As countries around the world enact legislation implementing Pillar Two, the Republican majority of the House Ways & Means Committee has made no secret of its dissatisfaction with the Biden Administration’s willingness to agree to the two-Pillar global tax agreement. On the eve of a congressional delegation to OECD headquarters in Paris, the Republican members of the House Ways & Means Committee released proposed legislation on May 25 that would impose new taxes on companies resident in countries that have enacted legislation implementing Pillar One or Pillar Two. The Biden Administration is sure to oppose this legislation. However, the bill is intended to send a strong message to the OECD and US trading partners that the House Republicans are not prepared to accept the current terms of the two-Pillar agreement which they believe were poorly negotiated by the US Treasury.
Didn’t the United States Already Agree to Pillar Two?
In October 2021, 135 countries (known as the Inclusion Framework or “IF”) agreed to a two-Pillar approach to make groundbreaking changes to the international tax landscape. Pillar One is an agreement to allow market countries to tax the profits of the largest, most profitable multinationals regardless of whether the company has traditional taxable nexus in that country. In return for this new taxing right, the IF agreed to repeal any existing digital services taxes and similar levies, as well as refrain from enacting new such taxes.
Pillar Two is the global minimum tax under which all profits of a multinational should be taxed at a rate of at least 15%. The Pillar Two model rules, which provide the template for legislation being enacted around the world, set forth a complex ordering mechanism to determine which country gets the first bite of the global minimum tax apple.
The ordering rules establish a priority waterfall to determine which country has the first right to tax undertaxed profits of a multinational, i.e., profits that are not taxed at a rate of at least 15% somewhere in the world. In general, the ordering rules operate as follows:
- Qualified Domestic Minimum Top-up Tax (QDMTT): a top-up tax that would operate to increase the effective tax rate of a local subsidiary to at least 15%.
- Income Inclusion Rule (IIR): if there is not a QDMTT applicable to a pool of profits (or the QDMTT is below 15%), the IIR operates as a controlled foreign corporation regime to impose a 15% tax at the parent company level on profits of subsidiaries not taxed at the 15% threshold. While the US GILTI regime was the model for the IIR, GILTI is not currently considered a qualified IIR because it applies on a global rather than on a country-by-country basis and because of the treatment of nonrefundable credits such as the R&D credit.
- UTPR (undertaxed profits rule or undertaxed payments rule): The UTPR allows a third country to tax undertaxed profits of a multinational group where a QDMTT or IIR does not achieve a 15% rate. Of particular relevance here, because GILTI is not considered a qualified IIR, the UTPR will be the rule most relevant to a US multinational.
- Subject to Tax Rule (STTR): The STTR imposes a withholding tax on payments that are not subject to a rate of tax of at least 9% in the hands of the recipient. The STTR is intended to support the tax base of developing countries but will only become effective when a treaty is renegotiated to permit the imposition of the tax.
The United States is a member of the Inclusive Framework, and the Biden Administration, through Treasury Secretary Yellen, signed onto the two-Pillar agreement. In fact, Secretary Yellen is credited with achieving the breakthrough to push the original two-Pillar agreement over the finish line. However, Secretary Yellen’s efforts never achieved the necessary support in the US Congress to result in the enactment of legislation that would conform the Internal Revenue Code to the two-Pillar model rules. Pillar Two legislation has already been enacted in South Korea and will become effective in a number of other countries as early as 2024. However, as discussed below, the United States is not likely to adopt implementing legislation anytime soon. Moreover, the House Republican legislation sends a signal that if the makeup of the US government changes in the 2024 elections, the new US government could instead enact legislation targeting countries that impose the UTPR on US companies.
Ways & Means Is In Control
Under the US Constitution, tax legislation in the United States must originate in the House of Representatives. As a result, any tax legislation required to conform the Internal Revenue Code with Pillar Two must start with the House Ways & Means Committee. Republicans gained control of the House of Representatives in the 2022 mid-term elections, thereby gaining control of the Ways & Means Committee. The Republican Members of the Committee have unanimously been highly critical of both the process by which the Administration agreed to Pillar Two as well as the underlying operating rules.
In a recent Ways & Means Committee hearing, Secretary Yellen was asked why the Administration did not consult with Ways & Means when it signed onto the two-Pillar global agreement. Since legislation implementing this agreement would need to originate in the House, Secretary Yellen was criticized for not involving Ways & Means in the process. Moreover, several Committee members criticized the agreement, in particular the provisions allowing foreign countries to impose what many believe are extraterritorial taxes on US companies (e.g., the UTPR) and the manner in which important US tax incentives (e.g., the R&D credit) are treated relative to how similar incentives provided by foreign countries are treated.1
As discussed above, the UTPR enables a country to tax a pool of profits that is not otherwise subject to a 15% tax under a QDMTT or qualified IIR. To illustrate this, consider a US parent company with two subsidiaries, one in Hungary and one in South Korea. Because the Hungarian corporate rate of 9% is below the 15% threshold and because GILTI is not considered a qualified IIR, South Korea is able to impose a UTPR on the Korean subsidiary that effectively imposes an additional 6% on the Hungarian subsidiary’s profits. While Administrative Guidance released in February 2023 provides a temporary mechanism to enable GILTI taxes at the US parent level to be “pushed down” to the Hungarian subsidiary for purposes of determining whether the Hungarian subsidiary is undertaxed, this is a only a temporary fix during a limited transition period based on the apparent assumption that the US Congress will act to fully conform the US tax system with Pillar Two in that timeframe. As noted above, that legislation is unlikely.
The “Defending American Jobs and Investment Act”
Given the disconnect between the Administration and the Ways & Means Committee, Committee Chair Jason Smith (R-MO) scheduled a congressional delegation to meet with the OECD in Paris and to further emphasize Republican members’ concerns with respect to the impact of the two-Pillar global agreement. That delegation is scheduled to depart on May 31.
As a precursor to the congressional delegation, on May 25, the Republican members of the Ways & Committee released HR 3665, the “Defending American Jobs and Investment Act” which increases income and withholding taxes on companies resident in countries imposing “extraterritorial” or “discriminatory” taxes. In his press release2 accompanying the proposed legislation, Chairman Smith indicated that the legislation is intended to send a “clear warning” to countries imposing such taxes that the Republican majority would “not allow a bad deal negotiated by the Biden White House to steal away Americans’ jobs and opportunity….”
“Extraterritorial taxes” are defined as taxes that are imposed on a corporation simply by virtue of being connected to another person through a common chain of ownership. While not mentioning it specifically in the legislation, the definition is clearly targeted at the UTPR.3
“Discriminatory taxes” are defined as taxes which are (i) applied to income which would be considered foreign source income under US-equivalent sourcing rules; (ii) imposed on a tax base that does not permit cost or expense recovery; (iii) exclusively or predominantly applicable by its terms or general practice to foreign taxpayers; or (iv) not considered an income tax by the country so as to be excluded from the application of a double tax treaty. While not mentioning them specifically, the definition is clearly targeted at digital services taxes and the UK Diverted Profits Tax. Withholding taxes on interest, rent, royalties or dividends, as well as value added taxes, goods and services taxes and similar taxes on consumption, are excluded from the definition of “discriminatory taxes.”
The proposed legislation requires the Treasury Department to issue a report identifying countries which have imposed an extraterritorial or discriminatory tax. If a country is so identified, the various income and withholding taxes imposed by the Internal Revenue Code on a taxpayer resident in that country are increased by 5-20 percentage points. The relevant taxes that are increased are the income taxes on foreign taxpayers under sections 871, 881, 882 and 884, withholding taxes imposed under sections 1441 and 1442, and withholding taxes imposed on the gains from the sale of US real property interests.
The relevant tax rate is increased by 5 percentage points in the first year a country is included on the report and is increased by another 5 percentage points for each subsequent year that a country is still listed, up to a maximum increase of 20 percentage points.
The legislation includes other punitive measures for a country on the Treasury list such as authorizing the president to restrict the US government procurement from listed countries, as well as taking the listing into consideration when negotiating income tax, bilateral investment and other treaties.
As noted above, the proposed legislation has little chance of enactment during the Biden Administration but is intended to send a strong reminder to the OECD and our trading partners that regardless of what the Administration may agree to, the Ways & Means Committee controls the destiny of any Pillar Two legislation. It further signals that, if control of the Administration changes as a result of the 2024 Presidential election, this or similar legislation may be more likely to actually be enacted.
What Would Democrats Do?
Even though the proposed legislation is partisan, with none of the Democrats on the Ways & Means Committee sponsoring the legislation, it is by no means clear that the Democrats would be capable of enacting legislation to conform the Internal Revenue Code with Pillar Two. In 2021, the Build Back Better Act bill would have made changes to the GILTI rules to more closely align them with Pillar Two. However, even when the Democrats controlled the House, Senate and the Presidency, they were unable to agree among themselves to push through those changes. The Inflation Reduction Act passed into law in 2022 did not adopt any such changes to the GILTI rules.
Many countries are expected to begin imposing a UTPR on US multinationals in 2025 (South Korea’s legislation provides for a 2024 effective date). At that time, if not sooner, taxpayers are expected to initiate litigation against any income tax treaty and bilateral investment treaty contesting the application of the tax. As noted above, depending on the outcome of the 2024 US elections, the proposed or similar retaliatory legislation could become law.
Achieving the Pillar Two agreement was a historic accomplishment in setting a global minimum corporate tax rate. The core purpose of the agreement—ensuring that countries have enacted a minimum level of taxation on global income—has bipartisan support in the US Congress. However, there are significant challenges as to how that core goal is ultimately implemented in the United States. The main question now is whether Republicans, Democrats, the OECD and the major US trading partners want to wager the gains made to date on the outcome of the 2024 US election, or whether other options exist to protect these achievements from that political risk.
1 See our August Legal Update on the subject.