On 8 October 2021, 136 jurisdictions reached agreement on the key aspects of the two pillars of the OECD’s initiative to address the tax challenges of the digitalization of the economy.
Pillar one introduces a new taxing right for market jurisdictions, whereas Pillar two introduces a global minimum tax for MNEs that are in scope of the new rules. While Pillar one for the time being only affects the largest MNEs[1], Pillar two has a much broader scope. The rules that will be introduced in respect of Pillar two apply to MNEs that meet the EUR 750 million turnover threshold, i.e. the same threshold that applies for country-by-country reporting under BEPS Action 13.
It is expected that the OECD will release model legislation in 2022. The target date for implementation of Pillar one and Pillar two is 2023.
If your MNE exceeds the EUR 750 million, or if you expect that you will exceed this threshold in the next few years, it is highly recommended to anticipate on the introduction of Pillar two.
As these Pillars -and given its characteristics Pillar 2 in particular – may affect your tax line and transfer pricing policies heavily we recommend identifying and analysing their potential effects already.
Quantera Global as a transfer pricing firm follows these developments closely. Therefore, please feel free to contact us https://www.quanteraglobal.com/contact/.
Key elements of Pillar two
The aim of Pillar two is to introduce a global minimum tax of 15% for all MNEs that have an annual turnover that exceeds EUR 750 million. In order to achieve this, the participating jurisdictions agreed on two sets of rules: (i) a set of rules to be introduced in domestic legislation and (ii) a rule to be introduced in tax treaties.
The rules that jurisdictions should include in their domestic legislation are also referred to as the Global anti-Base Erosion rules (“GloBE”) rules. The GloBE rules consist of (i) an income inclusion rule and (ii) an undertaxed payment rule.
GloBE rules
Income inclusion rule
The income inclusion rule demands that the ultimate parent company or under certain circumstances the intermediary parent entity, includes an amount of income of a controlled foreign entity in its tax base in the jurisdiction where the latter and other MNE group entities are taxed below the global effective tax rate.
The income inclusion rule is the primary rule to be applied. The undertaxed payment rule applies as secondary rule, for example in case the parent jurisdiction has not included the income inclusion rule in its legislation.
Undertaxed payment rule
The undertaxed payment rule supplements the income inclusion rule and functions as backstop for situations in which the income inclusion rule is not applied. The application of the undertaxed payment rule differs from the income inclusion rule as the undertaxed payment rule is applied at the level of a paying entity / subsidiary instead of the (ultimate) parent, and increases the tax base of the payer. In practice this means that under the undertaxed payment rule deductions could be denied in the state of the payer, or an adjustment could be made by the tax authorities when a payment is made to a jurisdiction where the recipient of the payment will not be subject to the global minimum effective tax.
The introduction of the GloBE rules therefore further enhances the importance of an at arm’s length allocation of results between group entities, which should be based on the added value of the functions performed, assets used and risks assumed.
Secondly, Pillar 2 introduces a rule to be included in tax treaties.
Treaty-based rule
Subject to Tax Rule
The Subject to Tax Rule (“STTR”) allows source jurisdictions to impose an additional source taxation (withholding tax) on certain related party payments (e.g. interest payments and royalty payments) if those payments are taxed below a certain minimum rate in the jurisdiction of the recipient. The minimum tax rate for the STTR is set at 9%. The additional source taxation is limited to the difference between the minimum STTR rate of 9% and the actual tax rate that is applied on the payment by the jurisdiction of the recipient. The STTR is in particular intended to protect developing countries. If a country taxes e.g. interest and royalties at a nominal rate that is lower than the STTR minimum rate, this country should implement an STTR clause in its bilateral tax treaties with developing countries when it is requested to do so.
In order to assess the application of the Subject to Tax rule, it is important to verify whether intercompany payments are made to group entities located in low tax jurisdictions. The impact can in particular be significant if for example treasury functions are located in low tax jurisdictions.
Also, it would be important to reassess the arm’s length character of the intercompany payments that may be affected by the STTR.
Exceptions and carve-out
The GloBE rules do not apply in respect of jurisdictions in which the MNE has a revenue of less than EUR 10 million and has profits of less than EUR 1 million.
Also, a carve-out applies. This formulaic substance carve-out excludes an amount of income that equals 5% of the carrying value of the MNEs tangible assets and its payroll.
During a transition period of 10 years, the amount of the carve-out is increased to 8% of the carrying value of the tangible assets and 10% of the payroll. These percentages will decline annually by 0.2 percentage points in the first five years, and by 0.4 percentage points for tangible assets in the following five years and by 0.8 percentage points for payroll in the following five years. I.e., after 10 years, the carve-out is equal to 5% of the carrying value of the MNEs tangible assets and its payroll.
In order to apply the carve-out rule correctly, it is therefore important that tangible assets are allocated and valued correctly, and that payroll costs are allocated correctly within the group.
As far as the undertaxed payment rule is concerned, an exception applies for MNEs that have tangible assets for a maximum amount of EUR 50 million abroad and are active in maximum five other jurisdictions. The exception for the undertaxed payment rule applies for a period of five years after the moment on which the MNE comes in scope of the GloBE rules for the first time. For MNEs that are in scope of the GloBE rules when these rules enter into force, the five-year period starts at the moment when the undertaxed payment rule comes into effect.
In order to accurately assess whether your group would be eligible for this temporary exception from the undertaxed payment rule, it is important that the tangible assets that are used within the group are allocated correctly.
Transfer pricing implications
As indicated above, Pillar 2 further enhances the importance of a correct allocation of revenue and profit amongst the various jurisdictions in which an MNE group is active. Each MNE group will have to examine whether the group has entities in jurisdictions with an effective tax rate below 15%. If this is the case, it is important to make an impact assessment in order to determine what the potential impact of the GloBE rules could be for the group.
The first question to be answered would be to verify whether your current transfer pricing policy is aligned with your business activities. If this is not the case, a reallocation of results between entities located in different jurisdictions may be required.
In case entities in countries with an effective tax rate lower than 15% are involved, this could have consequences for the application of GloBE rules. Also, you may want to consider whether it would be appropriate to restructure certain activities, or to reallocate functions, assets, risks and the corresponding results. Such a restructuring or reallocation can lead to an outcome which is not only more in line with your business activities, but also limits the application of GloBE rules.
Furthermore, a correct allocation is relevant for a correct application of the carve-out rule. As the carve-out rule allows for a carve-out that is equal to a percentage of the value of tangible assets, an incorrect allocation of tangible assets within an MNE group can have consequences for the calculation of the carve-out amount. This is also the case with payroll costs, the second element that is relevant for the determination of the carve-out amount. An incorrect allocation of payroll costs between group entities can affect the calculation of the carve-out amount.
The Subject To Tax rule exclusively applies to payments that are made to related parties. It is therefore important to verify whether certain intercompany payments of for example interest and royalties within your group could be affected by the Subject to Tax rule. If this is the case, it would be recommended to reconsider your intercompany financing policy. As the application of the Subject to Tax rule limits the tax benefit of payments of interests and royalties to low tax jurisdictions, you may want to consider the allocation of your treasury activities within the group. Also, it would be important to reassess the arm’s length level of intercompany payments that fall within the scope of the Subject to Tax rule.
How can we help?
Quantera Global can assist you in assessing what the impact of the GloBE rules could be for your group. We can help you to determine whether your transfer pricing policy is aligned with your business activities, or whether a reallocation of functions, assets, risks and corresponding results would be appropriate.
Also, we can offer a software solution that can help you amongst others in monitoring flows of income and costs within your group, as well as the effective tax rate per entity. This allows you to be really in control, gives you up-to-date information on the group’s tax position, and gives you the possibly to timely make adjustments if necessary.
[1] I.e. MNEs with a global turnover that exceeds EUR 20 billion and with a profitability of more than 10%.