The Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project has been a work in progress for some time, but 2024 could be a watershed year for the effort to address the tax rate “race to the bottom,” make international tax rules more coherent, and improve transparency in the taxation of multinational enterprises (MNEs). The project uses a two-pillar approach to realign global tax systems, with Pillar 1 focusing on a coordinated reallocation of taxing rights over the world’s largest and most profitable companies and Pillar 2 focusing on a global minimum tax that would reduce the effectiveness of business efforts to concentrate income in lower tax countries.
Many countries’ OECD Pillar 2 minimum tax provisions effective in 2024
The OECD Pillar 2 framework would create a minimum tax of 15% on MNEs with global annual revenue of 750 million euros (roughly $820 million USD). The framework would achieve this minimum tax rate through a model of global anti-base erosion (GloBE) rules made up of the following three components:
- A qualified domestic minimum top-up tax (QDMTT) that allows a constituent entity of a MNE with an effective tax rate below 15% to impose their own top-up tax in order to comply with the Pillar 2 framework.
- An income inclusion rule (IIR) that allows an Ultimate Parent Entity (UPE) in another country to assess a top-up tax if the MNE(s) are not paying an effective tax rate of 15% in their jurisdiction.
- An undertaxed profits rule (UTPR) that acts as a backstop to allow other constituent (brother/sister) entities to assess a top-up tax on a constituent entity (including the UPE) that does not meet the 15% effective tax rate threshold, and that isn’t already subject to IIR.
In short, QDMTT rules allow the home country of the constituent entity to collect additional taxes within its borders, while IIR and UTPR protocols would allow countries outside of the constituent entity’s home country to collect taxes based on shortcomings in the home country’s tax code.
While development and implementation of law and regulation seemed to move at a snail’s pace, a flurry of laws were proposed or enacted by countries within the last two weeks of calendar year 2023 to come into compliance with the framework. Many of the 140 countries supporting the framework (including the EU) have now enacted or are expected to enact QDMTTs and IIRs for tax year 2024 and UTPRs that will go into effect in 2025. In some cases, MNEs that are subject to SEC reporting rules may be required to disclose potential expected impacts of GloBE taxes as early as their 2024 quarterly financials.
Pillar 2 calculations start with financial statement income
One potential pitfall for the unwary is that OECD Pillar 2 calculations start with applicable financial statement income of the MNE group and use certain OECD-defined adjustments for purchase accounting, tax credits and incentives, and other items to get to the amount that’s tested for the 750-million-euro threshold. Because financial statement income can vary widely from tax return income, some MNE groups could unexpectedly find themselves included in the GloBE rules. If a MNE’s financial statements are not audited, the OECD provides guidelines for compiling financial data.
The key piece to note is that businesses that are potentially subject to the rules can’t necessarily rely on statutory corporate tax rates or corporate tax returns to determine if their income or their effective tax rates trigger the OECD Pillar 2 rules, as the effective tax rate tests are based on adjusted financial statement data and definitions of covered taxes. Tax teams will need to have a greater understanding of accounting rules under GAAP or IFRS and how they differ from corporate tax rules, as your tax provision deferred tax items in your financial statement can have an impact on your Pillar 2 calculation. Additionally, internal and external tax teams will need to develop more effective channels for gathering and using financial statement data from multiple jurisdictions.
Some safe harbor rules allow for relief during a transition period including a de minimis test, a simplified effective tax rate test, and a routine profits test. Developing countries can also benefit from a permanent safe harbor under the rules. The transitional safe harbor rules are applicable for years beginning before December 31, 2026 and ending before December 31, 2028, and allow a zero top-up tax for a jurisdiction where at least one of three tests is met:
- De minimis test – If the MNE group revenue for a jurisdiction is less than EUR 10 million and Profit(Loss) before income tax is less than EUR 1 million on its Qualified CbC report for the fiscal year
- Simplified ETR test – If the MNE group’s simplified ETR in such jurisdiction is equal to or greater than the Transition Rate (15% for years beginning in 2023 and 2024 and increasing to 16% and 17% in the following two years)
- Routine profits test – The MNE group’s profit (loss) before income tax for entities in a jurisdiction is equal to or less than the Substance-based Income Exclusion amount calculated under GloBE rules
There is a “once out, always out” rule that’s also worth noting. If an entity in a jurisdiction fails to meet one of the three tests in any year, it will be disqualified from using the safe harbor in future years. To the extent a jurisdiction meets one of the simplified safe harbor tests above, that jurisdiction will not be subject to top-up tax for that year. Safe harbor rules are generally calculated using Country-by-Country reporting (CbCr), but some exceptions exist. In the case that a jurisdiction is not able to use the safe harbor calculation, it will default to the full GloBE calculations to determine if they are subject to top-up tax under either the IIR or UTPR.
U.S. companies may be indirectly impacted by Pillar 2 and detailed information requests
While the U.S. has not enacted GloBE legislation, many U.S. businesses will still be impacted by legislation enacted throughout the world. Many U.S. businesses and their directly owned subsidiaries may fall below the revenue threshold, but to the extent they are part of a larger global multinational group, the worldwide revenues of the group could subject the entire MNE group to the Pillar 2 rules.
Particularly, U.S. companies that are foreign-parented or owned under common control of a larger U.S.-parented group with foreign subsidiaries should expect questions from participating tax jurisdictions. The mechanics of the IIR and UTPR work such that multiple entities in the structure with GloBE legislation may have an opportunity to collect additional tax on jurisdictions with an effective tax rate falling below the 15% threshold, with the IIR taking priority over the UTPR. Given the impact of credits and incentives on the ETR, the U.S. and its directly owned subsidiaries could very well fall below that threshold. With no U.S. QDMTT to top up tax to the minimum threshold, those tax dollars will go outside of the U.S. It’s worth noting that a safe harbor for U.S.-parented MNE groups was negotiated to delay application of the UTPR to 2026.
Pillar 2 and U.S. tax law
Current U.S. tax law includes a hybrid territorial tax regime, with controlled foreign corporations calculating global intangible low-taxed income (GILTI) tax and Subpart F inclusions from foreign subsidiaries, which is included in the taxable income base for the U.S. parent entity and taxed at corporate income tax rates. While the U.S. statutory corporate rate of 21% is above the 15% global minimum tax threshold, certain incentives such as the Sec. 250 deduction can reduce the effective tax rate on GILTI income inclusions to as low as 10.5%. Additionally, foreign tax credits must be considered in determining the effective tax rate under the GloBE model calculations.
Part of the disconnect between the U.S. and the GloBE model rules arises because most other countries and the GloBE model rules apply CFC taxes on a jurisdictional basis, while the U.S. system is referred to as a blended CFC regime. A U.S. parent nets all of its subsidiary GILTI or Subpart F income and taxes together. The GloBE rules require a MNE to determine the effective rate by jurisdiction for all of its constituent entities, so the blending of income and taxes of subsidiaries held under a U.S. parent as part of a larger MNE group poses additional calculation burdens on the group. In developing the framework, administrative guidance was released recognizing the U.S. GILTI regime as a blended CFC tax regime and provided a simplified allocation for blended tax regimes for purposes of the safe harbor rules; however, the effective tax rate calculation is different under the full GloBE rules. To the extent a jurisdiction meets the safe harbor, but a UPE is subject to the full GloBE calculation, the safe harbor jurisdiction does not need to recompute their ETR under the full rules for purposes of the other entity’s calculation.
Mixed reception of the Pillar 2 framework within Washington has stifled efforts to bring the current U.S. tax regime closer in alignment with GloBE. Some provisions in recent legislative proposals such as the Build Back Better Act were intended to align the Internal Revenue Code more closely with GloBE rules but were not enacted. Under the Inflation Reduction Act, the enactment of the corporate AMT/“book minimum tax” (CAMT) provision creates an effective minimum corporate tax rate of 15%, but the calculation is based on the financial statement income of a U.S. entity and its CFCs. Additionally, the threshold for the application of the CAMT is corporations with global adjusted financial statement income over $1 billion (and $100 million of U.S. taxable income), meaning that many U.S. companies that might be subject to GloBE won’t be covered by CAMT.
Additionally, in anticipation of the impact of GloBE taxation and reporting on U.S. companies and their controlled foreign corporations, the IRS has issued guidance on the impact of Pillar 2 GloBE taxes that U.S.-based MNEs pay in other countries on calculations of foreign tax credits and the impact of dual consolidated losses.
Pillar 2, CAMT, and Financial Statement Reporting of Income Taxes
Companies issuing financial statements under US GAAP are required to report current taxes as well as deferred tax assets and liabilities (i.e., the future tax effects of deductible and taxable temporary differences between tax and GAAP accounting) in accordance with ASC 740. As this accounting standard requires deferred tax assets and liabilities to be measured at the tax rate expected to be applicable to the future tax deduction or income (based on currently enacted law), companies should consider how the minimum taxes will impact that expected tax rate. Similarly, future tax credits that will be generated by the application of these taxing regimes should be carefully considered in modeling the impact of Pillar 2 and CAMT.
What’s ahead for Pillar 2 and BEPS?
It’s reasonable to expect that many of the 140 countries participating in the OECD BEPS initiative may raise their corporate tax rates in order to comply with the Pillar 2 rules; however, that would increase rates on small businesses that would fall under the 750-million-euro threshold. For that reason, we expect many countries will be implementing QDMTT provisions so that the effective rates on MNEs that exceed the BEPS threshold of 750 million euros will reach 15% in their home countries. On top of the QDMTT provisions that apply to MNEs based in a country, multinationals can expect to see increasing use of IIRs and UTPRs to assess taxes in countries where they operate if they cross the revenue threshold and are paying an effective tax rate below 15% in such jurisdictions.
The OECD continues to issue administrative guidance while polling for feedback from businesses, tax advisors, and countries. How the guidance is implemented is dependent largely on how Pillar 2 legislation has been enacted in each jurisdiction, and so it’s important to start with legislation for jurisdictions in your MNE footprint when determining how rules are applied.
While the U.S. has not adopted the OECD’s Pillar 2, many U.S. companies may be indirectly subject to it either because they are a member of a larger global group, are controlled by a foreign parent, or have foreign subsidiaries in jurisdictions with Pillar 2 rules.
