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  • Writer's pictureInternational Lawyers Project

Fiscal Stabilization Clauses and Their Impact on the Implementation of Pillar 2

Updated: Nov 24, 2023

The international tax landscape is in flux. Under the proposed Pillar 2 rules created by the OECD/G20 Inclusive Framework (IF) group of countries, the members of the IF are working towards curbing tax avoidance, profit shifting, and a race to the bottom. This is to be achieved by applying a globally agreed minimum corporation tax of 15% on in-scope Multinational Entities (MNEs) and is to be implemented using model rules and their accompanying commentary.

Countries have three options when responding to Pillar 2. They may either:

  • Enact a domestic minimum tax that is either a Qualified Domestic Minimum Tax or a general domestic minimum tax that is consistent with the GloBE rules;

  • They may review tax incentives in their domestic law (whether in investment contracts or domestic legislation) so that the Effective Tax Rate of in-scope MNEs is above the minimum tax; or

  • They may opt to do nothing, where they are of the view that it is unlikely that they will be significantly impacted by the rules. If this approach is followed, then that jurisdiction would be ceding taxing rights to jurisdictions implementing the rules if its tax rules did not satisfy the GloBE minimum tax rules.

The tax incentives that are most likely to be affected by implementing Pillar 2 are tax holidays, export processing zones, withholding tax relief, reduced tax rates, additional deductions for qualifying expenses, tax deferrals, and investment allowances, among others. These incentives are often spread across different legal instruments, such as corporate income tax laws, investment promotion laws, laws governing special economic zones, bilateral investment treaties, and sector-specific laws, amongst others.

In order to comply with Pillar 2, states may opt to withdraw tax incentives. These incentives may, however, be locked in by fiscal stabilization clauses, and their withdrawal may result in breaches of those clauses.

Fiscal stabilization clauses generally operate by limiting a jurisdiction’s ability to change fiscal law as is applicable to an investor in their territory without offering compensation for the unfavourable change in the law. These clauses may exist in domestic law, investment contracts, or bilateral investment treaties (BITs). Breach of these clauses may result in arbitration under Investor-State Dispute Settlement (ISDS) rules. Given that few developed countries have agreed to stabilization provisions, this will primarily be a problem for developing countries.

ISDS Arbitration

Tax-related measures are increasingly being challenged in ISDS arbitration cases. At present, at least 15% of the ISDS cases challenge tax-related measures. Arbitration tax cases may involve violations of stabilization clauses and/or violations of the fair and equitable treatment and expropriation provisions contained in BITs.

Violation of a stabilization provision – Jurisdictions may seek to satisfy Pillar 2 by reducing or eliminating the tax incentives they have previously granted to a MNE. The MNE may then argue in an ISDS arbitration case that this action is a violation of their contractual right to the tax incentives given to them and, as such, violates the stabilization provision covering the incentives. As part of this argument, they will seek damages for the loss of the tax incentive in an amount equal to the additional amount of taxes they are being required to pay or for a restoration of the incentives.

Violation of a BIT – The Fair and Equitable Treatment (FET) standard and the Expropriation standard contained in most BITs pose high risks. This is because the FET standard is far-reaching when it comes to the withdrawal of stabilized incentives. The standard will usually apply irrespective of a country’s change in tax policy for legitimate reasons. These clauses have been invoked in approximately 83% of all ISDS arbitration. The types of actions brought under this standard include the withdrawal of incentives, amongst others. This is because investors can argue that they have legitimate expectations that incentives in investment contracts will not be withdrawn. In addition, the standard gives a broad-based right to foreign entities because there is no clear-cut definition of what is “fair” and what is “equitable.”

The Expropriation standard also poses a risk when considering the withdrawal of tax incentives. Expropriation can either be direct or indirect. Direct expropriation involves the outright removal of MNEs from operating in a state’s jurisdiction. These cases are fairly straightforward. Indirect expropriation in tax matters, on the other hand, arises where the application of a tax law is so punitive as to indirectly compel a taxpayer to leave the host jurisdiction. There will usually be a finding of indirect expropriation where a tax is deemed to be “confiscatory” i.e. the tax measure substantially deprives the investor of the value of their investment. The indirect expropriation standard is the second most relied upon standard after cases involving FET and poses a medium-level risk to the withdrawal of tax incentives. This is because it would be necessary for the taxpayer to show that the change in policy was punitive and arbitrary. Given that there is no clear-cut definition of permissible and non-permissible tax measures, countries withdrawing their tax incentives face the risk of being challenged on this ground. Examples of expropriation standards being successfully relied upon in ISDS include measures such as the withdrawal of tax-free status, withdrawal of exemptions, and withdrawal of tax benefits such as those relating to special economic zones, among others.

The potential solutions for minimising risk when implementing Pillar 2

The first solution would be to argue that the withdrawal of tax incentives pursuant to the GloBE rules is based on a change in public policy and/or interest. The case may be made that the OECD/G20, together with the members of the Inclusive Framework, has created a new international norm that would allow for derogation from obligations under fiscal stabilization clauses in BITs.

The absence of an express public policy exemption in arbitral cases makes it difficult for states to rely on it in ISDS claims. Although the public interest exemption expressly exists in the New York Convention and the United Nations Commission on International Trade (UNCITRAL) Model Law on Commercial Arbitration, it would be difficult to claim that these set a precedent in all arbitral claims irrespective of whether there is an express public interest exemption.

There may, however, be some support for the reliance on this exception. For example, the OECD commentary to the OECD Guiding Principles on Durable Extractive Industry Contracts has indicated that anti-avoidance measures that aim at protecting the tax base against erosion and profit shifting do not amount to a breach of stabilization clauses. Given that this is yet to be tested, it would be advisable for the renegotiation of BITs to include a public interest exemption.

A second solution would be the requirement for members of the InIF to give their broad-based support for the withdrawal of incentives by agreeing that such measures would not conflict with their obligations under investment treaties. In addition, they should commit to a statement that the adoption of GloBE rules is not arbitrary and/or contrary to public policy and, as such, is not in breach of international law.

Another solution would be the use of carve-outs against the application of the above clauses to taxation matters. These carve-outs may apply by restricting access to investor-state arbitration on tax matters. This may, however, require the renegotiation of investment treaties already in force.

It should be noted that there are reform processes that are ongoing pursuant to UNCTAD’s policy research, intergovernmental process, and toolkits. In addition, UNCTAD has also launched IIA Reform Accelerator to speed up the reform of unbalanced provisions prevalent in the existing stock of IIAs. Developing countries should take advantage of these reform processes to ensure a consistent approach to tax matters in BITs by the suitable use of carve-outs and exceptions.


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