Is the UTPR a 100 Percent Tax on a Deemed Distribution?

The UTPR is one of two global anti-base-erosion (GLOBE) rules advanced by the OECD/G-20 inclusive framework on base erosion and profit shifting. Originally, it stood for the undertaxed payments rule but transformed into a stand-alone acronym that some understand as the undertaxed profits rule. The other GLOBE rule is the IIR, or the income inclusion rule.

The inclusive framework led over 135 countries to sign an October 2021 statement on a two-pillar solution to address the tax challenges arising from the digitalization of the economy.¹ The GLOBE rules are part of pillar 2, and would apply to multinational enterprises that meet a €750 million revenue threshold. The United States signed the statement but has not implemented any of the two-pillar rules.

The inclusive framework published the GLOBE model rules on December 20, 2021.² The stated purpose of the rules is to “provide for a co-ordinated system of taxation intended to ensure large multinational enterprise (MNE) groups pay a minimum level of tax on the income arising in each of the jurisdictions where they operate.”³

The GLOBE rules look at low-taxed constituent entities (LTCEs) of the MNE group. LTCEs are constituent entities (which are subsidiaries or permanent establishments) of the group that are located in a jurisdiction whose effective tax rate regarding the net aggregate income of the constituent entities is less than 15 percent. In that case, a jurisdictional top-up tax for the group is determined (as the tax amount that, subject to certain adjustments, would bring the ETR of the LTCEs to 15 percent) and allocated between the LTCEs in proportion to their income.

The IIR would require the home country of an MNE’s ultimate parent, or certain intermediate entities, to impose on the parent or intermediate entities their allocable share of the top-up tax for each LTCE.

The UTPR kicks in if there is an IIR underpayment or no IIR at all. Under the UTPR, constituent entities of the MNE that are located in compliant countries would be denied deductions, or required to make equivalent adjustments, that would result in local top-up taxes on resident constituent entities that would make up for the difference between the top-up taxes of the LTCEs and payments, if any, made under an IIR.⁴ The total UTPR amount would be allocated between the UTPR countries in proportion to the number of employees and value of tangible assets in each country.

A jurisdiction can prevent other jurisdictions from applying an IIR or a UTPR regarding constituent entities located in it by collecting its jurisdictional top-up tax under a qualified domestic minimum top-up tax (QDMTT).

To illustrate the operation of the UTPR, assume the following facts. P is a Country X corporation. Country X imposes a corporate income tax but not an IIR and is not compliant with pillar 2. P has two wholly owned subsidiaries, YS and USS. YS is a Country Y corporation. USS is a U.S. corporation. Country Y does not impose an income tax or a QDMTT and is not compliant with pillar 2. YS has $100 of net income in Y and pays no taxes. USS has $100 of U.S.-source income and pays $21 of U.S. tax. P has no independent income.

If Country X had an IIR, it would collect a $15 top-up tax from P because of YS’s untaxed income.⁵ But Country X does not collect any top-up tax because it does not have an IIR. If the United States were to implement the GLOBE rules, it would collect $15 of a top-up tax from USS under the UTPR because of YS’s untaxed income and P’s nonpayment of a top-up tax under an IIR. See Figure 1.

The UTPR is unusual. It is determined by factors that are external to the UTPR entity: a sister or parent entity’s undertaxed income that cannot be economically or normatively associated with, attributed to, or allocated to the UTPR entity and the nonpayment or underpayment by parent entities of a top-up tax under an IIR. Naturally, that triggered a lively debate about the nature and character of the UTPR, its desirability, justifications, compliance with customary international law, compliance with EU law, creditability, and interaction with treaties.⁶

The debate took the UTPR at face value as a tax imposed on the UTPR entity by the UTPR jurisdiction on the foreign income of a foreign sister or parent entity. For example, in the customary international law context, the debate focused on questions of nexus and jurisdiction to tax that income; and in the income tax treaty context, it focused on treaty coverage, the saving clause, the right to tax business profits, and nondiscrimination.

This article takes a different approach and proposes to look through face value in characterizing the UTPR from a U.S. tax perspective. The question whether that approach could extend to other jurisdictions is beyond the scope of this article.

I. The Proposition

The proposition floated here is that from a U.S. tax perspective, the UTPR top-up tax under the GLOBE model rules is the mathematical, conceptual, and legal equivalent of a 100 percent withholding (or branch) tax on a deemed distribution by the UTPR entity (or PE) equal to the entity’s (or PE’s) UTPR liability.⁷

If this proposition is correct, questions would follow regarding the desirability of such a confiscatory tax, and regarding its interaction with income tax treaties. From a treaty perspective, a U.S. UTPR, if enacted, would not be protected by the saving clause, would be a covered tax that is subject to the dividends or gains articles, and would raise a PE nondiscrimination concern.

The proposition could raise questions that are beyond the scope of this article, including questions of creditability and customary international law.

II. The Math

The math is simple. A cash tax expense that has nothing to do with the entity’s income would have a dollar-for-dollar negative effect on the entity’s earnings and profits (or capital), but no other effect on the entity or the group of which it is a member. That is precisely what a 100 percent withholding tax on a deemed distribution by the entity equal to the cash tax expense would do.

Figure 2 shows the mathematical equivalence under the same facts of the example above. USS will have $79 of E&P after paying the normal U.S. corporate income tax. If the United States were to implement the GLOBE rules, it would collect from USS an additional $15 under the UTPR because P (and YS) did not pay a top-up tax under an IIR (or a QDMTT). That would leave USS with $64 of E&P and have no other effects on the group. YS would still have $100 of E&P, and P zero.

The imposition of the UTPR is the same as having the United States instead (1) deem USS to have distributed $15 to P, (2) impose a 100 percent tax on the distribution, and (3) collect the resulting tax liability by withholding.⁸ In both cases, the United States would collect $36 in taxes ($21 plus $15); and USS, YS, and P would be left with $64, $100, and zero of E&P, respectively.

The example assumes that USS has E&P, but the equivalence would hold even if the UTPR liability and the deemed distribution exceed USS’s E&P. A deemed distribution would be a dividend to the extent of E&P, if any. To the extent the deemed distribution exceeds E&P, it would be a return of capital or capital gain, depending on P’s basis in USS.⁹ Unlike the regular treatment of section 301 distributions, the deemed distribution here would be one that is subject to a 100 percent withholding tax on all its elements. The UTPR can be accounted for in the same way.

The equivalence would also hold if USS were a U.S. PE of P, with a 100 percent branch tax replacing the withholding tax.

The equivalence would still hold in complex structures that may complicate the UTPR analysis. But what matters for the mathematical equivalence is only the final UTPR liability of each UTPR entity.¹⁰ Once that is determined, the UTPR analysis ends and the simple mathematical equivalence analysis described above (for each UTPR entity separately) begins.

III. The Concept

It is true that any tax on an entity that is not triggered by the entity’s income would also be mathematically equivalent to a 100 percent withholding tax on a deemed distribution by the entity equal to that tax liability. But typically, those taxes have a clear tax base and are not triggered because of the entity’s shareholder.

The UTPR, however, is triggered because of the UTPR entity’s shareholder (either as an ultimate parent or intermediate entity or as an LTCE). That appears to make the UTPR the conceptual equivalent of a 100 percent withholding tax on a deemed distribution by the UTPR entity equal to the UTPR liability: A taking from a subsidiary because of the parent is a taking of a deemed distribution made by the subsidiary to the parent.

One way to think about this is that, in our example, the $15 of UTPR would be collected from USS because P, as a parent, did not pay $15 under an IIR.¹¹ The income that would have triggered the IIR and that triggers the UTPR is YS’s income. That income is connected to USS only through P. However one looks at this, the UTPR is collected from USS because of its parent, P. This means that there is a deemed capital transaction here, which can either be a deemed contribution to the capital of USS or a deemed distribution by it. The math and economic reality support the latter. While USS’s E&P or capital would be impaired by the UTPR, P and YS remain intact.

In a way, the UTPR operates like a reverse controlled foreign corporation rule that reverses the taxing jurisdiction (with the necessary changes if the UTPR entity is a PE). CFC rules can be reconceptualized as a deemed dividend mechanism from the parent country’s perspective. The UTPR can be similarly reconceptualized as a deemed distribution mechanism but from the UTPR country’s perspective. Conceptually, if P is taxed under CFC rules or an IIR on YS’s or USS’s income, Country X would be taxing P as a shareholder on income that P economically derived through what is legally viewed as its separate subsidiary entities, YS or USS. USS, however, cannot be said, just by reason of being a group member, to have economically derived the income that is legally viewed as the income of its separate parent or sister entities. That is why the group hierarchy matters.¹² If P’s share of YS’s or USS’s income ends up with P, that would be income to P. If P’s or YS’s income ends up in USS, that would be a contribution to USS’s capital, not income to it. Collecting a tax from USS because of P can still be reconceptualized as a taking from USS of what would ultimately belong to P. That would be a taking of a distribution deemed made by USS to P. Legal abstractions aside, that is what the UTPR would do.

IV. The Law

Characterizing the UTPR for U.S. tax purposes would be a case of first impression. Two Supreme Court decisions — PPL¹³ and Biddle¹⁴ — provide guidance.

In PPL, the Supreme Court considered the creditability of a U.K. windfall tax. Using “a commonsense approach that considers the substantive effect of the tax,”¹⁵ the Court determined that the U.K. windfall tax was an income tax in a U.S. sense. That commonsense approach was based on a mathematical equivalence to an income tax, which led the Court to recharacterize both the rate and base of the tax. Rejecting the commissioner’s criticism of its approach, the Court said:

The Commissioner argues that any algebraic rearrangement is improper, asserting that U.S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt. As a result, the Commissioner claims that the analysis begins and ends with the [foreign] government’s choice to characterize its tax base. . . . Such a rigid construction is unwarranted. It cannot be squared with the black-letter principle that “tax law deals in economic realities, not legal abstractions.” Given the artificiality of the U.K.’s method . . . we follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.¹⁶ [Internal citations omitted.]

The same logic can be extended to the UTPR. The artificiality and arbitrariness of the UTPR from the perspective of the UTPR entity are clear. As noted, the tax is triggered and determined by factors that are external to the UTPR entity. It is then applied to the UTPR entity through an artificial and arbitrary mechanism of denial of deductions (or making of equivalent adjustments) that is meant to produce a predetermined amount of a cash tax expense.

Therefore, a substance-over-form approach is warranted here, too. The analysis above suggests that the UTPR is the conceptual and mathematical equivalent of a 100 percent withholding tax on a deemed distribution. As the Court said, “The algebraic reformulations illustrate the economic substance of the tax and its interrelationship with net income.”¹⁷

As noted, PPL recharacterized the rate and base of the tax, but did not redetermine the taxpayer. The question of who pays a tax came up in Biddle, 75 years before PPL. Biddle considered the creditability to a U.S. shareholder of U.K. taxes imposed on, and paid by, a U.K. corporation that were credited against the shareholder’s U.K. tax. The Court held that U.S. principles control, and that those principles do not treat a shareholder as paying taxes paid by a corporation even though the burden of the tax was borne by the shareholder. Biddle is known for establishing the technical taxpayer rule for foreign tax credit purposes, which was later codified by the regulations.¹⁸

The technical taxpayer rule, however, is not relevant, or at least not critical, here. Both Biddle and the regulations limit the scope of the technical taxpayer rule as an interpretation of the statutory language “taxes paid or accrued” in section 901, which is not relevant here.

It is true that in interpreting that statutory language, the Court in Biddle turned to U.S. principles and said that U.S. statutes “have never treated the stockholder for any purpose as paying the tax collected from the corporation,” nor “have they treated as taxpayers those upon whom no legal duty to pay the tax is laid.”¹⁹ But laws change, and the technical taxpayer rule is no longer absolute. For example, the regulations treat certain foreign withholding wage taxes as imposed on the employee even though technically they are imposed on the employer.²⁰

Also, Biddle suggested that different factors could affect the decision whether the shareholder pays the tax within the meaning of the statute.²¹ The tax base element, probably the most important factor, was not an issue in Biddle but is clearly an issue in the case of the UTPR. The artificiality of the UTPR is another factor to consider here that was not an issue in Biddle. And the practical value of imposing on a foreign parent a legal liability for a source tax on its dividend income is insubstantial if the domestic subsidiary paying the dividend is held liable for the tax.

Therefore, there appears to be a good basis for the argument that Biddle does not carry much weight outside the FTC context, and that PPL controls.

V. Implications

If the proposition suggested here is correct, policy and income tax treaty implications would follow. As noted, creditability, customary international law, and other potential implications are beyond the scope of this article.

A. Policy

Policy implications would follow regardless of how the legal question as to the characterization of the UTPR would turn. If the proposition that the UTPR is the mathematical and conceptual equivalent of a 100 percent withholding (or branch) tax on a deemed distribution by the UTPR entity is correct, the UTPR’s desirability becomes questionable. A 100 percent tax is a confiscatory tax, and that is not something to celebrate.

Another confiscatory aspect of the UTPR would be that it could reach return of capital. If the UTPR liability would exceed the UTPR entity’s E&P, all or part of the deemed distribution would be a return of capital. Taxing return of capital (basis recovery) is confiscatory no matter what the tax rate is.²²

B. Income Tax Treaties

If the UTPR is characterized from a legal perspective as a 100 percent withholding (or branch) tax on a deemed distribution by the UTPR entity, income tax treaty implication would follow. Because the UTPR would be recharacterized as a tax on the owner of the UTPR entity that would be collected from the UTPR entity by withholding, as far as U.S. treaties are concerned, the UTPR would not be protected by the saving clause.²³

As a tax on income, a U.S. UTPR, if enacted, would be a covered tax.²⁴ It would be subject to the dividends or gains articles to the extent the deemed distribution would be treated, depending on E&P (and the shareholder’s basis in the UTPR entity’s stock) as a dividend or capital gain,²⁵ or in the case of a PE, as a dividend equivalent amount.²⁶

The dividends or gains articles would provide for U.S. exemptions or reduced rates. Unless the UTPR legislation would expressly override treaties (and violate international law),²⁷ those treaty benefits would reduce or eliminate the 100 percent tax on the deemed distribution without affecting the deemed distribution amount. That would effectively create a tax-free account payable by the UTPR entity to its owner equal to the treaty-exempt portion of the deemed distribution.

In the case of a PE whose UTPR liability exceeds its E&P, the deemed distribution would exceed the dividend equivalent amount. That excess would not be covered by the treaty provision that shields taxing dividend equivalent amounts from the nondiscrimination article.²⁸

VI. Conclusion

A lot has been said about the UTPR. This article suggests a different approach for thinking about it, with the hope that this suggestion can add something to the conversation and contribute to our understanding of this unusual tax.