Can the OECD Make a Fool-Proof Pillar Two Safe Harbor?

Officially, the Organization for Economic Cooperation and Development’s Pillar Two 15% global minimum tax is live, having been enacted in many jurisdictions, and the key taxing provisions are in effect.

That comes with an asterisk, though–we’re still in the transitional period, when various forms of relief are available and taxpayers can use safe harbors to ease potential compliance headaches. In some cases these actually reduce the amount of tax due under the system, such as the increased percentage of the substance-based carveout during the early years. In other cases, the protections aim to come to the right results through simpler, back-of-the-napkin-type rules that are good enough, in theory, while everyone gets their systems up-and-running.

The safe harbor for the under-taxed profits rule, the “Transitional UTPR Safe Harbor,” effectively prevents other countries from applying the UTPR on the domestic income of U.S. companies, regardless of the company’s effective tax rate. (Normally, the UTPR would apply anytime a multinational company has an entity, in their home jurisdiction or a subsidiary, with income that’s taxed at below 15%.) And the Transitional CbCR Safe Harbor aims to leverage the OECD’s prior country-by-country reporting system, to allow companies to use that information to show that they are outside of Pillar Two’s scope. These both apply through 2025.

Already, the safe harbors have proven to be, well, not entirely safe.

The OECD has already published additional administrative guidance in response to alleged tax avoidance schemes to take advantage of some of the oversimplified rules. In particular, December 2023 guidance introduces the concept of “hybrid arbitrage arrangements,” or situations where differences in national accounting standards or financial accounting and tax rules create arbitrage opportunities–such as doubled deductions or income that mysteriously vanishes in between jurisdictions.

The OECD’s guidance provoked a backlash among practitioners who claim it will capture completely normal and even commonplace transactions. For some companies, especially in the U.S., this could make the CbCR Safe Harbor all but unusable. Those companies may not owe anything under Pillar Two, but they won’t be able to rely on the safe harbor’s assurance against the full reporting and compliance requirements.

The OECD has promised further guidance on the safe harbor, and it’s possible the problem is already being fixed. (This kind of back-and-forth is becoming the equivalent of a formal public comment process which the OECD dropped from Pillar Two years ago.)

But as some hope that safe harbors could be expanded to smooth out Pillar Two’s remaining sharp incongruities, this process–the overbroad initial rules, discovery of potential loopholes, and then complex add-ons that provoke more concerns–demonstrates the potential hazards of such an approach.

The basic problem is that to keep the CbCR Safe Harbor relatively simple, the OECD allows for different reporting standards within a single report. The country-by-country reports are, of course, by country. But because they are a mostly tax-based system, the OECD had to require adjustments through “qualified financial statements.”

Those financial statements can either be those used by the company in its home jurisdiction, or an acceptable standard already used by a subsidiary. In theory, this should come to a decent approximation of income as it would be measured under Pillar Two’s formal definition.

But it still apparently could give companies cover to engage in tax avoidance without triggering Pillar Two’s enforcement rules, through “hybrid” entities which different jurisdictions evaluate differently. (The classic case is a payment that creates a deduction in one country, but doesn’t create corresponding income in another.)

According to the OECD, those strategies contrive to report the “income, expenses, gains, losses or taxes under that arrangement in an inconsistent or duplicative manner,” that technically satisfies the safe harbor requirements but clearly allow for low-taxed income. Their solution is to identify versions of these arrangements–a “deduction/non-inclusion arrangement,” a “duplicate loss arrangement,” and a “duplicate tax recognition arrangement”--and make adjustments to the data based on the amount of income that’s allegedly being hidden. (That doesn’t mean that income will be taxed, necessarily–what it could mean is that the company can’t use the safe harbor to claim they shouldn’t be subject to Pillar Two at all. It triggers another, more extensive calculation, in other words.)

Some practitioners say these definitions go beyond what would be necessary to capture clear arbitrage.

“What they've written is significantly broader than what they were targeting. And what we're finding in a lot of cases is perfectly normal commercial arrangements are being swept up by the broad definitions in the hybrid rules,” said Calum Dewar, a principal at PricewaterhouseCoopers LLP, in a May podcast. “And for US multinationals that may be more severe than anyone else, and that's partly because the US tax system is very different than anyone else's tax system.”

The U.S. worldwide (in part) tax system, including check-the-box and other rules that allow for flow-through income, could in particular trigger these anti-hybrid rules, Dewar said.

An analysis of the December release, also from PwC, said that U.S. companies with foreign permanent establishments or “disregarded entities” could fall under the rules due to how income is reported for those, which are seen as distinct entities by the CBC rules but not for U.S. tax rules. Deductions could come seemingly out of nowhere, which the OECD framework would see as an indication that income was being hidden–even if the income is actually being accounted for elsewhere.

Hybrids aren’t new to the OECD–the 2015 Base Erosion and Profit Shifting included a report on similar arrangements, including model legislation that was enacted in the U.S. through the Tax Cuts and Jobs Act. For that matter, the Pillar Two model rules include more extensive anti-hybrid measures as part of the permanent system. What’s causing the potential problem here is rules that are meant to be imperfect, “good enough” rules for the transitional period, that are optional for taxpayers and mostly rule out clear cases where Pillar Two shouldn’t apply.

In some cases, the OECD may just have to accept that some income will slip around the rules, if they are to remain workable. I don’t think the goal of Pillar Two was ever to stamp out all tax avoidance. (It allows for income-shifting within a jurisdiction, for instance, so long as it doesn’t reduce the national effective tax rate by too much.)

But at what point do safe harbors become so porous they negate the system, or seriously undermine it? That may be the balancing act that OECD officials and delegates need to perform as the system continues to evolve.

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.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• The big news of the week was that the United Nations Ad Hoc Committee to Draft Terms of Reference for a United Nations Framework Convention on International Tax Cooperation finally approved, well, a draft terms of reference. The vote was 110-8, with 44 nations abstaining, revealing some fault lines in the U.N. tax debate that seem to be solidifying. While the U.S. initially offered lukewarm support for the project, it was among the eight “no” votes, along with other OECD members like Australia and Canada. Their primary objection was that the document didn’t include a consensus-based process (like the OECD’s). It’s unclear how those countries would ever come around, and if the U.N.’s process doesn’t have unanimous support it’s unclear how it would replace the OECD’s role as the global tax arbiter. But, we’re still a long way from the endgame here, so plenty of diplomacy to be done.
• The U.S. Internal Revenue Service announced new criteria for application to its Compliance Assurance Process, which begins in September for the 2025 tax year. The CAP is a way for the agency to work with large companies throughout the year, addressing potential issues–including international tax issues–before a return is even filed, let alone when one would be raised by audit. The U.S. CAP became a model for the OECD’s similar ICAP program. These updates include changes to the filing eligibility in response to the Inflation Reduction Act, which enacted massive new tax subsidies with novel and complex requirements–something that’s bound to be a source of controversies for years or decades to come.
• As bespoke national filing requirements for Pillar Two continue to compound, the OECD is still hoping that a single global informational return for the GloBE Information Return will help streamline and standardize compliance. The organization issued draft “XML Schema” for that global return in July, and the deadline to submit comments was August 19. The National Foreign Trade Council released its comment on Tuesday, outlining concerns that the proposed system doesn’t do enough to coordinate filing requirements and that it includes “excessive requirements for data.” For those into the nitty-gritty of compliance (this includes how to incorporate special characters is certain languages, for instance) this is definitely worth a look.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Yankee Doodle Jones, appearing in Yankee Doodle Comics #1 in 1941. Created Frankenstein-like from the bodies of three WWI vets who volunteered their lives to help create a super-soldier, Yankee Doodle Jones has, aside from giant size, near-invincibility and super-strength thanks to enhancements from his deceased scientist creator. Teaming up with Dandy, the scientist’s son–who also has superhuman enhancement, although is normal-sized–the duo fight dastardly Nazi villains and monsters.

Contact the author at amparkerdc@gmail.com.