At a Loss

Several jurisdictions have enacted, or will soon enact, legislation to implement Pillar Two, the 15% global minimum tax designed by the Organization for Economic Cooperation and Development and agreed to at the G-20.

This follows years of debate about the major design elements–the tax base, the enforcement rule (UTPR) and tax credits are just a few. To say those debates were concluded would be wildly optimistic–but the legislation is moving ahead regardless.

Now we’re at the stage where smaller issues with the tax’s design are bound to come forward. No policy this big advances without a multitude of glitches, and Pillar Two could either elicit its fair share, or so many that they slowly devour it.

One of those could be the question of loss years–especially how to incorporate loss-making entities with profitable ones in the same corporate group. The technical guidance, issued in February, noted a potential problem with “loss-making parent entities of [controlled foreign corporations],” where domestic rules on how to forward unused foreign tax credits could collide with the Pillar Two framework.

It may be a problem with a relatively easy fix--or not. But it demonstrates how complex the implementation of the global minimum tax agreement will be when it meets reality and a near-infinite number of specific situations its designers never considered.

Controlled foreign corporation rules, such as Subpart F in the U.S., immediately repatriate certain categories of foreign income. Royalties and interest, for instance, are immediately pulled back to the parent country and taxed, on the theory that they’re especially mobile and often used in tax avoidance structures. Rather than come up with some special new tax to deal with them, CFC rules just tax it along with the domestic income as if they were both the same, after foreign tax credits are applied.

Sometimes, though, there isn’t domestic income at all. If a company has a loss in its domestic entity, but still pulls home some overseas CFC income, it creates a befuddling situation. Typically the foreign income will offset the domestic loss–if a company lost $50 at home but earned $50 abroad, it washes out to zero. No taxes are owed, and there’s no loss to carry forward.

The problem is that this still leaves the company with foreign tax credits, and no tax to use them against. (And even if there were profits at home, the rules prohibit using foreign tax credits on domestic income.) In a sense, the income gets taxed twice–once by the foreign jurisdiction, and again in the U.S. as the CFC income negates what would have been a valuable net operating loss to use in future years. The value of the foreign tax credits evaporates.

Most jurisdictions have a remedy for this. In the U.S., the Overall Domestic Loss regime allows those tax credits to be used against domestic income in the future.

But, as you might have guessed, the OECD Pillar Two–which operates much like a CFC rule–doesn’t have such protections. Or rather, it didn’t until the administrative guidance was released. The section includes a lengthy addition to the rules outlining the “The Substitute Loss Carry-forward [Deferred Tax Asset], which tweaks the existing rules on “temporal differences” to ensure that companies in this situation aren’t disadvantaged.

At least, that’s the idea. In a commentary on the guidance, Ernst & Young LLP said it was “helpful, but complex, relief.”

Danielle Rolfes, a principal at KPMG LLP and former U.S. Treasury Department official, who worked on an earlier anti-tax avoidance project at the OECD, called it “the beginning of a solution.”

“It needs work,” she said in a recent KPMG podcast.

But, at least the OECD isn’t alone here. Rolfes also noted that the new 15% corporate alternative minimum tax, enacted by last year’s Inflation Reduction Act, has the same problem. Much like Pillar Two, CAMT is a global tax which only applies when a company pays less than 15% in taxes, based on a different tax base. (Except CAMT is truly worldwide, while P2 only applies to jurisdictions that are foreign to the one implementing it.)

The situation with CAMT adds insult to injury, though–not only does the company in this situation lose out on foreign tax credits to apply to CAMT taxes, but when it uses those credits in the future against normal income tax, it could reduce its effective tax rate enough to subject it to CAMT again.

Treasury may end up fixing this with its broad authority to smooth out the CAMT base, although it’s yet another area where it may be forced to make policy decisions instead of merely technical tweaks.

For those who’ve been following these debates for a while, it’s turning into a recurring theme–minimum taxes and other anti-avoidance regimes don’t like losses. They have a tendency to scramble the formula and create distortions.

Losses were a problem with Pillar One, the new global taxing mechanism meant to capture digital transactions. And they are especially a problem for the tax on global intangible low-taxed income, part of the international framework of the 2017 Tax Cuts and Jobs Act.

GILTI was partially the model for Pillar Two, and both operate in similar ways. But GILTI’s formula for calculating low-taxed foreign income doesn’t include any of the provisions which are usually available to loss-making companies to help absorb their bad years. It doesn’t allow for net operating losses, or carryforwards of unused foreign tax credits. Each year is essentially a snapshot, disregarding what came before or what comes after.

This was less a specific design choice than a product of political economy–while desperate to keep the TCJA’s cost in line, lawmakers found that this was the path of least resistance. As you might guess, profitable companies have more sway in Congress than unprofitable ones do. Almost all multinational companies became painfully aware of this issue a few years later, when the COVID pandemic caused some drastic swings in profitability.

Some of the proposals to tighten GILTI by raising the rate and having it apply per-country also would have allowed for NOLs and FTC carryforwards as a kind of tradeoff. But those proposals didn’t end up making it into law, at least for now.

At the design phase and in political rhetoric, it’s easy to imagine that all of these companies are just endlessly profitable. But in reality, many of the companies we think of as successful aren’t necessarily always in the black. Many explicitly choose to prioritize investments and growth over strict bottom-line returns. Others are just in industries that are naturally cyclical or unpredictable. This is one reason I think that simple effective tax rate calculations—”X companies paid no income tax!”--can be misleading. But these issues can also flummox tax administrators at the ground level, as we’re seeing.

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.

For my American subscribers, Tax Day is just around the corner. Have you paid your income tax today? If you need inspiration, watch Donald Duck learn about the patriotic duty to file taxes, in an ad sponsored by the U.S. Treasury Department during World War II, as the income tax spread to cover most citizens instead of the richest few.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• U.S. Secretary of the Treasury Janet Yellen spent the past few days at the 2023 Spring Meetings of the World Bank and the International Monetary Fund, where most of the discussion centered on the perlpexing state of the global economy. But the Group of 24, a counterpart to the G-7 and G-20 representing developing countries, used the opportunity to continue to push for the United Nations plan to take a larger role in international tax matters. In their IMF Communique, they praised the "welcome reform principles" of the OECD agreement, but said the U.N. could address "urgent issues that have so far been excluded from the OECD workstream." There isn't much here that wasn't also in their official comment to the U.N. proposal, but this campaign to keep the issue in the spotlight is interesting.
• Microcaptives and reinsurance are issues that I've never been able to wrap my head around. I just know that they're important, and that the Internal Revenue Service has claimed they can be manipulated for tax avoidance and evasion. The agency released new proposed rules on the issue this week, that fine-tune which transactions are considered part of this group. For those unaware, these are insurance contracts that a corporate group takes out for itself, so they fall under the transfer pricing regime for intercompany payments. The IRS Large Business and International division has targeted some microcaptive structures in a campaign for the past several years.
• The International Accounting Standards Board finalized a plan to grant "temporary relief" to companies trying to account for tax liabilities in financial statements amid the new Pillar Two rules. This mostly has to do with deferred tax accounting--how Pillar Two accounts for companies with timing differences between financial statements and actual tax payments. IASB also enacted a new rule which it said will help investors better understand companies' exposure to Pillar Two tax liability.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Rainboy Boy, appearing in Reg'lar Fellers Heroic Comics #14. With apparently unexplained rainbow-related powers, Jay Walton fights crime along with Hydroman. His powers only work in sunlight--presumably, he needs all of the colors of the spectrum to perform his magic.

Contact the author at amparkerdc@gmail.com.