Challenging The Undertaxed Profits Rule


Robert Goulder of Tax Notes and Jefferson VanderWolk of Squire Patton Boggs (US) discuss the problems with the OECD’s pillar 2 UTPR, formerly known as the undertaxed profits or undertaxed payments rule.

This transcript has been edited for length and clarity.

Robert Goulder: Welcome to the latest edition of In the Pages, I’m Bob Goulder, contributing editor with Tax Notes. Our topic for the month of January is the same as it was for the month of December; we’re talking about the OECD pillar 2 proposal, in particular, the UTPR or undertaxed profits rule.

As you may know, late last year, the European Union approved a directive to formalize a pillar 2 proposal that would have the UTPR as part of it. And separately, outside of the EU, there’s a sprinkling of countries that are doing the same thing. So what this really reflects is a major development in international taxation, something that U.S. multinationals and the U.S. government are going to have to come to terms with, for better or worse.

Now, for our purposes, there is a heated debate within international taxation as to whether the UTPR contradicts international law or existing, well-established precedent. Our publication, Tax Notes, has published some very thought-provoking materials on this topic, both pro and con. In fact, the last time we recorded one of these video segments, we profiled an article that took a favorable view towards the UTPR.

This time out, we’re showcasing the other side of the issue, equal time for opposing views, you might say. Now, among the more insightful of the articles by these UTPR skeptics is the writings of our featured author, Jefferson VanderWolk, partner with Squire Patton Boggs (US). By way of disclaimer, his views are his own, they don’t reflect those of his clients or his employer, the law firm.

We’re highlighting his viewpoint titled, “Global Minimum Tax: The Road Ahead,” which debuted in the January 2, 2023, edition of Tax Notes International. We could very easily have profiled any of his other writings on the UTPR, such as his recent letter to the editor commenting on the UTPR, tax treaties, and the CFC [controlled foreign corporation] rules. Really, thematically, all of these materials go together, they all overlap, and they’re all relevant for this discussion, which leaves us with a lot of ground to get to.

So with that, let’s go. Jefferson, welcome to In the Pages.

Jefferson VanderWolk: Thanks, Bob, it’s my pleasure to be here.

Robert Goulder: All right, now you saw the last broadcast that we did, with Allison Christians and Tarcísio Diniz Magalhāes. You saw that, so you heard what they had to say — we’ll get to that later.

Let me start by asking you about this EU directive that I mentioned in my intro. Your article provides a nice little roadmap sort of showing, “What can we expect?” You give the example of a multinational with a French parent and a Kenyan subsidiary. And the Kenyan isn’t paying any taxes locally because there’s a tax exemption scheme in place, and it’s taking advantage of that. It’s there to encourage foreign direct investment. As I understand it, France, being an EU member and adopting pillar 2, would have an income inclusion rule (IIR) in place, and that would basically suck up all of the tax savings associated with that Kenyan subsidiary.

So my question to you, out of the gate, first question: How is this going to affect source countries, a country like Kenya? What do they think of their tax incentives being soaked up by another government?

Jefferson VanderWolk: Well, I think there are concerns in developing countries that have used tax incentives to try to attract foreign direct investment, that the pillar 2 global minimum tax rules would reduce the attractiveness of those incentives. I should say there is still a bit of benefit from an incentive like that, to the extent that the substance-based exception in pillar 2 would apply. To the extent that a multinational is still putting people in a country, and business assets and the investment, they get a certain return on that that’s not caught by the global minimum tax, but certainly, incentives will be less attractive.

The OECD and countries that are in favor of this global minimum tax have tried to say, “Oh, well a lot of these incentives aren’t very good for the economies that use them. [It] will be better to have a sort of nontax focus for incentives for foreign direct investment rather than just a reduced tax rate.” But there is concern, and I think that’s behind movements in Latin America that we’ve seen recently, the Colombian finance minister saying the Latin Americans are going to sort of make their own deal. The African Tax Administration Forum is very much in favor of going to the U.N. to sort of find a new deal.

I think there is concern that the rich countries are sort of imposing this on the rest of the world.

Robert Goulder: Well, we’ve got to move on to the money question now, which is the UTPR. Other authors who’ve published with us have likened it to the use-it-or-lose-it concept, which isn’t necessarily a tax concept — we see it in daily life in various ways — but it’s use it or lose it with respect to the corporate tax base. If one country declines to tax profits to a certain degree, a gaggle of other countries will come in and tax it for them. Essentially positioning themselves as, I want to use the term, “fiscal interlopers.”

What gives them the right to do that? Aren’t there a host of treaty problems there?

Jefferson VanderWolk: Yeah. Well, those are the questions that were bothering me until I finally responded in writing back in, I think it was early October, in response to an article in Tax Notes by professor Ruth Mason, who had written about the structure of the global minimum tax and what she calls “the diabolical machinery of the UTPR,” to basically force countries to go ahead with the whole regime because if they don’t, other countries will step in and tax low-taxed profits arising in their country.

It just didn’t sit right with me that a country could impose tax on profits that have nothing to do with that country, especially if there’s a treaty in place, an old bilateral tax treaty instead of a business profits article that prevents the taxation of business profits of a nonresident — that’s a resident of the other treaty partner — if they aren’t attributable to a permanent establishment in the taxing country. So clearly, the UTPR, as it’s been designed, is at variance with that.

Many people have said to me, “Oh, in practice, nobody’s going to bring a case in the courts because it just won’t be worth it. It’s not clear how it’ll be raised and resolved.” And I don’t have an answer to that, I really don’t know how that might play out.

But just as a matter of principle, I think the way the rules have been designed, there is a problem. This has been pointed out by other people. There are some lawyers who also wrote in Tax Notes who said a multilateral convention seems to be necessary for pillar 2 as well as pillar 1; everyone agrees it’s needed for pillar 1. Others, I think, have before me raised this question of, “How can you assert jurisdiction, with respect to profits, of a sister subsidiary?”

So you’re taxing a subsidiary who’s a resident in your country on profits that have nothing to do with that subsidiary’s business; they belong to some sister subsidiary in another country. The answers that folks like Allison and Tarcísio have given are that, “Oh, well, this is new, but it’s been agreed on by 137 countries, so we have to accept it now.” I’m not convinced by that.

Robert Goulder: As you say, all over the world now, this is a trend, right? It’s the EU and other countries are doing it. Every few weeks we hear that some other country is putting forth draft legislation for something that looks like a pillar 2 legislative process. We’re going to see governments taxing profits that have zero connection to the taxing jurisdictions. It’s as if somebody has decided the nexus concept just doesn’t exist anymore. Is it an exaggeration to say that the UTPR is killing the PE doctrine?

Jefferson VanderWolk: Well, as I said, it’s clearly inconsistent with the business profits article of tax treaties. The OECD’s justification back in the blueprint for pillar 2 in 2020 was that, “Oh, bilateral tax treaties usually have a so-called saving clause, which says that each party to the treaty can tax its own residents in any way that it likes.” So because the UTPR says you’re taxing a resident taxpayer, with the exception of a couple of specifically mentioned articles that don’t include the business profits article, you don’t have to worry about the treaty or the business profits article of the treaty.

Again, I’m not convinced that the saving clause is enough because negotiators from the two countries, when they’re negotiating a bilateral tax treaty, never would’ve considered this scenario where one country is wanting to tax its own resident with respect to profits of a resident of the other country that have no connection to a permanent establishment in the taxing country. If they did think about it, I don’t think they would agree that that’s an appropriate exercise of taxing jurisdiction.

People can disagree with me, they might say, “Oh, yeah. That’s fine.” I think the folks who don’t have a problem with this say, “Well, it’s adopting a sort of global approach. The taxpayer isn’t just each constituent entity within the multinational group, it’s really the multinational as a whole. And they do have nexus with the taxing jurisdiction because they have a subsidiary there.”

The fact that the profits arose in some other part of the world doesn’t really matter because it’s one global taxpayer in their mind, but actually that’s not the way the rules have been designed.

Robert Goulder: When scholars are debating the legality of the UTPR, they often bring up CFC regimes. In that context you have a corporate shareholder which suffers attacks on attributed income, and it might have no nexus to the jurisdiction where the CFC is, although there is an element of control there. And then people say, “Well, is control really the point?”

But let me get your thoughts on how you’d respond to this sort of analogy. I don’t know if it’s really an analogy, but it’s saying that, if you don’t have a problem with CFC rules, then you shouldn’t have a problem with UTPR. You seem to be among the people saying, “Not so fast.”

Jefferson VanderWolk: Yeah, I think there’s a clear difference. CFC rules operate on the principle that the taxpayer who’s being taxed in its own country of residence has a beneficial interest, ownership interest, whether direct or indirect, in the controlled foreign company whose income is being attributed up to the shareholder. It’s accelerating income that may be distributed in the future or may be realized economically through a sale of the shares of the controlled foreign company if no dividends have come up to the shareholder, but there’s no kind of conceptual problem in my mind with that top-down approach to taxing the shareholder on its interest in the profits of the controlled subsidiary.

What the UTPR is doing is very different because the resident taxpayer who’s being taxed may have absolutely no ownership or indirect interest in the company whose profits are being taxed to that resident. It’s brother-sister, sideways within the group, rather than top-down. So I think the operative principle that justifies CFC rules doesn’t exist with the UTPR.

Robert Goulder: There was one article that we published that talked about, I think it used the term, “customary international tax law,” and you alluded to this before in one of your responses. You noted that we had, through the OECD inclusive framework, this high-level political agreement that came out, I believe it was October of 2021, and it was endorsed by what was 137 of the countries that made up the inclusive framework. What I hear being made is the argument that if that many countries, almost 140 countries, if they agreed to this, doesn’t it effectively become part of this body of customary international law?

In other words, that sort of rebuts the argument that this is outside the norms, this is unorthodox. It’s kind of saying the orthodoxy has changed. My beef with that is that what we saw in October of 2021 with that high-level political agreement, that isn’t really what we’re talking about today with the UTPR. Can you comment on that?

Jefferson VanderWolk: Yeah, so the agreement in October 2021 was, as you say, a high-level political agreement. It’s not been embodied in a treaty-type instrument; it hasn’t been ratified by the countries that signed the political agreement. The exhibit No. 1 there is the United States, where United States Treasury delegates signed that agreement. Actually, they sort of led the process that resulted in that agreement, but Congress has not passed any legislation to implement that agreement and the Republicans in Congress have made it very clear they’re skeptical and are not likely to do that anytime soon. So you can’t really say that the United States agreed to this, it was just the Treasury Department delegate [who] agreed. But until countries actually implement an agreement in their laws and people start following the laws, then I don’t think you can say customary international law has sort of kicked in on anything like that.

Secondly, the UTPR that most people thought was part of the two-pillar agreement was the undertaxed payments rule that had been outlined in the 2020 blueprint for pillar 2. Now, that changed at some point during 2021, but nobody, even close observers of the process — other than the folks who were sitting in Working Party No. 11 at the OECD, which was drafting the model rules for pillar 2 — nobody else was aware that they had changed from the blueprint version to this new version where there was no longer a connection to deductible payments made to a low-taxed offshore group company, and you can impose the tax on a resident in a country that has no connection at all to the profits in question.

That was not something that I think the delegates in October 2021 were likely to have been focused on. They were focused on other issues like, what’s the minimum tax rate? Is it 15 percent or 20 percent? That was the big debate at the political level in 2021. The technical details of the UTPR, I think it’s highly unlikely that any of the country delegates in the inclusive framework were thinking about that.

Robert Goulder: One of the submissions you sent us responded to a piece that talked about global formulary apportionment, and the nature of that piece was to basically imply that the UTPR can be viewed as a de facto attempt at global formulary apportionment, which is kind of interesting to me because I didn’t think that the objective of pillar 2 was to address separate-entity accounting, but there you have it. People are saying that’s where this is going: global formulary apportionment. Do you have any thoughts on that?

Jefferson VanderWolk: Well, I do. I think clearly that’s the concept that’s being used to justify the UTPR. If you look back at Allison and Tarcísio’s piece on the use-it-or-lose-it principle, I think Allison and Tarcísio say at one point, “People have to get over this notion of separate-entity taxation. This is a new world of the global MNE is the taxpayer,” essentially.

I wouldn’t have a problem with that if that’s what the model rules actually said, but they don’t. They’ve preserved separate-entity taxation, they compute an effective tax rate in each jurisdiction based on each separate entity’s taxes paid and income computed according to the model rule tax-based rules. So if the GLOBE [global anti-base-erosion] agreement in pillar 2 doesn’t depart from separate-entity taxation, I don’t think you can justify this odd UTPR taxation on that basis.

Although the folks who think this is just fine and a great idea seem to be saying, “This is where we are. We’ve now moved on to a global taxpayer.” My view is if countries want to do that, fine, they can do it, but they haven’t done it yet.

Robert Goulder: Yeah. I thought the same thing, maybe a bit of aspirational thinking there as far as formulary apportionment goes. It’s not in the architecture of the pillars, but yeah.

Jefferson VanderWolk: Well, in pillar 1. Pillar 1, yes, but —

Robert Goulder: Oh, yes. I’m glad you mentioned that because pillar 1 is about nexus and it is about these taxing rights, and that’s not what pillar 2 is supposed to be about. Pillar 2 is supposed to be about the race to the bottom and responding to that. It’s almost as if they took the objective of pillar 1 and they’re sort of assigning that to the UTPR under pillar 2, but —

Jefferson VanderWolk: I can understand the argument that in order for pillar 2 to really work and be effective, it needs this backstop, OK. My point is just that the backstop hasn’t been quite properly designed to be compatible with the law, and what they need is a sort of pillar 2 multilateral convention that can be ratified and sort of have a backstop that’s legally defensible.

Robert Goulder: All right. Well, that leads me to the final question, Jeff. Do you have any predictions as to how this is going to play out or what this is going to look like in five years or 10 years? Will it stay at the OECD? Will it move to the U.N.? Will there be lawsuits in court? Will there be treaty disputes that are settled outside of a judicial forum? I know you don’t have a crystal ball, nobody does, but what do you think? What does your gut tell you?

Jefferson VanderWolk: Well, we can already see some unraveling of this global consensus to the extent there ever was one on just pillar 2 alone. As I mentioned, the Latin Americans have just announced they’re going to do their own thing, go beyond what had come out of the OECD. The U.N. is working on the possibility of a whole new global tax policy forum. Countries are already departing from some consistent implementation. The first country to have a sort of legislative enactment of pillar 2 is Korea, South Korea. They say the UTPR will come into effect at the same time as the IIR. Whereas the Europeans have said, “No, no, we’re going to delay the UTPR for a year.”

Countries are sovereign, they can do what they like in tax. The idea that there would be a perfectly consistent rollout of the GLOBE model rules is unrealistic to me. I think we’ll have a piecemeal implementation around the world; it’ll be messy. The multinationals in the frame will probably have some level of double taxation. Whether it gets relieved or not in the end depends on a variety of factors.

Whether the UTPR is ultimately litigated or not, I really don’t know, but I don’t think the whole sort of global implementation of pillar 2 is going to be smooth or clear. I suspect it’s going to be a bit messy and it’s going to take several years. I think the U.N. and other perhaps regional [groups] for this tax policy making will be much more in the frame. The OECD’s role may sort of recede and be much less important going forward.

Robert Goulder: Even though they’re the ones that got this all started.

Jefferson VanderWolk: Well, yeah. I mean, remember I was there just post the BEPS [base erosion and profit-shifting] project, the first part of the BEPS project, and could see how this was developing, right? The OECD’s role has always been to provide guidelines like the transfer pricing guidelines or the model tax treaty, but countries are always free in their sovereign powers to either take those things and use them in their domestic law or not.

The BEPS project tried to push that a bit and say, “Well, we’ve got minimum standards, and anybody who signs up here has got to do these minimum standards.” And now this two-pillar project took it a whole step further [when] they said, “Well, you can’t just have one pillar or the other pillar, you’ve got to take both pillars.” Countries that wanted pillar 1 had to agree to pillar 2, even though they might not have liked it, or vice versa.

Of course, nobody expected that the United States was not going to do it. If they had known that, maybe they wouldn’t have agreed to the whole thing. So it’s been a bit crazy getting to where we are now, and I suspect that now we’ll see countries sort of being a bit more cautious about what they agreed to in the OECD inclusive framework setting.

Robert Goulder: Yeah, I do think that’s true.

Thank you very much. Again, just to review, the article is “Global Minimum Tax: The Road Ahead.” The author is Jefferson VanderWolk with Squire Patton Boggs (US). You can find it in the January 2, 2023, edition of Tax Notes International. It’s a good read, don’t miss it. And look for his continued writings I hope in the future as we get more UTPRs going live. Jeff, I think we’ll have more to comment about.

Jefferson VanderWolk: No doubt.

Robert Goulder: Thanks much.

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