In 2021, the Organization for Economic Cooperation and Development (OECD) released its Pillar 2 global minimum tax model rules. Although the U.S. has not enacted legislation to align U.S. tax law with Pillar 2, many OECD/G20 Inclusive Framework on base erosion and profit shifting (BEPS) initiative members are in the process of implementing these rules, which are set to take effect in 2024. Therefore, U.S. MNEs with operations in these jurisdictions will be affected.
Background
Pillar 2 is a framework of global anti-base erosion (GloBE) minimum tax rules for MNEs with an agreed-upon effective tax rate (ETR) of 15%. The GloBE rules generally apply to MNEs with a consolidated annual revenue of €750 million or more. Income and ETR under the GloBE rules are calculated on a country-by-country basis whereby MNEs are subject to the minimum income tax rate of 15% on their profits in each country where they operate and earn revenue. A system of top-up taxes ensures that MNEs pay a minimum 15% ETR.
The primary top-up tax rule is the income inclusion rule (IIR), which imposes top-up tax on an ultimate parent entity (UPE) with respect to MNE profits subject to tax in a jurisdiction with an ETR of less than 15%. For example, if an MNE operates in a jurisdiction where profits are subject to a 10% ETR, the UPE is required to pay a top-up tax of 5% on GLoBE income. If the UPE is in a jurisdiction that has not adopted Pillar 2, the IIR is imposed on the intermediate parent next in the chain of ownership that is in a jurisdiction that has adopted Pillar 2.
The undertaxed profits rule (UTPR) is a secondary rule that serves as a backstop to the IIR if neither the UPE nor any intermediate parent in the group is in a jurisdiction that has adopted Pillar 2. The UTPR imposes top-up tax through a denial of deductions or other adjustments in Pillar 2 jurisdictions where the MNE operates.
A qualified domestic minimum top-up tax (QDMTT) that countries can adopt also ensures that MNEs pay a 15% minimum ETR on income derived within that jurisdiction exclusive of any extraterritorial income. An MNE gets a credit for top-up tax paid under a QDMTT when calculating top-up tax under an IIR or UTPR.
Transitional country-by-country reporting (CbCR) safe harbor
In December 2022, the OECD released rules for a transitional CbCR safe harbor that applies through 2026. If one of the following tests is met, the jurisdiction qualifies for the safe harbor, and the top-up tax for the jurisdiction will be deemed to be zero for the fiscal year:
- De minimis test. The MNE’s CbCR revenue in the tested jurisdiction is less than €10 million, and the MNE’s CbCR profit (or loss) before tax, is less than €1 million.
- Simplified ETR test. The tested jurisdiction has an ETR that is more than the transition rate for the fiscal year (15% in 2023 and 2024, 16% in 2025, and 17% in 2026). The simplified ETR is computed by dividing the tax expense reported in the MNE’s financial statements by the MNE’s CbCR profit (or loss) before tax.
- Routine profits test. The MNE’s CbCR profit (or loss) before tax in the tested jurisdiction is equal to or less than the substance-based income exclusion (SBIE) amount. The SBIE amount is computed based on the wages paid and fixed assets deployed in the jurisdiction.
Crowe observation
For any jurisdiction that does not meet the safe harbor, a detailed GloBE income calculation will be required.
Relief for U.S. MNEs
While the Biden administration supports implementation of Pillar 2, many in Congress do not. As a result, the U.S. has not made meaningful progress in amending U.S. tax laws to avoid penalizing MNEs that operate in the U.S. The OECD has taken steps to provide some relief to MNEs that operate in the U.S.
In February 2023, the OECD released administrative guidance treating the global intangible low-taxed income (GILTI) regime as a blended controlled foreign corporation (CFC) regime through 2026 for calendar year taxpayers. As a result, when computing their jurisdictional top-up tax, a U.S. MNE can allocate tax paid under the GILTI regime to jurisdictions where the MNE has CFCs.
In July, additional administrative guidance was released to provide an elective transitional UTPR safe harbor available for any UPE in a jurisdiction with a nominal statutory corporate tax rate of at least 20%. If elected, the UTPR will not apply to calendar year taxpayers in 2024 and 2025. The guidance also includes a QDMTT safe harbor that allows an MNE subject to a QDMTT to exclude the QDMTT jurisdiction from further top-up tax calculations that it undertakes under an IIR or UTPR if certain conditions are met.
Looking ahead
Even though the U.S. has not taken steps to implement Pillar 2, many countries have made substantial progress. As such, U.S. MNEs need to understand how they will be affected with regard to tax planning and financial reporting.
MNEs should work with their tax advisers and consider the following to prepare for and measure the impact of Pillar 2:
- Monitor legislative developments in operating jurisdictions. UTPR, QDMTT, and safe harbor rules are not fully reflected in the current draft legislation of many countries.
- Review your CbCR and financial statements for 2023 to determine whether one of the transitional CbCR safe harbor tests will be met. Consider whether changes might result in meeting the safe harbor. For example, plant expansion might increase the SBIE, allowing the routine profits test to be met. In contrast, claiming a large research and development credit might adversely affect an MNE’s ability to meet the simplified tax rate test.
- Evaluate the potential applicability of the safe harbors in reference to UTPR or QDMTT.
- Consider planning opportunities to reduce the impact of top-up taxes.
