Hybrid Financial Instruments Might Reduce Impact of Pillar Two Proposals

The aim of the Organization for Economic Cooperation and Development (OECD) Pillar Two proposals is to ensure that multinational enterprises (MNEs) pay a minimum level of tax, regardless of where they are headquartered or the jurisdictions in which they operate.

Pillar Two seeks to achieve this broadly by the operation of two mechanisms:

the Global Anti-Base Erosion (GloBE) rules, which apply a global minimum effective tax rate (ETR); and
a separate Subject to Tax Rule (STTR).

This article is focused on the operation of the GloBE rules and how hybrid financial instruments could effectively allow an MNE to artificially manipulate their ETR.

GloBE Rules—a Summary

The operation of these rules at a high level is relatively straightforward. In essence, they require an MNE to calculate the ETR in the countries it operates in, based on the tax base and taxes imposed on a jurisdictional basis. This ETR is then compared to an agreed global minimum ETR which will be set at a minimum rate of 15%.

If an MNE’s ETR for any particular jurisdiction is below the global minimum ETR, the MNE will be liable for an additional amount of tax in its parent company’s residence jurisdiction to bring the total amount of tax on the excess profits up to the global minimum ETR (referred to as “top-up tax”).

The top-up tax is collected by applying an Income Inclusion Rule (IIR) or, where no IIR applies, by the application of an Undertaxed Payments Rule (UTPR). Both the IIR and the UTPR use a common tax base and a common definition of taxes.

The GloBE rules would apply to MNE groups and their constituent entities within a consolidated group that have annual gross revenue exceeding 750 million euro ($870 million). These are also entities that are generally subject to country-by-country reporting (CbCR) obligations under the OECD BEPS Action 13.

The GloBE Rules—Jurisdictional Effective Tax Rate

Key to the operation of the GloBE rules is the calculation of the jurisdictional ETR.

The GloBE ETR is determined by dividing the amount of covered taxes by the amount of income determined under the GloBE rules. This is to be based on profit (or loss) before tax in the financial statements.

The rules then require certain adjustments to be made to the profit before tax figure to calculate the GloBE tax base. This includes intragroup dividends, dispositions of stock and fair value accounting gains, stock-based compensation expenses, fines and penalties and investment returns of life insurance policy holders.

For the purposes of the GloBE rules, taxes are any compulsory payment to a general government. State and local level income taxes are covered taxes, even if they are deductible at the national level.

Therefore, the ETR is calculated based on a combination of the tax payable under the tax law and profit or loss from the financial statements, which is subject to certain standardized adjustments.

The relevant financial reporting framework for calculating the GloBE tax base is the framework used by the parent company in the preparation of its consolidated financial statements. Acceptable financial reporting frameworks are International Financial Reporting Standards (IFRS) and any equivalent financial accounting standard: These include the generally accepted accounting principles of Australia, Canada, China, Hong Kong (China), India, Japan, New Zealand, Singapore, South Korea and the U.S. In addition, other accounting standards issued in the parent company’s jurisdiction can be used, providing this will not result in any material competitive distortions in the application of the GloBE rules.

Income, gains, expenses, and losses attributable to transactions between members of the GloBE tax group are recorded in the entity level financial accounts in accordance with the arm’s-length principle.

The OECD/G-20 October 2020 Pillar Two Blueprint and the July 2021 Statement do not favor an approach based on “global blending,” which would have calculated the ETR at group level. Instead, the OECD favors “jurisdictional blending” which requires MNEs to calculate the ETR for each jurisdiction in which they have a taxable presence.

Adjusting the Effective Tax Rate

The application of the top-up tax by the parent company is dependent on the ETR in the subsidiary jurisdiction, using a jurisdictional approach.

For example, let us assume the global minimum tax rate was set at 15%. A parent company has two subsidiaries—Subsidiary 1 which had an ETR of 12%, and Subsidiary 2, which had an ETR of 20%.

The parent company would be subject to top-up tax for Subsidiary 1 based on the 3% difference between its ETR and the global minimum rate. This is in spite of the fact that Subsidiary 2 suffers an ETR significantly above the global minimum rate. This is in fact the whole point of jurisdictional blending, as opposed to global blending.

It would therefore be in the MNE’s interest to look to effectively level out its ETR. If, for instance, transactions between the subsidiaries could be undertaken to reduce Subsidiary 2’s ETR by 3%, and increase Subsidiary 1’s rate by 3%, the net effect would be that the ETR of Subsidiary 1 would be 15% and Subsidiary 2’s would be 17%. The parent company would then not be liable for top-up tax as both companies operate at an ETR that is not less than the global minimum rate.

How Could This Be Achieved?

As the ETR is in essence covered taxes divided by GloBE base, if transactions were undertaken that did not impact on the actual tax payable, but had the effect of reducing the GloBE base, this would increase the ETR.

For example, if taxes payable (i.e., covered taxes) were $1 million and the GloBE base was $10 million, the ETR would be 10% (1/10).

If the GloBE base was reduced to $8 million, the ETR would then be 12.5% (1/8).

An MNE could therefore potentially use certain arm’s-length intragroup transactions to shift income from one jurisdiction to another to manage the ETR without actually increasing the tax payable.

Hybrid Financial Instruments

This then raises the issue of the treatment of hybrid financial instruments, in particular, transactions which have a different treatment for financial accounting and tax purposes.

We are not looking at financial instruments which are treated differently for tax purposes in two countries (for example, as debt in one country and as equity in another country, to obtain a tax deduction in one country and non-taxable income in the other), which are the focus of a number of anti-avoidance measures.

What we are concerned with are arrangements that are deductible for accounting purposes but not tax purposes in one jurisdiction, and correspondingly in the other are included in financial accounting income, but not taxable income.

International Accounting Standard (IAS) 32 and IFRS 9 deal with the accounting treatment of financial instruments and in particular, when they should be reflected in the accounts as debt or equity.

In short, a financial instrument is classified as debt if there is a contractual obligation:

to deliver cash or another financial asset to another entity; or
to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity;

In the case of preference shares, for instance, if an entity issues preference shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation to deliver cash and therefore should generally be recognized as a liability. In fact, even if the entity is obligated to deliver shares of its own stock, it can still be a financial liability providing the value of those shares is attached to a fixed amount and not its own financial instruments (for example its stock price), and the number of those shares is variable.

In contrast, preference shares that do not have a fixed maturity, and where the issuer does not have a contractual obligation to make any payment, are generally equity.

Classification as debt would mean that inter-company payments would reduce accounting profit (and assuming no other adjustments, the GloBE tax base) for the group debtor and increase profit (and the GloBE tax base) for the group creditor.

However, for corporate tax purposes, in many jurisdictions preference share dividends are not tax deductible and may not be taxable for the recipient (for example, under a participation exemption). Therefore, there would be no impact on the tax payable for tax purposes.

Another example could be profit participating loans. Typically, these are structured as:

subordinate to the claims of other creditors;
long-term loans (for example, a term of more than 50 years); and
providing for interest payments that are dependent on the profits or turnover of the borrower.

As for preference shares, it may be possible to structure these loans as debt for financial accounting purposes, but equity for tax purposes, given that many jurisdictions include provisions in their domestic law to treat interest payments that are dependent on financial results as a distribution of profits (i.e., a dividend).

This different treatment of a transaction for tax and accounting purposes could have a direct impact on the relevant ETRs.

How This Would Work—an Example

As stated above, modifying just the GloBE base, without any impact on the actual tax payable, would modify the ETRs in the relevant jurisdictions.

Facts

Company A is resident in Country A. Company A is the Ultimate Parent Entity of a qualifying MNE group that has consolidated revenue above the 750-million-euro threshold. The IIR applies to the group in Country A.
Company A owns 100% of Company B. Company B is resident in Country B. Company B has a GloBE base of $50 million and has covered taxes of $6.5 million. Its ETR is therefore 13%.
Company A owns 100% of Company C. Company C is resident in Country C. Company C has a GloBE base of $100 million and has covered taxes of $20 million. Its ETR is therefore 20%.

We assume the minimum global ETR is 15%.

Analysis

The jurisdictional ETR of Company B is below the 15% global minimum ETR. As such, top-up tax under the IIR applies to the parent company.

The top-up tax rate is equal to the excess of the 15% global minimum ETR over the jurisdictional ETR, which is 13%. Therefore, the top-up tax rate for Company A is 2%. In this case, the top-up tax paid by Company A on its Country B income is $1 million.

Hybrid Instrument

Company C grants Company B a long-term, profit participating loan that is classed as debt under IAS 32 and any other relevant accounting standard. The loan is for a capital sum of $150 million with interest at an arm’s-length rate. In this case we will assume an arm’s-length rate is 5%. For financial accounting purposes the balance of the loan would be shown in Company B as a liability in the balance sheet and in Company C as an asset. The interest payment of $7.5 million would reduce the profits of Company B to $42.5 million.

If the loan was classed as equity for tax purposes, the dividends would not be tax deductible for tax purposes and therefore the tax payable would remain the same. The ETR would then be 6.5 divided by 42.5 = 15.29%.

Company C would include the interest in its income, increasing (assuming no other adjustments) its GloBE base to $107.5 million. Again, assuming that for tax purposes the receipt is exempt from tax as a dividend distribution, the covered taxes remain the same at $20 million, and its ETR would be 18.6% (20 divided by 107.5).

Both Company B and Company C would then have an ETR above the global minimum rate, and Company A would not be required to pay any top-up tax.

Note that the above is clearly a very simplified “scaled back” summary and is subject to a number of assumptions, including those stated above, and also that withholding tax is not levied on outgoing payments due to a participation exemption and there is no anti-avoidance legislation in place.

Conclusion

The original October 2020 Blueprint did not include any specific measures to target the use of hybrid financial instruments in this type of situation. It did note that “adjustments may be required where differences between tax and financial accounting could have a disproportionate impact on the outcomes under the GloBE rules.” It remains to be seen whether the latest guidelines (expected to be issued in October 2021) will include measures to combat this.

If not, the sheer number of jurisdictions in which MNEs typically operate would give rise to arbitrage planning opportunities along these lines, with the ability to adjust the ETR giving MNEs the ability to significantly lessen the impact of the Pillar Two proposals.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.