OECD/G20 Agreement on a Two-Pillar solution to address tax challenges arising from the digitisation of the economy

Following the publication of a statement on the key components of the two-pillar solution to address the tax challenges arising from the digitisation of the economy in July 2021 (‘July Statement’), the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (‘IF’), agreed on a statement outlining the contents of each pillar on 8 October 2021 (‘Agreement’). The IF Statement has been joined by 136 countries including Malta.

The Agreement incorporates the details of the July Statement, addressing pending matters and providing substantive details, including an outline of the final rules detailing the allocation of profits to market jurisdictions under Pillar One, as well as transition rules and expanded carve-outs under Pillar Two. The Agreement also provides a detailed implementation plan which reflects the implementation plan unveiled in the July Statement.

Key points

Pillar One:

• Reallocation of taxing rights on 25% of the residual profit of MNEs having a worldwide turnover and profitability exceeding €20 billion and 10% respectively to market jurisdictions;
• Tax certainty through mandatory and binding dispute resolution;
• Removal and standstill of digital services taxes and similar measures;
• Establishing a simple and streamlined approach to the application of the arm’s length principle.

Pillar Two:

• The Global anti-Base Erosion Rules (‘GloBE’) establish a global minimum tax rate of 15% on MNEs with an annual revenue over €750 million;
• A ‘subject to tax rule’ to be included in bilateral tax treaties with countries having a nominal corporate income tax rate below 9% for interest, royalties and other defined payments;
• A carve-out to allow for tax incentives afforded to substantial business activities.

Pillar One

Nexus rule and tax base determination

To determine the threshold for the allocation of profits (referred to as ‘Amount A’) to a market jurisdiction, the special nexus rule shall apply with respect to market jurisdictions from which at least €1 million in revenue is derived. The nexus for jurisdictions with a GDP of less than €40 billion shall be reduced to €250,000.

The tax base will be determined using the MNE’s financial accounting income with limited adjustments and losses may be carried forward. Furthermore, ‘residual profit’ to determine the 25% of residual profit to be allocated to market jurisdictions shall be defined as profit in excess of 10% of revenue.

Carve-outs

Extractives and regulated financial services are excluded from the scope of Pillar One.

Revenue sourcing

The end market jurisdiction (i.e. where the goods or services are consumed) shall levy Amount A using detailed sourcing rules for specific categories of transactions depending on the MNE’s particular facts and circumstances. 25% of the residual profit of an MNE (i.e. profit in excess of 10% of the revenue) is set be allocated to jurisdictions having the established nexus.

Prevention of double taxation and compliance

The credit or exemption method will be employed to relieve the double taxation of profits allocated to a market jurisdiction and a mandatory and binding dispute prevention mechanisms shall ensure that any conflict is resolved. A safe harbour rule will also cap residual profits allocated to a market jurisdiction where the MNE’s residual profits are already taxed. Another identified objective in the Agreement is the streamlining of tax compliance and filing obligations through a system which allows the process to be managed through a single entity of the MNE.

Amount B

Work to simplify the application of the arm’s length principle to in-country baseline marketing and distribution activities is also underway, scheduled for completion by the end of 2022.

Pillar Two

Design

The GloBE rules are comprised of an Income Inclusion Rule (‘IIR’) and an Undertaxed Payment Rule (‘UTPR’) whereby the IIR imposes a top-up tax on a parent entity in respect of the low-taxed income of a constituent entity (subject to a split-ownership rule for shareholdings below 80%) and the UTPR requires an equivalent adjustment or denies a deduction to the extent that low tax income is not subject to the IIR.

Furthermore, the Subject to Tax Rule (‘STTR’) will be a treaty-based rule which allows a source jurisdiction to limitedly tax certain related party payments which are subject to tax below the minimum rate established at 9%, and this will be creditable as a covered tax under the GloBE rules.

Scope

MNEs meeting the €750 million revenue threshold as determined by BEPS Action 13 are within scope of Pillar Two, however countries may still apply the IIR to MNEs that do not meet this threshold but are headquartered in their jurisdiction. Government entities, international organisations, non-profit organisations, pension funds and investment funds that are the Parent Entities of MNEs are not subject to GloBE rules.

Carve-outs

GloBE rules shall provide for:

• A formulaic substance carve-out excluding income equating to 5% of the carrying value of tangible assets and payroll. The amount of income to be excluded will initially be set at 8% and 10% respectively during a 10 year transition period and shall gradually decrease on an annual basis;
• A de minimis exclusion for jurisdictions where MNEs have less than €10 million of revenue and €1 million of profit;
• An exclusion for international shipping income as defined in the OECD Model Tax Convention.

A novel addition also provide for an exclusion from the UTPR for a period of 5 years in relation to MNEs in their initial phase of their international activity in cases where MNEs have a maximum of €50 million in tangible assets abroad and that operate in no more than 5 other jurisdictions.

Calculation of effective tax rate

The GloBE rules shall utilise a tax rate which is calculated on a jurisdiction basis, using a common definition of covered taxes and a tax base determined by reference to financial accounting income. No top-up tax liability with respect to existing distribution tax systems shall arise on earnings that are distributed within 4 years and taxed at or above the minimum level.

Implementation timeline

Pillar One

Amount A will be effective in 2023 and its implementation shall take place through a Multilateral Convention (‘MLC’), and changes to domestic law, where necessary. The MLC and its explanatory statement shall be concluded by early 2022 and signed by mid-2022. Furthermore, works on Amount B will be concluded by the end of 2022.

Digital service taxes and similar measures shall be removed and no new similar measures shall be imposed on any company between 8 October 2021 and 31 December 2023, or the coming into force of the MLC, whichever comes first.

Pillar Two

Model rules giving effect to GloBE rules will be developed by the end of November 2021 and shall include substance rules for the determination of the effective tax rates and the respective carve-outs, administrative provisions including MNE’s filing obligations and use of administrative safe harbours, together with transition rules and a commentary on the model rules.

An implementation framework facilitating the coordinated implementation of the GloBE rules will be developed by the end of 2022 at the latest. This framework shall cover agreed administrative procedures and safe harbours to facilitate MNEs’ compliance obligations, and may include a MLC to ensure further coordination and its consistent implementation.

A model treaty provision providing for the STTR will be developed by the end of November 2021 which shall be supplemented with a commentary. The IF will also develop a Multilateral Instrument by mid-2022 to ensure the consistent implementation of the STTR. Furthermore, The UTPR shall become effective in 2024.

The IF statement may be accessed here.