The US Inflation Reduction Act, Pillar Two and the prospects for a global minimum tax

The US originally supported this global minimum tax, or GMT, but recently developed a similar tax of its own as part of the Inflation Recovery Act (IRA). The US’s recent tax is one factor among many that has hindered the global attempt to unify jurisdiction-specific tax laws.

This article looks at the origins of Pillar Two and the US’s new alternative minimum tax, provides an overview of each and outlines key differences.

The goals of a global minimum tax

Corporations have a strong incentive to plan their global tax outlay so it maximises shareholder value. When a global corporation operates in multiple tax jurisdictions, it can lower its tax burden by locating its business and operations in lower tax jurisdictions, allowing it to route taxable income through those jurisdictions. Some countries have benefitted significantly from inward investment due in part to their low-tax regimes.

Tax is based on tax-adjusted profits, with the associated taxable income calculated in a variety of ways depending on tax credits, the timing of deductible expenses and other factors. In recent years, there has been increased pressure on corporations to move beyond paying tax in accordance with the strict interpretation of tax provisions across jurisdictions, towards the difficult-to-define concept of paying a “fair share” of tax wherever they operate or have sales. The OECD’s GMT is in part a response to this pressure and is intended to create a common framework for taxation to reduce perceived profit shifting.

If this effort is successful, it will in theory create a global corporate tax “floor,” reducing the incentive for corporations to route their business activities, sales and taxable income through low- or no-tax jurisdictions.

An attempt to bring order to a chaotic global tax situation

Running to several hundred pages, the OECD’s Pillar Two proposals are detailed and reflect the complexity of the domestic and international tax framework and regimes globally. Below are some of the important points of the Pillar Two proposals.

The proposed rules apply to multinational enterprises (MNEs) with more than €750 million in revenues in two or more of the preceding four years.

• A domestic minimum tax rule enables countries to claim the first right to tax profits that are now being taxed below 15 percent.
• The Income Inclusion Rule determines when foreign income should be included in an MNE’s taxable income.
• The Undertaxed Payment Rule allows a country to increase taxes on an MNE if a subsidiary in another jurisdiction is being taxed at a rate below 15 percent.

After initial support, the US goes its own way

In the initial Build Back Better (BBB) bill, the US had agreed in principle to using the global minimum tax. The BBB was to align the existing US global intangible low-taxed income, or GILTI, tax with Pillar Two by increasing the GILTI rate from 10.5 to 15 percent to match Pillar Two.

This didn’t happen, as the BBB failed to pass the Senate. Negotiations finally led to a scaled-down bill, the Inflation Reduction Act. One of its provisions is a corporate alternative minimum tax (AMT) of 15 percent that, like the GMT, applies to the adjusted financial statement or book income of companies with more than US$1 billion in revenue.

Despite these similarities, the AMT differs from Pillar Two in a number of ways. Here are some of the most significant differences.

• The AMT applies to the global income of US companies while Pillar Two requires MNEs to disaggregate income to every taxing jurisdiction. The lack of country-by-country reporting fails to reduce the incentives for MNEs to shift profits to low-tax jurisdictions, one of the key motivators behind Pillar Two.
• The AMT allows a variety of tax credits and capital write-offs, while Pillar Two allows only a few tightly defined refundable tax credits.
• The AMT does not exclude any payroll costs, while Pillar Two provides a 5 to 10 percent carve-out.
• The AMT has full credit for foreign taxes, while Pillar Two recasts the 15 percent rate.
• The AMT exempts research and development credits but not stock options, while Pillar Two exempts stock options but not R&D credits.
• The AMT contains an explicit carve-out for private equity.

The US AMT is not the only problem for Pillar Two

Lack of support from the US will slow the adoption of Pillar Two. It’s important to note that Pillar Two faces resistance from other quarters as well, and scheduled implementation dates will need to be adjusted.

For example, the current Pillar Two proposal requires unanimous agreement among the 27 EU member states. Hungary vetoed the proposal in June 2022, and Poland has also objected. The new Italian government might come out against it as well. These objections largely stem from internal political considerations, while Ireland has long benefitted by providing a lower corporate tax rate regime.

If unanimity at this level proves impossible, there are procedures the EU can invoke. Meanwhile, Germany has announced that it will unilaterally implement its own version of Pillar Two. This may be in part to motivate recalcitrant EU members, but its example may induce others to also go ahead with their own implementations. Pillar Two provides a usable template to accomplish this, and a large economy like Germany can lead the way in doing so outside of EU legislation.

Tax legislation is never smooth

Large proposals almost always take longer to implement, stimulate more disagreement and require more effort to align interests than originally predicted. That is the business of politics, whether domestic or international, even more so when the legislation involves taxes.

At the moment, the OECD remains committed to implementing the initial stage of Pillar Two in 2023. However, each country must pass its own legislation to enable Pillar Two, and it is unlikely that any of them will be able to meet this ambitious timeline.

Despite the obstacles, over 130 countries have committed to introducing Pillar Two rules. So, while the pace will be slow and uneven, and the differences between Pillar Two and the US’s AMT will continue to be an obstacle, the OECD’s Pillar Two goal remains. Multinational organisations are now tasked with understanding the potential application of the proposed frameworks to their own internal and external supply chains. Given the uncertainties surrounding future minimum tax rules and their application, organisations must keep apprised of OECD and country-specific changes and be prepared to adjust strategies and procedures accordingly.