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Analysis of Pillar Two Primary Rule IIR—and Comparison With CFC Rules

May 6, 2022, 7:00 AM

In 2019, the Organisation for Economic Cooperation and Development (OECD) proposed the Pillar Two rules in an effort to provide a solution to all unresolved issues of BEPS Actions 2–15. According to the October 2020 Pillar Two Blueprint, the GloBE primary rule, namely the income inclusion rule (IIR), operates as a “super” controlled foreign company (CFC)-like rule, but with a broader scope. Although similar in operation, the IIR and CFC rules can co-exist because they have different policy objectives.

CFC rules are not new. They have existed since 1962, when the U.S., to protect its tax base and prevent long-term deferral, became the first country to adopt such rules. The 1998 OECD Report on Harmful Tax Competition noted that more than 19 countries adopted CFC rules. The 1998 Report was also used as a basis for designing CFC rules for both the 2015 OECD BEPS Action 3 Final Report and the 2016 EU Anti-Tax Avoidance Directive (ATAD 1). By 2013, 28 countries had enacted CFC rules, and with EU ATAD 1, this coverage was extended within the EU. Under OECD BEPS Action 3, the OECD provides six building blocks for designing a CFC regime that will be used for comparison purposes with the IIR.

Rules for Defining a CFC

The first building block is to define a CFC, and the critical consideration is whether the resident shareholder(s) exercises control over the foreign entity or entities. As a result, it first needs to be considered whether the type of the foreign entity is in scope, and second—if the entity is in scope—whether the resident shareholder has sufficient influence or control over such an in-scope foreign entity.

From the perspective of in-scope entities, the IIR and CFC rules seem to be in line, as they both include a wide range of entities such as a company, a permanent establishment, a partnership or a trust, provided they are residents in the country of creation. In this context, the IIR has rules with respect to both the allocation of income of transparent entities and anti-hybrid rules that are often found in CFC regimes.

In contrast, control is partly aligned. CFC regimes typically define the term “control” based on their domestic tax laws, and they require two different elements. First, the type of control (e.g. legal or economic or de facto control), and second, the level of control. For example, the EU ATAD defines control in article 7 as holding directly or indirectly more than 50% of the voting rights, capital or the right to receive profits, and some other countries have a lower level of control, for example 40% in the U.K. or even lower at 10% in the U.S., under certain circumstances.

However, the IIR in-scope entities are those that are consolidated on a line-by-line basis, and as a result, the term “control” is not based on tax laws but rather on accounting principles, for example under International Financial Reporting Standard (IFRS) 10. Notably, the IIR “control” based on consolidation is similar to the approaches above and is not considered to be fundamentally different as it is a combination of legal and de facto control.

Exemptions and Threshold Requirements

Under the second building block, CFC rules largely comprise three different types of CFC exemptions and threshold requirements: first, a de minimis amount (a threshold); second, an anti-avoidance requirement mainly based on motive or purpose; and third, a safe harbour rule primarily based on the tax rate.

Both the IIR and CFC rules provide for a de minimis threshold. Specifically, under CFC rules, for example under ATAD article 7(4), the de minimis exemption is provided to entities with accounting profits of no more than 750,000 euros ($789,000), and non-trading income of no more than 75,000 euros; or with accounting profits amounting to no more than 10% of its operating costs for the tax period. And under the GloBE Rules, there is a de minimis exclusion for multinational enterprises (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.

CFC regimes with a de minimis threshold typically provide anti-fragmentation rules, such as the German rules to prevent circumventing the system. Yet the IIR does not provide such a rule since the calculation is based on a jurisdictional basis, whereas CFC rules are typically based on a per entity basis. Another significant difference is that Pillar Two applies to large MNEs having a consolidated revenue exceeding 750 million euros, whereas CFC rules usually apply without such a threshold.

Turning to the anti-avoidance exemption, while CFC rules have such a provision, for example, under ATAD article 7(2)(b), CFC rules apply to income arising from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage. Yet the IIR does not have such an exemption. As a result, it is evident that the IIR is not a substance-based rule, but rather its purpose is to tax the profits of an MNE at 15%, regardless of where they are headquartered or the jurisdictions where they operate.

Finally, for the purposes of simplicity in applying the CFC rules, some jurisdictions provide for white, black, and gray lists to identify jurisdictions with low or acceptable tax regimes. In this context, the OECD will develop safe harbor rules to further reduce the compliance burden, which are expected to be released later this year. In the event that a CFC is not included in the white list, then a comparative approach on a case-by-case basis is followed.

Therefore, whereas CFC regimes typically compare the resident shareholder tax rate (either a portion or percentage) with the CFC jurisdiction on a per entity basis to determine whether it is considered to be low taxed, the IIR compares the effective tax rate (not the statutory rate that some CFC regimes use) of the CFC calculated on a jurisdictional basis with the global minimum tax rate of 15%.

Defining Income

According to the third building block, CFC rules typically distinguish between active and tainted or passive income; and because active income is considered less abusive than highly geographically mobile passive income, CFC rules are mainly focused on passive income—for example, ATAD article 7(2) dividends, interest, royalties, capital gains, income from finance leasing and financial activities, and income arising from related parties—for example, intra-group income from sales and services.

The GloBE Rules, however, largely include all income. This is because 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 adjustments items under article 3.2.1. and ten under articles 3.2.2. to 3.2.11.

As a result, the IIR is wider in scope than the CFC for two reasons: first, the IIR does not exclude any income from the in-scope entities such as active income. Second, CFC regimes typically focus on preventing parent stripping (foreign to domestic stripping), whereas the IIR focuses on preventing both foreign-to-foreign stripping (income generated in third countries) and parent stripping.

Computing Income

The fourth building block: normally, CFC income is computed according to the domestic law of the resident shareholder on the presumption that the CFC is resident there (i.e. recalculating the tax base of the CFC in accordance with the parent domestic law). A typical example would be ATAD article 8(1) and the U.K. On the contrary, the IIR computation would be according to the GloBE rules as noted above (Defining Income).

Another critical issue is how to treat brought-forward and carried-forward losses. On the one hand, CFC regimes normally take into consideration the pre-existing domestic laws of the resident shareholder for existing losses and allow carried-forward losses to be surrendered only on CFC profits or CFCs in the same jurisdiction. Yet CFC rules might not attribute losses, for example, under ATAD article 8(1).

On the other hand, the GloBE rules under article 4.4 require an adjustment to be made to Covered Taxes by way of the total deferred tax adjustment amount to take temporary differences and prior year losses into account for GloBE purposes, and a simplified loss carry-forward equivalent may be elected under article 4.5 in lieu of applying the deferred tax accounting rules set out in article 4.4.

Rules for Attributing Income

Under the fifth building block, in determining income attribution CFC regimes undertake the following four-step approach: first, determine to which taxpayer the income should be attributed; second, how much income; third, when and how such income should be included; and finally, at what rate. The IIR rules in identifying the taxpayers for attributing income follow a top-down approach that depends on the level of each ultimate parent entity or intermediary parent entity, or partially owned parent entity shareholding taking into consideration indirect holdings as well.

On the contrary, CFC regimes follow a bottom-up approach but attribute income largely in the same way as the IIR. For example, ATAD article 8(3) provides that income to be included in the tax base shall be calculated in proportion to the taxpayer’s participation in the entity and article (7)(1)(a) refers to direct or indirect participation. Finally, as noted above, CFC regimes would have priority over the IIR.

Relieving Double Taxation

According to the final building block, CFC rules, to avoid double taxation and achieve single taxation, normally allocate to the resident shareholder any foreign tax paid by the CFC. As with the other building blocks, the domestic tax legislation of the resident shareholder will be used. For example, under ATAD article 8(7) requirements, an EU member state allows a deduction of the tax paid by the entity from the tax liability of the taxpayer in its state of residence.

In the context of avoiding double taxation, CFC rules may also include provisions for both differences in timing between attribution and distribution and when CFC rules are applied by more than one country at the same time. On the other hand, to avoid double taxation under Pillar Two, coordination is required among multiple jurisdictions in applying Pillar 2 rules uniformly. Thus, a strong dispute resolution mechanism needs to be in place.

Permanent Establishments and Switch-Over Clause

The issue of long-term deferral is not problematic when it comes to foreign permanent establishments, and thus CFC regimes may not include permanent establishment rules since such income would be picked up at the level of the head office. This would be the case provided that the country of the resident shareholder taxes under a foreign tax credit system and not under an exemption system.

Thus, Pillar Two rules provide for a switch-over clause—switching from an exemption method to a credit method—that would complement the IIR to remove such tax treaty obstacles (i.e. making the IIR inapplicable).

Planning Points: Going Forward and Impact on MNEs

In light of the above, the IIR seems to be an advancement of BEPS Action 3 and would work as a super CFC rule to pick up any income of an MNE’s group (consolidated revenue of at least 750 million euros) in case such income was not subject to a 15% effective tax rate calculated on a jurisdictional basis, normally taking into consideration entities included on a line-by-line basis in the consolidated financial statements of such MNE group.

Importantly, the IIR deviates from the typical CFC rules as it picks up all income that is taxed less than 15% without an economic substance-based carve-out, but rather using tangible assets and employees as proxies. In doing so, the IIR relies heavily on both accounting principles such as IFRS, which is the starting point for determining the GloBE tax base and international tax rules (GloBE Rules run to about 45 pages with another 15 pages of definitions and accommodate a diverse range of tax systems).

In practice, MNEs can follow a five-step approach in both calculating and allocating the Top-Up Tax amount:

Step 1: Identify the MNE Group and Its Constituent Entities Within Scope
Step 2: Determine the GloBE Income or Loss of a Constituent Entity
Step 3: Compute Adjusted Covered Taxes
Step 4: Compute the Effective Tax Rate and Top-Up Tax
Step 5: Impose Top-Up Tax Under the GloBE Rules.

The above five-step process was analyzed in my previous article Deconstructing Pillar Two—Impact on Multinational Enterprises and is depicted in this flowchart.

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.

Author Information

Christos Theophilou is a Tax Partner at Taxand, Cyprus.

The author may be contacted at: ctheophilou@cy.taxand.com