Payroll Tax Incentives, Generally
Payroll tax incentives can take numerous forms.
For example, there could be an enhanced tax deduction for hiring new employees (eg India’s 30% additional tax deduction for new employees under Section 80JJAA of the Income Tax Act) or a
reduction or waiver of employer-paid payroll taxes (eg as implemented by Bermuda in its Payroll Tax Amendment Act 2020
). Another option (amongst others) could be a tax credit granted for a specified proportion of certain employee costs.
Whichever option is chosen, the key aim is the same – to encourage local employment. However, the nature of the incentive offered will have a different impact under the Pillar Two GloBE rules
Under Pillar Two
, tax incentives need to be carefully considered to determine the extent to which an in-scope MNE will actually derive benefit from the incentive.
The risk is an incentive that significantly drives down the Pillar Two GloBE ETR
such that top-up tax payable then eliminates any benefit from the tax incentive offered. This benefits neither the MNE or the tax authority as without a qualifying domestic minimum top-up tax
(QDMTT) in place it could see tax revenue flow to a foreign jurisdiction. Even if a QDMTT is in place it would still be left with the costs of administering an ineffective incentive.
Types of Incentive under Pillar Two
In general terms, tax incentives at the most risk of significantly reducing the GloBE ETR are income-based incentives that apply to a wide taxable base. This would include a tax holiday or a reduced corporate income tax rate applying to all income of an entity.
This is not to say that expenditure-based incentives could not significantly reduce the GloBE ETR
. The GloBE rules apply equally to both types of incentives.
However, firstly, in practice expenditure-based incentives don’t tend to be that wide in scope (the same would also apply to more narrow income-based incentives such as a very limited tax exemption applying to a specific type of income such as IP income).
Secondly, expenditure-based incentives can more directly encourage local investment. This is important as the substance-based income exclusion
is a key aspect of the Pillar Two Rules and effectively provides a carve out for profit that is not subject to top-up tax.
Payroll Tax Incentives
The GloBE ETR calculation is:
Adjusted Covered Tax/GloBE Income
Payroll tax incentives are generally expenditure-based tax incentives that impact on adjusted covered taxes in the GloBE ETR calculation.
For instance, assume a jurisdiction provided a 50% additional tax deduction for eligible payroll expenses of new employees.
The eligible payroll expenses were 1 million euros.
Accounting profits were 10 million euros.
The tax rate was 15%.
For tax purposes, taxable income would be 9.5 million. Tax payable would be 1.425 million euros.
The accounts would show profits of 10 million euros and tax of 1.425 million euros – ie an ETR of 14.25%, below the 15% global minimum rate
The payroll tax incentive has therefore directly impacted on adjusted covered tax
for GloBE ETR, has reduced the ETR (that would otherwise have been 15%) and could potentially lead to top-up tax – subject to the substance-based income exclusion.
Payroll tax credits impacting on income would generally arise if there was a tax credit granted that was a qualifying refundable tax credit
for the purposes of the GloBE Rules. This is treated as income for Pillar Two purposes.
If the accounting treatment reflected that, no GloBE adjustment would be necessary. If the credit had been reflected in the current tax expense, it would need to be added back and added to GloBE income (ie in accounting terminology, Debit Current Tax Expense, Credit Income).
Payroll tax incentives that don’t impact on covered taxes such as a reduction in employer payroll tax would impact on both taxable profits and accounting profits, reducing profits that would otherwise be taxed.
Substance-Based Income Exclusion
Therefore, even if the jurisdictional GloBE ETR was less than 15% this does not necessarily mean that Pillar Two top-up tax would apply, as the substance-based income exclusion reduces GloBE income before top-up tax is calculated.
As such, if there were relatively low profits but a large substance-based income exclusion this could reduce any top-up tax and even eliminate this. This applies irrespective of the Pillar Two top-up tax percentage. ie even in a zero-tax jurisdiction that may have a 15% top-up tax percentage under Pillar Two, the substance-based income exclusion could eliminate any GloBE income and therefore any top-up tax.
One of the advantages of expenditure-based tax incentives over income-based tax incentives is that they can more directly impact investment. Income-based tax incentives by contrast give rise to profit shifting risks for tax authorities.
This can make payroll tax incentives particularly attractive for MNEs and tax authorities in a post Pillar Two environment.
Article 5.3.3 of the OECD Model Rules
provides that the payroll carve-out is equal to 5% of the constituent entities’ eligible payroll costs of eligible employees that perform activities for the MNE Group in the jurisdiction.
Therefore, there are three aspects to determining the payroll carve-out:
1. Ascertain eligible employees
2. Identify their location
3. Ascertain their payroll expenses
Eligible employees can be full-time, part-time or independent contractors if they work in the ordinary activities of the MNE group and act under its supervision and control. This means independent contractors can still qualify if they are employed by a separate agency but work for the MNE under its control.
The location of employees is where they perform activities.
Eligible payroll costs are wide and don’t just include salaries paid. Qualifying payroll costs include:
• Medical insurance
• Pension contributions
• Stock-based compensation such as share options and warrants
• Other benefits
• Payroll Taxes
• Employer social security contributions
As with other aspects of the Pillar Two GloBE rules, eligible payroll costs are based on the amounts included in the financial accounts of the constituent entities in the jurisdiction. Note that the nature of the payroll tax carve out does raise some issues for group payroll companies, see The Impact of Pillar 2 on Group HR/Payroll Companies.
Under transitional rules in Article 9.2 of the OECD Model Rules
, for the first 10 years, the amount excluded under the payroll carve-out will be 10%, reduced by 0.2% for the first 6 years, and 0.8% for the last 4 years. This will therefore make payroll tax incentives even more beneficial.
An MNE entity has:
Revenue: 100 million
Payroll costs: 20 million
Other costs 30 million
Profit: 50 million
The tax rate is 10%. Assume that there are no GloBE adjustments
to profit or tax such that they also apply for GloBE purposes.
Ignoring the substance-based income exclusion, the ETR is 10%. The top-up tax percentage is therefore 5%. Top-up tax would be 2.5 million.
In Year One, the Payroll carve out is 10%. The substance-based income exclusion is 2 million which reduces profits to 48 million. Top-up tax after the substance-based income exclusion is therefore 2.4 million.
The table below shows the revised top-up tax payable over the next 4 years assuming a 10% increase in payroll costs year-on-year and taking account of the reducing carve-our rate under the transitional rules.
Note that increasing payroll costs will also reduce profits. This would also be expected to have an effect on income and is reflected in the table below.
In the table below we assume an equal correlation between increasing payroll costs and revenue.