income (MAGI) goes over a certain amount.

What is an incentive example? ›

An incentive program signals to employees they recognize and value the work they are doing while also encouraging employees to continue driving the results that the company is looking for. For example, an advertising agency might reward their sales department for meeting a certain quota at the end of a quarter.

What is an incentive give an example? ›

For example, a rise in the price of any good is an incentive for us to back off from buying it as much as we used to. Perhaps we'll buy a different good instead. So, for example, a rise in the price of butter creates an incentive to buy less butter.

What are market incentives examples? ›

6 Types of Marketing Incentives and Why They Work
  • Free to join loyalty programs. These are the offers that you often see at the entrance to major supermarket brands. ...
  • Referral Programs. ...
  • Premium Membership Features. ...
  • Exclusive Prices for Loyalty. ...
  • Early Access. ...
  • Competitions and Giveaways.
Nov 30, 2021

What does incentive mean in stock market? ›

Incentive stock options (ISOs) are popular measures of employee compensation received as rights to company stock. These are a particular type of employee stock purchase plan intended to retain key employees or managers. ISOs often have more favorable tax treatment than other types of employee stock purchase plan.

References

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