Pillar 2 and Tax incentives: Implications for the IFSC exemption

The objective of Pillar 2 is to discourage Multi-National Entity Groups (“MNE Groups”) from using Low Tax Jurisdictions solely to obtain tax benefits.

Introduction

With the Organization for Economic Cooperation and Development’s (“OECD”) Pillar 2 initiative expected to be set in motion in a couple of years, tax regulators around the world must evaluate its impact on the tax incentives provided in their respective jurisdictions. While jurisdictions with low Corporate Income Tax (“CIT”) rates primarily stand to lose out on potential tax revenue, jurisdictions that have a moderate to high CIT Rate (such as India and Singapore) could also stand to lose tax revenue on account of targeted tax incentive schemes. This article explores the interplay between Pillar 2 and targeted tax incentive schemes in general, and Pillar 2’s impact on tax incentives provided to Financial and Fin-Tech sectors in particular.

Background

The objective of Pillar 2 is to discourage Multi-National Entity Groups (“MNE Groups”) from using Low Tax Jurisdictions (“LT jurisdictions”) solely to obtain tax benefits. This is done by prescribing a global minimum CIT rate of 15%. The design of Pillar 2, however, penalizes the LT jurisdictions themselves for having an Effective Tax Rate (“ETR”) below the prescribed 15% minimum CIT rate. This is done by allocating the shortfall of tax (“Top-up Tax”) payable in such LT jurisdiction to other jurisdictions that have implemented the Pillar 2 rules in their domestic law.

In determining the Top-up Tax for a particular jurisdiction, the reason for the ETR falling below the prescribed minimum CIT rate does not matter. Consequently, Pillar 2 rules would apply in the same manner to jurisdictions which have a 0% CIT rate as they would to jurisdictions which offer targeted tax incentives that brings the taxpayer’s ETR to 0%.

Given that such a mechanism could impact targeted tax incentives that promote economic development (such as tax incentives for manufacturing activities, research and development, etc.), the Pillar 2 rules provide for a ‘Substance Based Income Exclusion’ (“SBIE”) rule. As per this rule, a prescribed percentage of the ‘eligible tangible assets’ (such as property, plant, equipment, natural resources, etc.) and ‘eligible payroll costs’ of the MNE Group in an LT jurisdiction are excluded from the Net GloBE Income while computing the Top-up Tax payable in such jurisdiction.

Implicit in the formulation of the SBIE rule is an assumption that labour and capital intensive industries add ‘substance’ to the economy, and tax incentives provided to such industries are legitimate. The OECD’s report on Pillar 2’s interplay with tax incentives cites the SBIE rule as a means to ensure that jurisdictions promoting such substance driven activities with tax incentives are not penalized and tax is paid where economic activity is being carried out. While such a carve out is necessary, one must examine whether this perspective of ‘substance driving’ activities is too narrow. The same is further discussed in the next segment.

Tax incentives for the Financial/Fin-Tech Sector

The Indian tax regime currently prescribes general CIT rates ranging from 17-40% (excluding surcharge and cess), which is well above the prescribed minimum CIT rate. The Income Tax Act, 1961 (“IT Act”), however, provides a range of specific tax benefits in order to incentivize certain forms of economic activity. While several tax benefits targeted towards manufacturing entities are provided (which come within the purview of the SBIE rule), the IT Act also provides tax benefits targeted towards the Financial/Fin-Tech sector. One such tax incentive is provided to units set up at the International Financial Services Centre (“IFSC”) located at the Gujarat International Finance Tec City (“GIFT City”). Launched in 2015, the GIFT City is a Special Economic Zone (“SEZ”) set up to help India emerge as a hub for international financial services activities. Aside from banks, investment funds, Insurance companies, and Offshore Banking Units (“OBU”) of foreign banks, Fin-Tech companies can also set up shop as a unit of the GIFT City IFSC.

The IT Act provides GIFT City units a tax holiday of 10 years with respect to business income earned by them, and a pass-through status with respect to Capital Gains earned by its beneficiaries. Such units would be subject to an Alternate Minimum Tax (“AMT”) of 9%, unless they are eligible and opt for the tax regime under section 115BAC of the IT Act.

The units set up at GIFT City would not have significant ‘eligible tangible assets’ and are not labour intensive establishments as well. As a result, the carve outs provided for under the SIBE rule would not protect tax incentives provided to these units. Consequently, MNE Groups with constituent entities established in GIFT City could potentially be liable for a Top-up Tax in India in relation to income earned by them. If India does not implement a qualified domestic Top-up Tax, other jurisdictions could derive the right to tax such income.

In the next segment, we make an argument for why the SBIE rule should also consider tax incentives provided for activities aside from labour and capital intensive businesses.

Revaluating the traditional view of ‘substance’ based economic activities

A strong financial services sector can significantly fuel a country’s economic growth, by providing employment, bettering infrastructure, creating wealth and developing business friendly policies. In this regard, a good case study would be Singapore. Over the past several decades, Singapore has developed itself as a global leader in the banking, financial services, and wealth management sectors (“Key Sectors”). These sectors continue to be a significant driver of economic growth in Singapore to date.

While several factors have contributed towards the emergence of Singapore as a leader in the Key Sectors, targeted tax incentives have also played a role in promoting the sameⁱ. Even today, Singapore’s Financial Sector Incentive (“FSI”) Scheme provides eligible banking and financial activities concessional tax rates, ranging from 5-13.5%.ⁱⁱ The concessional rates would be in force till 31 December 2023, subject to extension. For the wealth management sector, the Singapore tax regime also provides targeted tax exemptions for family offices (MAS Section 13O and 13U companies) set up in Singapore, subject to certain conditions being fulfilledⁱⁱⁱ. These tax incentives are also at the risk of being rendered otiose in light of Pillar 2.

Over the past several years, India has witnessed a rapid growth in the banking as well as the mutual fund industry. In particular, the Assets under Management (“AUM”) for India’s Mutual Fund industry stood at USD 559 billion in September 2023. There is a significant increase in the number of India’s Ultra-High Net Worth Individuals (“UHNWI”), which is expected to increase by 58.54% in the next five years.

India has also seen an exceptional rise in its Fin-Tech sector, with the Unified Payments Interface (“UPI”) project proving to be an extraordinary success. Within a span of a few years, UPI has accounted for more than 50% of the total digital transactions in India. The total value of UPI’s digital transactions amounted to 50% of India’s nominal GDP in Financial Year 2022-23. The National Payments Corporation of India (“NPCI”) is also pushing for the adoption of UPI powered apps in international markets such as Singapore, UAE, France, etc. The Fin-Tech revolution in India has contributed towards an inclusive financials sector, which has eased digital transactions and increased access to much needed credit.

Just like Singapore, India is currently a fertile ground for developing the Key Sectors. Targeted tax incentives can pave the way for India to become a global leader in these sectors, thereby unlocking India’s true economic potential. The growth of the manufacturing as well as financial services sector would together usher India to a golden age of economic growth and development.

Our Comment

As economies progress, there is a tendency for substantial economic activities to shift from the Primary and Secondary sectors (i.e., agriculture, mining, manufacturing, etc.) towards the tertiary sector (which includes financial services). While a strong manufacturing sector plays a key role in driving economic growth, one must not underplay the contribution made by the financial services sector.

While the primary and secondary sector’s impact on the economy can more easily be discerned (with the immediate rise in employment, for example), the contributions by the financial sector are much more discreet. In spite of the significant benefits that tax incentives for the financial sector can provide, the SBIE rule continues to adopt a restricted view businesses that contribute ‘substance’ to the economy.

Units in GIFT City might still fall outside the radar of Pillar 2 on account of the monetary thresholds prescribed for the application of the GloBE rules. Nevertheless, there is a need to initiate discussions regarding the value that financial services can contribute to the economic growth of developing countries as a whole. In particular, we must examine whether a similar SBIE rule can be introduced that can accommodate tax incentives provided for Financial and Fin-Tech sectors.