A Path Forward for the OECD?

For tax wonks, Monday was something like Christmas in July. The Organization for Economic Cooperation and Development uncorked a geyser of new guidance and commentary for its global tax project--the “Two-Pillar Solution”--timed to coincide with the organization’s progress report to the G-20.

The two most important items–at least from the U.S. perspective–from new administrative guidance both provide a bit of relief for companies worried they might be targeted by the under-taxed profits rule, the backstop enforcement tax for the 15% global minimum tax. Clarifications to the definitions of tax credits, in particular non-refundable but transferable credits, could protect some of the new green energy credits enacted by Congress last year in the Inflation Reduction Act, that could have been diluted by the OECD plan. And a transitional “safe harbor” will likely delay application of the UTPR for U.S. companies until 2026, giving both them and Congress some breathing room.

But companies may want to check the fine print before celebrating. For the transferable credits in particular, the favorable treatment may not apply in all cases. The guidance distinguishes between “marketable” and “nonmarketable” transferable credits, and also includes a slew of conditions and caveats. Most IRA credits can only be sold once, so the party buying the credit will likely be hit harder by the Pillar Two tax. (If it applies to them.)

The UTPR safe harbor and the new transferable credit definitions actually make an interesting contrast. The new credit guidance runs for 52 paragraphs and 15 pages, including charts and tables, and it outlines yet another complex new framework to apply ever-more finely tuned distinctions and special conditions. It may ultimately help many taxpayers, but these narrowly applied fixes never seem to quite hit their target. Likely, taxpayers will continue to be wary of being hit by the UTPR, despite these new protections.

The section on the transitional UTPR safe harbor, on the other hand, is a scant two pages and seven paragraphs. It won’t be simple–nothing ever is in this sphere–but it’s likely to be much smoother than the other issues tackled by the guidance. It only lasts for two years, however, far too short to give companies the long-term assurances they need.

Nevertheless, I think that the UTPR safe harbor–largely because it’s cruder and simpler than the tax credit fine-tuning–could ultimately be the more important new policy. It shines a light on a potential way forward for the project, to use rough rules-of-thumb to smooth over the small but stubborn incongruities that have threatened to hamstring the whole thing.

That would require some political dexterity, though–and some clarity about the ultimate goal of the global minimum tax, and the OECD project in general.

The global minimum tax works by having a single, universal measurement of income as well as taxation. It’s based on financial accounting data, which isn’t supposed to be used for tax purposes but was close enough to a global taxable income standard, with some tweaks. The tax kicks in when corporate income, under this measurement, is taxed below 15%. If that income is earned by a subsidiary, the corporation’s parent jurisdiction taxes the difference through the income inclusion rule. The IIR works like a controlled foreign corporation rule, such as the U.S. tax on global intangible income or its Subpart F regime. In the cases where the parent jurisdiction declines to do so, however, other jurisdictions where that corporation is present pick up the difference through the UTPR. Originally conceived as a denial-of-deduction regime, UTPR ended up a much broader tax, allowing countries to tax income outside of their jurisdiction in a way that flouts previous global tax norms.

While the Biden Administration planned to enact changes to the U.S. tax code to conform with Pillar Two, (or at least be close enough that some kind of handshake deal could be made), the failure to pass Build Back Better left the U.S. clearly out of compliance.

Before then, the UTPR seemed sort of theoretical, a way to deal with some tax haven scofflaw that refuses to participate in the new system despite OECD pressure. But for countries like the U.S. which won’t move ahead with Pillar Two legislation, the UTPR “effectively operates as the primary mechanism” for imposing the minimum tax, the OECD notes in its new guidance. Other countries’ UTPRs could apply even on the purely domestic income of U.S. multinationals. This made the exact way that Pillar Two considers domestic tax credits much more important than previously thought.

The OECD already came up with tweaks to deal with tax credits for low-income housing. To protect green energy credits, U.S. officials began pushing for the OECD to consider transferability as the same as refundability, which would mean lighter treatment under Pillar Two. Refundable credits are treated as almost the same as a government subsidy–they increase the taxpayers’ income, reducing its effective tax rate somewhat. But the change is not as dramatic as with a nonrefundable credit, which reduces the company’s amount of taxes paid outright, tilting the effective tax rate calculation much further.

As I wrote earlier, the question of whether transferability and refundability should be seen as the same is hardly clear-cut. Just like refundability, transferability allows a credit to be immediately monetized, regardless of whether the taxpayer has taxable income to pair it against. But unlike a refundable credit, that monetization isn’t guaranteed by the government–it relies on another party to agree to the transaction. And the amount isn’t guaranteed either, as the price of the transfer is whatever the two parties agree to.

The OECD’s latest guidance considers all of these issues, and lays out how they all affect the taxability of the credit under the Pillar Two regime. As I noted earlier, it’s a complex process that’s likely to be even more headache-inducing for domestic manufacturers who aren’t used to dealing with the intricacies of global taxes.

The UTPR transitional safe harbor, on the other hand, could be much simpler to apply. It only covers when a corporation’s ultimate parent entity is located in a jurisdiction that has a headline tax rate of 20% or higher. The OECD never explains why it picked 20%, although one might guess the U.S. rate of 21% had something to do with it. For the transitional period–lasting through fiscal years that begin after Dec. 31, 2025 and end before Dec. 31, 2026–the amount of UTPR to be collected from that ultimate parent entity is reduced to zero.

This ensures that during the transition period, countries won’t be able to levy UTPR taxes on the domestic income of U.S. companies, regardless of that income’s effective tax rate. (They could still levy it on foreign subsidiaries of U.S. companies, but that will probably be rarer as most jurisdictions enact the Pillar Two rules.) This gives everyone some breathing room, and perhaps gives Congress some time to work up a fix. In 2025, much of the Tax Cuts and Jobs Act will expire, and the parties will likely need to forge a grand bargain to extend the politically favored portions. Time will tell.

Even if Congress fails to act, I wonder if this safe harbor can’t be the basis for a permanent path forward. It can’t be extended outright as it is–that would be inviting countries to drop Pillar Two implementation plans and enact 20% tax rates with generous workarounds.

However, this isn’t the only safe harbor under consideration. The OECD has also highlighted plans for several similar protections, including for a safe harbor based on the country-by-country reports that companies must already submit to tax authorities. Those include information such as earnings, taxes paid, workforce and facilities, broken down by jurisdiction. These also happen to be the basic building blocks of Pillar Two, including the “substance-based income exclusion,” based on payroll and tangible assets, that’s meant to distinguish between intangible income (often involved in tax avoidance) and income from real activities.

A 20% headline rate, on its own, isn’t enough to guarantee compliance with Pillar Two–but perhaps a 20% headline rate, a certain amount of workforce and several years of appropriate tax payments in the jurisdiction may be?

That would likely leave out some companies, but that’s the nature of safe harbors. They’re not meant to be perfect–they’re an option for taxpayers to protect against further audits and enforcement, if they hit benchmarks the government deems to be adequate. As the global tax system becomes more and more intricate, safe harbors have also risen in prominence as a way to soften the hard edges and corners. (I’ve called it the “rough justice, soft application” approach.)

It’s a cornerstone of Australia’s “zoned” approach to audit risk, in which taxpayers can predict their risk of audit by reporting certain profit margins for different offshore activities. (This isn’t technically a safe harbor, since the tax authority can still audit if it finds something suspicious–but it’s an assurance they’ll face a higher bar for enforcement action, perhaps an option which the OECD could consider.)

What this gets at is that many of these situations with the UTPR are, depending on how one looks at it, arguably technicalities. Companies claiming IRA green energy credits or research and development credits in the U.S. likely have considerable workforce there, and probably aren’t involved in profit-shifting into the jurisdiction. There may be cases where the UTPR nevertheless applies, but it’s more often going to be single years with odd profit swings than the result of long-term tax planning.

If the goal of Pillar Two is truly to capture mobile income from intangible assets (like patents) used in profit-shifting, then it’s in everyone’s interest to find a way to move past those types of situations. If the goal is broader–to “end the race to the bottom,” as the Biden Administration has often put it, and stem tax competition over real activities as well as on-paper income, then that’s a different, harder discussion. (Although it’s still arguable whether the U.S. could realistically “win” that race, even with its generous R&D and green energy credits–we’re still firmly in the middle of the pack when it comes to effective tax rates, according to the OECD.)

As I said earlier, some clarity on the OECD goals could help it find the way forward. But are all of the sides willing to find it?

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

• I’ve only really scratched the surface of the OECD’s releases this week so far–there was also more guidance on the informational return for Pillar Two that companies will submit to countries under the system. And there’s a new report on the subject-to-tax-rule, sort of the UTPR codified into a tax treaty. (Don’t forget last week’s “Outcome Statement” on Pillar One, either.) Perhaps most interesting, though, is a planned consultation on Amount B of Pillar One, which aims to ease the burden on poorer countries’ tax enforcement by coming up with set prices for certain “baseline” distribution and marketing activities–possibly through, once again, safe harbors. While Pillar One as a whole faces an unclear future, many think Amount B could survive as a standalone project that’s especially important to the developing world, struggling with the complexity of international tax enforcement.
• If the OECD expected Monday’s release to mollify the political firestorm around the OECD agreement, their hopes were quickly dashed. Republicans fired off a dismissive statement within hours, and the House Ways and Means Tax Subcommittee is still planning a hearing on the agreement (“Biden’s Global Tax Surrender Harms American Workers and Our Economy”) Wednesday at 2 p.m. EST. Michael Plowgian, deputy assistant Treasury secretary for international tax affairs, will be testifying before the committee, along with academics and industry group representatives. Plowgian has been a leader of Treasury’s negotiations at the OECD, so expect plenty of fireworks–here’s the livestream on Youtube. The Congressional Joint Committee on Taxation also released an analysis of the international tax situation in anticipation of the hearing; this follows up their Pillar Two revenue estimates from last month.
• As part of the “Outcome Statement” on Pillar One mentioned above, 138 jurisdictions agreed to hold off on any unilateral digital services taxes for another year, as negotiators work on creating a multilateral convention to implement a consensus solution. Canada shocked many by refusing to sign on, pushing forward with its plan to enact a DST targeting revenue from Web activities like online marketplaces and advertising. The country is already starting to get pushback on this decision–the U.S. Chamber of Commerce published an open letter Friday calling on Canada to delay its plans. What’s interesting about this standoff is that, as the Chamber notes, there are specific North American free trade agreements and mechanisms for resolving trade disputes between Mexico, Canada and the United States. So if the U.S. wants to retaliate (as it tried with European DSTs), it could play out differently. As if all of this needed another X-factor.

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