On 12 October 2020, the OECD released for public consultation updated reports on its two-pillar proposal to address the tax challenges of the digitalisation of the economy.
The Pillar One proposal focuses on new nexus and profit allocation rules for certain business models, whereas the Pillar Two proposal pursues more broadly a global minimum effective taxation. The reports identify key issues, both political and technical, where divergences remain to be solved. The goal is to reach consensus amongst the 137 participating jurisdictions by mid-2021. Stakeholders are invited to provide their written comments no later than 14 December 2020.
What is the purpose of Pillar Two?
Pillar Two effectively seeks to enforce a global (yet to be determined) minimum level of effective taxation on income derived by large multinational enterprises (MNEs). To that end, it combines domestic and treaty-based measures that allow the other jurisdictions where the MNE operates (notably the jurisdiction of the ultimate parent entity) to charge a top-up amount of tax on resident group entities.
Which taxpayers are targeted?
Pillar Two would apply to MNEs and their constituent entities where the annual gross revenue of the MNE group, as determined under applicable financial accounting standards, is at least EUR 750 million (or the equivalent in another currency) in the previous fiscal year.
Certain ultimate parent entities, including certain investment funds, pension funds and governmental entities, would be excluded from the application of the rules to preserve their tax neutrality. Lower-tier groups or sub-groups controlled by exempt entities may, however, still be in scope of the rules.
Special rules would also apply in connection with associates (an entity or an arrangement over which the investor has significant influence), joint-ventures and 'orphan entities', which are not consolidated with the MNE group (or not consolidated in the same manner).
How would it work?
The proposal includes four different rules: the income inclusion rule (IIR), a switch-over rule (SOR, to facilitate the application of the IIR in a treaty context), an undertaxed payment rule (UTPR, which serves as back-stop to the IIR) and a subject-to-tax rule (STTR). The IIR (with the SOR) and UTPR are together referred to as the "GloBE Rules". The STTR and SOR would require changes to tax treaties.
What will be the trigger event for the GloBE rules?
The general principle is that the GloBE rules are triggered when the effective tax rate of an MNE group (that is in the scope of the rules) in a jurisdiction is below the minimum effective tax rate (yet to be) agreed upon.
Both components of the GloBE Rules rely on the same effective tax rate computation, which is determined on a jurisdiction-per-jurisdiction (rather than entity-per-entity) basis. The effective tax rate would be equal to (i) the total amount of covered taxes (essentially, taxes on corporate profits and other economically equivalent taxes) paid by MNE group entities in a jurisdiction, divided by (ii) the total amount of profits earned by the MNE group in that jurisdiction. The tax base would start from the consolidated financial accounts of the ultimate parent entity, subject to various adjustments to avoid distortions between jurisdictions in the computation of the tax base and to take into account certain timing differences.
The Income Inclusion Rule
The IIR would require the ultimate parent entity (or sometimes an intermediary parent entity) to include in its tax base a portion of the income of a controlled foreign entity where the latter and other MNE group entities in the same jurisdiction are taxed (on a jurisdiction-wide base) below the global minimum effective tax rate. The shareholder shall be subject to the top-up tax in respect of its proportionate share of the income of the controlled foreign entity for that period.
The Switch-Over Rule
As the IIR may be blocked by tax treaties when applied to certain branch structures, the proposal includes a switch-over rule to remove treaty obstacles. Where a tax treaty requires the parent jurisdiction to exempt the income of a permanent establishment, the SOR would allow to switch from the exemption method to the credit method where the profits attributable to the permanent establishment in the other contracting state are low-taxed profits.
The Undertaxed Payment Rule
The UTPR would complement the IIR and is based on the same determination of the effective tax rate on a jurisdiction-per-jurisdiction basis. Instead of triggering an additional income inclusion at the level of the recipient, it increases the tax base of the payer. The UTPR would target profits arising from transactions between connected entities that are not in scope of an applicable IIR: the jurisdiction of the payer (or on a subsidiary basis, of other entities that have net-intragroup expenditure) could deny a deduction or make an equivalent top-up tax adjustment where the payment to another group entity is not subject to tax at – at least – the global minimum effective tax rate at the level of the recipient. It would also catch ultimate parent jurisdiction's profits when that jurisdiction's effective tax rate is below the agreed minimum rate.
The Subject to Tax Rule
The STTR would catch certain payments that present a high risk of profit shifting to low-tax jurisdictions: interest and royalties, and some other payments such as franchise frees, (re)insurance premiums, guarantee fees and financing fees. This rule would subject a payment to withholding or other means of source-taxation and deny treaty benefits when a payment made between connected persons is subject to tax below an agreed minimum nominal tax rate.
Ordering / coordination of rules
The Pillar Two report considers that the STTR shall take priority over the other rules, as the STTR-induced tax liability will be considered in determining the effective tax rate paid by MNE group entities in a jurisdiction for purposes of the effective tax rate test. The IIR (with the support of the SOR, in a treaty context) shall apply subsequently, with a top-down approach. The UTPR should apply last and is not expected by the OECD to apply in many cases.
Pillar Two rules would apply after Pillar One (for a summary of the report on Pillar One, please see our Tax Flash here. The coexistence with the U.S. GILTI rules is subject to ongoing discussions.
What are the main open items?
Various sections of the report refer to further work to be undertaken (and/or a political agreement be reached), amongst others on:
- The level of minimum effective taxation;
- The application of jurisdictional blending;
- Carve-outs for certain taxpayers;
- Simplification measures to make the rules easier to implement for taxpayers and tax administrations;
- The exclusion of certain types of income from the GloBE tax base; and
- Transitional rules when an MNE becomes subject to the Pillar Two rules.
Which actions can businesses take?
In the short term, MNEs that may be in scope of the future rules should take the opportunity of the public consultation to share concerns they may have in terms of complexity and administrative burden. The written consultation runs until 14 December 2020 and should be followed by a public consultation meeting mid-January 2021.
In the coming months, MNEs subject to country-by-country reporting obligations (or which may reach the EUR 750 million turnover threshold in the next 2 years) are advised to assess whether or to what extent they may be affected by top-up taxation, and in which countries this may occur.
The new target deadline for an overall political agreement on Pillar One and Pillar Two is mid-2021. We will keep you informed about further developments. Should you have any question, please contact a member of our Digital Economy Taxation team or your trusted Loyens & Loeff adviser.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.