Under P2, a top-up tax (‘TT’) is imposed on low-taxed excess profits of group entities located in a country to the extent that the effective tax rate for P2 purposes (‘ETR’) in that country is below 15%. This means that a TT can also be imposed with respect to US group entities if their ETR in the US is less than 15%. This could be caused by the fact that they benefit in the US from the Foreign Derived Intangible Income (‘FDII’) regime for their IP-related income or that they benefit from tax credits in the US, such as the research and experimentation (R&E) tax credit and/or the renewable energy tax credits as introduced in the recent Inflation Reduction Act. The treatment of these US tax credits under P2 is important.
For P2 purposes, a distinction has to be made between, amongst others, a (i) qualified refundable tax credit (‘QRTC‘) and a (ii) non-qualified refundable tax credit (‘NQRTC’). A QRTC is a tax credit that is refundable in cash or cash equivalents within four years, whereas a NQRTC is refundable after four years. New OECD Guidance clarifies that certain transferable tax credits are treated similarly to QRTC.
QRTC and NQRTC are treated differently for P2 purposes in the ETR calculation. The ETR is determined by dividing the adjusted covered tax (‘P2 Tax’) by the income for P2 purposes (‘P2 Income’). A QRTC is treated as P2 Income, resulting in an increase in the denominator. This is generally in line with the treatment of non-tax incentives (e.g., subsidies) which are also treated as P2 Income. NQTRC decreases the amount of P2 Tax and, thus, the numerator.
A group entity has 100 of P2 Income and 15 of P2 Tax before applying a tax credit of 10.
If the tax credit qualifies as a QRTC, it will be added to the P2 Income. As a result, the P2 Income is 110 (100+10), and the P2 Tax remains 15. The ETR is equal to 15 / 110 = 13.64%. However, if the tax credit is an NQRTC, it will reduce the P2 Tax. In such a case, the P2 Income remains 100, but the P2 Tax is reduced to 5 (15-10). The ETR is equal to 5 / 100 = 5%.
The above means that a TT of (15%-13.64% =) 1.64% will be imposed if the tax credit qualifies as a QRTC and that the TT would increase to (15%-5% =) 10% if it qualifies as a NQRTC.
As illustrated by the example, a QRTC generally gives rise to a more beneficial outcome under P2. It is therefore important for US MNEs to analyze whether their tax credits qualify as QRTCs or NQRTCs to determine the ETR in the US. The new OECD guidance is helpful for US MNEs benefiting from transferable (renewable energy) tax credits, as it mentions that these may be treated similarly to QRTC.
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