Richard Jones, Business Tax Manager of the ICAEW Tax Faculty, provides a high-level explanation of the proposed rules.
Agreement on a package of reforms designed to manage the taxation of large multinationals at an international level was reached by 136 countries of the Organisation for Economic Co-operation and Development (OECD) inclusive framework in October 2021. The measures, referred to as pillars one and two, are due to be implemented in 2023.
Pillar one involves a partial reallocation of taxing rights over the profits of the largest and most profitable multinational businesses to the jurisdictions where consumers are located. So, it is about where they pay tax. One of the main impacts of this will be to ensure that highly digitialised businesses in particular are taxed more in line with the value they generate from their customer base in each jurisdiction.
Pillar two is designed to ensure that multinational groups pay a minimum rate of tax in every jurisdiction they operate in, through a framework of rules known as the Global anti-Base Erosion (GloBE) rules. So, it is about how much tax they pay. The aim is to reduce opportunities for profit shifting and aggressive tax planning by multinationals. It will place a floor on tax competition between jurisdictions, while leaving appropriate flexibility for countries to use corporate income taxes as a policy lever for supporting business investment and innovation.
Consultation is now taking place both at an OECD and individual jurisdiction level on how to successfully implement these rules.
On pillar one, work is progressing in the OECD on finalising the detailed framework for reallocating taxing rights. This began with the publication of draft rules for Nexus and Revenue Sourcing on 4 February 2022, followed by public consultation on the draft model rules for the scope of Amount A. Further building blocks are expected to be published over the course of this year. The aim is to introduce a multilateral convention that will be available for signature in 2022, with the rules becoming effective in 2023.
The OECD has finished the design of model legislation for pillar two that countries are to give effect to in their domestic legislation. Detailed technical guidance on these rules was published on 14 March 2022. HMRC and HM Treasury issued a consultation document in January 2022 setting out how they anticipate the model legislation will be incorporated into UK domestic law. Since then, the OECD sought input on its commentary to the GloBE rules and issued accompanying examples.
The rest of this article takes a high-level look at how pillar two is expected to be adopted in the UK.
How will pillar two work?
The overall objective is that large multinationals (defined as groups with revenue of more than €750m) will pay a minimum 15% effective corporate income tax rate in each jurisdiction they operate. This will be determined by calculating the group’s effective tax rate (ETR), which is the group’s combined tax charge in a territory divided by its combined profits derived from that territory. If the ETR falls below 15%, a ‘top-up tax’ will be charged on certain entities within the group.
The design of the GloBE rules allows multiple jurisdictions to apply top-up taxes to the same group, but applies priority rules to prevent these from causing the group’s ETR to exceed the minimum rate in any jurisdiction.
Which entities will be included?
The first step will be to determine which entities’ taxes and results are to be included in the calculations. Broadly, this will include companies that are resident or incorporated in the jurisdiction concerned and permanent establishments (PEs) of other entities set up there. There will be special rules to deal with transparent entities, such as partnerships.
How do you calculate the income of each entity?
The next step will be to calculate the income of those group entities and aggregate them. Known as ‘GloBE income’, this will be based broadly on the entity’s financial accounting profit, subject to certain adjustments, including the following, which mirror some of the adjustments included in the UK corporation tax rules:
- removing dividend income from shareholdings of greater than 10% or shareholdings of less than 10% held for more than 12 months;
- removing gains or losses from the sale of greater than 10% shareholdings;
- removing reorganisation gains and losses where these are deferred for local tax purposes;
- adjustments dealing with foreign exchange gains and losses created by differences between tax and accounting functional currencies; and
- adjustments addressing differences between the tax and accounting treatment of defined benefit pension schemes.
Cross-border intra-group transactions will also be valued in accordance with the arm’s length principle and profits will be allocated to PEs according to their attribution for tax purposes.
What taxes will be included?
The taxes in scope will broadly be restricted to corporate income taxes and withholding and other taxes imposed in lieu of these. Sales and payroll taxes are not included. The taxes will be measured broadly using the current tax expense recorded in the entity’s financial statements.
The treatment of tax credits follows the relevant accounting treatment. A non-refundable tax credit, or one only refundable after four years, is treated as a repayment of tax, whereas a refundable tax credit, which is paid regardless of the entity’s profitability, is equivalent to a grant. These rules will ensure the UK’s research and development expenditure credit (RDEC) will be treated as an addition to income rather than a reduction in tax in the ETR calculation.
Where an entity pays taxes in more than one jurisdiction, the entity’s accounting tax expense will be assigned to those jurisdictions according to where the income was recognised.
Adjustments will be made for timing differences, such as the difference between accounting depreciation and tax allowances on capital expenditure, by taking into account the entity’s deferred tax income or expense result for the period. There will be a recapture rule for deferred tax liabilities that have not unwound within five years of the fiscal year in which the liability was originally recognised.
Similar rules will apply where an entity utilises a tax loss in a different period to the one in which it was realised.
As with group income, the tax result for each entity is then aggregated to determine the total tax expense for the group in each jurisdiction.
How do you calculate and apply the top-up tax?
A top-up tax will be applied to group entities if the ETR for the group falls below 15%, subject to a de minimis rules applicable where GloBE revenue and GloBE income are below €10m and €1m respectively, or where the jurisdiction qualifies for a GloBE ‘safe harbour’. One potential safe harbour could be based on country-by-country reporting.
The top-up tax will be calculated after deducting a ‘carve-out return’ from group income and then multiplying the resulting net income by the difference between 15% and the group’s ETR.
The carve-out return will begin in 2023 as 10% of payroll costs plus 8% of the carrying value of fixed assets located in the jurisdiction and will gradually reduce to 5% of each over the following nine years.
The top-up tax will be charged using a ‘top-down’ approach known as the income inclusion rule (IIR). In the first instance, it will be charged on the group’s ultimate parent entity, if that entity is located in a jurisdiction that has implemented pillar two. In other cases, complex rules set out how intermediate parent companies may be charged instead.
An undertaxed profits rule (UTPR) may apply as a back up to the IIR where insufficient additional tax has been charged under the IIR. The OECD’s model rules do not set out how the UTPR should be applied. In its consultation, the UK government sought views on the following two alternative approaches.
- Deny corporation tax deductions on payments made by members of the group, most likely to apply to the most profitable group members first.
- Place a charge on UK-based group members by reference to payments made by entities in the UK.
Where the group is loss-making or there are insufficient payments for the top up tax to be charged in full under the UTPR, any uncollected portion is to be collected in the next tax year.
Is it going to happen?
In response to the invasion of Ukraine, it is possible that some jurisdictions that may potentially lose out on corporate tax revenues as a result of implementing these proposals may become more reluctant to implement them.
This is more likely to happen in relation to pillar one, which is focused on a re-allocation of taxing rights between jurisdictions. However, the whole package may fail unless agreement is maintained in respect of all aspects. It is therefore a case of ‘wait and see’ while the OECD continues to press ahead with its consultation process.
About the author
Richard Jones, Business Tax Manager, Tax Faculty