Introduction
On the 15th of December 2022, the EU Council has adopted the long-waited EU Minimum tax Directive[1] (the “Directive”), which broadly mirrors the OECD’s set of Model Rules introducing Pillar 2 (the “Model Rules”)[2], albeit with some necessary adjustments to ensure conformity with applicable EU law provisions[3]. In short, the Directive provides for a global minimum tax applicable to constituent entities[4] located in a given Member State which are part of multinational groups or large-scale domestic groups with minimum consolidated revenues of EUR 750 million (“Group”)[5]. Through jurisdictional blending, the aggregate GloBE income/loss and covered GloBE taxes of a given Group in the jurisdictions where it has constituent entities are considered; the GloBE effective tax rate (“ETR”) per jurisdiction should then be effectively compared to the 15% minimum tax rate[6] and, in case it falls short of this threshold, top-up tax may potentially apply.
Permanent Establishments under the Directive
The definition of permanent establishment (“PE”) comes into play as one of the first steps to tackle when addressing the Directive, given that any PE that qualifies as a constituent entity should be treated as such separately from its main entity/head office, as well as from any other PEs of the main entity[7].
Article 3(13) of the Directive prescribes that a company should have a PE when it has a (deemed) place of business in a jurisdiction (source state) different from its residence jurisdiction[8] and:
- A PE is recognised under an applicable double tax treaty (“DTT”) between the residence and source states, provided that the source state taxes the income allocated to such PE under a provision similar to Article 7 of the OECD Model Convention[9] (Article 3(13)(a) of the Directive) – treaty PE. The treaty PE should be located in the jurisdiction where it is recognised as such and liable to tax under the relevant DTT[10];
- No DTT is applicable, but the source state taxes the income attributed to such place of business under its domestic law following a net basis similar to the one applicable to its own tax residents (Article 3(13)(b) of the Directive) – domestic PE. The domestic PE should be located in the jurisdiction where it is subject to a net basis taxation because of its presence[11];
- If the source state does not have a Corporate Income Tax (“CIT”) system, that place of business would be treated as a PE according to the OECD Model Convention rules provided that the right to tax the income allocated to it would have been attributable to the source state under Article 7 of the OECD Model Convention (Article 3(13)(c) of the Directive) – deemed PE. The deemed PE should be located in the jurisdiction where it is situated[12]; and
- Where Article 3(13)(a), (b) and (c) of the Directive do not apply, the residence jurisdiction of the company exempts the income attributed to the (deemed) place of business[13]. The PE in this situation shall be regarded as being stateless[14] and therefore no jurisdictional blending is possible; rather, its ETR shall be computed on a standalone basis, separate from the ETR of all other constituent entities[15].
Once a PE qualifying as a constituent entity has been identified, its GloBE income should be computed. In case of a PE falling within Article 3(13)(a),(b) or (c) of the Directive, its financial accounting net income or loss shall correspond to (i) the income or loss recorded in the PE’s own financial accounts (which should generally be drawn in accordance with acceptable accounting standards[16]) or, in their absence, (ii) to the amount that would have been reflected in its accounts had they been prepared on a standalone basis and in using the accounting standard applicable at the level of the ultimate parent entity of the Group[17]. The financial net income/loss is then subsequently adjusted as follows[18]:
- For treaty and domestic PEs, the adjustment operates to only reflect the items of income/expenses considered in determining the results allocated to the PE under the applicable DTT or domestic tax law provision[19];
- For deemed PEs, the adjustment operates such that only the income/loss that would have been allocated to the PE under Article 7 of the OECD Model Convention would be considered; and
- For stateless PEs, essentially the income that is exempt from tax as well as the non-deductible expenses at the level of the main entity relating to operations conducted outside its residence jurisdiction are allocated to the stateless PE.
Based on the amount of GloBE income/loss that is allocated to the PE, the amount of covered taxes in the financial accounts of the main entity that relates to the PE’s GloBE income/loss is allocated to it[20], which may therefore include the CIT levied in both the jurisdiction of the PE and the residence jurisdiction of the main entity[21]. Double taxation relief should therefore also be considered[22].
Challenges
Notwithstanding the considerable progress in constructing the rules on PEs under the Directive, there are several outstanding points that require further clarification. Some of these challenges are outlined below.
- Definition overlaps
There are in practice some situations where it is not clear-cut where the (deemed) place of business should fit within the four categories of PE governed under Article 3(13) of the Directive. Indeed, some PEs may potentially fall under two categories (notably due to the interaction of domestic provisions and DTTs) and no guidance is available on how to determine which category may apply. Arguably an overlap between the first three categories (i.e., of Article 3(13)(a) to (c) of the Directive) should be immaterial, given that the (deemed) place of business should in any case be located in the jurisdiction where the branch is situated and effectively subject to tax. The same does not however hold true for cases where there is uncertainty as to whether Article 3(13)(d) of the Directive should apply, since the (deemed) place of business would in this situation qualify as a stateless PE and, consequently, no jurisdictional blending would take place (ETR computed on a standalone basis, as per Article 26(4) of the Directive).
These instances require clarification, namely as stateless PEs cannot make use of covered taxes allocated to other constituent entities located in the same jurisdiction.
- Loss allocation
As per Article 18(4) of the Directive, the GloBE income/loss allocated to a PE should not be taken into account when computing the GloBE income/loss of the main entity namely to avoid instances of double counting or omission[23]. An exception is nevertheless made for the cases where the loss of the PE is taken as an expense when computing the (domestic) taxable income of the main entity, and it does not offset items of domestic taxable income which are subject to tax in both the main entity and the PE’s jurisdictions[24] (as otherwise the reattribution of the loss could potentially result in the understatement of the ETR of the main entity’s residence jurisdiction[25]).
A cash flow benefit is achieved at the level of the main entity, by decreasing the denominator of its ETR fraction with the PE loss utilisation and therefore reducing the likelihood of a top-up tax charge. Nevertheless, this “advantage” comes potentially at the cost of a reduced ETR in future years[26]. Indeed, the second part of Article 18(5) of the Directive provides for a “clawback” mechanism, pursuant to which the PE’s GloBE income in subsequent years (as well as covered taxes attributed to it, with certain limitations[27]) shall be considered as being GloBE income (and related covered taxes) of the main entity up to the amount of the PE qualifying loss utilised in the past by the main entity. The numerator in the ETR fraction of the main entity’s jurisdiction would therefore be diluted with the additional reattributed GloBE income of the PE.
Worth highlighting that the OECD clarifies that PE losses carried forward which are time-limited should be accounted as an expense at the level of the main entity’s domestic taxable income (subject to the aforementioned conditions) regardless of whether the carry-forward mechanism expires (in the PE jurisdiction) before the loss is fully utilised[28]. Symmetrically, if the time-limited PE loss carry forward expires before it was used in full in the main entity’s jurisdiction, the PE’s income of future years should still be reattributed to the main entity up to the amount of the PE loss which effectively decreased the ETR denominator of the main entity’s jurisdiction in the past year(s)[29].
Arguably, by focusing only on the actual utilisation of the PE loss, to the extent reattributed as GloBE loss of the main entity, the interplay with loss carry-forward mechanisms should not be too burdensome for enterprises captured by the Directive. Guidance though is nevertheless only provided in the OECD Commentaries to Pillar 2[30] (and not on the actual legal text), the Directive being completely silent on this matter. Clear confirmation as to whether the same should apply within the EU context would be in this regard desirable.
Moreover, it may also be questioned if there is no time limit for the future PE GloBE income to be reintegrated at the level of the main entity. The current guidance, as it is, implies that no such limit exists until the past PE loss is fully “compensated”, meaning that enterprises may potentially have to account for a one-time loss for and administer it for an indefinite period of time.
- Tax credits for elimination of double taxation
As mentioned above, the elimination of double taxation should be accounted for when allocating the covered taxes to a PE. Complexities may in this respect arise when the credit method is followed.
For starters, whilst the computation methodology is clarified in the OECD Commentaries to Pillar 2[31], the Directive also falls short of providing any answers in this respect. The development of guidelines is nonetheless particularly pressing, given that the calculation may prove to be quite complex in instances where the tax credit is awarded against other foreign income that the main entity earns[32]. The same goes for situations where the main entity was subject to tax on the income of more than one PE. In principle, the tax credit in these cases should be computed by determining the pre-credit tax liability for each PE income included at the level of the main entity and afterwards deducting the credit for foreign taxes on each included pre-credit tax liability[33]. The applicable rules at the level of the main entity’s jurisdiction should also be factored, leading to an additional layer of complexity – for example, attention should be paid as to whether cross-crediting of taxes[34] is barred or otherwise (fully or partially) allowed.
These complexities may be difficult to manage and lead to an increase of the compliance burden for enterprises falling within the scope of the Directive.
- Anti-hybrid rules
Lastly, the interplay between anti-hybrid rules and the Directive’s rules on PEs may also give rise to difficulties in practice.
Article 9(5) of the ATAD II Directive[35] prescribes that, in cases of hybrid mismatches concerning disregarded PE income which ends up not being subject to tax in the Member State where the taxpayer is tax resident, that Member State “shall require the taxpayer to include the income that would otherwise be attributed to the disregarded permanent establishment”[36]. The Directive is nevertheless silent on how the tax charge levied as a result of the anti-hybrid mismatch rules should be accounted for.
Whilst a case-by-case analysis should be undertaken, hybrid PEs are most likely to qualify as stateless PEs, meaning that a standalone ETR computation should be followed. Nonetheless, no guidance is specifically provided as to whether the tax charge levied at the level of the main entity’s jurisdiction[37] should be reallocated to the stateless PE or not. The absence of reallocation though is most likely to end up in top-up tax being levied at the level of the hybrid PE, with the overstatement of the main entity’s jurisdiction ETR, and seems to go against the ratio of Article 24(1) of the Directive, pursuant to which the amount of covered taxes should be allocated to a PE based on its qualifying income/loss (corresponding here to the portion of income that would have otherwise been attributed to it).
Conclusion
The long-waited minimum tax Directive has been put forward as an ambitious game changer for the EU tax landscape, with the potential to curb harmful tax competition and bar aggressive tax planning. The definition and rules on PEs come out, in this respect, as being crucial for a precise delineation of the constituent entities part of a qualifying Group, and correct allocation of GloBE income/loss and covered taxes. The Directive nevertheless leaves out important PE related subject matters, for which further clarification would be desirable. Whilst the guidance provided by the OECD may to some extent aid in closing some of these gaps, the EU legislator should endeavour to thoroughly clarify them. Cross-border investment within the EU may end up being hindered and the Directive’s goals thwarted if unsatisfactory or inexistent answers are provided.
Vasco Chuaqui
February 2023
[1] COUNCIL DIRECTIVE (EU) 2022 on ensuring a global minimum level of taxation for multinational enterprise groups and large-scale domestic groups in the Union.
[2]https://www.oecd.org/tax/beps/tax-challenges-arising-from-thedigitalisation-of-the-economy-global-anti-base-erosion-model-rulespillar-two.htm
[3] Cfr. in particular, p. 1 and 6 of the Directive.
[4] I.e., “any entity that is part of an MNE group or of a large-scale domestic group; and (b) any permanent establishment of a main entity that is part of an MNE group referred to in point (a)”, the income of which is consolidated on a line-by-line basis or would have been consolidated in case the group had prepared consolidated financial accounts (cfr. Articles 3(2)(a) and (b), as well as 3(6) of the Directive).
[5] Article 2 of the Directive.
[6] Cfr. in particular p. 5 and 12 of the Directive.
[7] Cfr. Article 3(3)(b) of the Directive.
[8] For both domestic and treaty purposes, or otherwise treated as located.
[9] Cfr. OECD Model Tax Convention on Income and on Capital 2017, https://www.oecd.org/ctp/treaties/model-tax-convention-on-income-and-on-capital-condensed-version-20745419.htm
[10] Cfr. Article 4(3) of the Directive.
[11] Idem.
[12] Idem.
[13] Through which operations are conducted outside the jurisdiction where the main entity is located.
[14] Cfr Article 4(3) of the Directive.
[15] Cfr. Article 26(4) of the Directive.
[16] Defined under Article 3(25) of the Directive.
[17] Cfr. Article 18(1) of the Directive.
[18] Cfr. Article 18(2) and (3) of the Directive.
[19] Also cfr. the last sentence of Article 18(2) of the Directive, which reads as follows: “regardless of the amount of income subject to tax and the amount of deductible expenses in that jurisdiction”. I.e., a distinction should be made between the tax rules on the attribution of income/loss to the PE and the tax rules on the actual computation of the taxable income, such as timing rules, which should not be taken into account for these purposes (cfr. p. 192-193 of the OECD Commentaries to Pillar 2).
[20] Cfr. Article 24(1) of the Directive.
[21] A. Greenbank, Unpacking Pillar Two: permanent establishments, https://www.macfarlanes.com/what-we-think/in-depth/2022/unpacking-pillar-two-permanent-establishments/
[22] L. Hadnum, Pillar Two : Permanent Establishments, https://oecdpillars.com/pillar-tab/pillar-two-permanent-establishments/
[23] Cfr. P. 198 OECD Commentaries to Pillar 2 on Article 3.
[24] Cfr. Article 18(5) of the Directive.
[25] Cfr. p. 202 OECD Commentaries to Pillar 2 on Article 3.
[26] Cfr. A. Greenbank, Unpacking Pillar Two: permanent establishments, https://www.macfarlanes.com/what-we-think/in-depth/2022/unpacking-pillar-two-permanent-establishments/
[27] As per Article 24(7) of the Directive, should the second part of Article 18(5) of the Directive apply and GloBE income of the PE be allocated to the main entity, “any covered taxes arising in the jurisdiction where the permanent establishment is located and associated with such income shall be treated as covered taxes of the main entity for an amount not exceeding such income multiplied by the highest tax rate on ordinary income in the jurisdiction where the main entity is located”.
[28] Cfr. p. 200 OECD Commentaries to Pillar 2 on Article 3.
[29] Cfr. p. 203 of OECD Commentaries to Pillar 2 on Article 3.
[30] OECD, Tax Challenges Arising from the Digitalisation of the Economy – Commentary to the Global Anti-Base Erosion Model Rules (Pillar Two).
[31] Cfr. p. 46-54 OECD Commentaries to Pillar 2 on Article 4. Broadly, (i) the PE’s income which is included in the main entity’s income should be identified, (ii) the tax liability of the main entity stemming from the inclusion of the PE income is subsequently ascertained and (iii) then the tax credit is determined considering the taxes paid by the PE
[32] Attention should be paid in these cases to the rules of the foreign jurisdiction and in using reasonable assumptions, as per p. 49 of the OECD Commentaries to Pillar 2 on Article 4.
[33] P. 51 of the OECD Commentaries to Pillar 2 on Article 4.
[34] I.e., the tax paid by the PE should be creditable only up to the tax liability stemming from the income inclusion of the PE at hand; as per p. 51 of the OECD Commentaries to Pillar 2, in these cases “the amount of residual Tax (i.e., tax in excess of the allowed credit for foreign taxes) on a particular PE income inclusion is (…) determined by subtracting the allowed credit from the pre-credit tax liability on the income inclusion”.
[35] COUNCIL DIRECTIVE (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries.
[36] This being the case “unless the Member State is required to exempt the income under a double taxation treaty entered into by the Member State with a third country” (cfr. Article 9(5) of the ATAD II Directive).
[37] Assumed to qualify as a “covered tax”.