The OECD, UTPR, and the Fine Art of Working Around Rules

The Organization for Economic Cooperation and Development recently released an update on its evaluation of potential harmful tax regimes–national tax benefits which could violate the organization’s standards. The report was perhaps more interesting for what it omitted than what it contained. The release detailed improvements by some of the usual suspects for tax haven practices, such as Bermuda, the Caymans, and Cape Verde. But there was no update on another country under an ongoing review: the United States, and its special tax rate for foreign-derived intangible income.

It’s unclear if the OECD will ever finish the review of FDII, which was enacted in 2017 as part of the Tax Cuts and Jobs Act. The tax is still listed as an Intellectual Property Regime under review, but the OECD notes that it is “in the process of being repealed.” There’s virtually no chance the new Congress will enact that repeal, but the OECD has not yet changed its designation.

In theory, this review could result in tax consequences from countries like Germany, which deny deductions or other tax benefits based on OECD determinations. But this never seemed like a huge deal in the overall tax landscape, especially since the OECD doesn’t have hard enforcement powers like the World Trade Organization.

But it does lead to an interesting question–if the organization can overlook technical non-compliance in this area, could it do the same in the far trickier and more consequential Pillar Two (the 15% global minimum tax) system? Could this be the key for moving the project forward with the U.S. still in the tent?

The Forum on Harmful Tax Practices' jurisdiction is ultimately about patent boxes–the tech tax benefit which swept through Europe from the 1970s well into the 21st century, as tax competition heightened to a fever pitch. At its simplest, patent boxes are a pure beggar-thy-neighbor scheme. Ostensibly a tax incentive for research and development, patent boxes invite multinational companies to register their IP in a certain jurisdiction to get a special, low tax rate. (The patent’s profits are “boxed” in with the low rate, hence the term.)

The country with the patent box gets to tax the income, albeit at a low rate, plus any ancillary or knock-on effects it spurs. But some other country is missing out. This created a lot of friction and animosity within the continent, climaxing with a threatened trade war between Germany and the United Kingdom, over the latter’s generous 10% patent box regime.

They ultimately came to an agreement, that the patent box should be tied to actual R&D activity in the U.K. This became the basis for an OECD standard, part of the 2015 Base Erosion and Profit Shifting project. Sometimes called the modified nexus standard, it requires a certain amount of R&D activity to justify a preferential rate on patent boxes. By now, all patent box regimes have either been modified to meet the standard, or abolished altogether.

Now, at the time the U.S. didn’t have a patent box. (It had, and still has, a R&D credit, which is different because it’s based on the amount of spending, not the amount of profit.) In 2017, Congress passed the TCJA, which included a two-sided anti-abuse rule meant to disincentivize profit-shifting based on intangible assets (like patents.) The tax on global intangible low-taxed income was the stick, a 10.5% levy on offshore intangible income. The carrot was a 13.125% tax on similar domestic income, called foreign-derived intangible income. That’s meant to balance out GILTI and make sure that it didn’t encourage offshoring. In both cases, the tax doesn’t target intangibles directly, but uses a proxy formula based on the amount of depreciable, tangible assets.

FDII (often pronounced “Fiddy,” like 50 Cent) looks a lot like a patent box. It’s cordoned off from the overall 21% corporate tax rate. But it includes no requirement for domestic R&D activity. Actually, it’s the opposite–the more tangible assets held onshore, the lower the tax benefit will be, because of how the FDII formula works. (Technically, it’s not a patent box regime at all, because it doesn’t actually grant benefits for patents or IP. But the OECD standard covers regimes that target IP in effect, not directly.)

So it was just a matter of time before the OECD looked into whether FDII was harmful. The FHTP is apparently waiting for the U.S. to take legislative action on FDII--but who knows how long it could wait.

Now, it would seem to be technically true that FDII violates the modified nexus rule. But whether this is something that the OECD ought to concern itself with is another matter. Perhaps it's both questionable and politically dicey to grant such favorable tax treatment to profitable tech companies, just for staying put and keeping their IP at home. But that's not "harmful," according to the OECD.

FDII only applies to U.S. companies, which almost always do have significant domestic operations. Sometimes, that’s where all of their R&D happens. The scenario where the OECD harmful tax rules would come into play would be a European company setting up a U.S. subsidiary to collect royalties from non-U.S. sales. Or a U.S. holding company purchasing some new European patent and moving it onshore. Either way, it would involve shifting income into the U.S., which isn’t something you hear about often, even if there's a slightly lower tax rate. It’s kind of like breaking into prison.

But rules are rules, and other countries can be especially sensitive to any time that the U.S. seems to get special treatment. That makes it a sticky wicket, politically. But that’s normally true any time a body issues rulings on blacklists or havens.

I connect this with the U.S., Pillar Two and its UTPR rule as another time when technical rules will require some political finesse. But it’s a much more complicated and substantive situation.

The UTPR–once known as the under-taxed payments rule and now only a nebulous acronym–is supposed to be a “backstop” to Pillar Two, a way to stop countries from attracting business by refusing to comply with the plan.

At its simplest, Pillar Two is like GILTI, but worldwide. The rules call for all participating nations to enact a version of the policy, taxing their own companies when they hold low-taxed intangible income offshore.

Ideally, the UTPR should be like nuclear weapons–always present but never used. It only applies for countries that refuse to follow the Pillar Two plan, either by neglecting to implement it or using cuts or generous benefits to dip effective tax rates below the agreed-upon 15% rate. Businesses which operate in those jurisdictions could see other countries tax them based on the income that’s under-taxed.

The Biden administration released plans to repeal GILTI, FDII, and the other int’l tax rules, and replace them with Pillar Two. But they never went anywhere. Congress couldn’t even pass the Build Back Better Act, which included changes to TCJA that would bring it about halfway to the OECD model. Now that any legal changes are off the table, all the U.S. is left with is the existing TCJA regime, which has some basic resemblances to Pillar Two but is far from compliant. Thus, if the rest of the world moves ahead on this plan, U.S. companies could face new UTPR taxes everywhere they operate. That’s bad–but if the U.S. decides to respond with tariffs or some other retaliatory action, it could be worse.

The chances that GILTI will be grandfathered into Pillar Two, despite the differences, seem remote. That may have been the plan earlier. But GILTI calculates income on an aggregate basis, while Pillar Two is country-by-country, allowing taxpayers less flexibility. It’s also a 15% rate, compared to the GILTI 10.5% rate. And since it was the Biden administration that pushed the rest of the OECD to go for a higher rate, those countries will likely be unsympathetic if the U.S. pleads for an exemption.

That leaves everyone looking for as much common ground as they can find.

But I can’t help wondering, is this a real policy problem? Or is it more like the FDII kerfuffle, a “rules are rules” kind of thing?

It’s a lot more complicated than the FDII issue, for sure. The most obvious reason for the UTPR is to prevent companies from moving to a noncompliant jurisdiction. If all countries but one enact a tough new tax, that one is likely to see a lot of new business. GILTI is probably more favorable than Pillar Two–although I think that deserves more debate than its getting. But is it so much more favorable that companies would move altogether to get it? That’s much, much less likely. GILTI may be flawed, but it’s hardly popular with taxpayers.

From that perspective, the U.S. could continue as-is, with the Pillar Two system intact. Sure, some U.S. companies may be getting away with profit-shifting, through GILTI’s aggregation. But that’s really a problem for the U.S. and its taxpayers, not the world at large. By definition, this is income that would otherwise be in the U.S., if not for profit-shifting.

But as the Pillar Two project moved on, its focus and apparent mission shifted and expanded. Officials, especially in the Biden administration, said it would end the “race to the bottom” in tax competition. That recognizes the strain that profit-shifting from one country can put on others, even if they’re not technically involved. And it encompasses more activities than pure, on-paper profit-shifting. Tax competition and the race to the bottom also include incentives for real, brick-and-mortar investment. The purpose of Pillar Two and the UTPR, according to OECD commentary released earlier this year, is to ensure that companies “pay a minimum level of tax on their profits in excess of a routine return in the jurisdictions in which they operate.” The UTPR also expanded to include a broader swath of companies and income.

Rather than target profit-shifting, narrowly defined, its purpose now seems to be to ensure a universal floor to income. (For the most part–I’ve written a lot about how the blurring of goals for the project has led to sometimes fuzzy or contradictory policies.)

Under that rubric, the lack of U.S. participation is a bigger problem. GILTI isn’t so enticing to convince companies to invert into the U.S. But one could argue that its lack of a higher rate and more lax rules give U.S. companies an economic advantage over foreign ones in the Pillar Two regime. That is potentially problematic to the goal of equalizing taxation and preventing economic distortions due to national tax differences.

Or maybe not. In the real world, this incongruity will exist alongside countless other factors and considerations. It could be like a whisper in a windstorm. In that context, it seems like a small, fine point to let hamstring the whole project.

The U.S. is in a unique position on the global stage, which makes comparisons to any other nation difficult. And we just do things our own way–always have, always will.

But ever since the World Wars we’ve also been heavily invested in globalism and multilateralism, which necessarily requires cooperation and compromise. To lead the world, you have to join it. This is a basic contradiction in America’s approach that will likely always cause problems and require some creative solutions.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• After some endless and well-televised jockeying around the Speakership, a new Republican House of Representatives is finally sworn in. And Rep. Jason Smith, R-Mo., is the new chairman of the powerful, tax-writing House Ways and Means Committee. (At my first internship in D.C., in 2001 with McClatchy Newspapers, one of the first things I learned was that the Ways and Means Committee always comes with "powerful" before it.) Smith beat odds-on favorite Rep. Vern Buchanan, R-Fla., for the spot, and has a firebrand populist streak that could define how he uses the chairmanship. For instance, in his statement following the appointment, he said he would use the committee to examine whether to keep "continue showering tax benefits on corporations that have shed their American identity in favor of a relationship with China." What that means for tax policy, I don't know, but it's definitely eye-grabbing.
• One key criticism of Pillar Two, the U.S. corporate alternative minimum tax, and any tax system which uses financial accounting as a base is that it gives the accounting standards bodies too much power. U.S. Generally Accepted Accounting Principles are set by the Financial Accounting Standards Board, which is much less transparent and accountable than government bodies. The global FASB counterpart, the International Accounting Standards Board, took the first step in implementing Pillar Two this month, issuing an "exposure draft" for amendments to deal with some of the issues from merging new tax rules into the financial accounting system. One key area is "deferred tax accounting," how the OECD system plans to account for timing differencs. Comments are due by March 10.
• The OECD announced Jan. 5 that Gaël Perraud, an official with the French Ministry of Economics and Finance, will be the new chair of the Committee on Fiscal Affairs, which handles tax matters. These kinds of appointments don't necessarily matter a great deal for policy, but it certainly shows that following the departure of Pascal Saint-Amans as director of tax policy and administration, France hasn't lost its pull in the Paris-based organization.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Black Bull, who first appeared in Prize Comics Western #71 in 1948. Son of a wealthy cattle baron, Dale Darcy dons a mask and horns to battle criminals and fight for justice in the "early days of the American southwest."

Contact the author at amparkerdc@gmail.com.