The Remaining Pillar Two Headaches

Facing the prospect of increased foreign taxes under the Organization for Economic Cooperation and Development’s 15% global minimum tax, many companies have pinned their hopes on Congress finally implementing the agreement in 2025 as part of a bipartisan grand bargain.

The odds may not be great, but it’s certainly a strong possibility. If the U.S. can enact legislation to match the OECD’s global minimum tax guidelines, also known as Pillar Two–or if it gets close enough–the enforcement rule that targets companies in uncooperative jurisdictions will be turned off.

Well, almost.

Even if the U.S. implements Pillar Two, there’s still one outstanding issue that could leave U.S. companies at a disadvantage. Unless the U.S. passes a qualified domestic minimum top-up tax, which seems at this point very unlikely, the enforcement rules could still apply on the domestic income of U.S. companies.

That means that some companies which claim U.S. tax incentives such as the research and development credit could face increased taxation on their foreign subsidiaries under the undertaxed profits rule. The UTPR targets any income that’s not taxed at below the 15% rate, even if it’s income in the company’s home jurisdiction.

Ideally, the UTPR is supposed to be like nuclear weapons–always present, never used. So long as everyone else follows the rules, the UTPR is negated in all of the jurisdictions where it might be applied. It just sits there, on all the countries’ books, never collecting a dime while providing deterrence for anyone else thinking of gaining an economic edge by dropping the system.

The main goal of the Pillar Two rules is to negate any incentive to park income in low-tax jurisdictions. Countries apply the primary taxing rule, the income inclusion rule, to any low-taxed foreign income earned by its own companies–similar to how U.S. Subpart F rules work. If that IIR is in place and fully compliant, it turns off any other countries UTPR for those foreign subsidiaries.

But that still leaves the company’s parent entity, or other subsidiaries in the parent jurisdiction. The UTPR can still be applied to those entities, unless the parent jurisdiction either passes an expansive IIR that applies to all jurisdictions, or enacts a QDMTT, which would effectively do the same thing. So long as one of those two rules taxes any income that would otherwise be taxed at less than 15%, the UTPR doesn’t come into play. (The notion of it being “turned off,” rather than simply not taxing what isn’t there, mainly serves to prevent unnecessary duplicative measurements or possible cumbersome overlaps.)

If the U.S. were to enact all of these rules, it wouldn’t have to worry either. But at this point, that seems very unlikely, in 2025 or any other year. It would mean either repealing all of the Tax Cuts and Jobs Act’s international framework, or laying the Pillar Two regime on top of it. Either way, this could be a massive headache not only for the law-writers but those at Treasury tasked with rewriting the international rules once again.

More likely, if Congress were to act at all, it would make key changes to the tax on global intangible income, or GILTI, to bring it closer to the Pillar Two standard. It could raise its rate to 15%, and change it to a country-by-country system, rather than aggregating global income as it does now. (It could also allow taxpayers to use net operating losses and foreign tax credit carryforwards–the current GILTI formula is actually harsher than Pillar Two in that regard.)

Indeed, these changes were included in later versions of the Build Back Better Act, until lawmakers ultimately nixed any international changes to the bill. Had Congress passed them, the OECD may have been much likelier to agree with “grandfathering” GILTI into the system, and considering it as a valid IIR, despite the remaining incongruences.

That would solve a lot of the taxpayers’ problems. But it still could leave entities within the U.S. itself vulnerable to the UTPR.

This would all depend on the exact nature and wording of the grandfathering offered by other OECD countries. Aside from considering GILTI to be a qualified IIR, would they also consider it to cover the U.S.? Or would they perhaps consider the U.S. corporate alternative minimum tax–an entirely different policy, but with some basic similarities to Pillar Two, including a 15% rate–to be a valid QDMTT?

Perhaps. But the differences between CAMT and the QDMTT may be a bit too far a gap for the rest of the OECD to bridge. CAMT has a different measurement system, and includes many carveouts not present in Pillar Two–most importantly, one for research and development credits. Because the U.S. R&D credit is nonrefundable, the Pillar Two system considers it a direct reduction in taxes, potentially pushing a taxpayer’s effective tax rate low enough that it would owe taxes under the IIR, UTPR or QDMTT. (Apologies for the alphabet soup here.)

Even if countries find new patience for U.S. demands, I’m not sure they’d ever be comfortable letting the R&D credit off-the-hook. It’s not necessarily an example of the outright base erosion that’s supposed to be Pillar Two’s main target, but it is a significant tax benefit. If foreign countries agreed to consider CAMT to be a compliant QDMTT, it would mean that U.S. companies can fully use R&D credits without fear of the UTPR coming into play–while their own domestic credits are limited by Pillar Two. In some cases, this disparity could provide the U.S. with a clear economic edge.

True, many countries have changed their own R&D incentives to be refundable tax credits, to reduce the Pillar Two impact. (Although refundable credits still aren’t totally exempt.) Economists will say that often there is no real difference between a nonrefundable credit, a refundable credit or an outright government subsidy. But I expect most countries would be very wary of creating a potential disadvantage here.

This would also be true if the U.S. tried to push for GILTI to be considered a compliant IIR applying to the U.S. Any way you try to imagine some wiggle room for a deal, the R&D credit emerges as a stubborn sticking point. And as the CAMT exception shows, it’s a credit with strong political support–so strong that I’m not sure Congress would ever consider altering it to achieve OECD compliance. (The U.S. is also unlikely to consider making it refundable.)

It may be that, due to the Pillar Two carveouts for economic substance, the instances where R&D credits would fall under the minimum tax would be relatively limited. Perhaps companies will find that it’s something they can bear through.

If not, then this could be a economic and diplomatic tangle without a clear answer.

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.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• House Ways and Means Chairman Jason Smith, R-Mo., and Senate Finance Committee Chairman Ron Wyden, D-Ore., finally unveiled a long-anticipated but also doubted tax deal, which enhances the child tax credit and other Democratic priorities while extending several favorable corporate tax provisions from the Tax Cuts and Jobs Act. The latter includes a looser limit on business interest deductibility--that serves several functions but acts as a deterrent for crossborder earnings stripping through unnecessary intercompany debt. The agreement also includes immediate expensing for research and development costs (not to be confused with the R&D credit discussed above), which the TCJA enacted in 2017 but then sunsetted in 2021. It doesn't include foreign R&D costs, which are amortized under a 15-year schedule. That's the "grand bargain" aspect to all of this, but it also includes legislation to enact an agreement with Taiwan to prevent double taxation--what would be a tax treaty, if not for Taiwan's status as a disputed territory. That passed out of committee with unanimous bipartisan support, and tax negotiators are apparently using it as a vehicle for their more controversial provisions. The sense on Capitol Hill is that while lawmakers widely support the policies in this agreement, there's a lot of trepidation about the politics and process. House Republican leadership hasn't signed off yet, and they've got their hands full trying to keep the government open. (Funding runs out on Friday.) So this has a ways to go before it reaches the finish line.
• A consortium of human rights experts appointed by the United Nations is continuing its inquiry into alleged human rights violations within the OECD's Two-Pillar project, with a second letter sent last December. It's a bit hard to figure out how seriously to take this, and the letter is frustratingly vague about what the exact abuses are. It claims that the Pillars could deprive developing countries of urgently needed revenues, but the focus seems to be more on additional revenue they could have gotten had the agreement been more tilted towards the concerns of developing countries. While technically acting independently of the UN itself, this seems like yet another escalation in the growing rivalry between the OECD and UN on tax matters.
• The U.S. Treasury Department is quietly working on the thankless task of implementing the U.S. CAMT, with all of its complexity and incongruences. It recently issued regulations addressing a troublesome double-counting issue with foreign subsidiaries. The National Foreign Trade Council released a comment Monday with additional concerns, another reminder of how complicated this seemingly simple policy will be in practice, especially when it comes to global taxation.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Wonder Man, premiering in Wonder Comics #1 in 1939. Through a mysterious Tibetan ring, Fred Carson possesses magical powers he uses to fight for justice. Created by the legendary Will Eisner, Wonder Man would only appear once before DC Comics brought the publisher to court, successfully arguing that it was a blatant Superman knock-off. (Eisner maintained that it was actually a blatant Phantom knock-off.)

Today I'm headed out to San Francisco, where it's cloudy and rainy but at least not as frigid as it is here on the East Coast. My destination: The American Bar Association Tax Section's annual winter conference on Thursday and Friday. (This is something like my 25th ABA conference--I'm officially a regular despite not being an ABA member or lawyer.) If you're attending, don't hesitate to say hi!

Contact the author at amparkerdc@gmail.com.