Crumbs in a Blender

Vice President Hubert Humphrey once said that in politics, you should never turn your back on a crumb.

What’s true in politics is also probably true in international tax diplomacy, especially when dealing with the Organization for Economic Cooperation and Development.

The Feb. 2 “technical guidance” on the implementation of Pillar Two, the OECD’s 15% global minimum tax, dashed (for now) hopes that the organization would craft an exemption for the U.S. and its current minimum tax regime, or special protections for U.S. tax benefits such as the research and development credit. It didn’t even address many of the green energy credits included in the Inflation Reduction Act, despite promises from the Biden administration that they would be covered. That probably will be dealt with, but companies will have to wait for more guidance as their anxiety continues to rise.

But this month’s guidance did clarify that the U.S. 10.5% tax on global intangible low-taxed income, the min tax that partially inspired Pillar Two, will count as a “blended controlled foreign corporation” regime. This means that GILTI taxes will count as foreign taxes for the U.S. companies that pay them–potentially reducing the amount of low-taxed income they hold in foreign jurisdictions, for the calculation of whether they’re above or below the 15% minimum.

In some situations, this could help U.S. companies avoid or reduce the punitive tax in Pillar Two’s design. In other situations, GILTI allocation may not be necessary, so long as the other countries are following the OECD recommendations.

But that still leaves the potential for U.S. companies to get taxed by foreign jurisdictions for credits they use in the U.S. By smoothing out the issues with foreign subsidiaries of U.S. parent companies, the OECD has put all the more focus on U.S. domestic tax incentives and how they mesh with the OECD rules.

To U.S. companies, the blended CFC regime is really an ancillary issue. But it’s a few crumbs they’ll not want to ignore.

The main problem is that GILTI is too far off from the OECD model for an income inclusion rule, the central tax of Pillar Two. Both are taxes applied by a country on the low-taxed foreign income of the parent companies based in its jurisdiction. Both use a substance-based carveout based on factors like tangible assets and payroll, to target the tax on intangible income. That’s the income most likely used in tax avoidance, because it’s highly mobile and based on intangible assets like IP that are hard to price.

But GILTI is applied at a 10.5% rate, while Pillar Two is at 15%. GILTI aggregates all of a company’s foreign income, including from high-tax jurisdictions, while Pillar Two applies jurisdiction-by-jurisdiction. And their definitions of income are dramatically different, as GILTI doesn’t allow taxpayers to carry forward net operating losses or unused foreign tax credits.

To guard against countries which neglect to implement Pillar Two, either in whole or in part, the system includes a backstop rule–the UTPR, once known as the under-taxed payment rule, now often called the under-taxed profit rule. (Though its exact name is now a little unclear.) Countries can apply the UTPR on companies that have low-taxed income anywhere else.

That’s a potentially broad rule–but the catch is that the UTPR is turned off if the low-taxed jurisdiction is covered by an IIR. If everyone implements the rules, the UTPR would be like nuclear weapons: always present but never used. This would greatly simplify things.

Congress decided against the simpler route, however. By not implementing changes to GILTI, the scenarios where the UTPR would apply need to be gamed out and have hugely more significance.

Having the GILTI tax payments divided up and distributed to low-tax jurisdictions provides some relief to companies, and may end up eliminating UTPR payments in many instances. But because the taxes aren’t the same, and because GILTI has a lower rate, some residual amount of tax liability still could arise.

It would be a moot point, though, if everyone enacted a qualified domestic minimum top-up tax. (Or the QDMTT, another unwieldy acronym–one practitioner joked that it should be pronounced “Cue-dammit.”) This is a purely domestic tax that countries can enact to ensure they get Pillar Two income from entities in their jurisdiction, whether they're parent entities or subsidiaries. The QDMTT gets priority over all other Pillar Two taxes, since domestic countries normally get first dibs at taxing income in their jurisdiction.

There’s been debate about whether QDMTT is a surprise, or in keeping with the overall OECD design, but it always made some sense to me. Implicit in the idea of a minimum tax is that countries would raise their rates to avoid it. The QDMTT is essentially doing that, but adjusting to the peculiarities of the Pillar Two measurement of income. It's something they could do with or without OECD assistance, but this provides some uniformity.

At least in the case of GILTI, the blended CFC payments are not allocated to jurisdictions which have enacted the QDMTT. That’s because, hopefully, they wouldn’t need to be–since the QDMTT rate is higher than the GILTI rate, GILTI wouldn’t apply in the first place. That’s so long as Treasury allows foreign tax credits against the QDMTT, which seems reasonable. (But given the recent FTC kerfuffle, who knows.)

So QDMTTs would cover Pillar Two taxes before UTPRs even come into play, and the blended CFC rules would cover, at least in part, when a jurisdiction decides not to enact one. (That’s probably the jurisdiction where the GILTI payments are coming from, anyways.) That just leaves the purely domestic U.S. tax credits, which are still uncovered. That’s the central political stalemate, that doesn’t seem to have a solution in sight.

I wonder if, ultimately, under this regime of overlapping rules both companies and tax authorities will spend a lot of time measuring and calculating, only to find that not that much revenue has shifted, after all. Between the allocation of CFC payments and the substance-based carveout, it may well be that UTPR payments end up being relatively rare for U.S.-based taxpayers. The idea was that the UTPR would be turned off once everyone is in compliance, and things would be simplified. But that’s not how it’s working out.

Safe harbors may help ease this over time, but those are uncertain and may not be followed by everyone.

This is hardly ideal. It would be better if compliance costs for both businesses and governments were roughly proportionate to the amount of potential revenue to bring in. But, for U.S. companies, it’s better than the alternative of high administrative cost and risk and high tax liability. It’s perhaps a crumb worth savoring.

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

• Rep. Jason Smith (R-Mo.), the new House Ways and Means chairman, has a reputation of being more populist and less business-friendly than his GOP predecessors. Only elected to his post a few weeks ago, he's wasting no time to showcase his fiery personality, especially with regards to the OECD project. In a scathing letter to OECD Secretary-General Mathias Cormann, Smith claimed that the “technocrats negotiating this backroom deal in Paris have sought to attack the United States, and delegates from the Biden Administration have not stopped them.” He also claimed that the deal will disproportionately help China, I guess because they can directly subsidize their companies without using taxes at all. The letter also hints at cutting the U.S. contributions to the OECD budget–a very sensitive area for the organization, given that U.S. withdrawal would effectively shut them down. (Republican lawmakers have threatened to pull funding many times in the past, but nothing has ever come of it.) Stay tuned, and bring popcorn!
• As if that weren’t enough criticism, the OECD will also soon be holding a public consultation on the “compliance and tax certainty aspects” of Pillar Two, relating to two documents they released back in December. They also published the 100+ public comments they received on the topic from stakeholders. A common theme: the rules still need to be further simplified, and the proposed single information form is too broad, and could be used for fishing expeditions by tax authorities.
• One thing that’s frustrating about the Pillar Two debate is that there are few concrete revenue estimates, so it all seems abstract and theoretical. The Tax Foundation, a D.C. think tank, has stepped in to round up the national revenue estimates that tax authorities have published so far. It’s very helpful to get your head around the scope of the project.
• And finally, the OECD, African Tax Administration Forum and World Bank published a “VAT Digital Toolkit for Africa” this week. The 400-page document (!!) aims to assist countries looking to apply their consumption tax regimes in the online realm. Many developing countries may look to this route, feeling that the OECD Two-Pillar project didn’t address their needs, so this is definitely worth a look.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Amazing Man, introduced in Amazing Man Comics #5 in September 1939. An orphan raised by Tibetan monks to become an unstoppable warrior, Amazing Man has super strength and invulnerability, as well as the ability to transform into cloud of green mist.

Contact the author at amparkerdc@gmail.com.