In 2013, the Organization for Economic Cooperation and Development (OECD) and the G-20 joined forces in an effort to prevent multinational enterprises (MNEs) from using aggressive tax planning techniques to avoid paying their fair share of tax. In this context, the OECD, after two years of work, published 15 actions to eliminate the base erosion and profit shifting (BEPS) activities of such MNEs. These 15 actions aim to ensure that profits are taxed where economic activities take place and value is created.
In brief, the OECD/BEPS project comprises three key pillars: first, introducing coherence in the domestic tax rules that affect cross-border transactions; second, strengthening substance requirements in the context of tax treaties; and, third, improving transparency and certainty.
Although the OECD/BEPS project has changed the international tax landscape, some issues remain unresolved. To this end, in January 2019, the OECD/G-20 Inclusive Framework (IF) countries agreed on a two-pillar approach: Pillar One on the digital economy (i.e., BEPS action 1); and Pillar Two to address the remaining BEPS issues (i.e., BEPS actions 2–15). Finally, following the agreement in October 2021 of 137 (out of 141) IF members, the OECD announced in December 2021 the Pillar Two Model Rules that were based on the Pillar Two Blueprint published in October 2020.
The aim of Pillar Two is first to reduce the incentives for MNEs to shift group profits to low-tax countries, and second to ensure that large internationally operating businesses pay a minimum level of tax of 15% regardless of where they are headquartered or operate.
Not surprisingly, a few days after the Pillar Two Blueprint was published, the European Commission proposed a draft directive to implement the OECD/IF Pillar Two Model Rules in a coherent and consistent way across EU member states.
Inevitably, a global minimum tax rate of 15% will affect the MNEs in scope because the IF and EU members represent more than 95% of global GDP.
Pillar Two Building Blocks
Pillar Two stems from the German–French initiative to introduce a global minimum tax on low-taxed foreign profits, and it is largely based on the U.S. Global Intangible Low-Taxed Income (GILTI) and Base Erosion Anti-Abuse Tax (BEAT) rules. Pillar Two rules comprise four building blocks: two of them apply in the residence state, that is, the Income Inclusion Rule (IIR) and the Switch-Over Rule (SOR), and the remaining two are source state rules, that is, the Undertaxed Payments Rule (UTPR) and Subject to Tax Rule (STTR).
Notably, the IIR and UTPR (together called the Global Anti-Base Erosion Rules or the GloBE Rules) are implemented in a country’s domestic tax law, while, on the other hand, the STTR and SOR are tax treaty rules. Furthermore, Pillar Two provides an ordering rule: The STTR applies first, then the IIR and SOR follow, and, finally, the UTPR applies. Importantly, only one of these rules can apply at a time.
In a nutshell, Pillar Two consists of two interlocking domestic rules, the IIR and UTPR; and two treaty-based rules, the STTR and SOR.
Global Anti-Base Erosion and Switch-Over Rules
Under the GloBE Rules, the IIR operates first as a “super” controlled foreign company (CFC)-like rule, but with a broader scope. In a nutshell, the IIR imposes a top-up tax on a parent entity with respect to the low-taxed income of a constituent entity. In the case of several tiers of parent companies, the IIR follows a top-down approach rather than a bottom-up approach. That is, in identifying which entities the IIR would apply to, the MNE should begin with the ultimate parent entity, if any, and then any potential intermediary parent entities moving down in the MNE chain structure.
If a tax treaty prevents the residence jurisdiction from applying the IIR (i.e., article 23A of the OECD Model Tax Convention provides exemption from tax), then the SOR would make such relevant tax treaty provision inapplicable (i.e., switching from an exemption method to a credit method). Thus, the SOR eliminates tax treaty obstacles for the IIR to apply accordingly. Finally, the UTPR serves as a backstop to the IIR in case the low-tax income of such constituent entity is not subject to tax under the IIR. This will be the case where the parent entity jurisdiction is either a low-tax jurisdiction or did not implement the GloBE Rules.
Subject to Tax Rule
The STTR is a defensive measure typically used by source states—normally high-tax jurisdictions—regarding intra-group outgoing payments that are insufficiently taxed in the hands of a related recipient resident in a low-tax jurisdiction. According to the Pillar Two Blueprint, the STTR will operate as a standalone tax treaty rule restricted to certain categories of intra-group passive income payments, known as “covered payments,” for example, interest, royalties, that are taxed less than 9%.
The STTR is limited to developing countries, defined as those with a gross national income per capita (calculated using the World Bank Atlas method) of $12,535 or less in 2019 (to be regularly updated). As a result, source developing countries will be able to protect themselves from base-eroding passive payments to low-tax jurisdictions.
MNEs should carefully consider the monetary impact of the STTR in their group structures, and could follow this three-step approach:
- identify the affiliates in scope, i.e., affiliates located in a developing country;
- determine whether there are any payments in scope, i.e., intra-group payments that are considered as covered payments; and
- ascertain whether such covered payments are below the minimum withholding tax rate for the STTR, which is 9%.
GloBE Rules: the Five-Step Approach
In applying the GloBE Rules (which run to about 45 pages with another 15 pages of definitions and accommodate a diverse range of tax systems), the OECD proposes a five-step approach.
Step 1: Identify the MNE Group and Its Constituent Entities Within Scope
Under step 1, an MNE should first determine whether it falls within the scope of the GloBE Rules and then identify the location of each constituent entity within the MNE group. According to article 1.1., an MNE will be in scope if its consolidated annual revenue exceeds the country-by-country reporting threshold, that is, 750 million euros ($822.5 million) in at least two of the four fiscal years immediately preceding the tested fiscal year. If an MNE is in scope, it should identify all constituent entities for which the GloBE Rules apply.
According to article 1.3., the term “constituent entity” comprises all group entities, including permanent establishments. The location of such entities (see article 10.3.) will be where the group entities are considered to be tax residents, and in the case of a permanent establishment, where it is located. If a constituent entity is considered to be dual resident, then the tie-breaker rule of article 4(3) of the OECD Model Tax Convention would normally apply.
Finally, under article 1.5, the GloBE Rules provide a list of excluded entities: governmental entities; international organizations; non-profit organizations; pension funds; and any investment fund or real estate investment vehicle that is considered to be the parent entity of an MNE.
Step 2: Determination of GloBE Income or Loss of a Constituent Entity
After identifying the MNE group and its constituent entity within scope, the next step is to calculate the GloBE Income or Loss of a constituent entity. The GloBE Income or Loss computation is necessary as it is the denominator in the effective tax rate (ETR) formula under step 4. Notably, unlike GILTI, where the computation is on a worldwide basis, the computation of GloBE Income or Loss applies on a jurisdictional basis and not a per entity basis. Hence, under the jurisdictional blending (per-country blending) approach, all of a constituent entity’s GloBE Income or Losses are aggregated to arrive at the net GloBE Income or Loss of a particular jurisdiction.
Under article 3.1., the starting point is the net income or loss used for preparing the Consolidated Financial Statements of the ultimate parent entity before eliminating intra-group transactions. Such net income or loss is adjusted to eliminate specific book to tax differences (nine adjustment items under article 3.2.1. and ten under articles 3.2.2. to 3.2.11). Notably, shipping income, subject to certain conditions, is explicitly excluded under article 3.3. Finally, the GloBE Income or Loss is allocated between a permanent establishment and the head office (main entity) or to owners of a flow-through entity under the local tax treatment.
Step 3: Computation of Adjusted Covered Taxes
Under step 3, an MNE is required to calculate the “adjusted covered taxes.” Effectively, article 4.2.1. provides four types of taxes that are included in the definition of covered taxes, and article 4.2.2. provides five types of taxes that are excluded. Like step 2 above, the calculation of the adjusted covered taxes applies on a jurisdictional basis and is the numerator of the ETR formula under step 4.
In accordance with article 4.1., the starting point in calculating the adjusted covered taxes is the current tax expense accrued for the financial accounting net income or loss. Further, under the same article, the GloBE Rules provide certain adjustments (additions under article 4.1.2. and reductions under article 4.1.3. to the current tax expense).
Moreover, under article 4.4. the current tax expense is adjusted to reflect certain timing differences (deferred tax adjustments and prior year losses). Then, under article 4.3. covered taxes are allocated to other constituent entities if necessary. Finally, where there is a post-filing adjustment—for example, during a tax audit or filing a revised tax return to correct an error—the ETR is recalculated to reflect such adjustments. Consequently, under article 4.6., increases in tax amounts for prior years are added to covered taxes in the current fiscal year.
Step 4: Computation of Effective Tax Rate and Top-Up Tax
Step 4 provides the mechanism for calculating the top-up tax on a jurisdictional basis where a jurisdiction’s effective tax rate is below 15%. In doing so, an MNE should, under article 5.1., determine the ETR for all jurisdictions; that is, the amount computed according to step 3 above—the sum of adjusted covered taxes of each constituent entity located in a jurisdiction—divided by the amount computed under step 2 above, (the net GloBE Income of a jurisdiction).
According to article 5.2.1., in the event that the ETR is lower than 15%, for example 8%, then the top-up tax percentage needs to be calculated—for example,15% minus 8% equals 7%. In accordance with article 5.2.2., to determine the top-up tax amount, the top-up tax percentage is then multiplied by the jurisdictional excess profit (Net GloBE Income minus Substance-based Income Exclusion). Lastly, under article 5.2.3., any Qualified Domestic Minimum top-up tax can reduce the top-up tax amount to zero. Such top-up tax amount is then allocated to the constituent entity in the jurisdiction in proportion to its GloBE Income.
Notably, under article 5.5. there is a de minimis exclusion for MNEs that have an average GloBE revenue that is less than 10 million euros; and an average GloBE Income that is either a loss or less than 1 million euros.
Finally, the OECD will develop safe harbor rules to further reduce the compliance burden. Such safe harbor rules are expected to be released later this year.
Step 5: Impose Top-Up Tax Under the GloBE Rules
Under this final step, the top-up tax calculated under step 4 is first imposed using the IIR top-down approach or the backstop mechanism of UTPR. Therefore, an MNE group needs to identify the ultimate parent entity that is liable to apply the IIR for all constituent entities based on the top-down approach. The top-up tax is then attributed to the parent entities in proportion to their allocable share. For any top-up tax amount that was not allocated (i.e., the parent entity jurisdiction(s) is either a low-tax jurisdiction or did not implement the GloBE Rules), the backstop mechanism, namely UTPR, will apply.
Further, the UTPR is limited when an MNE is in its initial phase of expanding abroad.
Finally, the GloBE Rules provide for a mechanism on how to allocate the UTPR top-up tax among the UTPR jurisdictions based on the following two factors: the net book value of tangible assets held; and the number of employees employed by all constituent entities that are located in such UTPR jurisdictions.
The mechanism to collect the UTPR top-up tax amount will be via a denial of any deductible expense (i.e., UTPR adjustment) which is similar to BEPS action 4 interest limitation rule.
Planning Points: Going Forward and Impact on MNEs
The impact of the Pillar Two Rules for in-scope MNEs will be at least twofold.
First, taking into consideration that Pillar Two aims to ensure that large internationally operating businesses pay a minimum level of tax, being an effective tax rate of 15% regardless of where they are headquartered or operate, it will arguably have an impact on their overall tax burden.
Second, to ensure compliance with Pillar Two, MNEs will need to be able to calculate the jurisdictional top-up tax in each country where they operate and allocate any top-up tax amount accordingly.
On the one hand, many of the GloBE Rules are simple to use. For example, in-scope MNEs are those that exceed the country-by-country reporting threshold, and the starting point for the calculation of top-up tax is the entity level financial information as used by the parent financial accounting standards. On the other hand, the GloBE Rules are 60 pages long (including 15 pages of definitions), accommodating a diverse range of tax systems and without taking into consideration the multilateral instrument to apply the tax treaty rules (STTR and SOR).
Thus, it is necessary to have a specialized team in place, which has an understanding of both international accounting standards and international tax systems, to be able to calculate precisely the jurisdictional ETR.
Going forward, in-scope MNEs are advised to take the following actions:
- identify the jurisdictions where the STTR applies (developing countries) and assess the impact of the 9% withholding tax concerning covered payments;
- perform a jurisdictional ETR materiality testing and impact assessment;
- as gathering the data to apply the Pillar Two Rules will be one of the biggest challenges facing MNEs, they should identify any data gaps that they might struggle to obtain and perform their data calculations, for example, when calculating the Substance-based Income Exclusion amount for each jurisdiction being the sum of the payroll carve-out and the tangible asset carve-out for each constituent entity;
- make a preliminary calculation of the jurisdictional top-up tax in each country that they operate in and identify what monetary amount should be allocated to each one;
- determine in which jurisdiction(s) the IIR might apply, based on the top-down approach;
- in case such jurisdictions refrain from implementing the GloBE Rules (staying IIR-free), then the potential UTPR jurisdictions need to be identified; and
- finally, despite the fact that the Pillar Two Rules are not entirely new, their functionality differs from the current international tax rules, so proper training will be required in order for MNEs’ in-house tax teams to be able to accurately calculate the jurisdictional top-up tax in each country where they operate.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Christos Theophilou is a Tax Partner at Taxand, Cyprus.
The author may be contacted at: firstname.lastname@example.org