Designing a Global Minimum Tax with Full Expensing

September 23, 2020

The work at the Organisation for Economic Co-Operation and Development (OECD) has included plans to propose a global minimum tax. While negotiations are ongoing, it is worth considering a design for the minimum tax that would be neutral toward investment decisions and minimize complexity and compliance costs.

Over the summer, a draft of an OECD document describing the calculation of the minimum tax was leaked. Because an official draft has not been released (there have been other leaks) the leaked draft referred to in this post may be outdated in some ways. However, at some point an important design option was in the discussion and should be at the top of policymakers’ minds as talks continue. The option would be to design the tax base for the minimum tax with full expensing for capital expenditures.

Any tax comes with two essential elements: a tax base and a tax rate. While the tax rate of the minimum tax is more likely to grab headlines, the tax base can be a much more challenging and important design element.

When making decisions on the tax base for the minimum tax, countries at the OECD should work to ensure the tax is neutral toward business investment decisions.

This post describes the challenges of designing the minimum tax and why the full expensing approach would be a sound approach for the OECD to adopt.

It is first important to understand how a global minimum tax might work. Say a business in Country A has a subsidiary in Country B. Country A’s statutory corporate tax rate is 25 percent while Country B’s is 8 percent. If the global minimum tax is 10 percent, then Country A would be able to tax the difference between the 8 percent tax in Country B and the minimum tax.

Things can get complicated fast, however. If Country A and Country B have different definitions of taxable income (as countries often do), then a question arises as to which definition prevails?

To have a consistently applied global minimum tax, all countries would need to apply the same definition of taxable income and taxes paid to determine whether a business is paying below the minimum rate. And because determining a common definition of taxable income is something the OECD has an opportunity to do, that definition should be neutral to investment decisions.

Full Expensing, revisited

What exactly does an investment-neutral tax entail? Put simply, such a tax allows businesses to immediately deduct the cost of new investments when calculating their taxable profits, an approach called “full expensing.” If a business earns $1,000 in revenue, has $900 in labor costs and costs of materials, that business will turn a $100 profit. If $90 of that profit is reinvested in the business with a purchase of new machinery or technology, then taxable profit is reduced to $10. The share of tax paid on that taxable profit would result in the effective tax rate and determine whether a business is paying above or below the minimum tax rate.

Under a full expensing approach, businesses pay taxes when profits exceed investment costs, so businesses that are planning large expansions and building new facilities need not account for the tax impact on those decisions except when profits exceed their investment costs. In economic terms, such profits are generally referred to as “excess profits” or “economic rents,” meaning they are profits above what investors might demand as a normal return on investment.

However, there are few instances of full expensing across the world. Instead of allowing businesses to immediately deduct their investment costs, most countries require businesses to deduct those costs over time according to depreciation schedules. This can mean a business may have to deduct its investment costs in small amounts over several years. The time value of money means that those costs will not be fully deducted, though. Depreciation schedules eat away at deductible costs and inflate taxable profits so that taxes fall on both economic rents and the normal return on investment and cause corporate income taxes to distort investment decisions.

Full expensing, though, avoids those distortions and some countries have adopted full expensing to promote investment. That includes policies that are available for some investments in the U.S. and Canada while other countries including Estonia, Latvia, and Georgia have designed their entire corporate tax approach around the idea and simply tax business cash flow.

Full Expensing for the World

The points about investment-neutrality are particularly important for the OECD’s work on the global minimum tax. The OECD is designing the minimum tax in the context of the diversity of country approaches on corporate taxes.

Because there is not a common, worldwide definition of taxable corporate income, the OECD’s leaked draft discusses using published financial profits as a starting point for defining corporate income for the purposes of the minimum tax. However, because financial profits can differ significantly from taxable profits, partially because of different tax treatments of investment costs, the leaked draft suggests an option to use a full expensing approach for investment expenses.

This essentially takes the concept of the minimum tax in the direction of not only a minimum rate but also a minimum base and could be a good approach with multiple benefits.

First, it would neutralize the effect the minimum tax has on new investment decisions. Investment is a key driver of global growth, and a minimum tax with a full expensing tax base could avoid creating new barriers to growth and investment.

Second, the minimum tax would become a tax on excess profits or economic rents. A business in scope of the policy would only pay the minimum tax if its profits (in excess of investment costs) are taxed below the minimum rate.

Third, full expensing for a minimum tax could create the right incentives for countries that may want to change their tax policies in response to the adoption of a minimum tax. If, for instance, a minimum tax of 10 percent is adopted with full expensing, a country that wants to align its policies with the minimum tax would have a template for a tax policy that minimizes investment distortions.

Fourth, a minimum tax with full expensing would be neutral in a way that special patent box regimes and research and development (R&D) tax subsidies are not. While a minimum tax with full expensing would be neutral toward new investments, it would likely erode the tax windfalls from patent boxes or the targeted subsidies towards R&D. Countries would still be able to offer these incentives, but if those incentives result in a low effective tax rate (after deducting investment costs), the global minimum tax would apply as a top-up tax.

Finally, a minimum tax that incorporates full expensing into its design would have an element of simplicity relative to the overall complexity of the proposal. Because countries differ on their definitions of taxable income and their treatment of investment, businesses must keep track of the multiple sets of rules and their implications for tax deductions. Full expensing would mean that businesses would not have to set up an additional tracking method for their deductible investment costs over multiple years—instead, those costs would be deducted immediately in the year they are incurred.

Putting It All Together

The design and implementation of a global minimum tax is not simple and straightforward. There are dozens of challenging issues that policymakers will need to consider, and this blog has focused on just one piece. So, when it comes to the way the minimum tax treats new investment, it seems clear that incorporating full expensing into the design would have significant benefits.

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A patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns.

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A tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.

Full expensing allows businesses to immediately deduct the full cost of certain capital investments, a pro-growth provision that alleviates a bias in the tax code. Businesses expensing the full value of capital expenditures is akin to the government directly investing in a portion of equipment or buildings purchased by businesses.

Instead of deducting the cost of capital expenses like regular business costs, the Modified Accelerated Cost Recovery System (MACRS) requires businesses to take depreciation deductions over long periods of time. Delaying, rather than immediately subtracting, reduces the value of the deductions to the business below the original cost. 

A corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.

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