Was the UTPR Necessary?

As the Organization for Economic Cooperation and Development’s Pillar Two global minimum tax agreement comes under more and more fire, the UTPR is increasingly the primary sticking point.

The UTPR–sometimes the under-taxed profits rule, sometimes just UTPR–is the OECD’s recommended law, already being implemented in many jurisdictions, which can apply to U.S. companies on their U.S. incomes. Republicans in the House of Representatives last month unveiled legislation to enact retaliatory taxes on companies or investors from jurisdictions which use the UTPR against American companies. It continues to be harshly scrutinized by major think tanks and tax experts.

All of this controversy raises the question–was the UTPR necessary? Could the new OECD system have worked without the rule at all, or with one that was substantially simpler and narrower?

Hypotheticals and hindsight are never very useful. The rules are here, countries are already implementing them, and everyone’s going to have to deal with them as they are, not how they could be. But still, to consider how we got here, and where we can go, is perhaps an interesting thought experiment.

The primary Pillar Two rule is the income inclusion rule, that countries enact on their own companies, those that are based in their jurisdiction. The idea is that it is a tool for them, to use if those companies are employing tax havens and mobile intangible income to avoid tax liability. The IIR is a relatively simple controlled foreign corporation rule to target that income and bring it home.

The UTPR is meant to be a “backstop” to the IIR, according to the OECD’s commentary. Because Pillar Two doesn’t have a multilateral treaty for enforcement–that would have been a whole other can of worms–there needed to be some way to deal with countries that choose not to participate. Otherwise, those jurisdictions could become enticing destinations for companies to invert or otherwise move their parent companies to.

The UTPR achieves this by authorizing countries to tax entities in their jurisdiction if they’re part of a group that has low-taxed income anywhere else. The UTPR picks up the difference between that low-taxed amount and what it would get with a 15% rate–the “top-up tax.” They can either achieve this by denying the local entity a deduction–more in keeping with anti-abuse rules already in use–or by just levying a tax. In the latter case, this means the tax is applied locally, but on unconnected foreign income, a major upheaval of current global tax practices. It also can significantly affect tax incentives that countries enact to spur various domestic activities, vexing notions of national sovereignty.

It’s probably true that some kind of backstop rule was necessary to hold Pillar Two together. But did it need to be as broad and all-encompassing as the UTPR, opening an avenue for countries to tax the U.S. income of U.S.-parented companies?

It reminds me a bit of the design challenges with the Tax Cuts and Jobs Act, enacted by a Republican Congress in 2017. The law exempted most foreign income from taxation, but included anti-base erosion measures in tandem to avoid an outflow of taxable income. (Democrats claim they failed in this regard, but that’s another debate.) The law includes the 10.5% tax on global intangible low-taxed income, GILTI, that was a partial inspiration for Pillar Two. Like Pillar Two’s income inclusion rule, GILTI applies to low-taxed foreign income of U.S.-parented corporate groups.

But they also enacted another rule, the base erosion and anti-abuse tax. I can’t claim insider knowledge of all of the behind-the-scenes back-and-forth that led to these dual measures, but it seems clear that the BEAT was included, at least in part, to avoid putting all of the enforcement pressure on American companies.

That’s a constant tension in international tax policy, between residence and source-based taxation. There’s an attractive simplicity to residence-based measures–a country can theoretically tax all of the income of its own taxpayers, no matter where they try to hide it. The catch–there’s always a catch–is that residence-based, worldwide taxation redirects all of the pressure from tax competition to a company’s residence, an increasingly arbitrary and artificial distinction. A company can escape the tax regime altogether if it can change its residence, and measures to block them from doing so can ultimately hinder real cross-border business. This is why most tax systems end up being a mix of both residence and source-based measures.

But even if BEAT was meant to primarily capture foreign-based multinationals by targeting income-shifting through outbound related-party payments, it became much broader. It applied to both U.S. and foreign-based companies, even though such outbound payments aren’t a major source of income-shifting by American companies. (That income would get swept up by Subpart F, among other safeguards.) A maze of formulas, calculations, and unfortunate cliff effects, BEAT became a cumbersome and difficult regime for everyone. It could be the least popular international tax policy in the U.S.--until the UTPR came along.

This is an example of how easily these types of rules can grow and evolve into different beasts than the policymakers initially envisioned.

Likewise, if inversions and other forms of expatriations were the primary concern, the OECD probably could have designed a much narrower and limited rule for the UTPR. It could have created a more outfacing anti-abuse system that stayed focused on truly substance-free tax havens, without getting into determinations about the various tax incentives and benefits of home countries.

But principles never survive fully intact when they run into practicality and politics. For whatever reason, UTPR became much broader. Some of this was surely due to implementation challenges–a simple denial of deduction rule wouldn’t have covered all companies in all situations, and satisfying all participants likely forced designers to consider something bigger.

And the focus spread from clear-cut examples of tax avoidance and base erosion, to other disparities in taxation–tax competition, differences in tax regimes and tax rates. The target became not just expatriations, but any situation where a country gains an advantage by setting taxation below the 15% threshold, even for its own companies.

Not to sound like a broken record on this point, but the mission creep from targeting purely intangible income, to the loftier goal of “ending the race to the bottom,” gave the project new, more far-reaching implications.

It’s not clear that all of the participants fully considered them, before the implementation gears began moving.

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 House GOP released a package of tax bills Friday to extend some provisions of the Tax Cuts and Jobs Act, which are either set to expire or have expired already. Strictly speaking this isn’t international, but the rules have significant international implications–most prominently the limitation on interest deductions in Section 163(j). Partially based on OECD recommendations, 163(j) limits the amount that companies can claim for deductions on business interest to 30% of the company’s EBITDA–earnings before interest, taxes, depreciation and amortization. But in 2022 that limit tightened to 30% of EBIT, not including depreciation or amortization. The 163(j) rules have been credited with TCJA defenders for cracking down on inversions, which are often enabled by excessive intercompany debt. There’s been a significant push at Congress to return to the looser standard, but so far lawmakers haven’t found a way to do it–we’ll see if this changes.
• As I’ve stated many times, the exchange of taxpayer data between countries has been revolutionary for hunting down tax evasion. If a wealthy taxpayer hopes to hide money from the IRS, or any major tax authority, he faces an exponentially larger number of financial tripwires than would have existed 10 years ago. But there’s some concern that poorer countries aren’t sharing equally in the revenue benefits of this. The OECD released guidance on securing taxpayer confidentiality and data privacy for developing countries on Friday, part of an overall initiative to help those jurisdictions participate in global exchanges.
• President Biden announced last Friday his pick for IRS chief counsel, former agency and EY official Marjorie Rollinson. Chief counsel is one of two political appointments at the IRS (along with the commissioner), and plays a key role in policymaking for the U.S. Treasury Department as a whole. Rollinson was previously associate chief counsel for international and has a long history of work in global taxes. At least, this pick shows how important these issues are for the agency and department.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Captain K.O., whose first and only appearance was on the cover of K.O. Komics #1 in 1945. Who was he, what were his superpowers, and how did he get them? What's the deal with the cape or the winged hat? We'll never know. (Apparently even the title "Captain" was added by fans after publication.)

Contact the author at amparkerdc@gmail.com.