World Investment Report 2022: International tax reforms and sustainable investment

This year’s World Investment Report (WIR) is the 32d edition of UNCTAD’s flagship publication. The WIR informs academics, policymakers, and business decision-makers on global trends and pertinent thematic issues pertaining to foreign direct investment (FDI) globally, multinational enterprises’ (MNEs) cross-border activities, and national and international investment policies. The report has typically considered the intricate interaction between FDI and economic development, and increasingly focuses on the Sustainable Development Goals (SDGs), MNEs’ sustainable strategies, and responsible investment.

This year, the report comprises four chapters: it begins with recurring chapters on Global Investment Trends and Prospects (Chapter 1) and Recent Policy Developments (Chapter 2). The thematic chapter (Chapter 3) presents an analysis on international tax reforms. This is a thought-provoking chapter amidst a global effort to introduce a global minimum tax on FDI that could result in increased revenue collection benefits for governments in developed and developing countries by reducing both the scope for tax avoidance and tax competition. The report ends with a chapter on Capital Markets and Sustainable Finance (Chapter 4). Regional trends (for Africa, Developing Asia, LLDCs – Landlocked Developing Countries, LAC – Latin America and the Caribbean, LDCs – Least Developed Countries, and SIDS – Small Islands Developing States) are published separately with overviews available on UNCTAD’s webpage. This review will first present Chapters 1, 2, and 4, before discussing Chapter 3 in more detail.

Following a sharp decrease related to the COVID-19 pandemic, Chapter 1 shows FDI flows recovered in 2021 reaching $1.58 trillion. Developed countries experienced the sharpest recovery, M&As boomed, MNEs boasted record profit levels, and international project finance grew rapidly due to loose financing and major infrastructure stimulus packages. UNCTAD warns the recovery is unlikely to be sustained in 2022, due to rising geo-political uncertainties, threats of renewed pandemic impacts, and unfavorable macro-economic factors (e.g., the likelihood of more interest rate rises in major economies, negative sentiment in financial markets, and signs of looming recession).

Developed countries have regained momentum, and FDI to developing countries continued its upward trend (an increase of 30% in 2021 to reach $837 billion – the highest level ever recorded). However, global FDI is still highly concentrated in a few locations. For instance, FDI flows to developing Asia account for 40% of global FDI inflows and increased by 19% in 2021, yet with just six countries accounting for nearly four-fifths of the flows (p. 13). The increase by 70% in international investment in sectors relevant for the SDGs is a positive trend for developing countries (p. 26). Investment in renewable energy and energy-efficiency projects boosts climate change-related investments, and international project finance increased thanks to favorable financing conditions, infrastructure stimulus, and appetite by financial market investors to participate in large-scale projects that necessitate multiple financiers. However, investment in the SDG sectors going to Least Developed Countries (LDCs) has declined sharply in 2021. In fact, FDI inflows to the structurally weak, vulnerable, and small economies (e.g., LDCs, LLDCs, and SIDS) accounted for only 2.5% of the world total in 2021 (p. 16). As such, a critical challenge for the international community will be to involve less developed economies in global investment and trade to ensure they can achieve the SDGs.

Chapter 2 presents recent changes in national and international investment policies. Amongst new investment policy measures, a key trend resides in the rise in tighter regulation of investment, including an increase in M&A controls (see Table II.1 on p. 63 of the report for an illustrative list of M&As withdrawn for national security reasons, competition or other regulatory reasons). Developing countries tend to adopt measures to liberalize, promote or facilitate investment, such as investment facilitation measures, the opening of new activities to FDI, or the introduction of new investment incentives. Focusing on this year’s topic for the thematic chapter, the report presents a useful analysis of global trends about tax regimes at the country level. Countries that adopted investment measures related to taxation mostly lowered taxes, introduced new tax incentives, or made existing incentives more generous. The most frequently used fiscal incentives are profit based, and the majority of new tax-based investment incentives over the past decade were introduced in developing countries (pp. 79–80). In a climate of geo-political uncertainty, including the war in Ukraine and tensions between the USA and China, numerous governments have recently introduced sanctions and countersanctions affecting FDI. Thus, looking ahead, tighter regulations may continue their upward trend.

Chapter 4 is dedicated to sustainable finance and efforts by various stakeholders involved in the investment value chain (e.g., institutional investors, issuers, market intermediaries and companies, as well as regulators and stock exchanges). UNCTAD reports that despite a welcomed rise (+ 63% in 2021, p. 164) in sustainability-themed investment products such as sustainable funds, green bonds, social bonds, mixed-sustainability bonds, and sustainability-linked bonds, there are numerous shortcomings. For instance, the sustainable fund market represents just 4% of the total global fund market (p. 166), and questions remain about the sustainable credentials of some funds. Funds mostly are concentrated in and for developed countries; institutional investors do not necessarily disclose or report on sustainability issues (p. 175), nor do they reorient portfolios fast enough; there are concerns over greenwashing (p. 188); and financial markets are slow in the integration of sustainability disclosure. At the country level, governments continue to develop regulatory frameworks for sustainable finance. At the company level, mandatory environmental, social and governance (ESG) reporting is rising, supported by both exchanges and securities market regulators. There is progress, but it seems imperative to speed up efforts to ensure capital markets work better for sustainable and inclusive development, and for investors, governments, and international organizations to remain focused on the financing, regulation, and promotion of the SDGs.

The remainder of this review will focus on this year’s main thematic chapter, Chapter 3, which discusses the impact of a global minimum tax on FDI. In 2020, the members of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS), corresponding now to 141 countries (representing more than 95% of global GDP), agreed to work on a two-pillar approach to tackle tax avoidance. Pillar I focuses on the allocation of taxing rights among jurisdictions to address the challenges arising from the digitalization of the economy. Pillar II, which is the focus of this chapter, proposes a global minimum tax of 15% on the profits of MNEs to discourage firms from shifting profits to lower-tax jurisdictions. It is expected to apply to MNEs, which are resident (ultimate parent entity) of the Inclusive Framework members, with revenues of €750 million or more (accounting for two-thirds of total FDI), on their income arising in each of the jurisdictions in which they operate. More specifically, this tax reform consists of having a top-up tax, which will bring the overall tax on the profits exceeding a certain amount called a carve-out, up to 15%. This carve-out, which can be seen as an indicator of the real activities of a firm in a country, reduces the tax base to which the top-up tax rate applies. It is calculated as specified percentages (declining over time) of tangible assets and payroll figures. In other words, it is only the excess profit (accounting profit less the carve-out) that will be taxed at a minimum of 15%, the carve-out will be taxed at an effective tax rate (ETR), which can be lower than 15%. This key feature of Pillar II is actually preserving, to some extent, the possibility for countries to compete over real investment.

UNCTAD expects the introduction of a global minimum tax rate to lead to fundamental changes to the international tax architecture, affecting profit-shifting, the location and volume of FDI, the revenues collected by governments as well as tax competition and policies to attract MNEs.

The increase in the tax liabilities faced by MNEs is estimated to reach 14% globally with the adoption of a global minimum tax rate, leading to a decrease of FDI of about 2% when a partial reduction of profit shifting is expected and in the presence of a carve-out (pp. 128–129). This decline can be compensated by the reduction in tax uncertainty brought by the tax reform, which provides uniform rules across countries. If it reduces the incentive to compete over corporate tax rates (since a floor is set), Pillar II will indirectly encourage other forms of non-tax competition to attract investments, over the quality of infrastructure for instance. However, with a global narrowing of tax rate differentials, a re-allocation of FDI can be expected, with some countries becoming more attractive than others, namely, the ones with higher corporate tax rates, since they are not impacted by the minimum tax rate.

The report indicates that developing countries are expected to gain the most from the change in the distribution of FDI, first because they tend to have a higher ETR than developed countries (less than a third of developing countries have an ETR below 15%; p. 114), second because the Offshore Financial Centres (OFCs), by losing their tax advantage, will be less attractive. Africa and Asia should experience the largest gains with an increase of FDI of 2.4 and 1.7%, respectively (pp. 129–130).

Regarding government revenues, Chapter 3 indicates that their global increase will come from two sources – the rise in taxes paid by MNEs subject to top-up taxes, and the decrease in profit shifting. With the top-up tax applying to income generated in OFCs, the incentive to shift profit should decrease. This increase in revenues ranges between 15 and 20% globally (pp. 125–126). How this additional revenue is allocated between countries is of paramount importance for the countries involved in the adoption of Pillar II. The top-up tax can be received either by the home country (through the application of the Income Inclusion Rule – IIR) or the host country (through the application of the qualified domestic minimum top-up tax (QDMTT)). Even with the assumption of the adoption of the QDMTT regimes by host countries, developing countries will gain less revenue (about half less) than developed countries with the implementation of the global minimum tax rate (p. 126). The difference in the revenue collected comes from the fact that developed countries should experience a higher increase in taxes paid by MNEs as their FDI-level ETR (which reflects the average taxes paid by MNEs on their entire FDI income, therefore including shifted profits) should rise by 2.7 percentage points as compared to the 1.9 percentage points rise for developing countries (p. 119).

The adoption of Pillar II will have tax policy implications since tax incentives leading to an ETR below 15% will be nullified by the top-up tax for large firms having a profit exceeding the carve-out. Incentives outside this scope will remain unaffected. UNCTAD experts expect the competition for investment to take other forms. It could be via a change in the tax structure with lower taxes on payroll and value added, via tax competition over tangible investment with favorable tax measures regarding accelerated depreciation, loss carry-forward (made possible by the carve-out) or improving the business climate via public spending.

The report is insightful and leads us to propose some suggestions for future research. First, this report suggests that two-thirds of developing countries will be better off with the adoption of Pillar II in terms of FDI attractiveness (their ETR being above 15%) and that apart from OFCs, there is no country in which tax payments are likely to fall as a consequence of Pillar II. However, this analysis considers national average tax rates with the drawback that they do not account for the fact that MNEs may face lower rates, as tax incentives are not granted uniformly across firms located in the same country. Indeed, the allocation of tax holidays, which are frequently used in developing countries (see Chapter 2 in the Report, and World Bank (2018), varies with the nature of the investment project (see for instance the Thailand Board of Investment (2021), which presents their various investment promotion criteria) and with its geographical location (see for instance the Chapter IV of WIR 2019 (UNCTAD, 2019) on Special Economic Zones which shows how widely used they are across most developing countries and many developed countries). Therefore, future research might explore how countries with an average ETR above 15% but providing tax exemptions to certain firms will be impacted by the minimum tax rate.

Second, since Pillar II will narrow tax rate differentials between countries, it is imperative to consider the reasons why they exist to anticipate the effects of the reform on FDI. The tax competition literature demonstrates that smaller countries set lower corporate tax rates to remain attractive when they are located near countries with a large market or economic agglomeration (Azémar et al., 2020; Baldwin & Krugman, 2004; Haufler & Wooton, 1999). Therefore, by compressing worldwide ETRs into a smaller range, it will be more difficult for some countries to maintain their attractiveness, as the tax differential with their neighbors might not be large enough to compensate for the weaknesses of their business environment. On this point, international business research could provide useful insights by investigating the effect of the new global tax system on firms’ locational strategies (Foss et al., 2019) building further bridges between international economics and international business (Beugelsdijk, 2022). For instance, firms might be better off relocating to larger and developed countries and serve neighboring countries via exports, though this effect could be mitigated if larger countries increase their corporate tax rate. This outcome is possible, as the floor imposed by Pillar II will alleviate the downward pressures on tax rates produced by tax competition.

Third, the adoption of Pillar II implies two important challenges for host countries: to review the way they promote investment and to implement the tax reform. This points to the need for more research on the impact of policy changes on MNEs’ activities and the implementation of policy changes – the focus of the Journal of International Business Policy. Indeed, a change in policy is inevitable since tax holidays and exemptions will substantially lose their attractiveness. Competition for investment might take the form of subsidies and public spending to improve the infrastructure and ideally also health and education. This would reinforce the long-term attractiveness of host countries, but also benefit every firm, domestic and foreign. Nevertheless, as compared to tax incentives which do not require direct use of government funds and can make a notable positive change in the short run, developing countries might find themselves at a disadvantage because of the substantial costs incurred to provide subsidies and to improve the economic fundamentals that influence the location of FDI. Regarding the second challenge, as emphasized in the subsection “implementation issues” of the report, the implementation of Pillar II is ambitious and complex, especially for developing countries which have lower capacities, and which have developed for decades their investment policy around tax incentives and the preservation of these incentives via the inclusion of a tax sparing¹ provision in many bilateral tax treaties.

To conclude, the adoption of a global minimum tax is a major achievement and a radical change to the international tax system, which has the potential to bring considerable benefits to governments by increasing their revenues. Globally, as emphasized by Eden (2020), the complex assessment of the economic impact of this reform deserves additional analyses and data transparency to not rely on a “leap of faith” with the implementation of Pillar II. More specifically, to make sure that this reform benefits developing countries, the report highlights that it will be crucial to provide “international support and technical assistance” (p. 155) to them both for the implementation of this complex reform and for the development of suitable policies to promote investment under the new regulations. One recommendation that we can add is that Pillar II should consider options which will allow smaller or less developed countries not to be penalized in terms of attractiveness by the potential compression of ETRs into a narrower range.

Notes

1. When a tax sparing provision is included in a Bilateral Tax Treaty, it allows the firm located in the host country to obtain at home a foreign tax credit for taxes that have been “spared” abroad. Therefore, tax sparing ensures that fiscal incentives granted to foreign investors by host countries are not cancelled by income taxation in the home country.