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Analyzing The OECD’s Pillar 2 Proposal

David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: pillar 2. On November 8th, the OECD released the second part of its two-pillar plan for the taxation of the digital economy. The pillar 2 draft explores design questions for a global minimum tax. A little later, we'll talk to Monika Loving, the national practice leader at BDO's international tax services group, to get her take on the new draft. But now, I'm joined by phone by Tax Notes legal reporter Ryan Finley to talk about what's in this latest draft. Ryan, welcome back to the podcast.

Ryan Finley: Thanks for having me.

David Stewart: Could you give us an overview of some of the key aspects of this pillar 2 proposal?

Ryan Finley: Sure. The pillar 2 proposal attempts to implement a global minimum effective tax through four basic components: an income inclusion role, an undertaxed payments rule, a subject-to-tax rule, and a switchover rule. The income inclusion rule would apply to a foreign subsidiary or a branch if its income is taxed below some minimum rate that hasn't yet been specified. The undertaxed payments and subject-to-tax rules would basically deny the deduction, deny treaty benefits, or impose a withholding tax in the case of payments to foreign-related parties that are taxed at a rate below this minimum rate threshold. These elements have been compared to the U.S. GILTI and base erosion and anti-abuse tax regimes that were enacted in 2017. There's also the switchover rule, which would amend bilateral treaties to switch from an exemption method to a tax credit method for income tax at an insufficient effective rate.

David Stewart: So what is the problem that the OECD is seeking to solve with this proposal?

Ryan Finley: Well, the consultation document basically highlights two things. One is to address the issues left unresolved after the BEPS project by ensuring that multinationals are subject to some minimum level of tax. According to the consultation document, pillar 2 would limit multinationals' incentive to engage in complex and artificial tax planning structures and it would curb tax competition between countries because there'd be no benefit to having a rate lower than this minimum effective rate.

David Stewart: Now, how does pillar 2 relate to pillar 1 and the original BEPS project?

Ryan Finley: Pillar 2 is designed to counter profit shifting and avoidance by multinationals like the original BEPS project in 2015, whereas pillar 1 was more about deciding on the allocation of taxing rights among countries, not really about multinationals' avoidance practices. Basically, the document says that the original BEPS project in 2015, it's still allowed multinationals to arrange structures that resulted in unacceptably low effective tax rates. If you look at the BEPS report, even though they tightened the economic substance standards, nothing would really prevent a multinational from moving some operations to a very low tax country and then benefiting from the lower rate.

David Stewart: What sort of design issues is the OECD grappling with in this proposal?

Ryan Finley: They highlight three basic things. The first thing is defining the tax base. The second thing is deciding on the level of blending between different subsidiaries and branches in different countries in determining the effective tax rate and deciding basically who to exempt through carveouts and quantitative thresholds. On the tax base issue, the consultation focuses on the challenges that arise as a result of countries' differing definitions of taxable income, particularly as they relate to timing issues. The consultation is pretty clear that to establish some level of uniformity, the best approach would be to use financial accounting standards because the level of variance in different countries, financial accounting standards, is less than the variance in their corporate tax laws. But even starting from financial accounting standards, there are still a lot of difficult technical issues. One would be whether you apply the accounting standards applicable in the subsidiary's country or in the parent's country or if there's some intermediate entity in that country. And there's also the issue of whether a country's accounting standards are appropriate for the purpose that pillar 2 is trying to address. The consultation also says that even though accounting income would be the right starting point, that for the regime to work there would have to be mechanisms to adjust for timing differences. Basically things like carryforwards, NOLs, things like that, if they're treated differently could significantly distort the results in any particular year. One proposal in the consultation is to allow companies to carry forward any excess tax liability, tax they paid above the minimum rate in prior years into future years, in which they pay tax at a rate less than the minimum rate. The proposal would also allow them to claim a refund if in later years they paid excess tax, but in previous years they paid tax at a rate below the minimum threshold. There are other proposals cited in the consultation, including using deferred tax accounting concepts or multi-year averaging. The second big issue is blending, so on the issue of blending, the consultation says that the options are blending at a global level, blending at a jurisdictional level or blending at an entity level or some hybrid of the three. The simplest would be to blend at the global level because countries would not have to look at every single subsidiary and apply the rules to each and every one and have excess tax in some jurisdictions and insufficient tax and other jurisdictions and not able to credit the overpayments against the underpayments in other jurisdictions in that year. On the other hand, it also says that global blending may partially undermine the goal of countering tax competition. Whichever approach they use, there are significant technical issues, including how to allocate income between transparent entities and between an entity and a foreign branch. On the carveouts and thresholds issue, the consultation sets out two basic alternatives. One would be to use quantitative criteria like revenue or some sort of allocation method to determine whether a company falls within or outside of the scope of the pillar 2 proposal. The other approach would be more of a facts and circumstances test. The consultation doesn't really come down one way or the other, but it says that using objective quantitative criteria may be more prone to allowing abuse, but it would also be much easier to administer.

David Stewart: So what specific issues is the OECD asking for comments on?

Ryan Finley: The document is basically asking for input on the pros and cons of all the different options it sets out, some of which I've mentioned. Questions on the tax base ask stakeholders whether they agree that financial accounting should be the starting point and for practical feedback regarding the exact mechanisms for dealing with these temporary timing tax differences. The questions on the blending issue tend to focus on whether they should use a global jurisdictional or entity level approach, and a lot of them focus on the level of uncertainty and administrative burden involved in each option. Carveout questions also include questions regarding which industrial sectors, if any, should be carved out of the regime.

David Stewart: So what is the timeline for this consultation process?

Ryan Finley: It's fairly tight. The consultation document came out November 8th and the consultation period runs through December 2nd. A public consultation meeting is scheduled for December 9th in Paris. But in light of the 2020 deadline for the OECD to reach an all encompassing agreement on both pillar 1 and pillar 2, there may be some doubts as to whether they're going to make that deadline.

David Stewart: Well, Ryan, thank you very much for being here.

Ryan Finley: My pleasure.

David Stewart: Joining me now by phone is Monika Loving. She's the national practice leader at BDO's international tax services group. Monica, welcome to the podcast. '

Monika Loving: Thank you very much for having me.

David Stewart: So what is your overall take on this pillar 2 consultation draft?

Monika Loving: I think about the goal for pillar 2 as a starting point. It's a big task: agreements on a coordinated design to operate a global minimum tax multinational groups being subjected to a minimum rate of tax on a global basis, potentially calculated on an entity-by-entity level. This would be a significant change in our global tax landscape. And I can't help as a U.S. tax professional to reflect upon pillar 2 sharing many of the concepts that we've worked through over the past two years as a part of the 2017 U.S. tax reform. The Tax Cuts and Jobs Act in the U.S. created a new vocabulary for international tax and I see a number of potential similarities in this consultation draft. It introduces an income inclusion rule, which operates in a generally similar manner to the U.S. GILTI, or global intangible low-taxed income rules. There's the undertaxed payments rule, which has similarities to the U.S. base erosion anti-abuse, or BEAT tax, in U.S. tax terminology. These provisions really could expand beyond the CFC rules that many countries currently have enacted, which have historically have focused on passive income. Pillar 2 also lays out a number of tactical points that must be agreed in implementing the global minimum tax. Most fundamentally, what's the starting point of the calculation? How would it be derived when each country has a different application of its domestic tax roles and financial income is also calculated under various different accounting principles? For example, the calculation could leverage from a local gap in the parent country or IFRS was the global standard and how to permanent and temporary differences between financial accounting and tax principles play in all questions raised for debate in the consultation draft.

David Stewart: Now, do you think that this draft gets at the questions that need to be answered to implement a minimum tax?

Monika Loving: You know, it's a big question to start with. And one of the questions that wasn't answered with a draft, I'll start there, is what's an appropriate rate of the global minimum tax? Most importantly, the consultation draft did not include a discussion on a suggested applicable rate for the minimum tax. OECD has deferred comments until more of the design elements are agreed, but the consultation draft does discuss a number of key definitional points which are very important. These are at the technical design stage. There are suggestions of potentially numerous carveouts for de minimis items as well as threshold level questions for potential application of the rules. So yeah, reflecting on the experience with the U.S. tax reform, experience from the TCJA, one of the most challenging aspects of addressing implications of the GILTI provisions has been the potentially profound impact in the case of a significant corporate life event such as an acquisition or disposition. So this is an area where I see further discussion could be needed because a global minimum tax would drive effective tax rate for large multinationals and understanding potential impacts in that scenario with a large scale transaction is a very important M&A point.

David Stewart: Now assuming they are able to reach an agreement, does this minimum tax create a potential for more complexity as each jurisdiction attempts to implement it?

Monika Loving: Yes is the short answer. The complexity of global tax reporting will increase substantially. Even with an agreed upon framework for determining that financial income as a starting point and the tax base as a starting point, multinational groups will have a very complex process to undertake on an annual basis to operationalize this. Calculating a global minimum tax on either a jurisdictional basis or an entity-by-entity basis would be a very significant compliance effort. Parent country, home country jurisdictions would need to agree a mechanism for reporting, for tracking, and for payments of potential top-up payments that would occur as a result of the minimum tax.

David Stewart: Do we have any sense of how this pillar 2 draft might affect developing countries? Will this potentially give them more taxing rights or does this just continue to divide the pie among the major economies?

Monika Loving: This is an important topic that is been subject to significant discussion as this work on the digital economy has progressed. Developing countries often offer various tax incentives to stimulate economic investment by non-resident businesses. A global minimum tax levels the playing field, levels an effective rate of tax across the global operations, which may impact attractiveness of local country investment incentive. One of the carveouts that was raised in the consultation paper is to potentially exclude incentives, which would be meeting the BEPS action 5 standards or some other substance-based activity levels. So from the standpoint of the objective of pillar 2 to remove the race for competition to the lowest corporate statutory rate, developing countries are very engaged in these discussions to ensure that they have a voice. Potential reallocation of tax revenue and potential attractiveness of their local tax incentives are critical from an economic standpoint.

David Stewart: Based on what we've seen in the pillar 1 and pillar 2 drafts, do you think that we're anywhere close to an agreement at the OECD level?

Monika Loving: I mean, I'll start by saying the scale of this project is very significant. We have a global tax redesign project that involves more than 130 countries as stakeholders. The OECD is really working through a very massive task and has many milestones it's already delivered on, but you continue to have additional milestones that it needs to hit as consensus is reached around some of these points addressed in the various consultation drafts and we think about the inclusive framework and the policy note that it issued on the digital economy. That was in January of 2019, so we're 11 months out. The progress that has been made over those 11 months is very significant. Yet there are still very fundamental design issues to be agreed. Consensus is critical to the success of the overall work. Without the consensus, there is concern on unilateral measures. So I think that we may see the timeline continue to progress and perhaps extend beyond the initial timeline that's been stated. As long as we continue to see that work toward consensus and movement on these key topics.

David Stewart: Now, from where you stand, having seen the pillar 1 and pillar 2 drafts, is there anything missing from this project that you want to see?

Monika Loving: You know, I think in terms of the areas that I would like to see are further work around operationalizing these areas. As I mentioned, in terms of the potential compliance burden for companies with a global minimum tax, this will be a very significant impact on how businesses operate their tax departments and will be important that we have a practical way to implement these rules from a reporting perspective. So I'd like to see in any further consultations and further comments from a practical element how businesses will be directed to meet the compliance requirements.

David Stewart: Now you mentioned that some of this might slip beyond the currently outlined timeline. Do you think that there's any possibility that they can finish this work in 2020?

Monika Loving: I think they will push as hard as possible. There is significant pressure to meet the 2020 deadline as countries continue to provide their input into this consensus process. There are jurisdictions that continue to move forward from a domestic law perspective around unilateral measures. So I think that the OECD will press as hard as they can to bring together the inclusive framework to meet the deadlines.

David Stewart: Now amid all of this uncertainty, what would you advise businesses to do? Are there any concrete steps they should be taking at this moment?

Monika Loving: Businesses, I think at this point, should be in a monitoring mode. Continued monitoring of this debate is really critical for a multinational business. We're talking about the architecture of our international tax rules potentially changing. We're really shaping beyond the digital economy. We're shaping the international tax rules for a very broad base of business, including many that are outside of a typical technology company or digital business. So I would say first it's awareness and monitoring is an important step. Also, the OECD is inviting comments. There has been a very robust public consultation process around pillar 1. The pillar 2 consultation process is now open. So I think it is important that the business community provide input on as many aspects of this design as possible. And companies can begin to analyze how these provisions may impact their global effective tax rates. These provisions are still in the design stage, so it would certainly be at a high level, but understanding the impacts of these provisions, how they might shape what the effective tax rate of the organization looks like as the OECD is laying out this framework is important. We know that there could be something like the income inclusion rule, a potential tax on base eroding payments. These could all be considered by the companies in the context of their current structures. High-level modeling of this impact on the total tax liability of the business and informing the key stakeholders, the potential impacts, the long-term effective tax rates, is an important next step.

David Stewart: All right, well it sounds like there's going to be a lot to be watching for in the next couple of months. Monika, thank you for being here.

Monika Loving: I appreciate you having me. Thank you very much.

David Stewart: And now for another edition of Wills Weighs In, where Tax Notes contributing editor Ben Willis discusses tax planning issues with Executive Editor for Commentary Jasper Smith.

Jasper Smith: Thanks, Dave. So Ben, today we'll be exploring two reader questions on business purpose hurdles related to your October 28th article on the principle purpose threshold. Let's get started. First question: does every transaction require a business purpose?

Ben Willis: Absolutely not. But sadly, the IRS has argued incorrectly in defiance of Congress's intent that a non-federal tax business purpose is required for many transactions.

Jasper Smith: Explain that a little bit more.

Ben Willis: Well, business purpose doctrine is designed to determine the intent of Congress. The Supreme Court made that clear in Gregory v. Helvering, the 1935 case that created the business purpose doctrine. The court looked to the section for tax-free separations of businesses and concluded that Congress required a non-federal tax purpose for that business separation while treasury incorporated that conclusion into the section 355 regulations based on the ordinary business transactions that Congress sought to protect. The courts have continuously distinguished Gregory from tax provisions having no business purpose requirements. That includes, for example, contributions to corporations and IRAs. Specific code sections going all directions on substance over form from entirely mechanical tax elections to substance-based provisions like section 385, which is generally intended to govern debt-equity determinations based on substance.

Jasper Smith: So when we're determining if a business purpose is needed, you're saying you've got to look at each provision?

Ben Willis: That's exactly right. When it comes to a required business purpose, the real question is whether Congress intended that provision to require a non-federal tax business purpose for the relevant transaction. In the Gregory case, the Supreme Court even referred to the right to minimize taxes as the rule that allows tax motivated transactions.

Jasper Smith: So, if I understand you, a lot of people today are glossing over a critical part of that case.

Ben Willis: That's right. Historically, the IRS has often tried to apply Gregory on its statutory construction principles. Although they got it right in Rev. Rule 2017-9, the North South ruling, which provides a rule for applying substance over form principles based on the intent of the applicable code provision. As for the part of Gregory that folks have glossed over, the Supreme Court stated, and I quote, "the rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation." The court said that because Congress intended tax-free spinoffs to allow real business transactions and focused heavily on the right of taxpayers to minimize their taxes. Gregory was a departure from the normal rule permitting tax planning because the relatively new divisive reorganization rules required a business purpose under the facts of Gregory. But if that provision imposed no business purpose requirement, the normal rule which has been repeated countless times for allowing tax minimization would have applied to allow the transaction to be a tax-free spinoff. But the Gregory case stands for the proposition that if the law allows a purely tax motivated transaction, then the government needs to respect it. So it is the intent of Congress that determines what hurdles, such as the business purpose requirement, must be met before statutory benefit is disallowed.

Jasper Smith: Wow, you're right. Actually, a lot of people read that case much differently than the way that you just stated. Well, that moves us to our second question. What is the principle purpose threshold and how does it fit in to business purpose?

Ben Willis: A business purpose is a flip side of a transaction that's undertaken with a principal, or primary, purpose to avoid tax, which is prohibited in roughly 40 code sections. Oddly, Treasury has used it in hundreds of regulations, but the courts have invalidated some of them including in the last few months. Treasury may continue to use the principle purpose threshold because it's easier than drafting clear rules that taxpayers can follow even though it can violate the law and Treasury's own drafting guidelines. This can occur when the IRS fails to properly interpret the term principle purpose and apply it in accordance with the principles of statutory construction including using the plain meaning of words.

Jasper Smith: Well, thanks, Ben. We really appreciate your perspective on those two questions and we'll make sure we include a link to any articles that you referenced in our podcast show notes. For listeners, we certainly look forward to getting more of your questions. You can send them directly to Ben on Twitter at @willisweighsin or by email at Please join us next time as Ben shares more about business purpose and the principle purpose threshold

David Stewart: And now, coming attractions. Each week, we preview commentary that'll be appearing in the Tax Notes magazine. I'm joined by Content & Acquisitions Manager Faye McCray. Faye, what will you have for us?

Faye McCray: Thank you, Dave. In Tax Notes Federal, Steven Shay argues that the proposed expansion of the GILTI high-tax election should not be adopted because the proposed regs directly contradict the statutory language. Walter Schwidetzky applies the new business interest expense deduction rules to partnerships and suggests an alternative approach that would keep partnership and partner levels aligned to limit the deduction. In Tax Notes State, Kathryn Pittman and Jordyn Farizo discuss the implications of the Supreme Court of Louisiana's decision and Smith v. Department of Revenue. Michael Lurie and Lee Zoeller discuss a recent bulletin from the Pennsylvania Department of Revenue regarding corporate tax nexus policy. And in Tax Notes International, John Bush offers a roadmap for implementing the OECD's proposed undertaxed payment rule. Jeroen Lammers makes the case that the OECD concept of user participation is ineffective in allocating more taxing rights to market jurisdictions. And on the Opinions page, Marie Sapirie discusses proposed legislation on Opportunity Zone information reporting.

David Stewart: You can read all that and a lot more in the November 18th editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me online at @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at And as always, if you like what we're doing here, please a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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