Courting Trouble for the OECD

It’s pretty clear by now, the OECD’s Pillar Two global minimum tax is going to have to withstand some especially strong resistance if it’s going to survive through the coming years intact.

The Organization for Economic Cooperation and Development’s project is still supported by a broad consensus of countries, in the OECD as well as the G-20, and that’s how it managed to overcome hurdle after hurdle during the design and negotiation process. But it’s a far-reaching plan–maybe more far-reaching than its creators even realized–with huge potential consequences for taxpayers. The backlash has already been almost unprecedented in the world of tax, and it's not subsiding soon.

Pillar Two is never going away completely, that’s a given. But depending on how durable it proves to be, its outline could end up looking very different than it does today.

Or, it could persevere.

One of the avenues for that resistance will no doubt be the court system, and the tax treaty network in particular.

This is one of the greatest remaining question marks from the project. Is it on a collision course with the century-old network of agreements that holds the global tax system together? While the OECD insists that this is a non-issue, it intuitively feels like it’s at least a wild card in the implementation process, and many experts see a potential vulnerability.

It could well be that the OECD is right, and treaties coexist with this new regime.

But this will be a key test of both the project’s and the OECD’s legitimacy in that crucial period where the rubber hits the road.

The primary taxing rule of the Pillar Two, the income inclusion rule, is simple enough: it allows countries to tax the offshore income of their own headquartered companies, if that income is taxed below 15% and meets other conditions. This is a somewhat novel concept, but it’s generally in keeping with controlled foreign corporation regimes, and the notion that countries have broad sovereignty to decide how to tax their own citizens.

A secondary rule, the under-taxed profits rule, aims to add a backstop to the system, ensuring that companies headquartered in non-cooperative jurisdictions are still taxed under Pillar Two. Through the UTPR, a company’s subsidiary jurisdictions–the local tax authorities where those subsidiaries are located–can tax the company if it holds income taxed at lower than 15% anywhere else, including the home jurisdiction.

This originated as a denial-of-deduction regime tied to outbound transactions, but eventually became a requirement for outright tax payments. Here is where Pillar Two broke away from traditional tax rules, and seemed to run into the plain language of tax treaties–it encourages countries to tax income not tied to the jurisdiction through a permanent establishment or local taxpayer. In addition, the formulaic key that multiple subsidiaries would use to determine who gets what amount of UTPR tax–based on factors like workforce and tangible property–flies in the face of the arm’s-length standard.

In theory, an aggrieved taxpayer could file for treaty relief from UTPR payments, and put the issue in the courts, or into the treaty dispute resolution process.

The OECD’s position is that Pillar Two is treaty-compliant due to the “savings clause”--the provision in both the U.S. and OECD’s model treaty that preserves a country’s right to tax its own citizens, notwithstanding the treaty’s limitations. This would seem to broad protection, applying in cases with both a parent organization and local subsidiaries–but critics claim that to interpret it this broadly would be to nullify the whole point of tax treaties. Why create rules for allocating income between related parties if both treaty countries reserve the right to disregard that allocation for anyone it has the ability to tax?

That’s not the only potential defense of the OECD, however. Maybe the UTPR isn’t an income tax at all, some have argued, and thus the tax treaties wouldn’t apply. (These P2 defenders and P2 critics would seem to agree that the UTPR isn’t consistent with longstanding principles of income taxation.)

And, furthermore, most countries that have enacted Pillar Two into their own legislation typically allow laws to override treaties–so it would be a moot issue, Michigan Law Professor Reuven Avi-Yonah argued.

The wild card, not only with the above argument but in much of the Pillar Two conception, is that not everyone decided to implement Pillar Two. Most notably, the U.S. has still neglected to conform its tax laws to the structure, leading to many potential one-sided disagreements.

One potential relief valve is the provision in the OECD Pillar Two commentary which effectively mandates that if one jurisdiction fails to collect the "top-up tax" due to a court or legal challenge, the rest of the UTPR countries pick up the difference. So from the perspective of the taxpayer, there’s little reason to pursue a case, unless you think you can successfully challenge all of the different countries’ rules. That’s unlikely–especially since most treaties are bilateral, only applying to two jurisdictions.

My guess is that the OECD holds the upper hand in this, and that tax treaty challenges could end up being a dead end. But it will likely rely on courts giving the organization a lot of leeway in these grey areas.

The OECD’s power has always been “soft power”--it cannot bind its members to any particular rule. First and foremost, this mean the OECD writes model treaties and legislation that countries tend to follow. But there’s another level to it, defining global norms and rules that become internationally recognized standards. (Sometimes known as "customary law.") Courts have always looked to global norms when making decisions, on everything from tax law to the death penalty. If the OECD insists that it has blessed this otherwise unconventional form of international taxation, courts–which have always found international taxes to be one of the hardest areas to delve into–might not be inclined to second-guess.

But there’s a danger here for the OECD as well. Part of why the OECD’s rules have stood the test of time is that they’re principles-based. Countries have not only agreed to rely on their recommendations, they’ve bought in on the underlying philosophy. The more that the OECD is perceived as relying on “Because We Said So” logic to justify new rules, the more its very legitimacy could be at stake.

And this happens as other actors–whether they be the United Nations or countries enacting unilateral measures–have become more blatant in challenging the OECD’s role as the world’s tax arbiter.

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

• Following months (years?) of hints and speculation, the Department of the Treasury finally last week released comprehensive proposed rules for the corporate alternative minimum tax, the other 15% minimum tax that’s altering the global tax landscape. It’s a massive 600-page document (although less than 200 when printed in the Federal Register) addressing a plethora of issues, that practitioners have barely started to digest even a week later. This is a worldwide tax applying not only to U.S. headquartered companies but also U.S. subsidiaries of foreign-parented ones, so it has huge implications for international taxes. Overprinting these rules on top of pre-existing foreign tax regimes like Subpart F has proven to be a major challenge with a lot of potential for snags, double taxation and loopholes. The enacting law, the 2022 Inflation Reduction Act, also gave Treasury broad power to implement it, and one interesting factor is how the regulations create new rules to identify “CAMT avoidance transactions” and some related party transactions deemed to be abusive. We’ll be hearing a lot more about this.
• Speaking of big releases, the OECD on Monday unveiled a batch of new progress reports for the original 2015 Base Erosion and Profit Shifting project, including an annual review of the country-by-country reporting system. The review found that most countries are following the guidelines, including protections to ensure that the reports are used appropriately by tax authorities, although the peer review gave many individual countries recommendations on how to improve. (If you’re curious, the OECD dinged the U.S. for issues with the definition of the revenue threshold requirement, and encouraged the signing of more information-sharing agreements.) The OECD also released 20 new peer review reports on the new standards for mutual agreement procedures for countries including Colombia, Egypt and Pakistan.
• Like I said before, the opponents of Pillar Two are keeping up the pressure, looking for any opening to push back on what they claim is an illegitimate and ill-conceived tax regime. Republicans in the U.S. House of Representatives released a public letter to the OECD yesterday, announcing support for a lawsuit by the American Free Enterprise Chamber of Commerce against the framework in the Belgian Constitutional Court. The arguments in the letter aren’t new but it shows that Republicans, especially House Ways and Means Chairman Jason Smith (R-Mo.), are hoping to keep this in the spotlight.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Commando Yank, first appearing in Wow Comics #6 in 1942. A WWII war correspondent, Chase Yale decided he could no longer stay on the sidelines--he grabbed a rifle and created his costume to fight for freedom, while maintaining his real identity to use his pen for that goal as well.

Contact the author at amparkerdc@gmail.com.