OECD Pillar Two Global Minimum Tax and the Implications for the Insurance Industry

The fundamental principles of the international tax landscape are set to change - and that change is due to happen from 2023. The G20/OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS) proposes a two-pillar approach to address the tax challenges arising from modern business practices. Whilst the proposals are described as relating to the “digitalisation of the economy”, they will apply across sectors, with Pillar Two having potentially significant and far-reaching implications for the insurance industry. The Inclusive Framework Statement published on 8 October 2021 provided some useful clarifications, but a number of important issues still need to be addressed.  November 2021 will be a significant month for the project, as the OECD is expected to publish model rules and explanatory notes. This article outlines some of the key issues for the insurance industry, as well as things to look out for when the additional detail is released, with a particular focus on Pillar Two.

Deloitte comments 

The de minimis exclusions announced in the recent OECD statement could take some insurance groups outside the scope of Pillar Two rules and ease the burden on others. However, for many in the insurance industry, a number of challenging issues will remain, requiring time and resource to address. Importantly, this could include businesses without a significant presence in low tax jurisdictions. With Pillar Two implementation proposed from 2023, multinational insurance groups within the scope of the rules will need to carry out impact assessments to understand the potential implications and communicate these to key stakeholders. 

Background

Since 2017, the 140 member countries of the Inclusive Framework have been jointly developing a ‘two-pillar’ approach to address the tax challenges arising from the digitalisation of the economy. This led to the publication of two detailed blueprints released on 12 October 2020 (the ‘Blueprints’) on potential rules for addressing nexus and profit allocation challenges (Pillar One) and for global minimum tax rules (Pillar Two). 

Political agreement by the G7 was achieved in June 2021 and on 1 July 2021 the Inclusive Framework published a statement on the key components of global tax reform, agreed by over 130 members. The updated Inclusive Framework Statement published on 8 October 2021 shows further progress in relation to some of the remaining political questions. 

The most important developments are the negotiations that have allowed Ireland, Hungary and Estonia to sign up to the agreement, paving the way for an EU Directive on Pillar Two to implement the OECD proposals. These include determination of the global minimum rate for the Income Inclusion Rule and Undertaxed Payment Rule as 15% (removing ‘at least’ in relation to the rate). The rate for the Subject to Tax Rule, the enhanced withholding tax for developing countries only, is agreed at 9% (removing the range 7.5%-9%).

Other relevant developments include an initial five-year exclusion from the Undertaxed Payment Rule for businesses with no more than EUR 50m of tangible assets and operations in fewer than six jurisdictions.  There is also an exclusion, from both the Income Inclusion Rule and the Undertaxed Payment Rule, for jurisdictions in which revenues are less than EUR 10m and profits less than EUR 1m.

Further details of the updated Inclusive Framework statement are in the main Deloitte alert available here.

Critically, the October statement reaffirms the Pillar One exemption for regulated Financial Services. The precise scope of this exemption is not yet clear, however, insurance is not expected to be in the scope of “Amount A”, the additional taxing right for what are referred to as “market jurisdictions”. This article therefore focusses on the implications of Pillar Two.

While some countries which do not currently impose corporate taxes have signed up to the proposals, there is no requirement for them to implement the global minimum tax rules themselves. However, these countries are likely to find their profits taxed at 15% by other countries.

An ambitious and challenging timetable has been set with plans for both Pillar One and Pillar Two to apply from 2023, which if achieved would be considerably earlier than many expected. The October 2021 statement also includes an implementation plan with model legislation and commentary on Pillar Two to be published by the end of November 2021. 

The OECD Statement says that there will continue to be consultation with business ‘within the constraints of the timeline’. Many insurance businesses will want an opportunity to comment on the interaction between industry specific factors and detailed technical provisions. 

Please note that this article is current as of the date of publishing, based on the Blueprints and Inclusive Framework Statements released to date.  However, this is a rapidly evolving topic and the issues should be considered in the light of further expected updates. 

Key features of Pillar Two

Pillar Two, the key component of which is commonly referred to as the "Global Minimum Tax", introduces a minimum effective tax rate of 15%, calculated based on a specific ruleset. Groups with an effective tax rate below the minimum in any particular jurisdiction would be required to pay top-up tax to the tax authority either in their ultimate parent entity location or another jurisdiction in which they operate. 

The tax would be applied to groups with revenue of EUR 750m or more, subject to an exclusion for countries in which revenue is less than EUR 10m and profits less than EUR 1m. The Global Minimum Tax attempts to limit tax competition by introducing a globally uniform floor for corporate income taxes, below which the effect of low tax rates or fiscal policy measures would be largely obviated. Large insurance groups (and insurers that are within sufficiently large wider groups) are expected to be in scope of Pillar Two.

The Income Inclusion Rule and the Undertaxed Payment Rule are the main mechanisms to ensure that all profits are subject to a minimum tax of 15%. The Income Inclusion Rule will apply in priority, with the Undertaxed Payment Rule acting as a backstop. They will use the same calculation methodology and ruleset. The major difference is which country’s tax authority gets the taxing right, and in the case of the Undertaxed Payment Rule, how much they will get. 

The Subject to Tax Rule is an additional treaty-based rule which allows developing countries to levy a gross tax on certain payments to jurisdictions where there is a low nominal corporate tax rate or low tax regime. The Subject to Tax Rule will reference a rate of 9% and will apply in priority to both the Income Inclusion Rule and the Undertaxed Payment Rule. However, the Subject to Tax Rule is narrower in scope and will only apply where a treaty is in place. Critically, for the insurance industry, insurance and reinsurance premiums as well as broker commission are expected to be within scope of the Subject to Tax Rule.

The details of the rules

Income Inclusion Rule

The Income Inclusion Rule is similar in operation to a controlled foreign companies rule. The Income Inclusion Rule will be applied by the jurisdiction of the ultimate parent entity of the group. It will apply in respect of each jurisdiction in which the group has a subsidiary or branch. 

Under the Income Inclusion Rule, the effective tax rate (or ETR) of each jurisdiction will be determined based on all of the consolidated companies or branches in that jurisdiction and calculated in accordance with specific Global Minimum Tax rules. This calculation will use “covered taxes” based on domestic and foreign taxes payable over a tax base determined by reference to the ultimate parent entity’s financial accounts. Notably for insurers, in the October 2020 Pillar Two Blueprint, deferred taxes were not included as covered taxes (meaning that the effective tax rate is, in effect, a measure of cash tax as a proportion of accounting profit). 

The effective tax rate calculated under a Global Minimum Tax basis will then be compared with the minimum tax rate of 15%. Top-up tax will be paid to the tax authority of the ultimate parent entity in respect of any shortfall in all jurisdictions other than that of the ultimate parent entity jurisdiction itself. 

The Income Inclusion Rule is potentially significant for many insurance groups, even those that only operate in countries with high nominal tax rates. This is due to the year-on-year differences in jurisdictions where local taxation does not follow the group accounting result and because the deferred taxes that reflect these may not be taken into account in the effective tax rate calculation. 

The Income Inclusion Rule will take effect from 2023.

Undertaxed Payment Rule

The secondary rule under the Global Minimum Tax is the Undertaxed Payment Rule. The Undertaxed Payment Rule is a backstop, where the Income Inclusion Rule does not apply. Scenarios in which the Undertaxed Payment Rule would apply include where the jurisdiction in which a group is headquartered does not implement the Income Inclusion Rule or has an effective tax rate below the minimum tax rate. Any top-up tax would then be collected under the Undertaxed Payment Rule by the countries in which other group companies are located. 

The allocation method for top-up taxes under the Undertaxed Payment Rule, including in respect of low taxed profits in the country of the ultimate parent, remains to be agreed. 

Groups with a maximum of EUR 50m of tangible assets in overseas countries and which operate in no more than five overseas countries will be exempt from applying the Undertaxed Payments Rule for up to five years.

 The Undertaxed Payment Rule is to take effect from 2024, to enable the Income Inclusion Rule to embed in domestic regimes before the ‘backstop’ is invoked.

Subject to Tax Rule

The Subject to Tax Rule applies separately and in priority to the Income Inclusion Rule and Undertaxed Payment Rule and will allow limited source taxation on certain connected party payments. The rule is expected to be incorporated into bilateral tax treaties by countries that apply nominal rates of tax below a minimum rate (9%) on such receipts, where requested by developing country members of the Inclusive Framework.  The taxing right will be limited to the difference between the minimum rate and the tax rate on the payment.

There are several key differences between the Subject to Tax Rule and the Income Inclusion Rule and Undertaxed Payment Rule: 

• the Subject to Tax Rule may apply irrespective of the size of the group (i.e. the EUR 750m threshold may not apply, and nor may the five-year exclusion referred to in the previous section); 
• the Subject to Tax Rule only applies to interest, royalties and a defined set of other payments made between connected persons, which is expected to include insurance and reinsurance premiums and broker commission; and 
• the Subject to Tax Rule does not reference the same calculation methodology or rate as generally applied under the Global Minimum Tax, rather it looks to the nominal tax rate applied in the jurisdiction, or to a regime in the jurisdiction applied to the connected party receipt.

The Subject to Tax Rule applies before the Income Inclusion Rule and Undertaxed Payment Rule and any tax collected under the Subject to Tax Rule should be included as a covered tax in the Global Minimum Tax calculations used for the purposes of the Income Inclusion Rule and Undertaxed Payment Rule.

The intention is that the Subject to Tax Rule will be effective in 2023. The Inclusive Framework will develop a model treaty provision by the end of November 2021 and a multilateral instrument (MLI) by mid-2022. This will facilitate the swift and consistent implementation of the Subject to Tax Rule into relevant bilateral treaties. 

The big issues for insurance groups

A number of issues could significantly impact the insurance industry.

1.Timing differences

In many countries the tax basis for insurance companies is significantly different from the accounting standards that the ultimate parent entity uses to prepare financial statements and which will form the basis of the Global Minimum Tax. For example, in many European countries the tax basis of insurance reserves aligns with local GAAP and/or the historic regulatory basis. Where the tax measurement of an asset or liability differs from its measurement in the ultimate parent entity’s financial statements, this will have an impact on the effective tax rate calculation. This factor is coupled with the length of insurance business cycles, which affects all insurers but is particularly extreme for life insurance business where policies commonly cover decades. The introduction of IFRS 17 in 2023 may introduce further variations, both in the year of transition and on an ongoing basis, due to differing profit profiles under IFRS and the local tax base.

The treatment of investment assets (often accounted for on a mark-to-market basis but taxed under a realisation basis) and deferred acquisition costs (also known as DAC) are also significant industry concerns in view of the substantial timing differences that could arise even in high tax developed countries. 

Finally, insurers operating in the Lloyd’s of London market are taxed on a three-year declarations basis. Therefore, the tax and accounting in any calendar year are generally unaligned, which could give rise to significant fluctuations in the effective tax rate calculated under the proposals. 

There has been much industry representation regarding issues such as the double taxation that will result if timing differences are not adequately addressed for insurers. The OECD has acknowledged the issues and mechanisms to mitigate distortions would be welcomed by the industry. 

The model rules will be closely scrutinised to see how timing differences are addressed. A modified deferred tax approach, under which the numerator in the effective tax rate calculation includes certain categories of deferred tax, is one possible option under consideration that might be used to address some of these issues.

2.Funds

Insurers are very significant investors in fund structures. There are many commercial reasons to do so, and one of the guiding principles is that the funds themselves are tax neutral as the investor is taxed upon their share of the fund return. 

Some investment funds are expected to qualify as excluded entities – this would mean they would not need to calculate an effective tax rate nor be subject to a top-up tax. However, some investment funds may not qualify for any exemption. Where any fund is required to do a jurisdictional level effective tax rate calculation, it is likely to result in very significant additional taxation. In fact, this is likely to be double taxation as the investing insurance company or underlying policyholder will already be taxed on the relevant income/gains. There are particular concerns in respect of:

• funds that only have a single investor or only investors from within the same group, for example where a UK life insurer is the sole investor in a unit-linked fund; and
• chains of funds, for example where a UK insurance company invests in an Authorised Contractual Scheme (ACS) fund which invests in a Luxembourg SICAV, the question being whether the fund exemptions or other possible mechanisms to carve funds out of the jurisdictional effective tax rate calculations would be applicable all the way down the chain.

Where there is incremental/double tax due to the fund structure implemented, alternative investment structures could be required. Considering the amounts invested by the insurance industry this could have significant market impacts.

This issue was not addressed in the October 2021 statement and insurers will look closely at the model rules to understand the scope of any fund-related exclusions or elections.

3.Subject to Tax Rule on insurance/reinsurance premiums and broker commission 

The Subject to Tax Rule only applies to certain specified payments including interest, royalties and a defined set of other payments made between connected persons, which includes insurance and reinsurance premiums and broker commission. 

Premiums differ from some of the other payments within scope, as economically there will be claims payments offsetting the premiums and, in some cases, this will even result in net outflows from the low tax jurisdiction to the source country. The application of the Subject to Tax Rule at 9.0% is expected to result in an effective tax rate in excess of the proposed 15% for the purposes of the Income Inclusion Rule and Undertaxed Payment Rule. This is because the Subject to Tax Rule is applied to a gross amount (e.g. the premium) while the 15% minimum tax rate is based upon a net amount (e.g. the profit after premiums and investment return have had claims and expenses netted off). Invariably, gross premiums will be of an order of magnitude larger than net profit.

It is not yet clear which countries the Subject to Tax Rule will operate between, however, insurance groups will need to monitor the position, particularly those with operations in developing countries and jurisdictions with low nominal rates. 

Any changes to the definition of in-scope payments in the model rules will be of particular interest to the insurance industry.

Other considerations for the insurance industry 

Under the Global Minimum Tax rules, there is to be some allowance made for physical substance – measured through a percentage of tangible assets and payroll. It is not, however, expected that insurance capital will qualify. The exclusion from the Undertaxed Payment Rule for up to five years for groups operating in no more than five overseas countries and with a maximum of EUR 50m of overseas tangible assets is something that some insurance groups may be able to benefit from. 

Even groups that do not believe they will need to pay a top-up tax could face a significant compliance burden. The extent of any simplifications for groups operating in high-tax territories are not clear. Where a jurisdictional effective tax rate calculation is required, this will involve preparing accounts on a jurisdictional basis to align with the Global Minimum Tax framework, performance of bespoke tax calculations according to the Pillar Two rules and tracking of any tax attributes for future periods. Finance and tax teams will need to work closely to achieve this.

Signing up to the Inclusive Framework agreement does not commit any country to making domestic tax changes or implementing an Income Inclusion Rule regime. One of the big unknowns at the moment is which countries that currently have low tax regimes will do one or both of these. Where insurers operate in low tax jurisdictions they will need to carefully consider the implications, not least when considering the compliance impacts such as which entity would be liable to calculate and pay any top-up taxes due under the Income Inclusion Rule or the Undertaxed Payment Rule.

The Blueprint proposed a cap on the amount of tax that could be collected through the Undertaxed Payment Rule. However, in a similar scenario to the Subject to Tax Rule, this cap would be calculated by reference to gross payments (e.g. premiums), and does not take into account that the profit realised by an insurer will be substantially lower than this due to offsetting costs such as claims. The Undertaxed Payment Rule cap as drafted is only expected to apply to limited insurance fact patterns.

Finally, one of the biggest tax areas of uncertainty is precisely how the US GILTI will be reformed and how it will interact with the Pillar Two rules, which is likely to lead to complexity. This will be a focus as the rules are finalised. 

Beyond tax, there will be impacts across underwriting, actuarial and finance, for example:

• the pricing of contracts may need to reflect changes to post-tax returns;
• reinsurance and other agreements may contain change in tax law clauses which are triggered by Pillar Two implementation;
• the current and deferred tax accounting implications of applying top-up tax will need to be considered;
• capital assessments under Solvency II and similar regimes will need to reflect any tax chargeable in respect of other jurisdictions; and
• tax-deductible payments accounted through Other Comprehensive Income or equity (such as pension deficit contributions and Tier 1 capital instruments) could reduce effective tax rates significantly.

Next steps

With Pillar Two implementation proposed from 2023, it is recommended that groups consider the following stages of work – with the impact assessment and internal communications being something that many groups are already undertaking: 

1. Impact assessment;
2. Internal and external communications;
3. Monitoring implementation;
4. Restructuring to mitigate any adverse tax consequences; and 
5. Getting ready to comply.

With action required in 2022 ahead of a 2023 implementation, Board awareness of the issues at stake is important, noting the potential implications on the group’s effective tax rate and increased compliance requirements. Similarly, as part of budgeting cycles in Q4 2021 for 2022, tax teams need to have Pillar Two flagged as an additional project. For many group tax teams, it simply will not be possible to do this “on the side of a desk”. Input will also be required from other parts of the business across all jurisdictions, including finance, but also likely to include actuarial, legal, risk and even internal audit.  

For further information please contact Murray McLaren, Dan Gallon, Hannah Simkin or your usual Deloitte contact.