Pillar II’S arsenals to enforce minimum tax of 15%
Pillar Two targets multinational enterprises (MNES) whose aggregated revenue exceeds €750 million in either of the preceding two years out of a four-year period. These enterprises are required to pay a minimum tax rate of 15 per cent on excess profits generated from each jurisdiction.
In jurisdictions where the effective tax rate falls below 15 per cent, Pillar Two introduces two interconnected regulations — the income inclusion rule (IIR) and under-tax payment rule (UTPR), collectively known as the global antibase erosion rules (GLOBE) — along with the treaty-based subject to tax rule (STTR). Furthermore, Pillar II specifies that these regulations for topping up taxes must be implemented in a specific sequence by adjusting the qualified domestic minimum top-up tax (QDMTT). Following this order, once QDMTT is adjusted, STTR takes precedence, followed by IIR, and finally, UTPR is applied.
QDMTT represents the initial top up tax implemented by the entity within its jurisdiction in accordance with the OECD'S proposed framework. For the remaining portion of the minimum tax, STTR, IIR, and UTPR come into play.
The STTR is enforced on transactions involving related parties, with an effective tax rate of nine per cent. STTR comes into effect when the tax rate in the supplier's jurisdiction is below nine per cent, prompting the customer to withhold taxes to elevate it to nine per cent. However, STTR does not apply to suppliers located in the UAE, given that the corporate tax rate in the UAE stands at 9 per cent.
Primary top-down regulation
The IIR serving as the primary top-down regulation, mandates that the ultimate parent company or the subsequent intermediate parent entity in the ownership chain, which has adopted the IIR, must increase the tax to 15 per cent on the excess profits of entities subject to tax rates below 15 per cent or those with no taxation. If the minimum top-up tax of 15 per cent cannot be achieved through IIR, the UTPR comes into effect. IIR follows a top-down methodology as the parent company adopting IIR holds the primary authority to implement the tax top-up. The UTPR is the backstop tax rule, to collect the 15 per cent tax which could involve disallowing deductions or introducing additional taxation measures, such as a withholding tax, to ensure that a constituent entity pays a minimum tax of 15 per cent.
For example, a parent company, X has two subsidiaries Y and Z. The parent company has office in a jurisdiction where tax rate is 20 per cent. Y and Z's jurisdictions has tax rates of 5 per cent and 25 per cent respectively. Y has given loan to Z; and annual interest income of Y is $100. Y's earnings before interest and taxes (Ebit) is zero, while Z has 200 Ebit, assuming there is no QDMTT and STTR ignored.
In this example, the effective tax rate of X is 5 per cent while the minimum tax rate applicable is 15 per cent, so the top-up tax rate is 10 per cent (15 per cent-5 per cent). The parent company will need to top up to pay to its own tax authority, is $10 [10 per cent (top up tax rate) *100(excess profit of Y].
In the same scenario, if we are assuming that a parent company holds investments in two sub-parents, SPI and SPII. SPI has a 40 per cent investment stake, while SPII has a 60 per cent investment stake in Y. The parent company itself has not adopted the IIR but both SPI and SPII have applied the IIR. The tax calculations and top-up amount determination will follow the same methodology, with the only difference being the application of IIR at the sub-parent level rather than at the parent company level (top-down approach). The SPI top-up tax amount is $4 (100*10 per cent*40 per cent); and similarly, for SPII the top-up tax amount is $6 (100*10 per cent*60 per cent). Therefore, the total top-up amount of $10 will be paid by Sub parents to its tax authorities.
If none of the group entities have implemented the IIR, the UTPR will come into effect (interlocking approach). Under UTPR, in the scenario where Z makes an interest payment of $100 to Y, $40 will not be considered as a tax-deductible expense for Z. Consequently, Z's tax base will increase by $40 [from 100 (200-100) to 140 (20060)], leading to an additional tax payment of $10.
Alternatively, when making the interest payment to Y, $10 will be withheld, resulting in Z paying only $90. In both cases, a top-up tax of $10 will be levied to ensure a minimum 15 per cent tax payment at the Y level.
The IIR and UTPR are called the interlocking rules since the application of UTPR depends on the outcome of the IIR.
The writer, Mahar Afzal, is a managing partner at Kress Cooper Management Consultants. The above article is not an official opinion of Khaleej Times but an opinion of the writer. For any queries/clarifications, please write to him at mahar@kress-cooper.com.