What's next for Pillar 2?Published on March 24, 2022
So, let’s start with a little bit of history.
The feeling that the international tax system has fallen behind modern business, particularly the digital economy, has been around and growing for some time now. Associated with this is the risk of a ‘race to the bottom’ as jurisdictions reduce their corporate tax rates to compete for more mobile business, which itself is often digital.
The OECD’s Base Erosion and Profit Shifting project, or BEPS, came out of this. Action 1 of the BEPS programme, published in 2015, was focused on Addressing the Challenges of the Digital Economy.
Perhaps reflecting that this is the most challenging and potentially far-reaching area of the original BEPS programme, it took until 2019 to really gather pace through consultations and the publication of more detailed Blueprints for:
- The ‘Unified Approach’ under Pillar 1 and
- The Global anti-base erosion proposal under Pillar 2.
The Unified Approach under Pillar 1 involved:
- A new taxing right for market jurisdictions over a share of residual profit calculated at a group (or segment) level – this is Amount A.
- A fixed return for certain baseline marketing and distribution activities taking place in a market jurisdiction – this is Amount B.
- And, dispute prevention and resolution tools to help provide tax certainty.
It also considers expanding taxing rights beyond a physical presence to look at wider participation in the economic life of a jurisdiction. This can include activities such as automated digital services or user participation.
Under Pillar 2, the global anti-base erosion blueprint sets out a means to achieve a global framework of minimum taxation through:
- An Income Inclusion Rule – a top up tax where controlled foreign entities are taxed below a minimum rate.
- A Switch Overrule removing treaty obstacles to this.
- The Undertaxed Payments rule, which effectively provides a top up tax along similar lines to the Income Inclusion Rule.
- A Subject to Tax Rule which would enable source countries to protect their domestic tax base by denying treaty benefits for intra-group payments made to low tax territories.
This is very much a summary, as the blueprints provide greater detail.
However, they also left the OECD with two big challenges – securing the political buy-in and commitment to the solution and addressing the remaining technical challenges.
Where are we now?
Step forward to mid-2021 and progress under one of those headings grabbed the headlines.
The G7 meeting in June threw their weight behind the concepts of Pillar 1 and Pillar 2. While their statement was stronger on intent than detail, the G7 aimed for:
- Market countries being awarded taxing rights on at least 20% of profit exceeding a 10% margin for the largest and most profitable multinationals.
- The removal of nationally led Digital Services Tax regimes.
- A global minimum tax of 15% on a country-by-country basis.
Shortly afterwards, the G20 and OECD Inclusive Framework on BEPS published a statement which both aligned with the G7 and offered more detail. Over 130 out of the 139 countries in the Inclusive Framework agreed the statement, showing the breadth of support falling in behind the plan.
It is worth running through the key points of the statement.
Pillar 1 will initially be targeted at the largest multinationals. To be in scope, to begin with businesses will need revenues of more than 20 billion Euros and a profit margin (based on profit before tax over revenue) of at least 10%.
The expectation is that the revenue threshold will reduce to 10 billion Euros if certainty over Amount A can be achieved, with a review after seven years following Pillar 1 going live.
So, initially this will be a concern for the largest multinationals. Even then, based on current plans there will be a carve out for the extractive industries and regulated financial services.
A new special purpose nexus rule is to be introduced. This will allow the allocation of Amount A to a market jurisdiction when an in-scope multinational derives at least 1 million Euros from that territory or, if it is a smaller jurisdiction with GDP lower than 40 billion Euros, the threshold will be revenues of 250,000 Euros.
This test will only be used to determine whether a jurisdiction gets an allocation under Amount A.
Excess profit will be allocated based on revenues, with the expectation that 20%-30% of residual profit – so profit in excess of 10% - should be allocated to market jurisdictions with nexus.
Revenue will be measured for the purposes of the allocation key based on the location of the end user or consumer of the goods and services supplied. Profits or losses will be determined from financial accounting income, although we should expect at least some adjustment to this to be needed as part of the calculation.
In some good news, losses will be available for carry forward. However, segmentation will only be expected in exceptional circumstances, so groups should work on the assumption that they will be addressed as a whole.
Where residual profits are already taxed in a market jurisdiction, a marketing and distribution safe harbour is proposed to cap the residual profit allocated under Amount A, and to essentially avoid double counting.
To relieve double taxation, the OECD propose a credit or exemption method along with mandatory and binding dispute resolution measures.
For Amount B, the aim is to streamline the application of the arm’s length principle for marketing and distribution activities in country.
For tax compliance purposes, the aim is for filling and management of the process to take place through a single territory.
In return for all of this, the successful implementation of Pillar 1 measures should trigger the removal of national Digital Services Tax regimes.
If this started to sound like a shopping list, that may not be too far from the truth.
The OECD will bring out model rules for Amount A in early 2022, with a multilateral instrument for Amount A due to be opened for signing in 2022 and the operation of Amount A going live in 2023. The work to streamline Amount B is expected to report by the end of 2022.
The aim is for Pillar 2
The Income Inclusion Rule to impose a top up tax on a parent entity in relation to low tax income in a constituent entity, working with an Undertaxed Payment Rule, which denies deductions or requires an adjustment where low tax income of a constituent entity is not subject to tax under the Income Inclusion Rule.
The Subject to Tax Rule, which will work through treaties to allow source jurisdictions to impose limited source taxation on related party payments that are subject to tax below a minimum rate. This would be creditable as a covered tax under the Global anti-base erosion rules.
The Global anti-base erosion rules will be treated as a common approach, so that jurisdictions may accept others’ application of the rules if the territory itself chooses not to implement the rules itself, and to implement and operate them in-line with the model rules it chooses to bring them in.
The threshold for applying the global anti-base erosion rules under Pillar 2 will be 750 million Euros, following the country-by-country reporting threshold. This is significantly lower than the threshold under Pillar 1.
The top up tax will be imposed based on an effective tax rate test calculated on a jurisdictional basis using a common definition of covered taxes and tax base, with reference to financial accounting income.
Where there is an existing distribution tax system, no top up tax liability is expected if earnings are distributed within three to four years and are taxed at least the minimum rate.
The minimum tax rate itself will be 15%, which is in-line with the G7 announcement.
Various exceptions are expected, including de minimis limits, safe harbours and a carve out that is calculated on a formulaic basis to exclude an amount of income which to begin with will be at least 5% of the carrying value of tangible assets and payroll. It is planned to increase this to at least 7.5% in the calculation after five years.
The minimum rate for the Subject to Tax Rule will be from 7.5% to 9%, with the taxing right limited to the difference between the minimum tax rate and the rate on the payment.
As with Pillar 1, the aim is for Pillar 2 to be implemented in 2022 and go live in 2023, subject to any transitional rules that may be required. Model rules are expected in November 2021.
What does this mean?
There are a lot of questions coming out of this – both theoretical and operational – and this is acknowledged by all involved. There is also the political question whether and for how long this consensus will last. That same question was no doubt partly driven by the ambitious timetable for the OECD to produce more detailed guidance in October 2021 ahead of a multilateral instrument in 2022, which would see the rules to take effect from 2023.
That makes this new world seem more likely. The operational date of 2023 is at best in the medium term. Pillar 1 and Pillar 2 – BEPS 2.0 as it has been termed – looks like the future and the near future at that.
So, what should we do now?
Well, the focus should be on anticipating the impacts of Pillar 1, Pillar 2, or both, understanding the operation of the rule and managing stakeholder expectations ahead of time.
The first and obvious step is understanding whether your business falls within the rules – or may do given a couple of years more growth. While Pillar 1 may be targeted to begin with at the largest multinationals, Pillar 2 will draw in many more groups by its alignment with the country-by-country reporting threshold. Carve outs, or potential exemptions, can also be considered, but while the rules remain in draft it may be wise to place only limited reliance on them.
It is clear from the blueprints that these rules are built around processes to identify and calculate appropriate amounts. This has a data requirement and associated reporting challenges. Can your systems cope – and ideally cope comfortably – with the expected requirements? What can be automated? And how much budget, lead time and interaction with the IT or ERP team will be needed?
Alongside this the aim should be to understand the cash tax impact. While there were plenty of operational questions coming out of the blueprints, taken together with the July 2021 Statement there is a basis to start to model or do some scenario analysis. Technical questions, unknowns or potential areas for dispute can be identified, and a sound platform created before the provision of more detailed guidance from the OECD.
Stakeholders can then be engaged based on the findings and outcomes of these steps. While it is an important message that these rules remain a work in progress, it is as important to provide an idea of what they would really mean in practice.
If the rules go live in 2023, a clear understanding of a budgeting process will be essential for many in 2022. In those terms, that leaves little time to prepare. Many businesses have made significant inroads already, and leaving this to the last minute could create great risk.
If you have any queries or if you would like to discuss any aspect of this in more detail, please get in touch with me or your regular RSM contact.