On the 22nd of December 2021, the European Commission published a proposed EU Directive laying down the rules to incorporate the OECD Pillar Two into European Member States. This directive aims to tackle the implementation of a minimum corporate tax rate of 15% per jurisdiction, for large group companies located in the EU.
Such directive reflects one of the main work streams discussed by the Organisation for Economic Co-operation and Development (OECD)/G20 Inclusive Framework in October 2021, where 137 member jurisdictions agreed on a minimum corporate taxation. The Commission has noted that given the highly integrated EU market, there is the need for a common approach on minimum corporate taxation. The objective behind the implementation of such rules via a directive is to have uniform transposition across the EU.
To whom do these rules apply?
The Directive shall apply to large groups, which either have a parent or subsidiary company located in any EU Member state, and which have combined financial revenues exceeding €750 million on a consolidated basis, in at least two of the last four consecutive fiscal years. To achieve consistency with EU laws, such as the freedom of establishment, the directive is not limited to cross-border transactions, but will also be applied to domestic groups which exceed the above-mentioned revenue threshold.
How will the effective tax rate be calculated?
The jurisdictional effective tax rate will be determined by dividing the tax paid by entities in that country, by the net qualifying income in that same jurisdiction. This is done by way of a formula. When the effective tax rate is lower than 15%, a top-up tax must be applied. This is known as the Income Inclusion Rule (‘IIR’). The top-up tax is calculated as the difference between the effective tax rate of the relevant jurisdiction and the minimum effective tax rate of 15%. This difference is then multiplied by the constituent entity’s income in that jurisdiction for that same relevant period, which income is calculated for Global Anti-Base Erosion (‘GLoBE’) purposes.
The calculation of the effective tax rate of each entity within the group will be made by the ultimate parent entity (‘UPE’) unless another group entity is assigned. Subsequently, the UPE will be required to apply the IIR top-up tax in respect of constituent entities located in low-taxed EU Member State jurisdictions. Where the UPE is located in a low-tax jurisdiction, it will also be required to apply a top-up tax on itself and on the constituent entities located in the same Member State.
If the UPE is located outside the EU, the low tax jurisdictions may be subject to the IIR top-up tax if the UPE jurisdiction applies the IRR. To ensure that the freedom of establishment principle is always respected, the UPE must ensure that the effective minimum taxation is payable not only at the level of the foreign subsidiaries, but also with regards to subsidiaries and permanent establishments located in the same member state. The Directive provides an option for a low tax member state jurisdiction to apply a domestic top-up tax on the resident constituent entity. When this applies, the UPE applying the IIR would need to provide a credit for that domestic top-up tax, when calculating the top-up tax for that respective jurisdiction.
What if the UPE does not apply the directive and does not have a Qualified IIR?
When this is the case, constituent entities established in EU Member States will apply the Undertaxed Payments Rule (‘UTPR’). This means that the collection of this top-up tax will be assigned to the constituent entities (the subsidiaries of the UPE). The determination of the top-up tax that will need to be charged by each EU member state will be determined by a formula which is based on the employees and tangible assets located in each jurisdiction.
What are the main administrative requirements?
Each constituent entity must file a top-up tax information return, unless this is filed in another jurisdiction with which the EU Member State has an exchange of information agreement. The return must be filed within 15 months from the relevant fiscal year end.
Are there any exceptions and carve-outs?
As mentioned above, groups with a consolidated annual revenue which is lower than €750 million would not be subject to the directive. The directive provides for a substance carve-out. Companies are allowed to exclude from the top-up tax an amount of income which is at least 5% of the value of the tangible assets and 5% of payroll. The objective behind this exemption is to encourage activities which have substance, like for example people and buildings.
Moreover, income from international shipping is also excluded, given that this is typically subject to special tax rules. As aforementioned, the UPE of large-scale domestic groups shall be responsible for any top-up tax of its constituent entities. Transitional rules apply to such groups, whereby the top-up tax will be reduced to zero for the first five years which the group fall within the scope of the directive. Furthermore, groups which fall within scope of this directive for the first time will be allowed a period of 18 months to comply with the administrative requirements mentioned above.
Are these rules intended to replace the EU Anti-Tax Avoidance Directives (‘ATAD’)?
This is not the case. The measures introduced in ATAD1 as amended by ATAD2, in particular Controlled Foreign Corporation (‘CFC’) and anti-hybrid rules, are designed to coexist with Pillar Two. It is expected that CFC rules will take precedence and any tax payable by the parent entity in connection with a CFC will be attributed to the low-tax jurisdiction under the GLoBE rules when calculating the effective tax rate. Similarly, taxes paid by an owner of a hybrid entity will be allocated to the jurisdiction of that same entity. CFC and anti-hybrid rules will continue to apply normally, even to groups which fall below the €750 million revenue threshold.
What are we to expect in the near future?
Although still at proposal stage, all EU member states except Cyprus have endorsed the proposed Directive. It is expected that Cyprus will also support the Directive in the future. For the EU Directive to be ratified, member states must agree unanimously. Such rules are expected to start to apply as from the 1st January 2023.
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