13 October 2020
On 12 October 2020, the G20/OECD Inclusive Framework on Base Erosion and Profit Shifting (‘Inclusive Framework’) released two detailed ‘Blueprints’ in relation to its ongoing work to address the tax challenges arising from the digitalisation of the economy. The ‘Pillar Two’ Blueprint proposes a set of interlocking international tax rules designed to ensure that large multinational businesses pay a minimum level of tax on all profits in all countries.
The Blueprint does not have the political agreement that the G20 had originally hoped for when setting the ambitious target of completing work on the tax challenges of the digitalised economy by the end of 2020. No agreement has yet been reached on the key issue of setting the minimum effective tax rate. Rates of 10%-12.5% are used for illustrative purposes across the Blueprint and associated economic impact analysis.
The Blueprint sets out the technical design components of the global minimum tax proposals and the further technical work required prior to finalisation. There are a number of political and technical issues where differences of views remain to be bridged. For example, it is recognised that political agreement needs to be reached on the co-existence of the existing US Global Intangible Low Taxed Income (GILTI) regime alongside the proposed income inclusion rule. Further technical work is being undertaken on coordination, such as how the GILTI regime would apply to US holding companies within non-US groups that apply the income inclusion rule at the parent company level. In addition the Blueprint ‘strongly encourages’ the US to limit the operation of the Base Erosion and Anti-abuse Tax (BEAT) in respect of payments to entities that are subject to the income inclusion rules.
A formulaic substance based carve-out based on payroll costs and tangible assets is under consideration to represent a modest fixed return for substantive activities considered to be less susceptible to BEPS risks. No further carve outs are outlined, including for regimes that are considered compliant under BEPS Action 5 rules on Harmful Tax Practices.
The Blueprint gives priority to the subject to tax rule, which is applied by source countries on intra-group payments where the receipt is not subject to a minimum level of tax based on an adjusted nominal rate. Applying this rule on a payment by payment basis is likely to be problematic from a practical perspective, and applying an appropriate minimum tax rate to gross payments is likely to be challenging where the gross amount is not reflective of the net profit arising in the low tax country. Businesses will also wish to ensure that profits are taxed only once and that there is effective and timely resolution of disputes between countries on the application of the subject to tax rule.
Implementing the Pillar Two rules on a global basis in a manner that is not distortive and that does not require disproportionate efforts in terms of compliance and administration remains a concern. A number of areas have been identified, particularly in respect of implementation and simplification, for further work.
The amount of tax expected to be raised by Pillar Two is expected to be considerably more than for Pillar One, with estimates (excluding modelling of the subject to tax rule and US GILTI revenues) of USD 42 billion - USD 70 billion annually.
The Blueprint sets out proposals, that do not yet have the political agreement of the Inclusive Framework countries, including the following key elements:
Multinational groups with consolidated group revenue below EUR 750 million (or equivalent) in the preceding fiscal year will be excluded from the scope of the income inclusion and undertaxed payment rules.
Investment funds, pension funds, governmental entities, international organisations, non-profit entities and entities subject to tax neutrality regimes may be excluded from scope. The rules can apply instead to subgroups controlled by such excluded entities. Further work will be required on whether, and to what extent, the rules will apply to the international shipping industry due to the global prevalence of tonnage tax regimes that are not based on profits.
The income inclusion rule applies on a top-down basis such that any tax due is calculated and paid by the ultimate parent company to the tax authority in its country. The tax due is the ‘top up’ amount required to bring the overall tax on the profits in each country where the group operates up to the minimum effective tax rate.
If the ultimate parent company is located in a country that has not implemented the income inclusion rule, the next intermediate holding company in the ownership chain calculates and pays top up taxes in respect of their low-taxed subsidiaries. Specific ‘split-ownership’ rules apply where a significant portion of the shares in a subsidiary are held outside the group.
A treaty-based switch-over rule will be designed to allow for the parent country to top up the tax on the income of overseas permanent establishments to the minimum rate.
The undertaxed payments rule applies as a secondary rule in cases where the effective tax rate in a country is below the minimum rate, but the income inclusion rule has not been applied by the ultimate or intermediate holding companies in respect of a group company in that jurisdiction.
The required top up tax is allocated to other companies in the group on an annual basis based on a formulaic approach. The primary allocation key will be the amount of deductible payments made by each of the other group companies to the low-taxed company.
No tax will be allocated to countries with an effective tax rate below the minimum rate, and any amounts will be capped at the domestic tax rates applicable multiplied by the deductible intragroup payments made.
The rules will apply on a jurisdictional-blending basis. The annual effective tax rate calculation required for each country will take into account the total covered taxes, profits, and losses attributable all of the group companies in that country.
Covered taxes (the numerator) are taxes on a group company’s income or profits. Both domestic and foreign taxes imposed on the company’s profits are included e.g. taxes paid under controlled foreign company rules further up the ownership chain are taken into account when determining the covered taxes for the group company’s country. Sales taxes, VAT, excise taxes, digital services taxes, stamp taxes, employment taxes and property taxes are not covered taxes.
The starting point for the tax base (the denominator) is the accounting profit (or loss) before tax of each group company, as used in the preparation of the parent company’s consolidated financial statements (prepared under an acceptable accounting standard) subject to a small number of adjustments. The allocation of profits of a permanent establishment is determined in accordance with the tax rules applicable in the permanent establishment country.
A limited number of adjustments for permanent items are required to determine the tax base from the profit before tax. Items for which adjustments are proposed include, dividends, gains or losses from the disposal of shares, and share-based compensation expenses. A mechanism will be developed to mirror any local tax deferrals applying to intragroup transfers of assets made in connection with a reorganisation. Adjustments to the tax base and covered taxes may also be required to properly reflect Pillar One outcomes. Whilst temporary differences are not generally adjusted in calculating the tax base, specific adjustment rules will be developed where immediate expensing and accelerated tax depreciation of business assets is available for local tax purposes. Additional rules are also set out for the treatment of government grants and tax credits.
To reduce the effects of temporary differences on the volatility of effective tax rates:
Further work will also be performed to examine possible transitional rules to account for losses or timing differences arising in periods prior to the application of the rules
In countries where the effective tax rate is below the minimum rate, a formulaic carve-out will exclude an amount of profit from the calculation of additional top up taxes due, intended to represent a fixed return for substantive activities less susceptible to BEPS risks.
The carve-out will have two components:
The carve-out is subject to further work, including agreeing each of the fixed percentage mark-up rates.
Additional simplification measures will be explored to reduce the number of countries for which detailed annual effective tax rate calculations are required. No decision has been taken on which countries, if any, will be included, and this will be an area for public consultation.
Simplifications under consideration include: a safe-harbour based on effective tax rate calculations derived from country-by-country reports; a de minimis profit exclusion; the ability for calculations to cover several years; and administrative guidance (e.g. tax administrations working together to identify ‘low-risk’ countries in respect of which effective tax rate calculation obligations would be reduced).
A simplified income inclusion rule is proposed for associates and joint ventures in which a group has a direct ownership interest, but which are not controlled group companies (i.e. because their results are not fully consolidated on a line-by-line basis in the consolidated accounts).
Special rules may also apply to companies (‘orphan entities’) which are controlled by the same common shareholders (e.g. a fund, foundation or group of connected individuals) which also control an in-scope group, potentially bringing them within the scope of the undertaxed payments rule.
The subject to tax rule operates separately, and in priority to, the other Pillar Two rules. It allows for source country taxation where a payment is undertaxed in the country of the recipient.
Further technical work will be undertaken to explore various administrative approaches to apply the rule. This will include exploring administering the top-up tax as a charge assessed annually post year-end, a certification system providing for reduced rates of withholding tax and/or interim contingent withholding taxes set at a lower level combined with an annual balancing payment.
Model legislation and guidance will be developed to set out the detailed rules for the income inclusion and undertaxed payments rules to promote consistent implementation in domestic legislation. Both the subject to tax rule and the switch-over rule will require changes to existing tax treaties, possibly through the BEPS multilateral instrument (MLI) or a new multilateral convention. A new multilateral convention could also be used to co-ordinate the application and operation of the income inclusion and undertaxed payments rules in a legally binding form.
The Blueprints will be presented to the G20 Finance Ministers on 14 October 2020 and work to address the political and remaining technical issues will continue. The OECD’s aim is to bring the process to a conclusion by mid-2021.
Comments on the Blueprint are invited by 14 December 2020 and a (virtual) public consultation meeting will be held in January 2021.
Deloitte’s EMEA Dbriefs webcast programme will also include a discussion on the Pillar One Blueprint on 29 October 2020 at 14:00 GMT (15:00 CET). Register for the webcast here or at www.emeadbriefs.com.