The OECD Inclusive Framework releases the Model Rules for the domestic implementation of Pillar Two

Summary of the draft model rules

Pillar Two aims to ensure a minimum level of taxation. It does so by imposing a top-up tax on profits arising in a jurisdiction where the Effective Tax Rate (ETR) is below 15%. MNEs can broadly apply the rules as follows:

These key components of the Model Rules have been summarized below:

• Scope: The rules apply to Constituent Entities (CE) that are part of a MNE group that has annual consolidated revenues of EUR 750 million or more in at least two of the four preceding fiscal years (FY). The rules do not apply to governmental entities, international organisations, non-profit organisations, pension funds and Ultimate Parent Entities (UPE) which are investment funds or real estate investment vehicles.
• ETR: MNEs within the scope would need to calculate the ETR in each jurisdiction where they operate, in order to identify in which jurisdictions, the group is subject to low levels of taxation. The ETR is computed by dividing the Adjusted Covered Taxes (ACT) by the GloBE Income or loss (GIL) of all CEs in the jurisdiction, as summarized below:
  • GIL: First, the GIL is computed based on financial accounts. This is further subject to adjustments, exclusions (such as international shipping income) and elections.
  • ACT: Second, the ACT attributable to the GIL must be calculated. ACT considers income taxes including taxes under an eligible distribution tax system, taxes in lieu of corporate income tax and taxes levied by reference to retained earnings and corporate equity. Rules also provide allocation rules for income taxes which are charged as a withholding tax or as a result of the application of a Controlled Foreign Company (CFC) regime.
  • Other relevant rules/aspects:
    • A group can elect to apply a de minimis exclusion for countries with revenues of less than EUR 10 million and profits of less than EUR 1 million.
    • Rules are provided to address temporary differences (e.g., losses), primarily based on deferred tax accounting principles, and subject to certain adjustments. However, an election is available which provides for a simplified approach.
• Computation of top-up tax: Once the ETR has been calculated, it is necessary to determine the top-up tax due. Below are the key elements to consider:
  • The top-up tax percentage is the difference between 15% and the ETR in the jurisdiction.
  • The top-up percentage is applied to the GloBE Income after deducting a substance-based income exclusion.
  • The substance-based income exclusion reduces the base and is calculated as a specific return on tangible assets and payroll costs.
  • Finally, if a jurisdiction has a domestic minimum tax that is consistent with the Pillar Two Model Rules, such domestic tax is credited against any Pillar Two minimum tax liability.      
• Determine the liability of the top-up tax by applying the charging provisions: If a top-up tax is due, the charging provisions apply. These provisions describe which entity within the MNE Group has to pay the top-up tax in respect of low taxed income arising in a jurisdiction. This is achieved by applying two rules – the Income Inclusion Rule (IIR) and the Undertaxed payment rule (UTPR). We have provided a brief overview on the mechanics of these rules below:
  • IIR (main rule): The primary rule is the IIR. The IIR allocates the tax obligation based on a top-down approach. In other words, the top-up tax is paid at the level of the parent entity in proportion to its ownership interest in entities that have low taxed income. If the UPE has not implemented an IIR, then the obligation is passed down to the next qualifying entity in the ownership chain. An offset mechanism is provided to prevent the double taxation. The Model Rules also provide special rules for partially owned parent entities (POPE) - i.e., entities that are more than 20% owned by third parties.
  • UTPR (secondary rule): If the low taxed income is not fully brought into charge under the IIR, the UTPR applies on the residual top-up tax. This rule requires an adjustment (e.g., denial of a deduction) that increases the tax at a level of the qualifying subsidiary(ies) to ensure that any remaining top-up tax following the application of the IIR is brought to tax. The share of the top-up tax is calculated based on a formula, in proportion to assets and employees. A five-year exemption is provided for groups that are in the initial phases of international expansion, provided certain conditions are met.
• Other components of the rules: The Model Rules provide special rules applicable to corporate restructurings, including mergers, demergers, group members joining and leaving a group, and transfers of assets and liabilities. In addition, specific rules apply to permanent establishments, tax transparent entities, stateless entities, investment entities, investment funds/real estate investment vehicles, joint ventures, multi-parented (including dual listed) groups, cooperatives, and minority-owned entities, as well as in respect of deductible dividend and distribution regimes.
• Transitional rules: The implementation of the Model Rules would be subject to the following transitional rules:
  • Existing tax attributes, including losses, reflected in the financial accounts of a CE in the first year are taken into account in the ETR calculations.
  • Deferred tax assets/liabilities are capped at the lower of 15% or the applicable domestic tax rate.
  • Deferred tax assets arising from items excluded from the Model Rules’ tax base computation and which arise in a transaction after 30 November 2021 are excluded.
  • Deferred tax assets/liabilities in respect of acquired assets (other than inventory) transferred between CEs after 30 November 2021 and before the group is within the scope of the rules, are based on the disposing entity’s carrying value.

• Compliance and administration: Business will be required to prepare a GloBE information return (GIR). We have set out the most relevant aspects of this obligation below:
  • Obligation to file the return: The UPE (or an appointed group member) will be required to file the GIR with its local tax authority, who will exchange the information with other tax authorities where a qualifying competent authority agreement is in place. Each CE will need to notify its local tax authority of the group member filing the return and in which country it is located. Absent exchange of information relationships, CE will be required to file a copy of the return with their local tax authority.
  • Format and form: A standard template will be prepared by the OECD. However, the MNE Group is expected to provide the following information: group members (including tax identification numbers), corporate structure, computation of the ETR for each country, amount and allocation of top up tax and a record of elections made.
  • Timelines: The return must be filed no later than 15 months after the last day of the accounting period, extended to 18 months for the first return.
  • Other aspects: Domestic laws will apply with respect to penalties and the confidentiality of information. Safe harbours may be considered to reduce the administrative complications where detailed ETR calculations are required for numerous countries

Next steps

As a next step, the OECD is expected to release the commentaries to Model Rules early 2022. In addition, the public consultation on the implementation aspects of Pillar One and Two is expected to begin in February 2022.

However, countries will need to respond to the Model Rules and implement these into their domestic laws to be effective as of 2023. This gives businesses little time to prepare, especially in those jurisdictions where a high impact is expected such as some countries in the Middle East.

 Deloitte webinar

On 17 January 2022, we will be hosting a webinar to discuss the Model Rules from a Middle East perspective. We will brief you on the Model Rules and how they are going to operate from a practical point of view. Our tax experts will cover the following topics:

• Relevant changes from the Pillar Two blueprint and their impact
• Operation and mechanics of the rules, focusing on the income inclusion rule (IIR) and undertaxed payment rule (UTPR)       
• Other key provisions, obligations, and potential compliance requirements
• Potential jurisdiction responses and trends
• Key considerations for UAE/GCC based entities

Click here to register.