The OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (that counts already 141 participating jurisdictions) agreed a two-pillar solution to address the tax challenges arising from the digitalisation of the economy and the proposed rules have significant impact on how multinational businesses (MNE) will be taxed on cross-border transactions. Those proposals may be summarized as follows:
- Pillar One Proposal – Pillar 1 involves a partial reallocation of taxing rights over the profits of the largest and most profitable multinational businesses (Ultra MNE) to the jurisdictions where consumers are located. So, it is about where they pay tax. Time will tell if this would resolve concerns over the digital economy and how highly digitalised businesses generate value. Pillar 1 was presented first in blueprint format and a public consultation issued on 4 February 2022 contains the first building blocks relating to nexus and revenue sourcing. Pillar 1 should be implemented via multilateral convention available for signature either in 2022 or 2023. As several countries have put on hold unilateral digital sales taxes, it is expected that pressure will increase to reach consensus.
- Pillar Two Proposal – Pillar 2 is focused on ensuring that MNEs pay a minimum rate of tax in every jurisdiction they operate. So, it is about how much tax they pay (rather than where they pay). Time will tell if this places an effective floor on tax competition between jurisdictions and reduces profit shifting. Pillar Two model legislation (GloBe Model Rules) were published by the OECD. A public consultation document on the implementation framework will be issued in February with a focus on the particular issues to be agreed by the end of 2022. Countries should introduce domestic legislation with effect as from 2023 and EU will implement GloBe Rules via a Directive already released in draft.
The following is an attempt to deconstruct in 20 points the inner workings Pillar Two GloBe Rules:
- Functioning of Pillar Two – An adjusted/common accounting measure of profit will be calculated for a group’s total operations for each jurisdiction to determine if a MNE has paid a minimum 15% level of corporation tax in each jurisdiction. If tax paid per jurisdiction falls below that minimum 15% level, the rules will then require countries to impose top-up tax on certain entities of the MNE group. In addition, Pillar Two will provide for a treaty-based rule, the Subject to Tax Rule, that is a top-up withholding tax on certain types of outbound payments that are made between related parties and are taxed at a nominal rate of less than 9%. The draft model provision of the Subject to Tax Rule (to be implemented by multilateral instrument) and its commentary will be released in March 2022.
- GloBe Threshold – Rules apply to MNEs with revenue in their consolidated financial statements is greater than €750m in at least 2 of the previous four Fiscal Years (like the rules for Country-by-Country Reporting – CbCR). The ones qualifying are called “in-scope MNEs”. Jurisdictions are allowed to apply the top-up to smaller MNE groups that are headquartered in their jurisdiction.
- Calculation Mechanisms – There are several steps to calculate the effective tax rate (ETR) and top-up tax payable by an in-scope MNE:
- Step 1: Determine the “in scope” entities of group per jurisdiction.
- Step 2: Determine the “in scope” profits and taxes that relate to each entities (including those which relate to timing differences).
- Step 3: Aggregate profits and taxes of Steps 2 and calculate group ETR per jurisdiction by dividing the aggregate taxes by aggregate profits.
- Step 4: If ETR in Step 3 is less than 15%, then calculate the group “top-up percentage” for the jurisdiction which is 15% less the jurisdictional ETR.
- Step 5: Calculate jurisdictional top up tax by deducting from profit calculated in Step 2 a 5% return on the tangible assets and payroll expenses and then multiplying that amount by the “top-up percentage” of Step 4.
- Step 6: Attribute that jurisdictional top up tax to the group’s individual entities in that jurisdiction based on relative contribution to total profit.
- Step 7: The top up tax is first charged under an Income Inclusion Rule or IIR which charges the entity’s parent entity (see point 15 below)
- Step 8: Any remaining top up not collected under Step 7 is charged upon by other group entities under the Undertaxed Profits Rule or UTPR (see point 16 below).
- GloBe Group – Model Rules rely on accounting principles to define the scope of the MNE Group (i.e. essentially entities included in the consolidated financial statements of the Ultimate Parent Entity/UPE including permanent establishments). Joint ventures are within the scope when the MNE has at least 50% of the ownership interest.
- GloBe Constituent Entities – as calculation of the ETR for a jurisdiction is based on the income and covered taxes of each constituent entity, each entity within the group is treated as a constituent entity and permanent establishments are treated as separate constituent entities. Constituent entities will be located in the jurisdiction where they are tax resident, and a tie-breaker provision applies for entities located in more than one jurisdiction.
- GloBe Excluded Entities (not constituent entity) – The following entities would not be subject to any top up under Pillar 2 or charged a top up tax under either the IIR or the UTPR: (i) Governmental entities; (ii) International organisations; (iii) Non-profit organisations; (iv) Pension funds; (v) Investment entities which are the UPE (investment funds and real estate investment entities). International Shipping industry is also excluded.
- Globe Calculating ETR – ETR is calculated by dividing the aggregate tax (i.e. the “covered taxes”) by the aggregate profit (i.e. the “Globe income”) in the jurisdiction. Average ETR is for the whole of a jurisdiction (per jurisdiction not per entity). High taxed profits in one jurisdiction cannot be used to offset low-taxed profits in another jurisdiction.
- Globe income – Entity’s financial accounting profit (as per accounting standard of UPE with certain exceptions) subject then to certain adjustments to reconcile the differences between accounting and tax definitions of profit. These adjustments include: (i) removing dividend income from qualifying shareholdings (10% or more shareholding); (ii) removing gains or losses from the sale of qualifying shareholdings (10% or more shareholding); (iii) removing gains and losses in relation to a reorganisation where the gain or loss is deferred for local tax purposes; (iv) adjustments to deal with foreign exchange gains and losses created by differences between the tax and accounting functional currencies; (v) adjustments to address differences between the tax and accounting treatment of defined benefit pension schemes. There are certain elections available to other situations and also an anti-abuse provision.
- GloBe covered taxes – covered taxes are limited to taxes on income (i.e. Corporate tax, withholding taxes and other taxes imposed in lieu CIT but not taxes on payroll or sales). Taxes paid by the head office on the profits of its permanent establishment are assigned to the PE state. CFC charges are “pushed down” to the CFC. Withholding taxes are assigned to the constituent entity who recognises the income in their financial accounts (i.e. the entity who suffers the burden of the tax). Refundable tax credits (within 4 years) are treated as Qualified Refundable Tax Credits and treated as income in the Globe.
- GloBe Timing differences – Those typically arise from differences when income and expenses are recognised for accounting and tax purposes (deferred tax accounting) and are relevant since covered taxes are adjusted by the constituent entity deferred tax income/expense in the period. Deferred tax liabilities (DTLs) and deferred tax assets (DTAs) are to be valued at the lower of the minimum rate and the applicable tax rate. Recapture rule for DTLs not unwound within 5 years of recognition. Timing differences from accelerated depreciations, fair value accounting and R&D expenses are excluded from recapture. The timing difference from a loss in a jurisdiction is reflected when DTAs are recognised, and this is carried forward to subsequent tax years to increase the Covered Taxes when it is used and the DTAs is unwind.
- GloBe Net Globe income in jurisdiction – This is the positive result only (as losses in jurisdiction will exclude the application of Globe rules) after excluding de minimis cases (GloBe revenue below €10m and GloBe income below €1m) or GloBe safe harbour explained in point 12.
- GloBe Deduction of Substance-Based Income Exclusion – This is a formulaic carve out designed to approximate the level of substance in the jurisdiction and is equal to 5% of its Eligible Payroll Costs and carrying value of Eligible Tangible Assets in such jurisdiction. The top up for jurisdiction is then calculated by deducting the substance based carve out from the Net Globe income in the jurisdiction. Transition rules apply a rate of 10% for the payroll and 8% for the tangible asset over ten years.
- Calculating ETR and top-up % for the jurisdiction – This is determined by first dividing the aggregate adjusted covered taxes by the net Globe income (if any) in the jurisdiction. The top up tax percentage is determined by subtracting the ETR from the 15% minimum rate and represents the additional tax rate that needs to be charged on the low taxed profits This top up is then allocated between the constituent entities in the jurisdiction.
- GloBe allocation of top up tax to constituent entities – this final step consists in allocating the jurisdiction top up tax to the individual constituent entities located in the jurisdiction and apply either of the collection mechanisms to charge the top up tax: (i) the Income Inclusion Rule (IIR) and the Undertaxed Profits Rule (UTPR).
- IRR – The IIR takes the top up tax calculated for a low-taxed constituent entity on a “top-down approach” and then charges this tax on the entity’s parent (just like a CFC rule would work). Top-down approach means the UPE jurisdiction will have the first priority to collect the top up tax. Parent entity subject to an IIR is charged an amount based on the top up tax calculated for the relevant low-taxed constituent entity multiplied by its “allocable share” of that entity (rights to the profit).
- UTPR – The undertaxed profits rule starts from the calculation of top up tax for each jurisdiction but allocates the top up between jurisdictions in which the group has constituent entities based on where the group’s tangible assets and employees are located instead of using ownership. This top up will then be charged on the constituent entities in the jurisdiction like a back-up rule to the IIR (for cases where parent is in jurisdiction that do not impose an IIR). IIR has priority over the UTPR in charging low-taxed profits outside of the UPE jurisdiction. The UTPR can be either set as a denial of CIT deduction or as a new charge on the local constituent entity based on the top up allocated to that jurisdiction.
- Domestic minimum top up tax – This is a minimum tax that is included in the domestic law of a jurisdiction in equivalent format to the GloBE Rules and designed to impose that top-up tax at subsidiary level rather than at UPE level via the IIR. The OECD Model Rules reduce the amount of top up tax that is due to be collected under either the IIR or UTPR by the amount of tax charged under an GloBe equivalent domestic top up tax.
- Globe tax return – MNEs will submit a standardised Globe return at UPE level providing Globe calculation, calculation of ETRs, any top up tax liabilities and allocation between different jurisdictions. These returns filed within 15-18 months of the end of the Fiscal Year are exchanged using procedure similar to transfer pricing Country-by-Country Reporting. There are transition rules governing the treatment of losses and other timing differences between accounting and taxable profits during the transition period.
- Example of Calculation: Step 1: Foreign UPE resident in Country A has two subsidiaries in Country B. Step 2:Sub XCO has 100 of GloBE income and 5 of adjusted covered taxes whilst YCO has 200 of GloBE income and 10 of adjusted covered taxes. Step 3: The jurisdiction ETR for Country B is 5% (i.e. below the 15% minimum tax). Step 4: The top-up percentage is 10%. Step 5: Substance-Based Income Exclusion provides for combined payroll expenses of 80 and tangible assets of 75 which applying transitory rates leads to a carve-out of 14 from GloBe income. Excess profit 300 – 14 = 286 * 10% top-up = 28.6. Step 6: XCO top-up tax is 9.6 and YCO top-up tax is 19. Step 7: Country A charges the top-up tax at UPE level; or Step 8: if UPE is not subject to Pillar 2 and Country A does not tax, Country C (other than B and where other subsidiaries are present) must apply the UTPR.
- Pillar Two Timetable – The plan to be effective in 2023 (with UTPR only by 2024) remains very ambitious as significant changes in the Model Rules were included compared with the initial Blueprint and the complexity of the rules are so evident that emphasis will be put on coordination of tax authorities and compliance matters. The US changes to its domestic GILTI rules, roll-out of the EU Directive, options for lower monetary threshold for in-scope MNE and public information and the introduction of domestic top-up taxes by certain jurisdictions are areas of concern that may even impact timetable. Certain countries are already responding with measures (such as Switzerland, Spain, UK, UAE).
We are close to the 10-year anniversary of the ground-breaking 2013 Action Plan on Base Erosion and Profit Shiftingand much has advanced since then but it is likely that 10 more years will be needed to be able to look back and conclude on the success of this major shift in international tax.
Tiago Cassiano Neves