Local jurisdictions now proceed to implementation
The OECD on December 20 released model rules to assist the 137 jurisdictions that agreed to the Inclusive Framework/G-2- Pillar Two framework to implement into domestic legislation a 15% minimum tax on those multinational enterprises (MNEs) that fall within its scope.
The model rules fill in the details regarding Pillar Two of the agreement announced on October 8 to address the tax challenges of the digitalisation of the economy. Pillar Two set out in broad strokes the parameters of the Global Anti-Base Erosion (GloBE) rules, which establish a “top-up tax” to be applied to profits in any jurisdiction if the effective tax rate is below the minimum 15% rate in that jurisdiction.
The rules, originally expected to be release in late November, represent the next step in a process that ultimately would reform the global tax system.
The 70-page model rules are organised into 10 chapters that deal with the scope of the rules, the computation of GloBE income or loss and the top-up tax, corporate restructurings and holding structures, administration and transition rules. The OECD explained that the model rules have been designed to accommodate a broad range of tax systems and business structures, and therefore many of the specific provisions may not apply to all jurisdictions or in-scope MNEs.
Chapter 1 of the model rules delineates the scope of the GloBE rules, which will apply to constituent entities that are members of an MNE group with annual revenue of EUR 750 million or more in at least two of the four fiscal years immediately preceding the tested fiscal year.
Specific types of entities are excluded from application of the rules, in addition to those that fall below the monetary threshold of EUR 750 million. These include government entities, international organisations and nonprofit organisations, as well as entities that meet the definition of a pension, investment or real estate fund.
Chapters 2 to 5 comprise the heart of the model rules. Chapter 2 sets out the charging provisions whereby the amount of top-up tax payable is determined, Chapter 3 provides rules for calculating the income (or loss) on a jurisdictional basis, Chapter 4 for determining the tax attributable to that income, and under Chapter 5, the top-up tax of each low-taxed constituent entity is determined.
In essence, the model rules establish a five-step process to determine an MNE’s top-up tax liability:
- As a first step, MNEs must determine whether they fall within the scope of the GloBE rules and must identify all constituent entities in the group and their locations.
- Step 2 is to determine the income of each of the MNE’s constituent entities.
- Under Step 3, the MNE would determine the pre-GloBE tax attributable to each constituent entity’s income.
- The results of steps 2 and 3 would allow the MNE to determine the effective tax rate of each of its constituent entities; if the effective tax rate of all constituent entities located in the same jurisdiction is below 15%, then the top-up tax would be applied to income in that jurisdiction.
- Finally, Step 5 would impose the top-up tax on the member of the MNE group that is determined to be liable for the tax in accordance with an agreed-upon rule order.
The determination of an MNE’s income or loss relies on financial accounts, after some adjustments to align those accounts with tax purposes. For example, dividends and equity gains are removed, as are expenses disallowed for tax purposes. For MNE groups that have international shipping income, the model rules exclude that income from the computation of GloBE income.
To determine the income taxes attributable to an MNE’s constituent entities, the rules provide that the calculation includes income taxes but does not include non-income-based taxes such as indirect taxes, payroll and property taxes. The rules also allocate income taxes charged as a withholding tax or following the application of a controlled foreign corporation (CFC) regime.
The model rules recognise that temporary differences that arise when income or loss is recognised in different years for accounting and tax purposes must be addressed. The rules adopt deferred tax accounting as the primary mechanism for addressing these timing differences; as a result, timing differences generally will not result in top-up tax. However, this is subject to a recapture mechanism in respect of certain deferred tax liabilities that do not unwind within five years. Therefore, even businesses that operate only in “high tax” jurisdictions will need to carefully follow how the model rules are translated into local legislation in the jurisdictions in which they operate to determine if top-up tax may be likely to arise in those jurisdictions.
Once the effective tax rate is calculated -- the calculated tax (paid?) divided by the income and aggregated on a per jurisdiction basis -- the rate of tax owed is the difference between the 15% minimum rate and the effective tax rate in that jurisdiction. That top-up tax percentage is then applied to the GloBE income in the jurisdiction, after deducting a substance-based income exclusion. This substance-based carveout has two components: the payroll carveout and the tangible asset carveout, and serves to exclude income equal to 5% of the carrying value of tangible assets and payroll. For purposes of the carveout, tangible assets include property, equipment and natural resources located in the jurisdiction, as well as a lease on rights to use tangible assets.
The final step of the process to determine an MNE’s top-up tax liability is to pinpoint which entity in the group is liable for the tax. The rules provide that the top-up tax is first imposed under the “Income Inclusion Rules” or IIR on a parent entity with an ownership interest in the low-taxed constituent entity. If any residual amount of top-up tax remains unallocated after the IIR applies, the under-taxed payments rule (UTPR) allocation mechanism comes into play, so that liability for residual top-up tax will land in the UTPR jurisdictions through a UTPR adjustment.
The model rules also address the administrative aspects of Pillar Two implementation and impose an obligation on MNEs to file a standardised information return in each jurisdiction that has introduced the GloBE rules to provide information on the MNE’s tax calculations.
The OECD expects to release a Commentary on the model rules in early 2022, as these rules will be subject to review and local implementation in jurisdictions across the globe.
The OECD will, for example, need to address the issue of the rules’ coexistence with the U.S. global intangible low-taxed income (GILTI) rules at that time.
The EU is expected to announce a proposed Directive on Pillar Two on Wednesday 22 December and we then expect other jurisdictions to follow suit with their own implementation plans over the coming weeks and months. We will be following up with further insights on the proposed EU Directive and as local countries move to implementation.
The OECD then plans to issue an implementation framework dedicated to administrative, compliance and coordination issues regarding Pillar Two. Although the OECD did not specify a date for the expected release of the implementation framework, it did state that it intends to hold a public consultation on the framework in February 2022.
The OECD is also working on model rules for the “Subject to Tax” rule, the second prong of Pillar Two, as well as on a multilateral instrument for its implementation. Another public consultation event on the Subject to Tax model rules and multilateral instrument will be held in March 2022.
Content adapted from BDO Global.