The R&D Sticking Point

In my July 17 newsletter, I said that the OECD might want to play the “Trump Card,” given the likelihood of his returning to the White House, to craft a deal with the U.S. on the global minimum tax, reducing the future president's potential leverage to crush the project.

Since then, President Joe Biden has dropped out of the 2024 race, Vice President Kamala Harris has picked up the baton, and Democrats are surging with the lead in many presidential race polls.

So that’s why I left political journalism–too hard to avoid bad predictions in our chaotic politics.

There’s no guarantee that a President Harris would continue Biden’s policies in international taxation, but a sharp deviation seems unlikely. Maybe current Treasury Secretary Janet Yellen would even stay on, to see the U.S. involvement in the Organization for Economic Cooperation and Development’s initiative all the way through.

The chances that the U.S. passes legislation to join or move closer to the Pillar Two model may be higher than they seemed a few weeks ago. If Democrats continue to surge, a November victory for both the White House and Congress could put them in a good position to push for Pillar Two enactment as part of the 2025 tax overhaul.

But the path towards resolution of the tension between the U.S. and the OECD remains fraught and unclear, even if Democrats win. Full enactment of Pillar Two legislation is very unlikely. Congress would probably try to make select changes to the existing U.S. global minimum tax, the tax on global intangible low-taxed income (GILTI), and then hope that the OECD would be willing to deem that a compliant regime. (Those changes would probably be making GILTI country-by-country and raising the rate to 15%--which, if they include other Pillar Two changes like allowing loss and excess foreign tax credit carryforwards, may not be such a bad deal for businesses.)

That wouldn’t solve everything, though. Congress would still need to pass a Qualified Domestic Minimum Top-up Tax (QDMTT), or other countries could apply the under-taxed profits rule on U.S. companies’ domestic income, should that income be taxed at an effective tax rate lower than 15%.

The U.S. already has a minimum tax covering the U.S., the corporate alternative minimum tax (CAMT or “Camtee”). Treasury could push for the OECD to deem that compliant as well, so the UTPR would be turned off on U.S. income. Or Congress could pass a real QDMTT, or something close to it, and achieve the same result if the OECD signs off.

But at least as things stand now, the only way the U.S. could fully protect U.S. companies from the UTPR would be to enact a domestic minimum tax that includes the R&D credit in its calculation–essentially, scaling the credit back in cases where it contributes to a domestic tax rate below 15%.

That’s the rub. Any way you approach it, the R&D credit is the stubborn sticking point, the roadblock that can’t be finagled around through creative diplomacy or political maneuvering. It’s not only the most consequential business tax credit in the U.S., but probably the most politically popular as well, with strong bipartisan support. Congress isn’t going to touch it. (Hence why CAMT specifically carves it out.) And it’s not going to convert it into a Pillar Two-favored refundable tax credit either, for reasons that seem obvious to U.S. policymakers but baffling to other countries, many of whom made that change without much fuss.

The OECD agreed to a safe harbor which effectively puts off the issue for the U.S. until 2026, but further delays can only work for so long. One way or another, the U.S. and the OECD will have to reach a deal, or risk a trade war and potential challenge to the framework just as it’s getting started.

U.S. officials still express hope that the OECD and Inclusive Framework could agree to new guidance granting favorable treatment to the R&D credit, or expenditure-based credits in general. Tax benefits tied to expenditures won’t offer skyrocketing tax cuts like income-based benefits sometimes can–and they’re guaranteed to be tied to real economic activities, at least depending on how the local country law defines expenditures.

I thought former Treasury Deputy Assistant Secretary Michael Plowgian articulated a clear, compelling argument for protecting expenditure-based credits in a recent KPMG podcast:

“I think from a policy perspective, a non-refundable tax credit can properly be viewed as a subsidy for the expenditures in that jurisdiction. And I really don't think credits that are designed that way undermine the policy goals of Pillar Two,” Plowgian said. “They don’t incentivize profit-shifting among jurisdictions.”

Refundable tax credits are favored under Pillar Two because they’re more akin to government subsidies, something the OECD concedes as a sovereign right for nations to use to boost their economies. Pillar Two can’t stop that, but it can try to curb purely tax-based incentives which are less transparent and easier to manipulate, in theory. Maybe expenditure-based incentives can be viewed as closer to the former category of subsidies?

The problem is that, as Plowgian noted, this is really about policy, something that the OECD has tried to avoid since the agreement was announced in 2021. It’s issued voluminous administrative guidance since then, but all under the guise of implementation. To re-open the policy debates behind the pact–even just to clarify the goals–is a Pandora’s Box which could undermine the whole deal, and give reluctant countries an excuse to bail.

For instance, the July 2023 guidance granting favorable treatment to transferable credits–such as the clean energy credits enacted by the 2022 Inflation Reduction Act–did so to resolve ambiguity in the agreement’s treatment of tax credits. (Or so it stated.) It turned to financial accounting standards such as U.S. Generally Accepted Accounting Principles and International Accounting Standards, which allowed for transferable credits to be considered as reductions in tax or an increase in income. Not surprisingly, the OECD opted for the latter, more taxpayer-favorable option. (An increase in income does decrease a company’s effective tax rate, but not as much as a reduction in tax would.)

That may seem like a thin reed to justify the tweak, but it’s the kind of reed that international diplomacy is built with. There’s not a similar hook for the R&D credit, at least as far as I know. Nor is there much ambiguity in the original agreement or commentary on the issue.

So that’s the conundrum. The positive side is that the U.S. isn’t the only country with an expenditure-based research credit. There are many countries which would probably benefit from some kind of special treatment, which could affect the dynamics as many participants grate at the idea of giving the U.S. yet another concession.

But it will test the OECD’s willingness to probe the original Pillar Two goals. There’s a pretty easy case to be made that the R&D credit doesn’t attract base erosion, if that's defined as separation between taxable income and the activities that generate it. Whether it contributes to tax competition is a harder question without an obvious answer.

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

• Ending months of speculation and jockeying, the Senate finally voted last week on the bipartisan tax agreement approved by the House of Representatives–and unceremoniously knocked it down. Despite being negotiated by Rep. Jason Smith, R-Mo., the chairman of the Ways and Means Committee, it faced stiff opposition from Senate Republicans over various objections over procedural issues and policy details. Really, the whole exercise shows how difficult it is to pass anything through both chambers of Congress, especially without clear support from party leadership. The bill included some big items for international taxation, including a loosening of the Sec. 163(j) limit on interest deductibility and an extension of faster expensing for R&D expenses. (Though only for domestic costs.) This is yet another indication of how chaotic the 2025 Tax Cliff could end up being.
• When Coca-Cola Co. lost in U.S. Tax Court in its long-running dispute with the Internal Revenue Service over its foreign affiliate royalty payments in 2020, it sent shock waves throughout the tax community. Much of the case involved pre-2017 law, and Coca-Cola's structure (as well as the circumstances behind the IRS adjustment) were somewhat unique, so the direct implications for other companies were limited. Regardless, after a long string of defeats, the vindication of the IRS position seemed like a sea change, and the court's recognition of the importance of U.S.-held intangible assets like branding was significant. (That it involved possibly the most iconic consumer brand in history also gave it a certain luster.) It hadn't been decided how much the company would ultimately owe, however, and that figure would depend on an additional dispute over Brazilian dividend payments. (It's complicated.) The same Tax Court judge ruled last week that Coca-Cola would owe $2.73 billion, and the company itself stated that after taking interest into account, the total amount would be an eye-popping $6 billion. Coca-Cola is, of course, vowing to appeal, and it will be interesting to see if the appeals courts confirm or revise the Tax Court decision.
• Last week, Deloitte Tax LLP issued its annual Tax Policy Survey, which polled over 1,000 tax and finance corporate officials about the global landscape. No surprise, Deloitte reports a lot of anxiety about increased complexity and compliance costs due to Pillar Two, something I’ve also written about. But one interesting caveat–38% of those surveyed are also expecting to see some simplification, as countries repeal older laws as part of “post-Pillar Two decluttering.” Also, nearly 80% expect to see Pillar Two-compliant tax incentives in their jurisdictions, so the “race to the bottom” may not be over yet.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Airboy, first appearing in Air Fighter Comics #2 in 1942. Yet another plucky, heroic (though non-super-powered) WWII-era characters, Airboy battles Nazis using a special aircraft designed by his adopted father, a Franciscan monk. The possibly self-aware plane flaps its wings to fly, can grip other planes with its wheels, and can fly remotely.

Contact the author at amparkerdc@gmail.com.