The "Exponential" Pillar Two Compliance Avalanche

It’s become something of a mantra at tax conferences and panel discussions about Pillar Two, the Organization for Economic Cooperation and Development’s 15% global minimum tax.

“It’s going to be a huge compliance burden. But we don’t expect to pay more in tax.”

Certainly, some countries will see a boost in revenue. But that amount could be dwarfed by the money that companies will need to spend drawing up new systems to fill out informational reports for every participating jurisdiction they apply in. (Despite the OECD’s single return that’s supposed to streamline this.) Rather than a boon to countries, it’ll be a boon to tax practitioners with a huge deadweight loss to the global economy.

(I’ll note that this observation probably doesn’t include new tax payments from countries raising their rates in response to Pillar Two, perhaps the primary way that the policy will end up increasing revenue.)

“For the vast majority of companies, in the vast majority of countries, Pillar Two is entirely a compliance exercise,” said Pat Brown, co-head of PricewaterhouseCoopers LLP’s Washington National Tax Services practice, at a conference co-sponsored by the OECD and the United States Council for International Business in Washington last Tuesday. “It is not an exercise that will lead to incremental tax collections, it is entirely about compliance.”

He added that “a sense of panic is beginning to set in across a number of companies who are facing the reality of complying with the full measure of these rules.”

Brown said that the compliance challenges would be “enormous.” Speaking later, Alyson Lawrence, vice president of global taxation at Johnson & Johnson, said the word she would use is “exponential,” as countries stack slightly different requirements on top of each other and companies prepare new financial records for Pillar Two alongside others they maintain for tax authorities and shareholders.

If all of this is true, it’s enough to make you take a step back and wonder, “How did we get here?” More to the point, “What was this supposed to be like?”

Was it originally supposed to be this convoluted?

I can’t claim to be privy to the discussions many years ago, but I expect not. In fact, I wonder if the designers thought that Pillar Two compliance would ever be a consistent, ongoing requirement, rather than an occasional enforcement action when something in the system goes wrong. Conceptually, you can imagine an alternate version of this policy where the agreement gets put in place, all participating countries raise their tax rates and repeal targeted incentives and loopholes–then everyone moves on and forgets about it.

So what happened? In all likelihood, several design choices, as well as unforeseen implications and dilemmas, compounded on each other until the system became much more expansive and intensive than the original idea. And there is little hope of walking back any of those now.

Probably the primary design choice which led to all of this–perhaps the original sin, as critics would put it–was to create a whole new measurement of taxable income for Pillar Two alone. This was actually supposed to be a shortcut, to make it easier to compare taxable income in different jurisdictions with different rules and see where it falls below the 15% level. It was based on financial reporting data, which made it sound easy for companies to produce, since they already use it in reports to shareholders.

But for a variety of reasons, it couldn’t be exactly like that, either. Financial accounting rules are designed for a different purpose than for income tax payment. A plethora of adjustments had to be made, and the end result, as practitioners and in-house tax officials put it, is “a separate set of books” for this completely new income system.

Creating and maintaining those is much more complicated than it sounds, practitioners say, because they have to be reconciled with the existing systems for measuring income and creating new reports. Brown used the example of a corporate merger that gets slowed down as the acquiring company realizes how long it will take to make sure all of the different systems can communicate with each other.

But that’s not the only issue. Because there was this new, quirky income tax base, simply raising tax rates, repealing incentives, and other limited actions wouldn’t be enough to ensure that there isn’t low-taxed income in the jurisdiction. Relatively late in the process, the OECD added the qualified domestic minimum top-up tax, so the countries where this income was being earned could ensure they’re able to collect all of the tax on it. Otherwise, they’ll be leaving that revenue for other countries to grab through the income inclusion rule, the system’s primary tax that a country imposes on its own multinational companies for low-taxed offshore income.

In perhaps a nod to reality, the OECD gives countries more flexibility to use their own accounting rules with the QDMTT. The result is that companies must view each country’s Pillar Two income as its own compliance issue, requiring particular attention. This is where the challenge starts to seem “exponential,” as Lawrence put it.

There’s also the under-taxed profits rule, which was originally the undertaxed payments rule. The name change itself demonstrates how much the concept has expanded. Countries apply it to local subsidiaries when their overall corporate group has low-taxed income elsewhere. Early OECD commentary on this suggested that it would be seldom-used, a “backstop” rule that’s only to ensure that opportunistic nations don’t try to steal companies by refusing to implement the rules.

I’ve compared them to nuclear weapons–always present, never used. OECD tax official John Peterson’s less apocalyptic analogy is to a bathtub plug, holding all of the water in. In both cases, the precise design of the tool is less important than whether or not it’s followed. (At least I think that’s the idea with nukes.) The UTPR would be turned “off” in jurisdictions following the system.

The (unanticipated?) X-factor turned out to be the United States, which has never enacted Pillar Two legislation and remains too far from its design for any kind of general exemption. As a result, the UTPR is live in the world’s biggest economy, and the OECD has been consumed with questions about how this incentive or that will be considered. Yet another escalating complication.

Given this reality of high administrative costs and low tax payments, all eyes continue to watch for possible permanent safe harbors. This is exactly the kind of situation where safe harbors are supposed to be used, when companies would welcome a way to volunteer that they’re in compliance. They typically allow companies to avoid or reduce the chances of audits, if they hit certain benchmarks or amounts of tax payments. In this case, they could rely on reporting already required under the country-by-country reporting system enacted in 2015, or other easily obtainable figures. If a rough outline makes it look like a company’s in the clear, maybe they should be able to rest easy, unless a tax authority can find evidence to the contrary.

(I still wonder if a safe harbor could be the answer for the U.S. research and development credit, when the substance-based exclusion would negate some or all of what would otherwise be paid through the UTPR.)

But it’s pretty clear at this point, safe harbors won’t be a panacea. The OECD remains wary of potential ways to abuse oversimplified rules, and has already tweaked the temporary safe harbors it’s issued. As Michael Plowgian, then an official at the U.S. Treasury Department put it last year, if the OECD delegates thought there was a simpler way to do this, that way would have been the original rule.

It may be that the system will need to have been up-and-running for a few years before all of the jurisdictions are comfortable with a safe harbor approach. For large multinational companies, those could be some bumpy years.

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

• It’s July 3, which means that the OECD’s self-imposed, and supposedly final, June 30 deadline for issuing text of the multilateral convention to implement Pillar One has come and gone. There’s still no text. (Though a website redesign at OECD.org makes it a bit hard to check.) OECD’s tax chief Manal Corwin told the tax press that they’re making progress and close to being finished. I actually believe them this time, but the last mile is always the longest. The fact that the deadline came and went without much notice is actually a more negative sign for the process–people are already starting to tune it out. Then there’s the issue of what happens next, which no one seems to know. But how they resolve these last remaining issues, if they do, will be interesting regardless of whether this agreement ever gets off the ground.
• Treasury and the Internal Revenue Service haven’t been idle in the meantime, however. The IRS on Friday issued long-awaited cryptocurrency reporting regulations, that require crypto brokers to report information about their sales starting in 2026. Implementing requirements that were in the 2021 Infrastructure Investment and Jobs Act, this is supposed to go a long way towards taming the Wild West of crypto, including assets held offshore. It doesn’t create new reporting requirements for taxpayers–they’ve always been there–but it will presumably make holders more likely to report crypto gains or income to the IRS. The rules also don’t apply to “decentralized” brokers who don’t take possession of the digital assets they’re trading.
• Treasury on Friday also issued final regulations on the Inflation Reduction Act’s 1% excise tax on stock buybacks. At first blush this may not seem like it’s related to international taxes, but as I laid out last year, the provision’s expansive “funding” and “per se” rules could capture some legitimate foreign transactions, especially merger & acquisition deals. (For more on this, check out the latest episode of PwC’s great Crossborder Tax Talks podcast–released two days before these regs.) These latest rules are mostly technical and don’t make many changes from what was proposed before, but they do include new details for a potential exemption for regulated investment companies (RICs) and real estate investment trusts (REITs).

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The Arrow, first appearing in Funny Pages #10 in 1938. A mysterious hooded archer who fights the bad guys, he's actually a U.S. intelligence agent. Allegedly the first superhero to use a bow-and-arrow, appearing three years before Green Arrow.

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