The Pillar Two/Foreign Tax Credit Continuous Feedback Loop

This is the year when the Organization for Economic Cooperation and Development’s 15% global minimum tax–also known as Pillar Two–goes from theoretical to very real.

Countries around the world have enacted or are working to pass legislation to implement the guidelines produced from the agreement. So far, only the income inclusion rule–the primary tax that countries will impose on their own taxpayers’ foreign income, similar to a controlled foreign corporation regime–will actually be in effect, as other parts of the framework have been delayed.

But the rubber is definitely hitting the road. Up until now, discussions about this have had a conceptual quality, like most policy debates. Now, as countries are translating these concepts into their own unique tax language and inserting them into massive tax codes, a new degree of practical questions and problems are likely to come to light.

In the U.S., there’s already an early example of this in recent regulatory guidance from the Department of the Treasury. Notice 2023-80, released in December, outlines some preliminary indications for how it plans to treat Pillar Two taxes imposed foreign countries, for application of the foreign tax credit. Tax practitioners are already raising concerns that it goes beyond statutory authority and could lead to double taxation in some instances.

Meshing the often byzantine and arcane U.S. tax code with this expansive, brand-new global tax regime is going to be a bumpy ride–especially as Congress is unlikely to provide any help.

The foreign tax credit is an age-old concept–to prevent double taxation, companies can claim it on income that has already been taxed by a foreign jurisdictions. In the old days of the income tax, it was pretty cut-and-dried. (Well, relatively.) But as countries have rolled out new, novel tax concepts, whether companies can claim credits has turned into a major, recurring question.

This is especially true regarding the OECD's Pillar Two plan. The December notice included several different pressing concerns about the foreign tax credit, including delaying a controversial new regime for determining when a tax counts as a creditable income tax. But primarily, the new proposed rules address Pillar Two, one of the first times that Treasury has begun to tweak its rules to accommodate this new system.

The department has yet to weigh in on one of the biggest questions, whether the “under-taxed profits rule”–which could apply to the domestic income of U.S. companies in many situations–will be creditable. (Though few expect it to be.) But it does look into whether U.S. companies taxed by Pillar Two’s primary rule, the income inclusion rule, can claim a credit. Turns out, in most cases they can’t.

This is the rule that, in theory, will be the primary deterrent against the use of tax havens once Pillar Two is fully in gear. Countries are encouraged to enact the IIR, which would then tax the low-taxed foreign income of companies headquartered in their jurisdictions. It works similar to a controlled foreign corporation rules like Subpart F and the tax on global intangible low-taxed income (GILTI), which also target certain kinds of income held in foreign subsidiaries.

They’re so similar, in fact, that they could overlap.

When the IIR targets companies based in a particular jurisdiction, that includes both parent companies as well as those which are both subsidiaries of a larger foreign corporation and parent to other subsidiaries in the overall group. For instance, many U.S. companies have regional headquarters which control lower-tier subsidiaries in nearby countries.

In cases where the ultimate parent country applies its own IIR, secondary IIRs won’t be much of an issue. But for those based in jurisdictions which haven’t enacted an IIR–like the United States–other IIRs can still apply in those regional parent organizations.

Because it seems unnecessary to apply Pillar Two to situations where another rule like Subpart F or GILTI is already doing the job, the OECD agreed to take those taxes into account with a “push-down rule” that includes those taxes in the effective tax rate calculation of foreign jurisdiction.

To give an example, a U.S. company might have an offshore shell subsidiary somewhere, which only collects income from all of the company’s non-U.S. operations. Below it are several regional headquarters subsidiaries which themselves also collect income from other lower subsidiaries in the chain.

If the shell subsidiary’s jurisdiction enacts the IIR, it may see that the regional headquarters have low-taxed income and apply the rule. But those regional headquarters may be paying GILTI back to the U.S. directly, skipping the shell entirely. The OECD requires that the IIR take those GILTI taxes into account, counting it as taxes paid for the effective tax rate for the regional subsidiaries. This ultimately reduces how much IIR tax is due. (But not entirely eliminating it, because GILTI is only 10.5%, less than 15%. GILTI also has to be spread out between all the jurisdictions where it’s collected, but let’s just forget that part for a bit.)

That all makes sense–but it gets more confusing once the foreign tax credit is added to the mix. If the U.S. company takes a U.S. foreign tax credit for that IIR payment, the IIR also takes that into account. Now the GILTI tax is lower and the IIR payment is higher. Which means that the U.S. company can now take another credit, which is also taken into account–and there’s a seemingly infinite loop of credits and adjustments.

Treasury addressed this with a Solomon-esque baby-splitting determination–while the IIR is a creditable foreign income tax, the credit is disallowed in this case. This will be a guiding principle for all of the Pillar Two taxes, which the notice terms “final top-up taxes.”

To be specific, the notice says that no credit can be granted “if, under the foreign tax law, any amount of United States federal income tax liability of the [taxpayer] would be taken into account in computing the final top-up tax.”

This would seem to follow the OECD’s Pillar Two commentary, which suggests that foreign tax credits should not be granted on IIR payments.

If Treasury is right, taxpayers wouldn't be any better off if the credit were to be granted. Nevertheless, the notice has already provoked some criticisms among practitioners. In particular, skeptics claim that this goes beyond the department’s statutory authority, no matter how justifiable it is as policy.

“It seems clear that Treasury and the IRS want to follow the direction of the drafters of the Commentary on the Pillar Two Model Rules and deny foreign tax credits for IIR taxes,” an analysis from Baker & McKenzie LLP stated. “But Congress has yet to tackle Pillar Two in a way that can allow Treasury and the IRS to do so.”

Treasury officials say that the regulations are in keeping with the original intent of the foreign tax credit, to only be used in instances of double taxation, and are a response to the IIR’s “novel” nature.

Congress could step in to fix this, but this could be a long ways off. Any tweaks to current law to accommodate Pillar Two–even if it’s just to deal with situations like these–could be seen as implementing the policy, something Republicans are steadfastly opposed to. (Democrats have taken a similar stance on TCJA fixes–”it’s your mess, you deal with it” is the basic idea.)

It’s not clear to me that this will be a major snag in Pillar Two implementation–especially if no taxpayers are seriously damaged financially by the disallowance. But it’s yet another example of how complicated these rules can be in practice. Who knows what unforeseen implications of Treasury’s new principles could lie beyond the horizon?

And so long as the U.S. is out of compliance, there’s likely a limit on the rest of the OECD’s patience with maneuvering around Congressional inaction.

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

• Australia on Monday released a new public consultation draft of its groundbreaking and controversial plan for public country-by-country reporting of large multinational corporations. It scaled back a bit from earlier versions--including to conform with OECD's own confidential CBC reporting scheme--but the basic idea is still largely intact. The system will require countries to report income taxes paid, employee headcount, profit or loss, tangible assets, related and unrelated party revenue, and an explanation should the effective tax rate diverge from the statutory tax rate. This will be for "specified jurisdictions," which the Treasury has already outlined– the list reads like a "greylist" of countries that are or used to be considered havens, and doesn't include any in the European Union. (Or the U.S., for that matter). Treasury is soliciting comments through March 5, and the legislation is scheduled to take effect for reporting periods that begin after July 1.
• The U.S., Austria, France, Italy, Spain, and the United Kingdom released a joint statement Thursday to extend an agreement to hold off on digital services taxes through June 30, when the OECD is supposed to finalize language on a multilateral convention to implement Pillar One, its alternative to DSTs. It's not obvious to me that this will have much of an effect, since these countries are all part of the larger DST pause announced at the OECD. It does at least show that these jurisdictions are still hoping for a resolution. Canada, which has already moved ahead with its planned DST legislation, isn't in the announcement.
• The United Nations Conference on Trade and Development issued Tuesday a report on "Double taxation treaties and their implications for investment." This is technically a separate entity from the one that is pursuing a new tax convention to compete with the OECD's, but it still seems part of the UN's overall push to become more involved in taxes.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Jet Powers, first appearing in Jet #1 in 1950. With no secret identity or apparent super-powers, Jet Powers is something even more formidable than a superhero--a government contractor. An inventor with military technology who answers to the President, Powers works out of his laboratory in the Southwest. Yet another character from the mind of mad genius Gardner Fox, creator of the DC Multiverse.

Contact the author at amparkerdc@gmail.com.