Pillar Two safe harbour rules

The OECD has published further guidance on the application of the Pillar Two rules. Importantly, this guidance includes details of two safe harbour rules, one applying where a sufficiently rigorous qualified domestic top-up tax (QMDTT) is in place and the other a temporary limitation on the application of the undertaxed payment rules to an ultimate parent entity where there is a corporate income tax rate of 20% in place.

Background

Following several years of discussions at the OECD concerning fundamental changes to the international tax landscape to deal with problems created by the digital economy, political agreement was reached in June 2021 on a two pillar approach, involving: revised profit allocation and nexus rules (Pillar One); and a global anti-base erosion proposal for a minimum level of taxation (Pillar Two). This was followed by the publication of a "Statement on a Two-Pillar Solution to Address the Tax Challenges Arising From the Digitalisation of the Economy" containing broad details of the agreed components of the Pillars and an implementation plan.

In December 2021, the OECD published model rules to assist in the domestic implementation of the Pillar Two minimum global tax rate of 15%. The Pillar Two model rules are designed to provide governments with a template for implementing Pillar Two. Since then, the OECD has published further guidance on the application of the Pillar Two rules.

The overall design of Pillar Two consists of:

• two interlocking domestic rules (together the Global anti-Base Erosion Rules (GloBE) rules): (i) an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a subsidiary entity; and (ii) an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a subsidiary entity is not subject to tax under an IIR; and
• a treaty-based rule (the Subject to Tax Rule (STTR)) that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate. The STTR will be creditable as a covered tax under the GloBE rules.

July 2023 guidance

The latest guidance published by the OECD, in addition to covering the detailed application of the rules in the context of currency conversions, tax credits, the substance based income exclusion and QMDTT, also includes two safe harbours.

QMDTT safe harbour

The first safe harbour relates to the operation of the QMDTT rules. The guidance notes that there may be differences between the amounts chargeable under a QMDTT and the GloBE rules but this does not, in principle, create issues due to the credit method by which a QMDTT operates (such that the GloBE rules will still pick up any shortfall). However, the operation of these rules will mean that at least two separate calculations remain necessary – one for the QMDTT and one for the GloBE rules. Clearly, the obligation to undertake separate calculations under parallel rules will result in increased compliance costs. The QMDTT safe harbour is intended to provide a practical solution to address this issue.

Where a QMDTT qualifies as a QMDTT Safe Harbour, the rules will exclude the application of the GloBE rules in other jurisdictions by deeming the top-up tax to be zero. To address the risk that the amount payable under a QMDTT may be less than under the GloBE rules, a QMDTT will need to meet an additional set of standards to qualify for the safe harbour. In particular, it will need to meet the following three standards:

• the QDMTT Accounting Standard which requires a QDMTT to be computed based on the UPE’s Financial Accounting Standard or a Local Financial Accounting Standard subject to certain conditions;
• the Consistency Standard which requires the QDMTT computations to be the same as the computations required under the GloBE Rules except where the Commentary to the QDMTT definition in Article 10.1 as modified by the Administrative Guidance explicitly requires a QDMTT to depart from the GloBE Rules or where the Inclusive Framework decides that an optional variation that departs from the GloBE Rules still meets the standard; and
• the Administration Standard which requires the QDMTT jurisdiction to meet the requirements of an on-going monitoring process similar to the one applicable to jurisdictions implementing the GloBE Rules.

The Inclusive Framework will rely on the peer review process to determine whether a QMDTT meets these additional standards and qualifies for the safe harbour.

It should be noted that these three standards are additional to the requirements for a domestic top-up tax to be considered a QMDTT in the first place. The domestic top-up tax has to qualify as a QMDTT before these standards are applied to determine whether, additionally, it can be considered as a safe harbour QMDTT.

UTPR safe harbour

The UTPR is designed to operate as a backstop to the IIR by encouraging jurisdictions to adopt the GloBE rules and MNEs to structure their group holdings in a way that brings their operations within the charge of the IIR. MNE Groups that are exposed to the potential application of the UTPR in the ultimate parent entity (UPE) jurisdiction have limited ability to change their ownership structure to bring the UPE’s profits within the scope of an IIR. The new guidance notes that the UTPR can be expected to apply with more frequency in the first years of operation of the GloBE Rules as jurisdictions complete the process of introducing qualified rules, including QDMTTs. This is regarded as undesirable for several reasons and therefore the Inclusive Framework has agreed the following temporary transitional safe harbour.

The UTPR Top-up Tax Amount calculated for the UPE jurisdiction shall be deemed to be zero for each fiscal year during if the UPE jurisdiction has a corporate income tax that applies at a rate of at least 20 per cent. This transitional UTPR Safe Harbour is designed to provide transitional relief in the UPE jurisdiction during the first two years in which the GloBE rules come into effect ie for fiscal years which run no longer than 12 months that begin on or before 31 December 2025 and end before 31 December 2026.

The corporate income tax rate for each jurisdiction is the nominal statutory tax rate generally imposed on in-scope MNE Groups. The nominal 20% rate test ensures that only MNE Groups whose UPEs are located in a jurisdiction with a corporate income tax system and sufficiently high corporate income tax rate benefit from this safe harbour.

The short transition period is designed to ensure that the safe harbour does not serve as a disincentive for jurisdictions to adopt the GloBE Rules or as an incentive for MNE Groups to invert into a jurisdiction that has not yet adopted a QDMTT or to shift profits into UPE jurisdictions that have lower effective tax rates. Accordingly, the transition period will not be extended.

Comment

The latest administrative guidance will be incorporated into a revised version of the Commentary that was first issued in March 2022. The Inclusive Framework will continue to consider administrative guidance where more clarity on the rules is needed with the aim of releasing further guidance throughout 2023.