Goals and key aspects of the BEPS Pillar Two rules
The Model rules are the latest step in an arduous process that has been underway since 2013 and represents a significant step forward for the Inclusive Framework on BEPS, a group of over 135 countries collaborating to reshape the global tax landscape at the behest of the OECD and G20. Interestingly, the concept of a global minimum tax was not part of the original BEPS proposals, but political momentum for a minimum tax has gathered pace in recent years.
At the July 2021 G7 meeting, it was announced that a broad agreement on international tax reform was reached by almost all Inclusive Framework members on a two-pillar plan to combat global profit shifting and base erosion. Pillar One deals with digital taxation, and it covers a more limited number of taxpayers (Generally companies with a global turnover above €20 billion and a profit margin above 10%).
Pillar Two’s objective is to impose a 15% minimum tax on the earnings of most multinational groups with revenues of €750 million and more. By deploying two interlocking rules, the income inclusion rule (IIR) and the undertaxed payment rule (UTPR), income taxed at less than 15% would be targeted for additional taxation. The OECD indicated that additional details on Pillar Two should be issued later this year.
The IIR imposes a top-up tax on the ultimate parent entity of a low taxed foreign subsidiary. While the UTPR seeks to deny deductions, or take similar actions, with respect to deductions where low-tax members of a group are not subject to the IIR.
Pillar Two rules also include a subject to tax rule (STTR) which permits source jurisdictions to withhold tax on certain types of related party payments (such as royalties) when such payments are not subjected to a minimum tax rate. Under the 20 December Model Rules, a low tax jurisdiction can itself elect to levy the additional tax due, as opposed to that tax being collected by a jurisdiction further up the ownership chain.
The 20 December 2021 Model rules provide guidance on the scope of the GloBE rules, the application of the IIR and UTPR, and a host of other issues. However, the STTR and other aspects were left for future guidance. The OECD document is 70 pages and was accompanied by a Fact Sheet and FAQ’s. The Model rules are quite complex, and many commentators fear they may pose practical challenges during implementation. Nonetheless, the OECD hopes the implementation of these rules can be accomplished in time for the rules to apply in 2023 for the IIR and 2024 for the UTPR.
Given that the OECD does not have the power to implement domestic legislation in any country, it will be up to each adopting country to make decisions as they develop their own domestic policy and legislation implementing the provisions.
"Digitalisation and globalisation have indeed had a profound impact on economies around the world over the last several decades and the challenges associated with taxing multinationals have been exacerbated by outdated income tax rules and evolving business models." - Vikas Vasal, global tax leader, Grant Thornton International.
The Inclusive Framework’s efforts and accomplishments in combatting these issues have been unprecedented and should be applauded.
SCOPE AND EXCLUSIONS
Groups with global consolidated revenues of €750 million or more for at least two of the last four fiscal years immediately before the tested year, will generally be in scope under the rules adopted by their jurisdiction.
However, not all Inclusive Framework members are required to adopt the GloBE rules. The adoption of the rules is, thus, optional for each member of the Inclusive Framework. Members adopting the rules must do so in a manner that is consistent with the OECD’s framework.
Certain entities are excluded from the scope including governmental entities, non-profits, pensions, and Investment funds, as specified.
Income from international shipping is specifically carved out and there are special provisions for banks and insurance companies.
The scope and application of the Pillar Two rules have been hotly debated since the very beginning of the BEPS project with various carve-outs being sought. The latest Model rules shed light on who the tax will apply to and how to determine whether your organisation is within the scope.
Gaining global consensus on this two Pillar plan is a monumental accomplishment for the OECD and Inclusive Framework and has demonstrated the power of global tax policymakers collaborating on an otherwise contentious issue. That said, complexity and compliance burdens remain top of mind for multinationals facing the new rules. As companies prepare for the arrival of Pillar Two legislation in their country, there are several opportunities and hurdles to consider.
Implementation approaches and timing
Each jurisdiction will need to implement the new rules into local law through their respective legislative process. This means proposing and passing laws in many jurisdictions over a relatively short period. As previously discussed, the new rules are set to take effect from 2023 leaving lawmakers very little time to transcribe the rules in a way that takes into account existing systems and tax frameworks. Taxing authorities will have to deal with administering the new laws including implementation of systems and processes for enforcement and collection. This monumental effort could play out unevenly from country to country. We outline some key considerations for those operating within the European Union, the United States and the United Kingdom.
Two days after the OECD release, on 22 December 2021, the European Commission (EC) published a draft directive implementing the OECD’s Pillar Two rules for EU member states. The draft directive would need unanimous approval from all EU member states to be adopted as an official EU Directive. EU member states would then implement the rules into local law no later than starting from January 2023 (IIR) and January 2024 (UTPR).
The EU Draft Directive appears largely consistent with the OECD Model Rules for Pilar Two but deviates from the Pillar Two model rules in certain aspects. The EU Draft Directive extends the application of the Pillar Two rule beyond groups having at least one entity or permeant establishment not located in the parent’s jurisdiction, while the OECD rules would not. This means that EU based domestic groups may see additional impact from Pillar Two even where their income-producing activities are wholly domestic to any one EU country.
The domestic application of the IIR is delayed based on the Draft Directive for a five year period from the time in which the wholly domestic group falls within scope.
Under the EU Draft Directive there is an obligation for constituent entities of an EU based multinational enterprise (MNE) group located within the EU to file an information return for the top-up tax unless the return is filed by the group in another country with which the EU member state can legally exchange the information under an agreement. The information return must be filed within 15 months of the end of the relevant fiscal year (18 months in the first year).
"The EU Draft Directive highlights the urgency of the EU to implement the long-awaited rules and provides a glimpse into some of the future implementation issues taxpayers may experience." - Peter Vale, partner - international tax, Grant Thornton Ireland.
Failure to comply with the information reporting rules or other aspects of the legislation will carry penalties and enforcement action under the Draft Directive. With a potential penalty of at least 5% of the constituent entity’s turnover, the EU Draft Directive includes a significant stick element. Taxpayers should closely monitor how the EU progresses in implementing the OECD Model Rules.
The OECD has indicated that future guidance will address whether and how the current US GILTI system will co-exist with the GloBE rules. By way of background, the US implemented the GILTI regime as part of the Tax Cuts and Jobs Act in December 2017. Starting for tax years beginning in 2018, US multinationals are subject to the GILTI tax which taxes certain foreign earnings at a minimum rate of at least 50% of the current US corporate tax rate, or 10.5% (50% of 21%).
The US rules accomplish this by including in income of US parents’ certain income of their foreign subsidiaries. This is regardless of whether such income is distributed to the US parent. The US parent is generally afforded a deduction, which is limited by taxable income, for 50% of the inclusion with the remaining 50% being subjected to the 21% rate in the US. Foreign tax credits are available to offset the resulting US tax but such credits are limited to 80% of the amount of qualifying taxes paid on the associated income.
The US system also offers a reduction to GILTI for investment in tangible property made by a controlled foreign corporation, referred to as Qualified Business Asset Investment or QBAI. Under current law the QBAI carve-out is 10% of the adjusted US tax basis of qualifying assets.
The US system differs from the GloBE system in several meaningful ways. There are no revenue-based scope limitations for GILTI to apply meaning that US based multinationals of any size are subject to the GILTI rules. Under the OECD’s Model rules, only entities with revenue of €750 million or more would be subjected to the GloBE rules.
Second, the GILTI system is currently not imposed on a country-by-country basis meaning that income and losses can be offset across jurisdictions while qualifying foreign taxes paid on GILTI income in one jurisdiction could potentially be credited against the US residual tax levied on the income from another country. The GILTI regime also does not have a substance-based carve-out for anything other than tangible property investment which differs from the OECD approach which affords substance-based carve-out for payroll and property investments.
Finally, and perhaps most importantly, the current GILTI effective tax rate falls well short of the 15% minimum tax rate agreed by the Model rules. As mentioned, GILTI is currently imposed at 50% of the US corporate rate. When factoring in the 20% haircut on foreign tax credits, taxpayers find themselves needing an effective rate of 13.125% under current law to avoid additional US tax on GILTI earnings.
However, under currently enacted US law, for tax years beginning on or after 1 January 2026, the deduction for GILTI income is reduced from 50% to 37.5% yielding an effective rate of approximately 16.4% after considering the 20% reduction of foreign tax credits. Thus, GILTI has a mechanism built in that would get the tax theoretically over the 15% threshold but not until 2026.
"Recently proposed US tax legislation would make major changes to the GILTI regime including imposing it on a country-by-country basis and raising the effective rate in 2023. The proposed changes would bring GILTI more in line with the OECD’s Model rules. However, the status of the legislation is very much in question with many wondering if any proposed tax legislation will be enacted in 2022." - David Sites, managing partner, international tax services, Grant Thornton US.
The failure of US lawmakers to enact laws changing GILTI to align it more with the OECD provision may be a difficult hurdle for the OECD to overcome. Taxpayers should be closely monitoring developments in OECD countries along with US legislative activity to ascertain how the interaction of GILTI and GloBE may impact them.
The UK has been an early mover on international tax developments in recent years and, despite its exit from the European Union, remains committed to the Two Pillar solution. A consultation document was issued by the UK tax authorities, HMRC, in January 2022 which includes various requests for taxpayer and advisor input on the implementation of GLoBE in the UK.
Notably, the UK consultation includes commentary regarding a Domestic Minimum Tax which may be introduced in conjunction with Pillar Two implementation. The possibility for jurisdictions to introduce a new Domestic Minimum Tax has been considered by the OECD If implemented, such a tax change would enable the UK Exchequer to levy its own top-up tax on the profits of its resident taxpayers that would otherwise be subject to GLoBE.
In broad terms, it would allow the UK to collect any possible top-up tax itself rather than the ultimate parent jurisdiction. This preserves taxing rights for the UK in scenarios where an IIR would apply.
"Such a proposal certainly makes economic sense, and this may not be the first proposal to implement such a measure as tax authorities 'level out' their possible tax take from resident companies to the effective 15% rate, to maximise the collection of tax revenues themselves." - Matt Stringer, partner, head of international tax, Grant Thornton UK.
Substance-based carve-outs and modelling implications for decision making
Companies will need to agree on a well thought out approach moving forward to address modeling implications. The Model rules seek to tax income at a minimum rate of 15% on all income apart from income qualifying for a substance-based exclusion.
Accordingly, GloBE income is reduced for any jurisdiction where eligible payroll costs or eligible tangible assets are present in that jurisdiction. Thus, the GloBE will generally apply to income that is over and above 10% of the eligible payroll costs and 8% of the carrying value of eligible tangible assets. These rates will be reduced to 5% over a ten-year period. The effect is to incentivise substance-based activities in jurisdictions where substantial income is earned by a multinational group by rewarding the placement of people and tangible property.
The substance-based carve-out also provides shelter for extractive industries which are typically heavily invested in tangible property in connection with their activities.
Conceptually, only jurisdictional income exceeding a 5% return on payroll and tangible assets will be exposed to additional taxation, resulting in the GloBE tax being principally focused on excess returns to intangible assets and forgoing minimum taxation of payroll and tangible asset-heavy taxpayers.
As businesses navigate these provisions, investment decisions will arise in multi-national groups; consideration should be given to workforce locations, tangible asset investments and other factors which will interplay with the GloBE determinations. Careful modeling will help ensure expected returns from investments are measured appropriately including consideration of any additional tax burden.
Complexity, cost, compliance
Compliance with these new rules is likely to be challenging and costly for taxpayers. Determining the quantum of taxes paid, the relevant income, substance-based investment data, treatment of certain local country credits and other relevant data will likely require new systems and global collaboration at unprecedented levels.
Given that the IIR will be applied on a country-by-country basis, allocations of taxes and income to separate jurisdictions will be of paramount importance for taxpayers. For example, as a general rule, GloBE income or loss is the financial accounting income of the relevant constituent entity. Income or loss is then subject to certain adjustments for items like stock-based compensation, pensions, and other items.
In addition, the rules include a complex system of reliance on deferred taxes for handling certain timing differences when determining a constituent entity’s results. Many organisations will have to update their ERP systems and implement new procedures to collect the information and comply with the law. Even organisations that may have little or no minimum tax liability may find themselves burdened with the complexities of compliance and reporting.
Taxpayers should embark now on implementing a plan to handle the incoming rules by involving stakeholders from various parts of the organisation and setting out a complete plan to absorb and implement these new and complex provisions.
The OECD indicated that the Pillar Two model rules are the first of three sets of expected guidance on Pillar Two. Following the release of these rules, an explanatory Commentary is expected in January or February of 2022 and a more detailed implementation document at some point in the middle of 2022. Given that the IIR is to be brought into law with effect from 2023, and the UTPR in 2024, countries will have to move with alacrity to ensure deadlines are met.
We already see evidence of that urgency with the EU draft directive discussed above. The EU is moving full speed ahead to make changes implementing these long-sought-after rules. Meanwhile, political divides in the US have stalled efforts to modernise the GILTI system transforming it into a more Pillar Two compliant regime, thus leaving questions as to whether the US, a key player in this deal, will be able to fully join the global accord.
"With eyes on Pillar Two, it must be noted that the GLoBE rules are only half of this story: the allocation of greater taxing rights to marketplace jurisdictions for very large companies is part of the Pillar One solution to tackle the tax challenges of the digital economy. The Pillar One rules have their own implementation plan, which includes a Multi-Lateral Convention which will be open for signature later this year." - Pierre Bourgeois, tax partner, Raymond Chabot Grant Thornton.
Where to start – key considerations for multinational tax functions
While lawmakers, regulators and tax authorities scramble to bring in the new regimes, taxpayers are faced with some vexing questions. With only partial details available, organisations face challenges devising strategies, systems, and processes to deal with the GloBE rules. Not only will new calculations and tax compliance burdens impact the organisations, but the application of tax regime will require global connectivity amongst tax groups in a manner unprecedented before. Tax departments will be heavily reliant on global coordination to ensure proper application of the law and related provisions. So, where should taxpayers start?
There are several key aspects of Pillar Two that should draw attention from tax functions at multinational groups. While the provisions dealing with Pillar Two are far from final, the businesses should evaluate how they are impacted and plan accordingly.
• Covered Taxes
A constituent entities’ Covered Taxes are a fundamental component of the GloBE. Covered Taxes are defined as the current tax expense for the fiscal year adjusted by several amounts including additions and reductions for certain items, deferred tax adjustments, and adjustments for taxes recorded in equity or other comprehensive income.
Taxes recorded for uncertain tax positions are not considered covered taxes. Organisations should compile an inventory of potentially covered taxes by jurisdiction to determine what taxes may or may not be available for GloBE purposes. Adjusted Covered Taxes of investment entities are excluded from the determination of the effective tax rate (ETR).
• GloBE income or loss
Another major input required is the amount of GloBE income or loss for a particular constituent entity. The GloBE income or loss is generally defined as the financial accounting net income or loss subject to certain adjustments. The net income or loss is determined before an intercompany adjustment or consolidating entries. The net income or loss is adjusted for net tax expense, dividends, gains, and losses on disposal of shares, pension expenses and other specific adjustments.
One such specific adjustment is stock-based compensation which generally can be adjusted, under election, so the amount deducted for GloBE purposes is equal to the amount allowable for tax. As local countries implement the law organisations will be well served to understand how each entity’s net book income will be impacted. In addition, companies may begin to include this information when making planning decisions about locations for income-producing activity and assets.
• Modeling effective rates and potential top-up tax
For each fiscal year the effective tax rate of the MNE group for a jurisdictional group with GloBE income shall be equal to the adjusted Covered Taxes divided by the net global income for the jurisdiction for fiscal year. With accurate modeling of the Covered Taxes and GloBE income or loss on a jurisdictional basis, taxpayers can begin to identify where the Minimum Rate (15%) exceeds the ETR potentially resulting in the imposition of a top-up tax. Again, this information can be valuable from a preparedness and planning perspective. This information should become part of the data set of considerations for organisations making business decisions potentially bearing on the imposition of the GloBE tax.
• Global tax coordination
Successful navigation of the GloBE will require an experienced multi-jurisdictional team managing data and developments for their respective parts of the organisation. In addition, stakeholders from outside tax will need to be part of the process to ensure that the relevant financial accounting data and underlying details are available.
Global business developments teams may want to consider future investments and transactions considering the new rules and potential associated tax burdens to ensure the return on any venture is appropriately measured. Finally, existing tax planning should be revisited to ensure that the desired outcome of such planning will still be attainable post Pillar Two implementation. Complex structures and tax-sensitive intercompany transactions will require a fresh review and potential adjustments in relatively short order.
While the BEPS project has seen tremendous progress in the last 24 months, many issues and details are still open for discussion or unsettled. Invariably, uneven implementation across 130 plus countries could challenge taxpayers for years to come and compliance risk may be high given the global nature of the provisions. The possibility for uneven implementation remains, despite the detail provided in the model rules: domestic legislation around the world will of course differ when it comes to detailed design principles, and while the OECD have taken huge strides toward developing this framework, it is specific legislation as enacted that will determine how Pillar Two operates in practice.
Taxpayers who establish processes, controls, and strategies that are flexible and compatible with the global changes will see a competitive advantage. Nevertheless, these are unprecedented changes for which businesses need to evaluate their current models and ensure that they are future ready.
Navigating Pillar Two to get ahead
Grant Thornton’s firms’ international tax professionals can help you assess and manage the tax complexities of changing BEPS rules, deal with business realities and help you be ready to operate in a digitised and globalised future. For more information contact one of the contributors below or speak to your local Grant Thornton tax team.