The Stock and Substance of the OECD Min Tax

Last month’s administrative guidance from the Organization for Economic Cooperation and Development on its 15% global minimum tax–otherwise known as Pillar Two–got the most attention for new language on tax credits and a safe harbor that effectively delays some of its new taxes for countries whose corporate rates are in the average range, like the U.S.

But the document touched on more than that, including what I think may be a crucial and under-discussed topic, the substance-based income exclusion.

My focus on the substance-based carveout may have more to do with how my brain works, than a strictly logical view of the proposal. To understand policies, I always need to understand the thinking behind them–what is this supposed to accomplish, and how does it go about accomplishing it? The carveout, an exemption on payroll and tangible assets, is supposed to be what distinguishes clear base erosion and tax avoidance from genuine government support for economic development. That issue, in a nutshell, is behind most of the controversies engulfing the OECD project.

So while everyone has focused on the exact definitions of tax credits and whether they’ll cover popular incentives, it may be that the details behind the substance-based carveout will ultimately determine how much and how often taxpayers will be impacted.

One interesting issue that the recent guidance weighs in on is stock-based compensation and how it will be factored into the measurement of the carveout. This is a bit ironic for followers of U.S. tax policy, as the recent corporate alternative minimum tax will likely fall disproportionately on companies that use stock options or other equity compensation. The tax exempted almost everything else.

Whereas, stock-based compensation can create favorable, or at least fair, treatment for the OECD tax, both for the carveout and for its basic measurement of income. While the latest guidance does limit that treatment a bit, it still confirms that stock-based compensation will be fully recognized in the system, which may be crucial for recent startups taking advantage of research and development credits, green energy credits, or other lucrative incentives, but have little in physical assets.

For a brief review, the OECD minimum tax kicks in for corporate entities paying less than 15% in taxes in a given jurisdiction. The company’s headquarter jurisdiction will tax whatever the gap is immediately through Pillar Two’s primary taxing mechanism, and if it doesn't the other jurisdictions where the multinational company is present will tax its subsidiaries. To simplify measurement of a single, universal income standard, the 15% calculation is based on financial accounting information, through recognized standards such as U.S. Generally Accepted Accounting Principles or International Financial Reporting Standards.

The financial treatment of stock-based compensation, and the disparity with how deductions for it are granted in the tax code, has always been a tricky concept. (Stock-based compensation wasn’t even recognized as a cost in financial accounting until a few decades ago, over the screaming protests of the companies using them.) There’s a timing difference between book income and tax, as the deductions aren’t recognized until the stock options are exercised, whereas they appear in financial statements as soon as they’re granted.

But that’s not as significant as the disparities in the size of the stock options as measured as a financial cost, and as they are measured for a deduction in taxable income. The deduction is based on the value of the stock at that moment, but financial accounting uses an estimate, since at that earlier point the value is only theoretical. And those estimates usually turn out to be under-estimates, so long as the stock value continues to rise. (Which, on average, it does.) For this reason, stock options have been reported as one of the most significant factors leading to low effective tax rates for huge multinationals in public filings.

This apparently favorable treatment for stock-based compensation has been controversial in the U.S.–Sen. John McCain used to rail against it–so it’s not surprising that last year’s CAMT didn’t include an exemption for it, even as it exempted accelerated depreciation, green energy credits and credits for R&D. The OECD plan, however, does include the option for companies to record options at the more generous tax rate, if the jurisdiction where they’re recognized grants deductions for them.

An OECD “blueprint” for Pillar Two from 2020 notes that “tax policy tends to treat the issue of stock-based compensation as an expense of the company and as income of the option holder,” whereas financial accounting rules “focus on the economic position of the reporting entity, where changes to the ownership of the entity are reflected in adjustments in respect of earnings per share.” And since the stock options count as taxable income for the recipient, the government still gets to collect taxes on it, and the underlying income isn’t double-counted.

As it happens, the OECD tax doesn’t include similar adjustments for R&D credits–Pillar Two and CAMT almost fit together like awkward jigsaw puzzle pieces.

That’s for the income measurement. Once that’s completed, there’s an additional adjustment, a carveout equal to 5% of depreciable tangible assets and 5% of payroll. This is similar to the 10% exemption for qualified business asset investment (QBAI) adjustment for the U.S. global intangible low-taxed income, and they have similar purposes. By taking out a profit return on physical attributes, the tax is supposed to focus on intangible income, such as income from valuable intellectual property, that is often involved in tax avoidance structures.

Much of the public discussion has focused on ways that GILTI is more favorable to taxpayers than Pillar Two, which is why the U.S. is now considered out of compliance. But the inclusion of payroll as a factor in the substance carveout is one of a few reasons why Pillar Two can potentially be more favorable, in some circumstances.

The definition of payroll used by the OECD is broad enough to include stock-based compensation, as well as pension and health insurance benefits and even payroll taxes. It can also include expenditures for contractors as well as employees. But July’s guidance clarifies that it can’t include the adjustment for tax-based measurement that companies can use for the underlying income calculation.

There’s no explanation given for why, but it makes sense given that the substance carveout is supposed to be relatively simple, and is an admittedly imperfect way to measure intangible income. There’s no need to get into the weedsy details for basic rules of thumb.

Other issues the July guidance weighs in on include “interjurisdictional” employees (all the more important in the work-from-home world), leased property as well as simplification measures. Factors like these could end up being very important for U.S. companies hoping to skirt potential taxation under the under-taxed profit rule (UTPR), which only kicks in if the U.S. entity is paying less than 15% in taxes after the substance-based carveout is included.

Until we have harder numbers to calculate where most taxpayers are likely to be, this all seems a bit theoretical. But whether or not it will be seen as a solution to some of the stickier Pillar Two issues will likely depend on both the details of how the carveout is measured, as well as the balance with simplification measures and safe harbors for companies to use. If companies can escape the UTPR, but spend an inordinate amount of time calculating and measuring their operations, unsure of whether they’re in or out until it’s completed, it may be a cure worse than the disease.

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 South Centre, a think tank focused on the needs of developing nations, which recently advised some caution regarding the OECD minimum tax, issued another policy brief last week expressing even further skepticism of the qualified domestic minimum top-up tax, another key part of Pillar Two. The QDMTT will allow countries to pick up the low-taxed income in their jurisdictions before the parent jurisdictions can under Pillar Two, but six experts from various tax advocacy groups claim its complexity and lack of clear enforcement mechanisms could make it a problematic policy for developing countries. The brief offers alternative minimum taxes–somewhat like the QDMTT but with some design differences–as well as reforms to tax incentives as alternatives. While many of these organizations have been against the OECD project from Day One, there does seem to be growing momentum against it in the developing world, even from countries which endorsed it and joined the agreement back in 2021.
• The OECD announced Wednesday that Tunisia had deposited its “instrument of ratification” for the multilateral convention to implement parts of the previous OECD project, the 2015 Action Plan for Base Erosion and Profit Shifting. This includes provisions like rules against “treaty-shopping” and dispute mechanisms. This isn’t really big news, but we’re deep into the summer lull period and I don’t have much else–not even a third item. Enjoy the rest of August!

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Nature Boy, first appearing in Nature Boy #3 in March 1956. David Crandall was a wealthy heir who nearly drowned at sea before being rescued by the gods, who gifted him with their powers--water, wind, fire, Earth and even "love." He uses these to battle crime as "Nature Boy." Yet another bizarre character from Jerry Siegel in his post-Superman years.

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