OECD Statement on Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalization of the Economy, issued on October 8th, 2021, updates and finalizes a political statement by 136 OECD member countries of the Inclusive Framework (IF) to fundamentally reform international taxation.
Pillar One attempts to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest and most profitable MNEs—winners of the globalization, and deal with the old tax concept of “physical presence”. In essence, it outlines an agreement to re-allocate some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether the taxpayer companies have a physical presence there. Specifically, MNEs with global sales above €20 billion and profitability above 10% will be covered (as “in-scope companies”), with 25% of profit above the 10% threshold to be reallocated to market jurisdictions.
Pillar Two introduces a global minimum corporate tax rate set at 15%. The new minimum tax rate will apply to companies with revenue above €750 million and is estimated to generate around USD $150 billion in additional global tax revenues annually.
The official stated goal of the global minimum corporate tax is not to eliminate tax competition, but place multilaterally agreed limitations on it.
This article explores how Pillar Two—global minimum corporate tax will shape the ongoing legislative negotiations and forms of U.S. tax code, especially with regard to the GILTI regime, Code §951A.
The overall design of Pillar Two consists of two interlocking domestic rules (together the Global anti-Base Erosion Rules (GloBE) rules): (i) an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a constituent entity; and (ii) an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR; and a treaty-based rule (the Subject to Tax Rule (STTR)) that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate. […]
Considering US leads and inspires the OECD negotiations and rule design—a likely thorny issue, in light of and compared to US GILTI regime, might be OECD Agreement’s country-by-country reporting rule. Under the Two-Pillars Statement, the GloBE rules will apply to MNEs that meet the €750 million threshold as determined under BEPS Action 13 (country-by-country reporting).
According to Rule Design: The UTPR allocates top-up tax from low-tax constituent entities (including those located in the Ultimate Parent Entity jurisdiction). And, Effective Tax Rate (ETR) to be imposed is calculated on a jurisdictional basis, applying a common definition of covered taxes and a tax base determined by reference to financial accounting income (with agreed adjustments consistent with the tax policy objectives of Pillar Two and mechanisms to address timing differences). The minimum tax rate used for purposes of the IIR and UTPR will be 15%.
Under most recently enacted US tax code, TCJA (Tax Cut and Jobs Act of 2017) and Treasury Regulations, however, US companies are not required to report income on “country-by-country” basis. Code §904(d)(1) sets forth four general categories, or baskets, for foreign tax credit (FTC) purposes, one of which is for non-passive category income that is includible in gross income under tax code Section 951A (the “GILTI basket”). The use of a single basket for all global intangible low-taxed income (GILTI), arguably, allows U.S. companies to earn income (through CFCs) in low-taxed jurisdictions without incurring residual U.S. taxes, via “cross-crediting” foreign tax credits resulting from higher taxed income from high-tax jurisdictions (to offset the lower-taxed income.)
If the US legislation cannot modify and amend the current GILTI tax rules, it will render US non-compliant as to OECD Pillar Two, and expose US companies to the burden of proving to foreign jurisdictions under Undertaxed Payment Rule (UTPR).
Second, economic substance-based carve-outs are included for companies that will face the new 15% global minimum tax agreed to by the OECD’s Inclusive Framework. The carve-outs recognize that certain tangible costs provide “substance”, or economic value in those jurisdictions:
The OECD Statement on “Carve-outs” reads:
The GloBE rules will provide for a formulaic substance carve-out that will exclude an amount of income that is 5% of the carrying value of tangible assets and payroll. In a transition period of 10 years, the amount of income exclude will be 8% of carrying value of tangible assets and 10% of payroll, declining annually by 0.2 percentage points for the first five years, and by 0.4 percentage points for tangible assets and by 0.8 percentage points for payroll for the last five years.
Compared to GILTI, the OECD’s carveouts are more generous as Code § 951A exempts deemed return of 10% of U.S.-headquartered MNEs’ qualified business asset investment, also known as QBAI; and under current U.S. law QBAI does not include payroll. The comparatively generous OECD Agreement carve-outs would incentivize and reward certain tax-driven behavior, including possibly structuring tangible assets and payrolls on jurisdictional basis, and creating a new front of international tax competition (especially considering the Biden administration and Democrat legislators’ push to raise effective GILTI tax rates).
That would, counterintuitively, render US GILTI regime qualify (for a “co-existence with Pillar Two”) as a comparatively high-tax jurisdiction—and, create an unexpected, urgent need for US incorporated MNEs to understand and address those new constructs on CFC taxation—seek sheltering away from, rather than sheltering under US GILTI regime (and associated Foreign Tax Credit).