Why There Won't Be a Global Min Tax Treaty

Two weeks ago, the Organization for Economic Cooperation and Development released public comments on a report outlining options for ensuring certainty in Pillar Two, the OECD’s 15% global minimum tax. There were 87 submissions, but on one issue there was remarkable consistency–dozens of stakeholders, including all of the Big Four accounting firms, companies such as Mercedes-Benz and Sodexo, as well as trade groups like the Business Roundtable and the National Foreign Trade Council, all advocate a global multilateral treaty to implement the framework.

“In order to ensure the consistent application of this common global standard, purpose-built, accessible and effective global dispute prevention and resolution mechanisms are required,” wrote Ernst & Young LLP. “We believe this requires a multilateral convention.”

A multilateral treaty “is not only appropriate but is essential for an effective and successful implementation of Pillar Two consistent with existing legal obligations under treaties,” the National Foreign Trade Council said.

PricewaterhouseCoopers LLP supported the idea as the “optimal, but harder” route to avoid disputes between participating nations.

There’s some precedent for this idea–the OECD’s 2015 Base Erosion and Profit Shifting project, a precursor to its most recent work, included a “multilateral instrument” to enact some of the new changes into existing double tax treaties. The U.S. didn’t participate, but that didn’t torpedo the idea, as it was always just an option for implementing parts of the overall package.

And this most recent document does outline a multilateral convention as an option to consider for Pillar Two, noting that it “could include tax certainty mechanisms, but also address other administration issues such as exchange of information.”

But if the public discussion among OECD and government officials is any indication, these requests might as well be on a list for Santa Claus. A multilateral convention has never been seen as a serious option for implementation of the global minimum tax. OECD officials have insisted that all of these proposals could be enacted without changes to existing tax treaties, brushing off concerns that some rules could be in violation. And the very design of the framework envisions it as self-enforcing through national laws.

If they had had treaties in mind while crafting Pillar Two, it would look very different.

Yet, it’s not hard to see why stakeholders view a binding treaty as necessary to make this policy workable. The potential for costly disputes between tax authorities, or even more dangerous trade wars, has grown exponentially. While it was never part of the original idea, the fact that tax treaties are entering the discussion demonstrates how much this project has evolved from its starting point.

It’s helpful to remember that Pillar Two was modeled on the U.S. tax on global intangible low-taxed income, which was itself an offshoot of the Subpart F tax on types of passive foreign income like royalties or interest. It’s ultimately an enhanced controlled foreign corporation regime, and those have always been a matter of national law, outside the treaty system.

Controlled foreign corporation rules are applied by a tax authority on the foreign subsidiaries of its own taxpayers. CFC regimes are the crude, blunt instruments of the tax world–and for that reason, they’re highly effective. The first was Subpart F, enacted during the Kennedy administration (a compromise from JFK’s goal of pure worldwide taxation), and they’ve since spread around the world. By directly targeting forms of passive income that are mobile and likely to be involved in tax avoidance, CFC rules sidestep the complex enforcement challenges that flummox other international tax laws.

They work parallel to double tax treaties, which have served as the backbone of the global tax system for more than a century, because of an important but very subtle distinction. Tax treaties are about the allocation of income across jurisdictions. They use transfer pricing principles, which base asset prices on what independent parties would have paid, to ensure that companies aren’t double-taxed because two tax authorities disagree on how much profit they made, and where.

Once the income is allocated, however, it’s up to each country to decide how to tax it. This is where CFCs come into play. Just because income is foreign doesn’t mean a tax authority can’t tax it. Even if the local jurisdiction has gotten its bite of the apple first. This is all up to national sovereignty. Countries can tax all of the foreign income of their companies, immediately or delayed until it returns home. They can also single out specific types of income for immediate taxation, which is what Subpart F and most CFC regimes do.

Double tax treaties prevent double taxation; CFC rules, almost by definition, create it. (Foreign tax credits are normally then used to rectify that overlap.) This is why CFC rules have always existed parallel and separate to the tax treaty system.

But (of course) there’s a wrinkle in this.

As I stated earlier, CFC rules normally capture passive income like interest, rents or royalties, as they’re the likeliest forms of income to be used in tax avoidance structures. This implies that somewhere, the treaty system has failed. If transfer pricing were perfect, the income from those royalty or interest payments would be fully recognized elsewhere, presumably in the home country’s jurisdiction. In this sense, CFC rules are less a parallel to the treaty system, but a patch to it.

The OECD’s 2015 BEPS report on CFC rules notes that they’re often considered a “backstop” to the transfer pricing rules; but it also notes that this term could be “misleading.”

“CFC rules may target the same income as transfer pricing rules in some situations, but it is unlikely that either CFC rules or transfer pricing rules in practice eliminate the need for the other set of rules,” the OECD report states. “Instead, while CFC rules may capture some income that is not captured by transfer pricing rules (and vice versa), neither set of rules fully captures the income that the other set of rules intends to capture.”

This is why I think of CFC rules as a blunt instrument–they just grab certain types of income, no questions asked. They’re not a renege on the original transfer pricing arrangement, they outright ignore it. It’s what makes them effective–but until recently, they were confined to only a few types of transactions.

Then came GILTI and the OECD’s Pillar Two. They responded to problems that Subpart F and other CFC regimes were having capturing all income associated with some arrangements. (Especially due to check-the-box.) GILTI worked on similar principles as Subpart F, but it cast a wider net, looking not at the type of transaction behind the income but attributes of the entities that earned it. It targets subsidiaries with large amounts of income relative to the value of their tangible property--meant to be a proxy for intangible income, such as profit from patents or trademarks. Those are the assets that the traditional system has difficulty pricing. Again, it’s parallel but also a patch for rules already in place.

The OECD took this concept, made some tweaks and turned it into the global minimum tax. And they also expanded it to a second rule, the “UTPR,” meant to apply in cases where a company’s parent country refuses to follow the new system. The UTPR had some precedent, including anti-abuse rules tied to outbound related-party payments in countries such as the U.S. and Germany. But it was much broader, and when they decided to disconnect it from deductions for individual payments–essentially a new extra-territorial tax–it became even more expansive.

The OECD found itself with a whole new definition of taxable income, and a system of national laws to tax it. But no new treaties to hold it in place.

Pillar Two has become very distant from the CFC rules that inspired it, and is starting to look more like an expansive, formula-based (in part) redefinition of global taxes. It’s no wonder that some are beginning to claim that new treaty arrangements will be necessary to keep it from falling apart.

Former OECD Director for Tax and Administration Pascal Saint-Amans used to joke that if countries don’t follow the organization’s rules, they could call in the U.S. Army to enforce them.

Of course, they can’t–the OECD has always worked by consensus, and the soft power of optional rules and standards. Aside from suggesting language that countries can use for binding tax treaties, the OECD sets optional policies that countries can either enact or ignore. The main reason most countries choose to enact is that they want to participate in the global economy and its rules; they also face potential retaliatory measures from other countries they do business with.

Can that type of soft law work to keep in line a new taxing system, filled with fine distinctions that can swing billions of revenue and the potential for disputes that could set off trade wars? We’ll find out soon enough.

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

• The Supreme Court ruled in favor of the taxpayer in Bittner v. United States, a closely watched case involving Foreign Bank and Financial Accounts Reports (FBAR), part of the new framework for international tax and financial reporting that has revolutionized global anti-tax evasion enforcement. The court ruled that in cases of non-willful violation, the government can only apply $10,000 in penalties for each report that wasn't correctly filed--not each account that should have been reported. Alexandru Bittner, a dual Romanian-American citizen, had been fined $2.72 million for filing failures between 2007 and 2011. I won't pretend to understand all of the nuances in this case, but at first blush it looks like the government now has a slightly higher standard to prove when it drops the hammer on non-filers.
• The OECD provided the G-20 Finance Ministers an update on the Two-Pillar negotiations for G-20 meeting of finance ministers and central bank governors in India last week. No news, exactly, but the report paints a rosy picture, touting that "the Global minimum tax is now becoming a reality" and noting that the treatment of GILTI has finally been dealt with. (For now.) Since it was the G-20 that set this project off in the first place, these official statements are always heavily scrutinized.
• Missouri Rep. Jason Smith, the new Republican Ways & Means chairman (who's spooking K Street with his Trump-like rhetoric), unveiled an "Oversight Plan" for the 118th Congress, outlining where he expects the committee to focus its investigatory powers. The committee approved the plan, strictly down party lines, during a Tuesday hearing. This is a routine statutory requirement, but Dems claimed that Smith broke tradition by using it to spout partisan talking points. The plan does include "International Tax Negotiations"--which Smith called an "unconstitutional global tax deal" in his opening statement--among the priorities, but I was surprised to see how far down on the list it was, well below higher-profile issues like the $80 billion boost in IRS funding. Nevertheless, expect to see this issue raised in hearings with Treasury officials during the next two years.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Bulletman, who first appeared in Nickel Comics #1 in 1940. A police chemist who invented a drug giving himself super-strength and super-intelligence, and also invented a bullet-like helmet that allowed him to defy gravity. He uses these abilities to fight crime with his girlfriend, who became Bulletgirl, as well as their dog, Bulletdog. (The publisher, Fawcett Publications, basically invented superhero families with Captain Marvel, who premiered a year earlier.) Bulletman briefly became a DC character after they acquired Fawcett--the legal wrangling over Capt. Marvel is fascinating, BTW--but they let him lapse into the public domain. DC's loss.

Contact the author at amparkerdc@gmail.com.