Understanding the UTPR

Something’s been nagging me from my newsletter two weeks ago.

“Part of why the [Organization for Economic Cooperation and Development’s] rules have stood the test of time is that they’re principles-based,” I wrote. “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.”

I was mostly talking about the undertaxed profits rule, the most controversial and probably most pivotal part of the 15% Pillar Two global minimum tax. On its face, it seems to flout some of the basic precepts of the international tax system–that taxation can only occur with a nexus established through a physical presence and that the income subject to taxation be measured in accordance with the arm’s-length principle.

Since the OECD and its member states define the arm’s-length standard–which mandates that internal assets be priced based on what independent parties would have paid–they can also describe when it does or doesn’t apply. But there presumably needs to be some logic to it. If it’s just, “the arm’s-length standard applies except when it doesn’t,” countries may be more willing to pursue their own variations on the rules, until those rules aren’t really rules anymore.

(Actually, this is exactly how Pillar One applies–but to be operative it would need to be incorporated into treaties, which would have their own limiting mechanisms.)

This has been a fear expressed by many critics of Pillar Two and the UTPR–if countries like using it, what’s to stop them from applying it at higher rates, or on more taxpayers? Can the OECD really argue that there’s something intrinsically special about the 15% rate?

So this begs the question (sorry grammar purists, raises the question), is there a principled logic to the UTPR? Forget, for a moment, whether or not you think it’s a good policy. Is there a way to explain it as part of an overall framework that includes the arm’s-length principle?

At the risk of losing credibility with a huge chunk of my readership, I think there is.

Again, I’m not saying it’s good logic. But when I look at the UTPR and its place with the rest of Pillar Two, I see an implicit argument underlining it.

Maybe it’s just my nature–I’ve always gone through life trying to understand everyone’s viewpoint, how things look to them, to see if maybe my point of view is wrong. (People like me are always a bit taken aback when we realize that other people aren’t necessarily extending us the same presumption.) It’s also how I understand policy–I have a difficult time wrapping my head around a complex, interconnected system unless I can see some intent or motive beneath it.

Often when it comes to a policy, there’s a lot of tension between what it claims to do, what it’s really trying to do, and what it ends up doing.

Last year, I wrote that the UTPR was clearly formulary apportionment, and noted that this was an under-discussed aspect of the policy. I got a little pushback on that–does the UTPR even follow the logic of formulary apportionment, to use formulaic factors as the best method for dividing income between jurisdictions? The UTPR doesn’t reallocate income, it just gives a country the right to tax some other country’s income. At least classic formulary apportionment goes through the trouble of divvying up taxable income before giving each country their bite.

The formulaic aspect of the UTPR is called the “UTPR Percentage,” and it’s based on the number of employees employed by the multinational taxpayer in the jurisdiction, and the value of tangible assets held by the taxpayer in the jurisdiction. This wouldn’t be the taxpayer’s home country–the UTPR is applied by subsidiary jurisdictions, whenever a different entity in the overall corporate group (the parent entity or another subsidiary) holds income that is taxed at less than 15% in any jurisdiction.

Countries tax that income until it’s brought up to 15%, then divide it between themselves based on the employees/assets formula.

In the Pillar Two commentary, the OECD says that employees and tangible assets are “substance factors,” which will facilitate “the coordination among tax administrations,” and will also indicate where the corporate taxpayer has the most “tax capacity (such as deductible expenditures) to absorb the UTPR.”

The UTPR Percentage is very, very similar to Pillar Two’s “Substance-Based Income Exclusion,” another formulaic aspect of Pillar Two. It grants an exemption to taxpayers based on a percentage of both their payroll expenses and tangible assets. Whether a company is taxed under the UTPR or Pillar Two’s primary taxing rule, the income inclusion rule (imposed by the headquarters jurisdiction), it only applies on “excess income” beyond that return.

This is one (of many) parts of Pillar Two where you need to read closely to parse the logic behind the provision. It’s somewhat based on a similar exemption in the U.S. tax on global intangible low-taxed income, which was explicitly meant to be a proxy for intangible income, such as profits from intellectual property or patents. That income is easily moved, and is often involved in profit-shifting. If you have a lot of intangible income, but not much in taxes being paid, there’s a pretty good chance something tricky is going on. (Or at least, that’s the idea.)

It’s pretty close to the concept behind the Pillar Two exclusion, but not exactly. According to the commentary, factors like payroll and assets “are generally expected to be less mobile and less likely to lead to tax-induced distortions.”

“Conceptually, excluding a fixed return from substantive activities focuses [Pillar Two] on ‘excess income,’ such as intangible-related income, which is most susceptible to [base erosion and profit shifting] risks,” the commentary states.

There’s the slight difference between a formulaic proxy for intangible income, and a larger category of “excess income” that can include intangible-related income. I’m still wrapping my head around that. (Is there something wrong with excess income in principle, or just when it contributes to BEPS risk?)

But regardless, there’s clearly an assumption that high returns without real substance are problematic and likely not indicative of true economic activity. Likewise, presumably an abundance of these factors does indicate real economic activity.

And since income has to come from somewhere, Pillar Two pushes it towards where it sees the real substance that (is presumed to have) created it.

That’s how I see the UTPR. Low-taxed income is presumed to have been shifted, and jurisdictions with real substance are likelier than not to have created it. Through these very rough formulaic proxies, Pillar Two aims to not only stem profit-shifting but reverse it.

Of course, the problem with this (well, one of a few) is that Pillar Two ended up applying to many more situations than outright tax abuse, and no one can seem to agree on whether this is a feature or a bug.

It’s much harder to look at income that is low-taxed due to, for instance, credits for R&D or clean energy as part of a base erosion structure.

Another issue is the lack of clarity about both the function of the UTPR and the goal of Pillar Two. Oblique, sometimes inscrutable language is a key tool of diplomacy–but countries may at some point find that they’ve agreed to a broader change than they realized, with logic that could go to some very unexpected places.

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

• Jack Chambers, the Ireland Minister of Finance, said the 14 billion euro windfall the country will be receiving due to the European Union Court of Justice’s ruling in the Apple Inc. state aid case could be “transformational.” But, in a speech before the Irish parliament on Tuesday, he also cautioned that it would only be a one-off surge–and, furthermore, that the country’s overall reliance on corporate tax revenue could be a risk, as it “is ‘windfall’ in nature and not linked to our domestic economy.” It’s an interesting comment on the nation’s peculiar position as a beneficiary of the new global tax paradigm, which rewards not only low-tax jurisdictions but economic substance as well. But, as Chambers noted, the repositioning will end at some point and the country can’t assume these gains will last forever. His insights on the potential consequences on new tax changes probably extend beyond the isle.
• The OECD last week issued a new model competent authority agreement for implementing Amount B of Pillar One, which aims to provide stability in the pricing of routine marketing and distribution functions. The model agreement is a mechanism to deliver the “political commitment” that OECD and Inclusive Framework members have made to respect Amount B outcomes for certain jurisdictions–generally, although not entirely, poorer developing nations. While Amount A of Pillar One is stuck in the mud, Amount B seems to be quickly integrating into the global tax system, so we could see many of these CAAs become operative.
• The OECD on Monday also released a report on recent national tax reforms around the world, finding that corporate tax rates are beginning to rise following cuts made during the COVID pandemic. 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.

Phantom Lady, first appearing in Police Comics #1 in 1941. A D.C. socialite and daughter of a senator, Sandra Knight fights crime as a costumed heroine. (Sometimes masked, sometimes not.) No superpowers, but she has fearsome fighting skills, along with ravishing good looks.

Contact the author at amparkerdc@gmail.com.