Why Pillar Two should be abandoned

By Allan Lanthier, Montreal, retired partner of an international accounting firm and former advisor to the government of Canada

On March 15, the EU finance ministers met to debate and vote on a compromise text to implement Pillar Two—the 15% global minimum tax. Unanimous agreement was required but not secured. The ministers will meet again on April 5, with countries such as France intent on ramming an agreement through. The recalcitrant EU member states should stick to their guns: Pillar Two is a flawed initiative that should be abandoned.

In October 2021, close to 140 countries agreed to an OECD framework for Pillar Two. Then, in late December, the OECD issued a 70-page package of model rules which included significant changes that had never been agreed to, including a new Domestic Minimum Top-Up tax and a significant rewrite of the Undertaxed Payment Rule (UTPR). The model rules are deeply flawed.

First, the tax is based on accounting standards, not tax rules. Securities law requires a company to report its financial results using accounting standards so that shareholders and creditors can assess their risks. These standards have nothing to do with tax rules, which define a tax base that can be understood and enforced.

To address this flaw, the model rules require that thousands of adjustments be made to accounting numbers to compute both “income” and “covered taxes,” and that these adjusted amounts be used to determine the effective tax rate for each group entity. Accounting specialists will have to gather, dissect, analyze and adjust data for every entity in a multinational group, in a way that has never been done before. And for what purpose? In many cases, to confirm what the corporation already knew—that except for one or two tax haven entities, in most countries group entities indeed have an effective tax rate above 15%.

The OECD and G20 political leaders lobbied for the tax to address the “race to the bottom.” But what race is that? While corporate statutory rates have been decreasing in many countries, there have been base-broadening measures, as well. As a result, corporate tax as a percentage of GDP has been increasing for close to 50 years for most developed countries other than the U.S.—for OECD countries on average, the ratio increased by 48% from 1972 to 2019.

Of course, there continues to be base erosion and profit shifting, as there has been for more than a century. But much of this was addressed by the 15-point action plan under BEPS 1.0, with one key omission: controlled foreign corporation (CFC) rules in most countries do not apply to base-eroding intragroup payments of interest and royalties, received by low-taxed, foreign subsidiaries. In many countries, this income could be added to the CFC base with a sentence or two of legislation—not 70 pages—likely capturing 90% of the tax at stake under Pillar Two (how much tax that might be is discussed further below).

Profit shifting to low-taxed countries was the original target of this tax, but the rules now hit everything in sight. If a government decides to introduce rate reductions or credits to help drive innovation and economic growth for a particular activity or industry sector, that is fine—go right ahead. But if the incentives cause the effective tax rate to fall below 15%, the minimum tax will claw back the incentive. The rules in effect give the OECD a veto over tax policy decisions taken by sovereign governments, and this for an initiative that was supposed to address tax avoidance by large multinational groups.

Next, the tax violates the fundamental tax policy principles of fairness and neutrality. Taxpayers in similar circumstances should bear a similar tax burden. However, under these rules, a corporate group with annual revenue slightly above the threshold of €750 million (about US $825 million) will face additional tax and a massive compliance burden, while somewhat smaller competitors will not. We have all seen situations where a government inadvertently creates this type of cliff, where one dollar or percentage point too much creates disastrous tax results, but never on such a massive scale. This design flaw may, in exceptional circumstances, cause a corporate group to spin-off parts of its business to a new, publicly-traded corporation.

Do the model rules also violate tax treaties and, if so, are they even enforceable? For example, under the new UTPR, a corporation may be taxed on income with which it has no nexus whatever, using formulary apportionment. The OECD believes the UTPR is treaty-compliant, based in part on Article 1 of the OECD model tax convention, under which a contracting state generally reserves the right to tax its residents. That argument may or may not prevail; however, many countries have not adopted that provision in their treaties.

Whether the model rules are treaty-compliant or not is not an abstract issue for legal scholars to debate—it is a real issue that may undermine the entire package. For example, if a Canadian corporation is assessed tax under the UTPR on income of another entity in another country, the taxpayer will likely challenge the assessment in the Canadian courts. And in a recent decision (Alta Energy), the Supreme Court of Canada stated that treaty bargains must be respected, even in situations involving flagrant treaty shopping. Depending on the terms of the relevant treaty, the same court challenge may also be available for tax assessed under the Income Inclusion Rule.

Finally, how much annual global tax revenue is really at stake? Last December, the OECD estimated the amount at US $150 billion, without a word as to how that amount was computed. In a 282-page “impact assessment” report issued in October 2020, the OECD suggested that annual global revenue from a 15% minimum tax would be US $41.5 billion, using a 10% substance-based deduction (very close to the percentage deductions under the model rules). I asked the OECD for an explanation of this gaping differential and was simply told that the amount of US $150 billion “…is derived from the 2020 methodology.”

We have been led astray by well-intentioned but unelected bureaucrats at the OECD, supported and emboldened by politicians in many developed and wealthy countries who see some cash they might be able to grab. It is time to put an end to this initiative.

• Allan Lanthier is a retired partner of an international accounting firm and former advisor to the government of Canada. He lives in Montreal.