Simplifying the OECD’s Pillar 2: a global tax reform

November 2022  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2022 Issue

In October 2021, the majority of the G20 countries joined the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) Inclusive Framework, in agreement of a landmark deal to address the tax challenges arising from the digitalisation of the global economy. BEPS 2.0, through a ‘two-pillar’ approach, aims to address gaps in current laws that allow large corporations to earn significant revenue in foreign markets without paying income tax there. The new rules ensure that large multinational enterprises (MNEs) pay a fair share of tax wherever they operate. While Pillar 1 ensures fairer distribution of profits by reallocating taxing rights to market jurisdictions with respect to the largest MNEs (those with revenues of more than €20bn and operating margins above 10 percent), Pillar 2 ensures that MNEs which have a consolidated turnover of over €750m pay a minimum tax in each jurisdiction in which they operate.

While Pillar 1 and its details are still being agreed upon, and its implementation will come in time, Pillar 2 is being introduced first and the OCED has issued detailed rules and commentary to enable countries to introduce it as soon as possible.

The overall architecture envisaged by Pillar 2 is designed in a manner to ensure that large MNEs pay a global minimum tax (GMT) of 15 percent in each of the jurisdictions in which they operate by introducing a top-up tax mechanism, which is triggered whenever the effective tax rate would otherwise be lower than 15 percent.

Pillar 2 model rules operate through two interlocking rules, collectively referred to as Global Anti-Base Erosion (GloBE) rules, namely: (i) an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a constituent entity; and (ii) an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR. Pillar 2 also includes a treaty-based rule, Subject To Tax Rule (STTR), that allows source jurisdictions to impose a top-up withholding tax on certain related-party payments which are not subject to a minimum tax rate.

Under the GloBE rules, the first step is to identify the constituent entities of the group that are in-scope of Pillar 2 and their role in respect of this minimum taxation, such as ultimate parent entity, partially owned parent entity, and so on. Subsequently, the GloBE income or loss is to be determined for each constituent entity, based on financial accounting income in the consolidated financials, considering any adjustments required under Pillar 2 rules. Thirdly, the covered taxes are calculated based on the tax expenses recorded in the financials, considering any specific adjustments.

The next step is to calculate the effective tax rate (ETR), on a jurisdiction-by-jurisdiction basis, by dividing the sum of the adjusted covered taxes of all constituent entities by the sum of the GloBE income of all constituent entities. Finally, the jurisdiction’s ETR is compared with the minimum tax rate of 15 percent and the top-up tax is calculated, which then ensures a minimum taxation of 15 percent. The substance-based income exclusion must be considered when arriving at the amount to be paid as top-up tax.

The GloBE rules will have the status of a ‘common approach’, i.e., while members of the Inclusive Framework are not obliged to implement the GloBE rules, they must accept the application of the GloBE rules by other members. Jurisdictions that choose to adopt the rules must administer them in a way that is consistent with the outcomes provided for under Pillar 2 rules.

The model rules are quite technical and complex, and will pose practical challenges during implementation, given the global nature of the provisions. The jurisdictions that have agreed to apply this framework are working through how they will incorporate them into their domestic legislation so that they do not lose out on tax revenues through the application of the IIR at the parent company level. Larger groups will be required to undertake a significant and costly compliance exercise to extract and maintain the source data for each jurisdiction at the consolidated level, apply the required adjustments and perform calculations to determine how and when tax is going to be collected. The OECD is in discussions to develop a common format in the form of GloBE Information Return to achieve a common data reference among all countries.

While the BEPS project has seen tremendous progress in recent times, there is still a lot of ambiguity, as many issues and details are still open for discussion or are unsettled. Despite the detail provided in the model rules, the challenges of introducing this into the domestic law of each country may lead to uneven implementation. The timeline for introduction is currently envisaged as from January 2024, provided EU member states and other countries introduce the rules into their domestic tax laws.

Recently, the governments of France, Germany, Italy, Spain and the Netherlands issued a joint statement that they will enact Pillar 2 unilaterally if the European Council cannot reach an agreement on it. While the OECD has taken huge strides toward developing this exhaustive framework, it will be interesting to see how Pillar 2 will be implemented in practice.

 

Nirav Shah is a director at FAME Advisory DMCC. He can be contacted on +971 43 964 885 or by email: nirav@fame.ae.

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BY

Nirav Shah

FAME Advisory DMCC

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