Undertaxed Profits and the Use-It-or-Lose-It Principle
Allison Christians (@profchristians on Twitter and TikTok; www.allisonchristians.com) is the H. Heward Stikeman Chair in Tax Law at McGill University in Montreal, where she writes and teaches national and international tax law and policy. Tarcísio Diniz Magalhães (@TarDMagalha on Twitter) is an assistant professor at the Law Faculty of the University of Antwerp, a research supervisor at the DigiTax Centre of Excellence, and a member of the Antwerp Tax Academy.
In this installment of the Big Picture, Christians and Magalhães defend pillar 2’s undertaxed profits rule, arguing that it is supported by fundamental principles of international tax law and economic logic.
In recent weeks, commentators have taken issue with the functionality, theoretical justification, and legality of the global anti-base-erosion (GLOBE) undertaxed payments rule, now called the undertaxed profits rule. A common thread among the various arguments is a claim that the UTPR permits some countries to tax without a justifiable entitlement to do so. On the contrary, we argue that the guiding principle of GLOBE is “use it or lose it”; that this principle can be supported both in theory and in practice that has been observed over decades; and that in pursuing this principle, the UTPR is a coherent component of the overall GLOBE scheme for taxing profits of large multinational entities at a minimum agreed rate. Because such profits belong, in economic terms, to a group of companies at once, the UTPR mechanism is not objectionable on either international law or economic reasonability grounds. Pending a multilateral fix to any possible treaty-based issues, competent authorities should apply treaties in light of their mutual recognition of GLOBE.
I’ll Tax if You Don’t
To understand the rationale of the UTPR requires contextualizing it within the overall scheme of GLOBE. That structure is an interconnected series of on/off switches, each of which supports the efficacy of the others in reaching the agreed minimum effective tax rate (ETR). The main switch is the income inclusion rule, but the IIR can be switched off by another country’s qualified domestic minimum top-up tax (QDMTT), and either the IIR or the QDMTT can switch off the UTPR. In this sense, each of the switches signals commitments toward the others, the functioning of each depends on the others, and none can be assessed in isolation. Each switch assures the participating countries that if one doesn’t tax, another one will. Without these assurances, the logic of tax competition would prevent the parties from engaging any of the switches.
GLOBE’s chosen structure is unwieldy, to be sure, but it can hardly be surprising to anyone paying attention to how international tax law has been made over the past century. The fact is that international tax law is the product of OECD/G-20-led consensus-building, and none of the relevant institutions have the mandate or the power to agree and enforce a single mandatory rule on any of their members. The predictable outcome of this kind of transnational legal order is indeed a series of interdependent but ultimately autonomous moves and countermoves by countries with massively different levels of influence over each other’s policy choices.
With that context in mind, readers will recall that in the first OECD documents and discussions, the abbreviation UTPR referred to undertaxed payments, not undertaxed profits, as it is now referred to in expert and academic circles. The underlying idea is constant, though: The UTPR’s role is to be a backstop to the IIR. In expanding from payments to profits, the UTPR effectively broadened the pool of source countries participating in the overall GLOBE scheme of collecting the difference between the ETR paid by an MNE’s low-taxed constituent entity and the agreed 15 percent rate. No UTPR amount gets collected unless none of the other relevant jurisdictions gets there first with an IIR or a QDMTT. When those elements are missing, the UTPR flip switches to on.
Robert Goulder and professors Allison Christians and Tarcísio Diniz Magalhães discuss the importance of the OECD’s pillar 2 undertaxed profits rule and its place in international tax law.
When UTPR Switches On
Under a payment-based UTPR, the jurisdiction from which one of the MNE’s entities (typically, a lower-tier entity) makes an outgoing payment (typically, upstream) collects the equivalent of the top-up tax. This equivalent can be collected, for example, by denying part of the deduction of the payment against domestic income, or by an equivalent measure such as increased withholding. Figure 1 illustrates.
Under a profit-based UTPR, by contrast, any source country within the MNE’s structure can collect a top-up-tax equivalent amount so long as there is no IIR doing so first. The overall effect is to switch the top-up tax collection from the unwilling top-level jurisdiction to basically any other willing jurisdictions downstream in the chain of companies that form the MNE group. For example, imagine a simple three-entity, three-country structure in which the parent (Company A) is in Country A, which does not adopt GLOBE; one of the subsidiaries (Company B) is in Country B, where its ETR falls below 15 percent; and the other (Company C) is in Country C, which adopts GLOBE. Upon Country B’s reluctance to tax Company B at 15 percent, and Country A’s unwillingness to collect the top-up tax via an IIR, Country C’s UTPR switches on. Figure 2 illustrates.
According to the model rules, this additional tax can be collected by way of a denial of deduction or any other domestic measure that results in an “additional cash tax expense” for Company C. The cash tax expense must match the amount of top-up tax that was computed for Company B but collected by neither Country B (via a QDMTT) nor Country A (via an IIR). Because in our example Country C is the only other available jurisdiction in the MNE structure, the entire top-up amount could be collected by Country C. The situation gets more complicated when there is more than one source country within the MNE’s structure willing to collect the top-up tax. If in the example, Country D (hosting another subsidiary) has an ETR above 15 percent and adopts GLOBE, the top-up tax amount is split between the UTPR jurisdictions according to a formula using the number of employees and net book value of tangible assets, again with a switchover rule if for some reason one does not collect its share.
Your MNE, Your Choice
This expansion of the UTPR is intended to make GLOBE overcome the logic of tax competition, even when all the other jurisdictions hosting the MNEs fail to cooperate with the agreed scheme, and even when there are no intercompany payments among the parties. By switching the top-up taxing right that would otherwise fall to another jurisdiction, the UTPR implements the use-it-or-lose-it principle. Either of the other two jurisdictions could collect the tax instead if they chose to do so.
Some of the commentary regarding the UTPR argues that there will be country-specific domestic law or even treaty constraints on a country imposing what amounts to a surtax on domestic income that is calculated by reference to a foreign entity’s profits. Some claim that it is nonsensical to treat a domestic subsidiary as anything but fully separate from its sister and parent entities because the domestic subsidiary lacks control over these entities and their incomes.
Before even considering whether those challenges could ultimately succeed on the merits, it is important to note that national courts may not be the ones making these determinations. Many disputes will be raised and settled not within domestic appeal processes but instead within the much less transparent context of bilateral tax treaty mutual agreement procedures. Here, the weight of geopolitical relationships, plus decades of evolution in nonbinding models, peer review, guidance, commentaries, and so forth — all the documents and all the politics that make up the pluralistic transnational tax law order — cannot be ignored. The relevant legal terrain is uneven. It is entirely possible that these kinds of disputes will be settled in ways that most observers will never have a chance to review and assess.
But even if we could predict the legal outcomes of dozens or hundreds of future controversies across multiple kinds and levels of dispute resolution processes in several jurisdictions around the world, the question that remains is one of principle: Is use it or lose it a defensible tax policy norm? More specifically to the UTPR: Is it justifiable that a country imposes tax on a domestic company in relation to income originally arising in a sister company, in cases where the controlling parent company’s jurisdiction declines to tax? While some commentators assume the answer must be no, both international tax law precedent and economic logic point to the opposite conclusion.
We’ve Seen This Before
Some readers may protest that use it or lose it is not a legal principle but a craven revenue-grabbing rule. To the contrary, use it or lose it has long been one of the unspoken fundamental principles of the international tax system. One could point to the mid-1930s, when the United States adopted personal holding company rules in 1934 (imposing surtaxes on companies earning passive income) and then foreign personal holding company rules in 1937 (imposing taxes on U.S. shareholders of those companies). Certainly, the use-it-or-lose-it principle became clear by 1962, when the United States enacted the first controlled foreign corporation regime. By virtue of the foreign tax credit, countries that impose a CFC regime ultimately only collect their tax to the extent the source country fails to tax the targeted income first.
The conversation we are having today about whether the UTPR violates international law norms echoes the thunder of history. When the United States adopted its CFC regime, it is not the case that everyone agreed that naturally one country could look through the corporate form in another country. On the contrary, when introduced for the first time, CFCs were, like the UTPR, seen as incompatible with prevailing assumptions about the legal personhood of corporate entities. It took time (and much academic debate) before it became widely accepted that the law could simply deem income to be paid from one legal person to another, at least when the first controls the second.
The question is whether the control must be top-down in order to allow one person to be attributed income earned by another. GLOBE advances a contradictory view — namely, that the MNE is a single economic unit so the low-tax status (call it a tax attribute) of any one of the entities under common control may be treated as that of any of the others. If this premise seems impossible to accept, it may be because we are still devoted to two ideas: first, that each entity in an MNE is a separate legal person; and second, that only a controlling interest can create the bond — namely, nexus — needed to transfer a tax attribute from one entity to another in the group for purposes of imposing a tax.
Nexus to Control and Back Again
The role of nexus as a threshold to taxation can be traced back to the century-old economic allegiance doctrine, a central principle in the consensus that originated the international tax system. The UTPR, so the argument goes, would allow countries to tax income from sources that are not directly connected with or linked to their territories. This is illustrated in Figure 2, where Country C, despite itself imposing taxes above the minimum rate, taxes its constituent entity more because Country B’s constituent entity has undertaxed profits. Some have even compared this situation with that of an individual being taxed on income pertaining to their siblings or cousins living abroad. But a group of affiliated companies is obviously not like a family group at all. Companies are not bound by the physical world: Their existence stems from a legal fiction that allows them to continuously expand, multiply, merge and separate, create and eliminate members, rearrange their activities at will, and, in doing so, spread their income among low- and high-tax jurisdictions in order to obtain economic gains through means not available to human beings. It is precisely because firms are nothing like humans that base erosion and profit shifting has been such an issue for corporate taxation systems, and what ultimately motivated GLOBE.
Going back to our simple illustration in Figure 2, the nexus problem looms if it is perceived that Company B’s income is being transferred to Company C in order for Country C to tax it. But this perspective ignores the single economic unit that the entities form by virtue of being under the common control of Company A. If all the entities were within one jurisdiction, consolidating their income and making each jointly and severally liable for taxes owed by any one of them would be uncontroversial. Further, it is just as accurate to say that what the UTPR shifts is not Company B’s income to Company C at all, but rather Country A’s unexercised taxing right to Country C. The taxing right in question pertains to profits that are under Company A’s full control, but Company A’s control of both Company B and Company C means that, economically, all the entities’ respective tax attributes pertain to and affect the entire group. With the support of 137 countries, the new global tax framework largely superseded the consensus that arose from deliberations among a few key players in 1920s and 1930s, when it was generally thought that physical connection was essential to establish nexus. The 2021 multi-country consensus for a global (and digitalized) economy is that any country that hosts an MNE member has a sufficient link with the group’s income and is therefore entitled to jump in to fill fiscal voids left by other countries. It would be contrary to the purposes of the inclusive framework to restrict countries (especially source countries) from fully participating in the overall scheme of collecting top-up taxes regarding MNE groups’ global income on grounds that century-old assumptions predating the agreement still stand. Figure 3 shows the workings of the UTPR’s taxing-right switching mechanism as an expression of the reality of the firm as a single economic unit and the principle of use it or lose it.
Tax Veil Piercing?
If it is difficult to overcome the assumption that control is needed to attribute income from one taxpayer to another, consider that there are plenty of examples of various legal attributes being assigned among the members of commonly controlled groups for other purposes. For example, we might point to domestic consolidation regimes that combine income and assign joint and several liability for taxes among related entities. Similarly, we might point to corporate law such as that in Canada, which defines affiliates by common ownership and then assigns liability to remedy harms to all affiliates. But even without express statutory authority, corporate veil piercing is sometimes a remedy for various behaviors in common law, and the approach is also applied across civil law countries. Perhaps the UTPR can be understood as calling for tax veil piercing by pushing down income that, under the agreed framework, should have been taxed in the hands of the upstream company.
We can see this idea being embraced elsewhere in GLOBE — namely, where CFC taxes are “pushed down” to the local company level. In so doing, GLOBE attributes tax payments of shareholders to their controlled entities. There are good reasons for this idea: If CFC taxes are not considered when computing a company’s ETR, then the ETR calculation runs the risk of appearing economically incoherent because CFC-level taxes are presumably borne by the underlying profits that gave rise to their existence. When GLOBE assigns the subsidiary a tax attribute of its owner, the principle must be that the CFC tax substituted for the missing local tax (because, if the domestic country had taxed instead, these would have been creditable taxes, thus reducing or eliminating the CFC taxes). If one asserts that, absent control, a taxpayer cannot be assigned the tax attribute of another, then pushing down CFC taxes to calculate a subsidiary’s ETR ought to be as controversial as the UTPR. If, however, one considers that shifting tax attributes for this purpose makes sense, then the argument against also doing so for purposes of the UTPR is on shaky ground.
The same principle is at work in the kill-switch provisions added to the U.S. model tax treaty in 2016. These provisions would turn off treaty rates for interest, royalties, and other income to preserve taxation in specified cases of BEPS — namely, through special tax regimes. The kill-switch mechanism would deny treaty application when a person makes a specified payment to a “connected person” who is eligible for a special tax regime. Persons are defined as connected not only when one has control over the other, but also when both are under the control of the same persons. That is, the provisions would impose a higher rate of tax on the domestic company whether it is the controlled or a controlling company in an affiliated group when one of the members of the group received a tax reduction through a special tax regime. This illustrates the principle of use it or lose it in altering the tax consequences of domestic companies by reference to the tax attributes of foreign-controlled as well as controlling entities. The model treaty thus demonstrates the intellectual path to the UTPR.
Because the UTPR satisfies the same underlying rationale for CFC regimes, for pushing down CFC taxes under GLOBE, for other corporate attribute-shifting regimes under tax and corporate law, and even for the 2016 kill-switch provisions, it cannot be dismissed as in defiance of any particular principle of international tax law or international law more generally. If the whole purpose of the GLOBE project is to reduce tax competition regarding specified income of in-scope entities that are commonly controlled (including by reference to consolidated financial statements), then a top-up tax imposed by any jurisdiction in which group entities are located must be understood as the point and purpose of the 2021 agreements and preceding rounds of negotiation.