Key Takeaways
- The new OECD Pillar Two agreement continues the emphasis on measurable indicators of substance like payroll.
- Congress recently changed U.S. laws to go in the opposite direction.
- Substance factors can raise questions about blowback.
- U.N. tax talks converging on nexus rules.
- New disclosures put corporate overseas structures in spotlight.
When the Organization for Economic Cooperation and Development released the details from the “side-by-side” agreement with the United States last month, it became clear that they were doubling down on a new tax regime based on measurements of “substance.”
The regime, the Pillar Two 15% global minimum tax, is now moving forward with the U.S. impasse resolved. Since the beginning, its design has relied on economic substance, such as jobs in a country or "hard" assets. Factors such as payroll and the value of tangible assets were used not only for the measurement of taxable income, but to determine how it was distributed in some cases. The final agreement goes further, using similar metrics when evaluating which government tax incentives are exempt, and which can cause a company to ultimately pay more in Pillar Two tax.
Ironically, the United States, an early trendsetter in this formulaic strategy, has taken a big step in the opposite direction in the One Big Beautiful Bill Act. Due to that legislation, the U.S. international tax regime no longer tries to distinguish tangible and intangible profits.
How this turnaround came about demonstrates how complex these systems can be in practice—and how they run the risk of unintended consequences.
The U.S. first enacted its own minimum tax on foreign income in the 2017 Tax Cuts and Jobs Act. The provision, then called the tax on global intangible low-taxed income (GILTI), looked to tangible assets as a baseline. Profit over 10% of that amount (called qualified business asset investment or QBAI) was considered to be intangible income. The GILTI tax targeted those profits because they’re less likely to be tied to real activities, and more likely to be involved in profit-shifting. The OECD, when it added its own “substance-based income exclusion” to the Pillar Two formula, largely followed the same idea, adding payroll costs to the calculation.
The OBBBA altered GILTI, renaming it the Net CFC Tested Income (NCTI) regime. It also removed QBAI from the formula, turning it into a simpler tax on foreign income. QBAI was also taken out of the incentive for foreign-derived intangible income—a provision meant to encourage companies to keep valuable intangible assets (like intellectual property) onshore. (FDII became FDDEI, foreign-derived deduction eligible income.)
Lawmakers haven’t elaborated on why they made this change, but there are some indications. Democrats had strongly criticized GILTI for encouraging companies to move facilities or jobs offshore, since increasing tangible assets abroad would decrease the amount of GILTI tax. Taking that out of the formula may have been part of the “Make America Great Again” philosophy, to bolster the incentive to keep profit and facilities onshore, as well as penalty for keeping them offshore.
“Neutrality” was a buzzword with the TCJA, as its authors said the goal was to take taxes out of the decisions on where to place IP and profit. The OBBBA seemed to go a step further, trying to not just even the playing field but tilt it towards the U.S.
There were other potential issues as well. Companies complained that it was a complex, burdensome formula. Many also said that it was a crude measurement of intangible assets–that many taxpayers far from the tech sphere, not engaged in profit-shifting, could end up with GILTI.
Why the OECD went further in using substance factors in the latest guidance is pretty clear. How to treat nonrefundable tax credits like the U.S. research and development credit had become a major sticking point between many countries involved in the negotiations. Ultimately, the organization opted for a new category that favors tax incentives–like the R&D credit–that increase based on measurable activities, rather than profit.
The bottom line—under Pillar Two, millions of dollars in taxable income and incentives will hinge on factors like payroll expenses, and the valuation of depreciable, tangible assets. How those measurements are made will come under increased scrutiny, as will the potential side effects.
Noteworthy Items This Week
U.N. delegates are engaged in intensive negotiations to produce a U.N. framework convention on international tax cooperation and two early protocols, one of which focuses on cross-border services taxation, by the second half of 2027. Countries are meeting in New York through February 13 to discuss and draft the convention and its protocols.
Companies’ Big Overseas Tax Bills Spur Profit-Shifting Concerns – Michael Rapoport and Ryan Hogg, Bloomberg Tax ($):
Tax advocacy groups said the disparities feed into longstanding concerns that multinationals are using aggressive strategies to move big chunks of US profit to lower-tax countries. The new information should prompt investors and policymakers to demand answers from companies about whether they’re trying to avoid US taxes, the groups said.
OECD Helping Countries Adopt ‘Amount B’ Transfer Pricing Method – Caleb Harshberger, Bloomberg Tax ($):
The US pushed for its inclusion in the global deal and began allowing US companies to adopt the method in 2024, though it hasn’t issued guidance for it yet. Singapore announced last last year that it would allow its taxpayers to adopt the method as part of a pilot program. So far they are the only two adopters.
The Crackdown on Malta Pension Plans May Be Quietly Ending – Lauren Loricchio and Chandra Wallace, Tax Notes ($):
Kenneth Kies, now acting IRS chief counsel and Treasury assistant secretary for tax policy, was engaged by a company offering Malta pension plans called Water Structures LLC, led by Joshua Gottlieb of the Gottlieb Organization. Gottlieb was barred from practice by the Financial Industry Regulatory Authority in 2017.
During a series of “town hall” meetings, Kies, then with the Federal Policy Group LLC, met with a group of advisers to devise a plan. Part of the strategy was to submit comments on regulations (REG-106228-22) that were proposed in 2023 to designate Malta personal retirement scheme transactions as listed transactions, which would require material advisers and participants in the transactions to file disclosures with the IRS.
Multinational enterprises need to navigate this new landscape and carefully evaluate how their existing and future incentives align with the qualified tax incentive criteria to optimize their effective tax rate under the Global Anti-Base Erosion Rules.
Public Domain Superhero of the Week
Every week, a new character from the Golden Age of Comics, who’s fallen out of use.
This week’s entry: Mr. Muscles
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Debut Year: 1956
Debut Publication: Mr. Muscles #22
Origin Story: A pro wrestler, he decided to use his strength to fight crooks--without a secret identity.
Superpowers: No super-powers, exactly, but he's the "World's Most Perfect Man" according to his publicity.
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