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Today in Tax: Model Global Minimum Tax Rules and Gain Exclusion for Software Companies

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Brief commentary on the past week’s cases, rulings, notices, and related federal tax guidance.

Model Rules for a Global Minimum Tax

Companies should start preparing for the implementation of the OECD’s global minimum tax regime. Importantly, while countries are wrestling with implementation, interpretation, exclusions, and safe harbors, companies should follow any developments from relevant jurisdictions. Additionally, companies should complete a jurisdiction-by-jurisdiction analysis to determine potential tax liability and determine whether tax planning is necessary.

In December 2021, the Organization for Economic Cooperation and Development (“OECD”) released model rules for a global minimum tax. The regime demands that multinational corporations with annual revenue of at least €750 million pay a 15 percent minimum global tax rate and aims to eliminate the incentive of shifting income to low- or no-tax jurisdictions. The model rules provide the scope of the tax and set out operative provisions and definitions to helping countries adopt and implement the regime.

Under the global minimum tax regime, countries can apply a “top-up tax” when companies headquartered within their jurisdictions pay less than a 15 percent minimum tax rate in other countries. If the top-up tax does not achieve the minimum tax rate or the company’s parent jurisdiction has not adopted the global minimum tax rules, then an undertaxed payments rule applies to allocate any residual top-up tax to other countries in which a company operates.

While the OECD hopes that jurisdictions implement the global minimum tax rules by 2023, several major hurdles may delay or prevent implementation. First, each jurisdiction must adopt the model rules through legislation, which can be difficult depending on the political climate of each country. Second, once legislation is adopted, each country must set out plans for implementing the tax. Several countries have indicated that meeting the OECD’s 2023 goal will be challenging at best. Finally, while the basic rules have been outlined by the OECD, countries are still pushing for exemptions and carve-outs. For example, certain countries are attempting to exempt their banking, insurance, or extractive industries from the global minimum tax rate. Disagreements about exemptions can derail or delay the implementation of this tax regime.

Certain Software Businesses Unqualified for Qualified Small Business Stock Gain Exclusion

When certain criteria are met, stockholders may be able to exclude proceeds from the sale of qualified small business stock from their taxable income. One of those criteria is that the stock being sold must be the stock of a corporation engaged in specified trades. For companies in those trades, or adjacent industries, meeting the requirements of qualified small business stock may be a powerful tool to obtain significant income tax savings—particularly if tax rates increase. For business owners whose operations do not fall within the ambit of specified industries, relying on the qualified small business stock gain exclusion will result in disappointment and a more expensive exit when they sell their companies.

On January 28, 2022, the Internal Revenue Service released a memorandum from the IRS office of Chief Counsel (Memorandum 202204007) addressing qualification of a business that facilitates leasing transactions between third parties for the qualified small business stock gain exclusion. The business at issue facilitated these leasing transactions via a website it maintained to match potential lessors and lessees.

The primary issue addressed by the memorandum is whether the company’s services via its website constituted “brokerage” services, which is a category of services that are specifically excluded from the ambit of the qualified small business stock gain exclusion. In concluding that the company’s activities through its website were, in fact, disqualified brokerage services, the memorandum notes that provision of services “by software created by people rather than [provided] directly by people does not change the functional nature of the services.”

Only a few months previously, the IRS issued a ruling (PLR 202144026) that drew a different conclusion, albeit on the same basis. In that ruling, the IRS found that a business whose software provided services related to the provision of medical services was qualified for the qualified small business stock gain exclusion even though the health industry is one of the trades specifically excluded from the qualified small business stock exclusion program.

Read together, the ruling and the memorandum imply that the distinction between a qualified and disqualified set of software hinges on whether the software directly renders the prohibited services or whether it may be used by the providers of such prohibited services.

This line of reasoning is significant for software companies, given the value of the qualified small business stock gain exclusion, and should be closely considered as part of any stock issuance by a software company.

Access the previous installment here.