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Interview: Defending the Undertaxed Profits Rule

Posted on Jan. 11, 2023

Robert Goulder and professors Allison Christians and Tarcísio Diniz Magalhães discuss the importance of the OECD’s pillar 2 UTPR (undertaxed profits rule) and its place in international tax law.

This transcript has been edited for length and clarity.

Robert Goulder: Hello, I'm Bob Goulder, contributing editor with Tax Notes. Welcome to the latest edition of In the Pages, where we take a closer look at some of the commentary from our print and online publications.

Now if you follow international tax policy at all, you might know that there is a raging debate going on these days. It concerns a particular aspect of the OECD's pillar 2 proposal for global tax reform, specifically the UTPR or undertaxed profits rule.

The tax community is basically split as to whether this rule violates international tax norms or treaty obligations or whether it complies with them. Tax Notes has published multiple articles on this topic, and I think perhaps the best one was written by our guest speakers today, conveniently. The article is titled "Undertaxed Profits and the Use-It-or-Lose-It Principle."

The coauthors are Allison Christians and Tarcísio Diniz Magalhães. Professor Christians is with McGill University in Montreal, where there's a lot of snow, and Mr. Magalhães is an assistant professor at the University of Antwerp over in Belgium, one of my favorite cities.

Their article takes a position that the UTPR shouldn't be so controversial and that if you dig enough and you do your research and you look at it, it's actually supported by international law and economic reasoning. In other words, UTPR skeptics like me need to settle down and appreciate the bigger picture.

Well, to help us with all of this, let's get right to it. Our guest speakers, Allison and Tarcísio, welcome to In the Pages.

Allison Christians: Thank you so much. It's great to be here with you again.

Tarcísio Diniz Magalhães: Hello.

Robert Goulder: So first, a little bit of background. You described the UTPR as a manifestation of the use-it-or-lose-it principle, which a lot of us are familiar with. If you have a flexible savings account, you have to go out before December 31 and buy a bunch of prescription sunglasses. You have to use those benefits or they go away forever. They don't carry forward. OK, "use it or lose it." We know the concept. How does that apply to the UTPR?

Allison Christians: Well, it's a great question, and of course we're trying to vulgarize the regime a little bit, because it's such a complex regime. But I think everybody can understand that use it or lose it doesn't mean that you're giving something up, it's that you have an opportunity here. So you have to look at the big picture of the global anti-base-erosion regime, what is it doing? It's creating a pool of tax revenues and it's allocating them to countries that want to collect them.

So if you choose not to collect them, then some other country is going to collect them. And the rationale is — because we're talking about cohesive multinational groups. So their income is a big pool and the tax revenues are a big pool, and it's not that one country has a superior claim over another. They have equal and competing claims and this is a coordinated regime.

So that's what going on. "Use it," meaning get the tax that you are entitled to get under any principle of domestic law, international law, but "lose it," in the sense of, if you don't tax it you know someone else is going to do that.

Tarcísio Diniz Magalhães: If I could just add something to what Allison said. I guess the part of the "lose it" also reflects a concern with not having overlapping claims.

The idea is, if you didn't tax, somebody else is going to tax it and then you lose the opportunity to tax that. You can't go back and say, "Well, so I had these profits with me, they were undertaxed and then somebody else taxed them, I going to tax it again." You have overlapping claims that would create double taxation, which is what we don't want.

Robert Goulder: All right. And just to clarify, it's implicit in your answer that the country trying to enforce a UTPR does not have first dibs. Your article does a very good job of describing the switches. First, there's the country that would have the qualified domestic minimum top-up tax (QDMTT), and then there's even another country that would have the IIR, the income inclusion rule. It's only when those countries, which are multiple jurisdictions, decline or refrain from taxing, then the UTPR kicks in.

Allison Christians: Yes, I really see the UTPR as a commitment projector. When I say that, it's kind of an international bargaining term. It's like, if I'm going to enter into a deal with you and we both are better off if we both carry through the deal, but we're both not sure if the other one's going to do it and we're worse off if the other one doesn't do it, then I need to get some commitment from you and I need to project my commitment to you.

The UTPR really fulfills that role. It's one thing to say there's going to be countries doing an income inclusion rule, but if countries aren't doing an income inclusion rule, then some countries won't want to do a qualified domestic minimum tax, because they were using their tax system to incentivize investment. So the UTPR, the QDMTT, and the IIR, they're all projecting each other's commitment to the global minimum. 

But somebody's got to jump first. If nobody jumps, then nobody wants to jump, because everybody's afraid that there are going to be negative consequences in terms of your ability to attract capital.

Tarcísio Diniz Magalhães: Maybe one thing is that, at the end of the day, it could be that the UTPR is not even that much applied. Because of all these signals that are being sent, you have to go through the QDMTT and then you have to go to the IIR, that's the end of the line. So it could well be that this is not even really much applied in practice, it just serves as what Allison said: a signal so that you do put in place an IIR or the QDMTT.

Robert Goulder: That's an excellent point right there. I mean, we're describing the UTPR as if it is the conceptual linchpin of pillar 2 operating effectively, and yet we can all envision a scenario where it doesn't collect any revenue at all. It collects zero tax dollars or zero euros. It doesn't collect anything, because it's inspired other jurisdictions to do what they're planning.

Allison Christians: Yeah, exactly.

Robert Goulder: Next question. I hear what you're saying and I see the title of your article, "use it or lose it," but there's something about that "losing it" that just doesn't sit well with me. I mean it sort of hints at somebody taking something that's not theirs. I'm just not comfortable with the "lose it" part and I've likened it to eating somebody else's leftover pizza. It wasn't yours, they left it in the fridge, and somebody else ate it.

In fact, Tarcísio, you've written actually sort of a follow-up to that. I don't know whether you or Allison want to take this, but illuminate for me and all of our viewers, what's wrong with that food metaphor?

Tarcísio Diniz Magalhães: OK, so the reason why I think we do not agree with the metaphor or that we see issues with the metaphor is that it seems to imply that we can know that some countries have an exclusive right over something, which is a portion of the multinational enterprise's global profits, and that when other countries tax that they're taking away that right. Some form of natural right that is not in a treaty somehow or that comes from general international law or something that is not so clear, but that we can still affirm and say, "Well, there's something that belongs to someone and somebody else is taking it."

The way that we see it is that we're not really discussing leftovers, we're discussing the whole sandwich, as you put it, right? 

What I did in my follow-up article was to try to explain that it's not really possible for us to know ex ante, and what I mean by that is without the law and the law that we have is treaties or domestic law. We cannot know who owns what if we do not recur to this body of law. There was even a follow-up by Sol Picciotto, saying, "Well, can I even know if that sandwich belongs to an entity within the multinational, because it's so convoluted and so structured in a way. But what really tells us what belongs to what is actually the law."

Allison Christians: I would just even go further. I don't think it's even a sandwich. It's a buffet. I mean, when you go to a buffet, you don't own the whole buffet. You're there with a whole lot of other people who've been invited to the buffet. Maybe it's even a potluck, everybody brought something to the buffet and now everybody has a chance to share in that buffet. But it doesn't make it yours exclusively any more than it makes it someone else's exclusively.

I think for me, the food metaphor, as much as I love to think about food and food metaphors, it's just inapposite here because the profits that we're talking about are generated through cooperation. They don't belong exclusively, they weren't produced by one country or another, but they were produced by the combined efforts of countries working on trade, investment flows, and tax cooperation as well. So the product, the profits that we're talking about are the product of their cooperation, not each one bringing something and then wanting to take it back home again. But their collective cooperation creates this surplus that does not belong to one or the other, but belongs equally to both.

That's why this is a coordination game, not an allocation, not strictly saying, "This is your right or this is my right." But rather, "What do we do when we both have rights to the same thing?"

Robert Goulder: Another part of your article that I really enjoyed is where you use the phrase, "piercing the veil." I think anybody who went to law school and took corporate law 101, they had to prep on this, you had to learn this material, this concept of piercing the corporate veil. It's not a tax concept at all. It has to do with the limited liability of shareholders, because one of the whole points where you have corporations is that the shareholders' liabilities are limited to what they invest. They're not going to be generally liable for the entity's debts.

You've likened, in your article, the UTPR as being kind of analogous to the tax equivalent of piercing the corporate veil. Can you elaborate on that and specifically why is the piercing justified? Because in the nontax context where you actually do have strict corporate law piercing the corporate veil, it's because somebody's done something wrong. The board of directors or somebody has not gone through their due diligence and they've done something wrong to get to that result where the veil is being pierced.

Tarcísio Diniz Magalhães: I guess the first thing that we have to remember is that tax laws do not always have to respect private law and private agreements among parties, right? This is one thing that law does a lot of times, which is to say, "Well, I'm going to attribute a different consequence to this situation." It's often that we're going to see the use of the expression, "for tax purposes," so that means that situation that we thought was going to have this consequence is going to have a different consequence for the purposes of tax law.

In the paper when we use this expression, "tax veil piercing," what we're actually referring to is this whole body of doctrines and approaches that disregards, to different extents, the corporate veil in order to attribute different consequences. That happens in all sorts of areas of the law, and that happens with different jurisdictions in common law and civil law countries. That happens with constitutional law, international law, corporate, antitrust, and also tax. But if we want to be perhaps more technical about it, we can also make a distinction, and this is a distinction that some corporate law lawyers are going to make, which is between piercing and lifting.

So the piercing gives that idea there, "I'm really going through the corporate structure and I'm attributing the consequences to ... connecting the shareholder to the assets automatically." But there's also the idea of lifting and that some people would say looking behind a veil or some other fellows would even call that peeking or veil peeking, which is just the idea that for a specific situation, for a specific scenario, you can disregard the corporate veil in order for some regimes and some loss to be effective. In the case of the UTPR, in a case of controlled foreign corporation regimes, what they basically do in the end is that they kind of look through the corporate structure and say, "Well, even though this income appears to be arising in a different jurisdiction in a different company, it's not really what that means for the purposes of tax laws."

Allison Christians: In the short form, for me, the private law is the private law and the tax law is the tax law. We use "piercing" because it's just something that helps people understand what's happening. But every deeming rule is, in some sense, going in that direction. So it's just unremarkable to me, it's not something to get that excited about, I guess.

Robert Goulder: Well, one thing that I know our readers do get excited about is whenever we mention separate-entity accounting, because I'm listening to everything you say and it sounds entirely reasonable, eminently logical, but are we assuming a unitary universe here?

In other words, the whole concept of separate-entity accounting is basically when you look at an integrated multinational corporation with, who knows, dozens, if not hundreds, of different subsidiaries, if each subsidiary is not a branch, if it's a sub, and it's incorporated, we pretend that it's this separate little entity. It's unique unto itself, it has legal personhood, and we respect that. There are supposed to be meaningful consequences in the tax world and otherwise about respecting legal personhood.

So let me ask you this question: Does separate-entity accounting need to fail for the UTPR to succeed?

Allison Christians: No, not at all. Look, 1930s you get the incorporated pocketbook rule and it all stems from that. You still have the incorporated pocketbook, it's just that you can't use that to eviscerate the tax results that otherwise would obtain. Nobody would say that that's a good idea. You wouldn't say, "I think what we should do is have a tax system where if you interpose an entity, you get a totally different result than if you do it directly." That's just not a good policy position.

You have to think about, well, what is the entity doing? Is it providing something? And you start thinking about this as a safeguard or, if I may, an antiavoidance regime. If you look at regimes that look through the corporation or the structure, what's often happening is that we're just trying to make sure that the income tax is accurately reflecting income. That's the job here. This is just new words to do the exact same thing.

If we didn't call it a UTPR, and if instead we call it a foreign personal holding company or a foreign company income regime, we used more familiar names, maybe we would have less consternation about it. But this is the exact same line. So we go foreign personal holding companies, incorporated pocketbooks, CFCs, passive foreign investment companies, and global intangible low-taxed income, and they're all of a piece. And UTPR is in the same sense doing the same thing.

Tarcísio Diniz Magalhães: I would even say that it could actually be the opposite. It could be that these rules are actually affirming the idea of separate entity as something that is going to continue. They are trying to preserve this idea of separate accounting instead of getting rid completely of the whole system. The UTPR doesn't even apply to all taxpayers or even to all MNEs, right?

It's really topical and it's really directed to a situation saying: "Well, so we have separability of companies, but this does create many problems? In this situation here, we are going to look at it differently so that we can actually implement the tax laws and what they're supposed to be doing."

Robert Goulder: I think there's an opportunity for history to speak loudly here, and you referenced that in your piece. You've got the section under the thunder of history, which is a very sort of poetic phrase, but you're getting to the point that if you go back far enough, we've seen this debate before. I mean not us, but in a different era, they did have this debate before. Can you elaborate on that?

Allison Christians: Yes. If you go back in history, we keep repeating it, just in a new and more fancy way each time. And that's great, we're tax lawyers, we love to think about history in new ways all the time.

If you go back far enough, go back to the '60s and you'll see a cascade of protests. That is the description of how people reacted to the U.S. CFC rules. A cascade of protests. They just thought, "This is unacceptable, it's inappropriate, it doesn't accord with corporate law," as we were just talking about, the piercing a veil and all of this stuff. You see articles, the scholars sort of wringing their hands and gnashing [their] teeth about the CFC rules. But then pretty soon the world starts to see the sense in a CFC rule as a safeguard or an antiavoidance regime, and you see it picked up.

Recently you may have seen a cascade of protests coming out in the form of the congressional letter about the UTPR. You see a cascade of protests, but this is sort of reactive. When we then start looking back and analyzing the underlying problems, I think we can see that each and every problem that is the subject of the cascade of protests is not something new. This is something we've seen before and it's not as if lawmakers always fully reflect all of the nuance that's going on in those problems.

For me the thunder of history is, when something is new, really the first thing you should do is say, "Well, but is it really new?" It's not really new. It's a lot like a lot of things we've seen before.

And I'll just add to that: "Why is that so?" Well, because there's only so many ways you can design a tax system. And the same problems have been with us for a hundred years. The income tax is porous in some way, the economy is globalized, the interposition entities have always been a problem, the ability to have hybrid instruments and entities is always going to disrupt the legislature's intent. Those are just common problems and we're just solving it over and over.

And then of course, an army of tax practitioners' job is to raise the cascade of protests each time we get a little closer to closing those doors. I think that's where we are. We can go back, we'll go forward.

And here's the good news for us, Bob. We're going to go through this again in our lifetime, I'm sure, and next week or next month or in a couple years, we'll have a new abbreviation and we'll be able to unpack all the cascade of protests around that new idea. But by then I hope we will have come to a realization that the UTPR, much like the CFC, is in a transitional moment now and we'll get some calmness and reflection about it in the days to come.

Tarcísio Diniz Magalhães: Maybe that gives a connection to something that we should clarify, which is this process that Allison's referring to, this dynamic process of the law. There's reform, and there's more law, and more lawyers put in place, and people question it, but then it stays or it goes away and we have more. So one thing, just to clarify, that we're trying to push through with our paper, is not that we are defending the GLOBE regime or the UTPR as the best scenario or the solution to the world, that now we're going to have the most beautiful tax regimes in the world.

But what we're actually saying is that there are not really legal arguments against this. This is a natural problem that's going to come and go. We're going to have different rules being put in place. Allison and I have been very, very critical, actually, of the OECD word. We're using the term "skeptical." We're very skeptical about the inclusive framework and everything that they do there. But we do accept that there is a process happening, taking place, and countries are getting together and rearranging things and redesigning things in order to achieve certain goals.

Now, if there is a real legal case based on real substance of international law, then that would be the situation where this couldn't move forward. But that's exactly what we don't see. We don't see a real legal case here.

Robert Goulder: Well, you're absolutely right about your history of calling out possible flaws in the OECD architecture when they come up. I remember Allison saying, "Hey, where's pillar 3?" We'll leave that for another interview. But I take your point.

Well, what about treaties? We don't want to get too much into it, but the cynic in me is saying: "Boy, there's going to be a lot of treaty disputes." Maybe, maybe not. But what are your thoughts on that? How does UTPR fit in with the treaty world?

Tarcísio Diniz Magalhães: First, let me start by saying we didn't try to address the treaty issue there because there are a lot of moving parts with the problem with treaties. Our first step was to say: "Well look, this is a process. This is a group of states getting together and deciding how they're going to redesign their own tax systems, which is valid and legitimate. And there's no international law violation there."

Now when we go down to treaties, there are a few steps that we have to look into. The first is if the UTPR is, as we are arguing, similar to CFC rules. If that similarity is accepted, then it could be that it is compatible with treaties as they stand now, as the view is when it comes to CFCs. But even if this is not the case, some have said that the savings clause should be a justification for treaties. The reason is because the UTPR is a tax that is imposed on a resident.

Allison mentioned before, for example, the congressional letter. One of the problems that we see there is the issue that is being raised that the UTPR is taxing a U.S. company, when in fact what the UTPR is doing is taxing its own resident. Now, there could be a discussion there on the allocation, but the object, the taxpayer that has been taxed, is a resident of the UTPR jurisdiction. In those terms, if you apply the savings clause, the savings clause would say that "Well, you can tax a resident any way you want and tax treaties don't stop you from doing that." But then again, some treaties don't have a savings clause. So there is a problem there, you have to look into each of the treaties.

Then there's the issue of treaty override. Now we know that some countries, including the United States, can override their own treaties with their domestic laws. Some other countries, like Germany or the United Kingdom, have some issues or some situations similar to that, but other countries just cannot do it. So the analysis of the treaty goes through a bunch of steps where we have to look into the specific treaty. We have to look into the domestic laws of the country. Does the country allow treaty override? 

Allison Christians: I'll just add something to this that I think sometimes gets forgotten in the treaty discussion. How do disputes under treaties arise and how do they get resolved? Well, they arise and they get resolved through the MAP process, the mutual agreement procedure. We know this is a competent authority process. It's in a box we can't see, there's no appealing what happens with the common authorities. So we have this system where there's conflicts, we will not learn from them. We will not be able to develop the law based on experience, because they will be resolved through competent authority procedures. But what we do in response to that in some way, is often through the OECD. We have a peer review mechanism, where we all say we're going to agree to the same rules, we're all going to carry out the same rules. And how do we hold each other to that commitment? Well, we do it through the peer review.

So I would say, we always have to come back to the big picture again. If you get too far in the weeds on this, I can see where you can twist yourself in knots and start thinking there's going to be some sort of treaty problem. But if you back out again, what was the point of GLOBE? Global minimum tax is an agreed idea to drop a floor, to create a floor against excessive tax competition. So why would a competent authority of one country fight the effort of another country to implement that minimum tax? They're only going to fight that if they themselves are trying to collect it and they think that there is a dispute and they need to resolve it.

That is something that competent authorities can do and are accustomed to doing. It's just that we don't see that. We don't count that as part of the legal fabric because it's just not something that most of us have access to. I think it's really important to remember that if you think that there's going to be some sort of treaty dispute, that you have a built-in treaty dispute mechanism already, and you have the principle that parties should be carrying out treaties in good faith. The good faith part of this has altered, as a result of the membership in the inclusive framework and participation in GLOBE. So any party that is part of this process, but then decides to start taking issue with things through a treaty, I think is violating that spirit and I think they should be called to task at the inclusive framework.

If the OECD is going to build an inclusive framework and say that everyone is entitled to be part of this process and everyone is going to be implementing, then there has to be some accountability. I don't understand otherwise why that inclusive framework exists. For me, this technical legal problem, I understand the legal problem. I understand that people want to see legal barriers, but I would point them to the process that got us to this and say, "How is the OECD going to resolve this problem?" I think if you take on the role of a global tax policy provider, then you have an obligation to step up and be the forum where countries can take those problems and get them resolved to the mutual satisfaction of all participants.

Robert Goulder: Well, sadly, we need to wind things up. It's time for our last question, and I'd like to end with a prediction. Allison, Tarcísio, five years, 10 years, 20 years, will we reach the point where the UTPR is as normal and as entrenched and as noncontroversial as our CFC regimes?

Tarcísio Diniz Magalhães: Twenty years from now, I would say we're going to have another rule, we're going to have another acronym. It's going to be a whole different thing, a whole different system, a whole different discussion. That's just the process. That's just how international tax law evolves. But I just wanted to emphasize that I don't think the UTPR is to be seen as controversial even today. It's just a rule that reminds us that law is dynamic and that corporations are a creation of legal systems. The way that we regulate them, the way that we tax them, the way that we design, and the way that we recognize property rights, juridical personalities, separability of companies — this is all part of the law.

Unless we have something of a customary or general international law that says, "Countries have to respect the ability of companies and they have to treat them differently and you cannot allocate profits or income from one entity to another," then I don't think there's really an argument there to say that the UTPR is controversial. It's just doing something that is pushing things forward in a direction that we already have done in the past. And again, we can go back to those examples that we discussed before, like CFCs and other forms that are attribution of companies.

Allison Christians: And I'll just end by saying, well, I have a crystal ball and I can see exactly what's going to happen in five, 10, and 20 years. Here's what's going to happen:

There will be a number of disputes. The disputes will get resolved in ways that are unsatisfying. They will leave threads open, people will pull on those threads and push on those threads. Base erosion and profit shifting will not be resolved. Tax havens will not be shut down. There will not be an end to tax avoidance, abusive tax avoidance, aggressive tax avoidance, or any sort of tax avoidance that you don't like. These will remain controversies.

And what will happen is that right now public appetite might be dying down, but it will ramp back up again. There will be some exciting stories and it will start a new cycle of global lawmaking again. The only question is whether that next global cycle will carry through the OECD again and the inclusive framework. Or whether the attempts to move tax policymaking over to the U.N. will be successful in some manner and create institutional competition.

So I have a crystal ball for what taxpayers will do and what tax lawyers will probably do, and the public's appetite for thinking about international tax might wax and wane. I think that where we should keep our eye now is this institutional transitional moment that we may be in. That might actually alter the conversation somewhat, but I think we can pretty much guarantee that all the haves will fight to keep what they have and all the have-nots will fight to change the status quo. Thus it has always been and thus it shall always be.

Robert Goulder: There you have it, professor Allison Christians and Tarcísio Diniz Magalhães. The article is titled "Undertaxed Profits and the Use-It-or-Lose-It Principle." If you haven't read it, you need to. It's brilliant. You'll find it in Tax Notes. Thank you so much for joining us. I hope you get to write about pillar 2 again sometime. We'll do this all again another year.

Allison Christians: I hope so, too. Thanks, Bob.

Tarcísio Diniz Magalhães: Thank you so much.

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