With the Organisation for Economic Development and Co-operation (OECD) proposals in the early stages of negotiation there are more questions than answers. We have tried to answer here a few of the questions we are commonly asked.
Frequently Asked Questions
- What payments/income are within scope of the “subject to tax rule” of Pillar Two?
The OECD work programme states that treaty benefits will be granted only if the item of income is subject to tax at a minimum rate. At paragraph 75 of the work programme this is further clarified to state that only “certain items of income” will be within scope where the payment is not subject to tax at a minimum rate and priority is given to interest and royalties.
Dividends and capital gains are also included; however, the repatriation of these flows is not explored further in the work programme.
One area that is not expressly covered in this aspect of the work programme is the interaction with exemptions. There is a risk that established reliefs, such as the U.K.’s exemption against corporation tax on the receipt of dividends, are largely redundant if a minimum tax is imposed on dividends paid up the ownership chain.
Furthermore, the implications for legitimate innovation tax incentives, stock compensation, group transactions, and how the rules will interact with losses, are not spelled out, but some jurisdictions will clearly be concerned that their tax sovereignty is being eroded.
These rules may also negate the benefits of participation exemption style systems; however, this is recognized in the consultation document and there are suggestions for a general carve out of special effective tax rates that would take these differences into account.
The idea of a minimum tax has similarities to the German royalty deduction barrier, which makes the deduction of outbound payments contingent upon the royalty income not benefiting from low taxation due to abusive regimes; however, the OECD proposals would not be limited to abusive or harmful regimes.
- What types of payments are within scope of the “undertaxed payment rule” of Pillar Two?
As it stands, there is limited information on the types of payment that the undertaxed payment rule includes, but at paragraph 73 the work programme states it is centered on payments to related parties.
The types of payments will be under further consideration by the OECD and it suggests that there are likely to be measures to address the anticipated problems this will pose for conduit and indirect payments.
We understand there are calls to ensure that payments made in the ordinary course of business, for example, cost of goods or intra-group service payments, are not within the subject to tax rule. The U.S. BEAT (base erosion and anti-abuse tax) regime, which targets “excessive” related party payments to non-U.S. entities, probably offers the most insight into how this rule is expected to operate, not least because the U.S. is a heavy proponent of this pillar.
- How will the rules interact with withholding tax?
The proposals do not explain how they anticipate the rules to interact with payments already subject to some level of withholding tax. The working assumption is that it will be possible to take into account (via a credit) withholding taxes suffered when calculating the effective tax rate. However, the OECD has admitted that it needs to investigate the operation of withholding taxes because it realizes that at the time of the payment, the effective tax rate is unlikely to be determinable.
Mechanisms for mitigating double tax, including foreign tax credits, are not spelled out, but it is frequently highlighted throughout the work plan as a priority.
The complexity of the proposals, i.e. how to accurately calculate the underlying effective tax rate at the time of payment, may make this very hard to achieve practically, especially when the complexity of multi-layered structures, as commonly used by asset managers, is taken into account.
- What definition of related parties will be used?
The working assumption is that the OECD is focused on transactions with related parties. However, at paragraph 77 of the work programme it says that it is contemplating how the subject to tax rule would operate in relation to unrelated parties for interest and royalties (these being identified as high risk areas). In our view, determining the effective tax rate for any payment to third parties would be almost impossible and commercial transactions with third parties are unlikely to be high risk.
A challenge for asset managers will be determining whether investors are “related” to portfolio companies. The consultation document suggested a 25% common ownership test for determining payments made to related parties and when to bring into account income for the income inclusion rule. At this stage it is not clear what will be agreed, but we understand the case is being made for a 50% threshold.
- What will the minimum tax rate be?
This is a pertinent question. Unsurprisingly, the work programme is mute on the minimum effective rate of tax, both for the income inclusion rule and the underpayment of tax/subject to tax rules. There are calls to use a set percentage of the domestic tax rate to allow jurisdictions to maintain a level of sovereignty on tax matters; however, the only thing that is clear at the moment is that reaching agreement on the rate will be a testing element of reaching any consensus.
It is worth pointing out that the OECD average statutory tax rate is 23.7% and the G-20 average statutory rate is 27%, but it is too early to tell if these are indicative of where agreement will land. Germany has reportedly put forward a rate of between 20–25% in representations to the OECD. In contrast, the lowest statutory tax rates of industrialized nations in the OECD are 9% and 12.5% (Hungary and Ireland respectively): therefore it is difficult to imagine a rate below double figures—not least because optically it is unlikely to be acceptable to many territories who will seek to use this as a way to demonstrate corporates are taxed “fairly.”
Examples from other territories may be instructive. The Netherlands, another proponent of a global minimum tax, has recently introduced a rule that requires companies based in countries with a corporation tax rate of under 9% to pay a 20.5% tax on any interest and royalties they receive from the Netherlands. In contrast the U.S. BEAT will transition from a rate of 5% to 12.5% by 2025.
- Will there be any exclusions?
The OECD is naturally reluctant to narrow the scope of the rules. From its perspective, the widest application of the rules means the risk of “gray areas” can be minimized, especially when taking into account the boundaries that might be created when designing exemptions for certain payments or certain industries.
Further thought clearly needs to be given to how the rules work with transparent entities or exempt investors as it is not apparent in the work programme or consultation document that the asset management industry has been taken into account in the development of the rules. This is not unusual. Many of the issues affecting asset managers during the BEPS process were either neglected or belatedly discussed. Interestingly there have been mixed calls from business: some would prefer these rules to apply to everyone, while some particular industries, including the asset management industry, have put forward a case to consider an industry exemption.
- Will the OECD consider an SME threshold?
It is not obvious at the moment whether there will be a size-based threshold: however, it is acknowledged that the administrative compliance that these rules will create for small and medium-sized enterprises will place a disproportionate burden on those businesses. It seems reasonable, and the OECD certainly acknowledge that they need to consider safe harbors and thresholds to reduce complexity in the application of the rules.
- What is the likely interaction between i) Pillar One and Pillar Two, and ii) between the two rules within Pillar Two?
The indication appears to be that Pillar Two will play a subservient role to Pillar One, effectively working as a backstop to ensure that irrespective of where profits are taxed, those profits will at least be taxed at a globally agreed minimum rate. Given the subtext of a “pillar,” it is unlikely that one pillar will fall away and risk the programme being seen to “collapse.”
The interaction between the two rules in Pillar Two is less clear, however, the coordination and hierarchy between the rules will be important. In fact, there are calls for the subject to tax rule to play second fiddle, such that it would only be brought in if the income inclusion rule does not apply. We understand that this is the OECD’s preference; however, there is a broad church of territories involved in the negotiations and some developing nations favor the subject to tax rule. Notwithstanding the ability to reach consensus, the OECD will need to balance simplicity with effectiveness.
- Is there the political support to make this plan a reality and what are the timescales?
The G-7 finance ministers’ agreement to support a two-pillar solution on July 18, 2019 indicates there is critical political support behind this project. The proposals do cut across the sovereignty of tax matters, in particular the ability for jurisdictions to set their own tax rate; despite this, there appears to be strong political support. The U.S. has written the playbook for the Pillar Two proposal given its GILTI and BEAT system of taxation so this is a good indication that they are on board. In fact, the G-7 finance ministers’ communiqué specifically highlighted the US’s GILTI regime as a mechanism to bring about a minimum level of effective taxation.
The U.K. has been quiet on the detail of the proposals but have said they will abolish the Digital Services Tax if a global agreement is reached that sufficiently captures the concerns of the U.K. regarding value creation of users in a market jurisdiction. There is a risk that in the OECD negotiations the concept of user value is watered down and provides an opening for the U.K. to retain its Digital Services Tax.
Another dynamic to take into account is the EU. Ursula von der Leyen, the new President of the European Commission, has already taken aim at digital companies, vowing to make them pay their fair share of taxes. It is anticipated that the EU would bind member states to enact these changes through another ATAD-style mechanism (the European implementation of BEPS).
What are the next steps?
The OECD is conducting an economic impact analysis for the jurisdictions involved in the programme (some 130 territories). There are expected to be more details released in October 2019. This will lead to further and more detailed proposals by early 2020. Actual implementation may be years away as some form of multilateral treaty would need to be agreed and ratified.
One indication of the timescale for implementation is the fact that the U.K.’s unilateral Digital Services Tax will not be reviewed until 2025.
Planning Points for Investment Managers
Funds based in or investing through Europe are getting used to operating in an uncertain environment following the implementation of BEPS and the EU ATAD, and it looks like there is more change on the horizon given these developments. It is clear that the tax features of investment funds have largely been ignored in the development of these rules and therefore considerable uncertainty remains. We set out below a number of areas that we think investment managers should keep an eye on as the rules develop.
- Will a typical Luxembourg master holding company structure work in light of these rules?
A typical Luxembourg-based fund structure that consists of a Luxembourg master holding company and separate Luxembourg companies for various investments is likely to be implicated by these proposals.
Take for example debt funding flows. Debt provided to the subsidiaries could come unstuck on the “undertaxed payments” aspect of Pillar Two. This could result in a denial of deduction for interest payments if the interest receivable is not subject to tax at the global minimum rate; imposition of a source based tax, which could be a withholding tax on the base eroding payment (effectively overwriting established bilateral double tax treaty agreements); or restriction of treaty benefits associated with those payment flows if the interest income is not subject to the global minimum rate.
It is not clear how transparent entities will be treated, but working on the assumption that the profits of a transparent entity such as a partnership will be treated as the profits of its members, it will be necessary to determine whether the members are subject to tax on the relevant profits. There could be a material difficulty for exempt entities/persons as they are not regarded as subject to tax.
- What about a typical Cayman structure?
Payments of interest or repatriation of profits in a typical Cayman limited partnership master fund structure will potentially suffer a similar fate. The Cayman Islands has no capital gains, income, profits, corporation or withholding taxes (whether on the investment fund or its investors); therefore satisfying the subject to tax rule will prove difficult.
- What will be the effect for structures that rely on participation exemptions?
Repatriating profits from subsidiaries up a chain may also become difficult. Under existing rules, dividend income may either be tax exempt (in full or in part), or if taxable, with a right to credit a potential withholding tax levied at source. If the dividend income is not subject to tax at the globally agreed rate, then you could anticipate a withholding tax levy in the source country and/or removal of the limitation on taxation of dividends in the source state.
Given the number of dividend exemption regimes in existence this will have a material impact on global repatriation strategies. Similarly, exemptions provided for capital gains on the disposal of shares in a portfolio company may trigger tax cost.
There are suggestions for a general carve out of special effective tax rates, like participation exemptions; however, there are some source countries that will want to make the case for more source territory powers, which could grant rights to tax capital gains arising (i.e. by removing the treaty provisions that restrict this) if the subject to tax rule is not met.
- What are the implications for an investment manager’s relationship with investors?
We expect that it will be practically impossible for a fund to take into account the tax status of each of its ultimate investors when structuring the fund’s investments. Further, the ongoing reporting requirements these proposals present would place an excessive compliance burden on managers.
The OECD recognizes the difficulty for shareholders and corporates to access and share the level of information that is potentially required in these proposals, which would effectively require an effective tax rate to be calculated on every flow of income through the various levels of the fund up to investors. Collecting this amount of information in a method that is timely and accurate appears to have been underestimated in the development of these rules, and represents new territory for private capital markets.
These new proposals contain some surprising results for asset managers.
Ceinwen Rees is a Partner and Rhiannon Kinghall Were is Head of Tax Policy at Macfarlanes.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.