Pillar Two draft law—Phase one: To be or not to be in scope of Pillar Two

At a glance

On 4 August 2023, the Luxembourg government submitted to the Luxembourg parliament the draft law (“the draft”) for implementation of EU Council Directive 2022/2523 of 14 December 2022 on ensuring a global minimum level of taxation (15%) for multinational enterprise (MNE) groups and large-scale domestic groups (“domestic groups”) within the EU (“Pillar Two directive” or “Pillar Two”). This step underscores Luxembourg's ongoing commitment to comply with the tax standards approved at the international and EU levels.

The draft applies to constituent entities located in Luxembourg that are members of an MNE group (i.e., any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the UPE) or a domestic group (i.e., any group whose constituent entities are all located in Luxembourg) with an annual turnover of at least EUR 750 million, as reflected in the UPE’s consolidated financial statements in two or more of the four fiscal years immediately preceding the tested fiscal year, with the exception of any excluded entities.

A closer look

The draft closely reflects the Pillar Two directive and the transitional safe harbor rules issued by the OECD/G20 Inclusive Framework on BEPS in December 2022. It also makes an explicit reference to recital 24 of the Pillar Two directive in its explanatory statement, accepting as sources of illustration or interpretation for implementation of the directive the use of the global anti-base erosion (GloBE) model rules and their commentary, together with the administrative guidelines published by the OECD in February 2023. However, it does not expressly refer to additional guidance issued since then, probably because the draft was elaborated before the issuance of that guidance. This could raise questions as to whether, from a Luxembourg perspective, such documents may be used as a direct source of interpretation. Clarification in this respect is expected to be provided during the legislative process.

According to the draft, the 15% global minimum level of taxation will be achieved in Luxembourg through the application of what is presented as three new taxes. These new taxes relate to the income inclusion rule (IIR or “impôt relatif à la règle d’inclusion du revenu” in French), the undertaxed profits rule (UTPR, or “impôt relatif à la règle des bénéfices insuffisamment imposés” in French), and the qualified domestic minimum top-up tax (QDMTT or “impôt national complémentaire” in French), the latter being an option left to the member states by the Pillar Two directive.

Luxembourg opted to implement the Pillar Two rules in a separate law, independent from the Luxembourg Income Tax Law. It is anticipated that the IIR and QDMTT will enter into force for fiscal years starting on or after 31 December 2023, and that the UTPR generally will enter into force for fiscal years starting on or after 31 December 2024 (although the date will align with that for the IIR where the ultimate parent entity (UPE) of a group is located in a member state that opted to delay its implementation of the Pillar Two rules). The draft still needs to go through the legislative process but has to be implemented by 31 December 2023 to comply with the EU deadline.

Given the numerous provisions in the Pillar Two directive and the multiple interpretive materials from the OECD implemented in the draft, this and future articles follow a phase-by-phase approach to help groups understand and assess the potential impact of the Pillar Two rules on their businesses.

The first phase in a Pillar Two analysis is the determination of the scope of application of the rules. This article summarizes the main principles driving this determination and provides a practical approach that may be followed to assess the Pillar Two Luxembourg perimeter.
 

Phase 1: To be or not to be in scope of Pillar two?

At a glance

The draft applies to constituent entities located in Luxembourg that are members of an MNE group (i.e., any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the UPE) or a domestic group (i.e., any group whose constituent entities are all located in Luxembourg) with an annual turnover of at least EUR 750 million, as reflected in the UPE’s consolidated financial statements in two or more of the four fiscal years immediately preceding the tested fiscal year, with the exception of any excluded entities.
 

Practical approach

Determining the Pillar Two application perimeter requires the following four main steps:

Step 1: Identification of the UPE

Determining the scope of application of the Luxembourg Pillar Two draft starts as a first step with the identification of the MNE group or domestic group and its UPE.

A UPE is an entity that (i) owns, directly or indirectly, a controlling interest in any other entity and (ii) is not owned, directly or indirectly, by another entity with a controlling interest; or is the main entity of a group that has one or more permanent establishments.

A controlling interest means an ownership interest (i.e., an equity interest that carries rights to the profits, capital, or reserves of an entity or a permanent establishment) in an entity such that the interest holder (i) is required to consolidate the assets, liabilities, income, expenses, and cash flows of the entity on a line-by-line basis in accordance with an acceptable financial accounting standard, or (ii) would have been required to consolidate the assets, liabilities, income, expenses, and cash flows of the entity on a line-by-line basis if the interest holder had prepared consolidated financial statements (deemed consolidation test).

The deemed consolidation test is intended to cover situations in which the UPE did not prepare consolidated financial statements either in compliance with an acceptable financial accounting standard provided in the draft, or with another financial accounting standard adjusted to prevent material competitive distortion. In this respect, further clarification was provided in the administrative guidelines published by the OECD in February 2023.

The consolidated financial statements in case of a Luxembourg UPE would typically be prepared according to IFRS or Lux GAAP. However, other accounting standards are accepted and listed in the draft.

While there are similarities in the determination of the UPE between the draft and the country-by-country (CbC) reporting rules, there are a few differences. It is essential to check that the UPE used for CbC reporting, if any, is effectively the UPE for Pillar Two purposes based on the draft’s definition.

Based on the current accounting rules generally applied by Luxembourg investment funds (e.g., IFRS 10 for investment entities, specific consolidation exemptions available for fund products) such funds would meet the conditions to be considered UPEs only in very specific situations.
 

Step 2: Assessment of the turnover threshold

Once the UPE is identified, the turnover threshold criteria have to be assessed.

To be considered in scope of the Pillar Two rules, the annual consolidated turnover of the MNE group or domestic group should be at least EUR 750 million in two or more of the four fiscal years immediately preceding the tested tax year. The annual turnover is determined by reference to the UPE’s consolidated financial statements (actual or deemed), including the turnover of any excluded entities.

A tax year is defined as a 12-month period. In this respect, whenever a tax year is shorter or longer than 12 months, the turnover threshold should be adjusted proportionally for the purpose of the turnover assessment.

To the extent a group’s entity has been incorporated during the tested fiscal year (e.g., year N), the subsequent third fiscal year (i.e., year N+3) may be the first year of application of the rules (because this is the first fiscal year for which there are two full previous fiscal years to be tested). Consequently, if the threshold was met for the previous two years, the constituent entities would fall within the scope of Pillar Two in the third fiscal year (regardless of whether they prepared consolidated financial statements in the previous fiscal years). The latter provisions could apply to restructuring operations that would have to be analyzed on a case-by-case basis (as further discussed below).

The draft and its commentaries do not provide any definition of “turnover,” referred to as “chiffre d’affaire” in both the French version of the Pillar Two directive and the draft. Similarly, no precise definition exists for CbCR purposes. The expectation is that clarification will be provided during the legislative process or by the OECD. Note that the English version of the directive refers to “annual revenues.”

Special rules under the draft address the effects of mergers (i.e., when one or more entities from different groups are brought under common control), demergers (i.e., when the entities of a group are separated into two or more different groups that are no longer consolidated by the same UPE), and other events resulting in changes to the MNE group or domestic group with respect to the consolidated turnover test.
 

Step 3: Identification of any excluded entities

Once the UPE and the EUR 750 million threshold are determined, excluded entities have to be identified.

The draft provides the following main exclusions from the application of the Pillar Two rules:

1. It provides a list of excluded entities that, in any case, normally would not be consolidated on a line-by-line basis (i.e., governmental entities, international organizations, non-profit organizations, and pension funds (including pension services entities)) together with investment funds and real estate investment vehicles, as defined in the draft, to the extent they qualify as UPEs. The last two are considered excluded to protect their status as tax neutral investment vehicles.
2. It grants an exclusion based on an ownership test and an activity test where either:

a) At least 95% of the value of the entity is owned (directly or through a chain of excluded entities) by one or more excluded entities from the list above (other than a pension services entity) and (i) all or almost all of the entity’s activities consist of holding assets or investing funds for the benefit of one or more excluded entities from the list above, (ii) it exclusively carries out activities ancillary to those performed by the excluded entities from the list above, or (iii) it carries out a combination of the previous two activities; or

b) At least 85% of the value of the entity is owned (directly or through a chain of excluded entities) by one or more excluded entities from the list above (other than a pension services entity), provided that substantially all of the entity’s income is dividends or equity gain or loss excluded from GloBE income.

Where an investment fund does not qualify as a UPE because it does not consolidate or is not deemed to consolidate its financial statements, the entity(ies) it owns could fall within the scope of the Pillar Two rules as they could not benefit from the exemption available for entities meeting the 95% or 85% tests mentioned above. Where there is another entity above the fund that is the UPE (e.g., a majority limited partner consolidating the fund on a line-by-line basis for financial statement purposes), the fund and its investments also could be excluded to the extent the UPE is an excluded entity itself and the fund and its investments meet the criteria in a) or b) above.
 

Step 4: Classification of each entity

Once the UPE is identified, the EUR 750 million turnover threshold is met by the MNE group or domestic group, and the excluded entities are identified, the final perimeter of the group needs to be determined, which requires a classification of all entities under the rules. The purpose of this step is to apply appropriately the provisions of the rules (e.g., specific effective tax rate perimeter computation, specific rules for payment of top-up tax).

The main relevant criterion for such classification is the ownership interest (i.e., a participation that carries rights to the profits, capital, or reserves of an entity or a permanent establishment). Entities may be classified, for example, as:

• A Luxembourg intermediate parent entity (IPE), which is a Luxembourg entity (other than a UPE, a partially-owned parent entity (POPE, defined below), a permanent establishment, or an investment entity) that owns, directly or indirectly, an ownership interest in another constituent entity of the group;
• A Luxembourg POPE, which is a Luxembourg entity (other than a UPE, a permanent establishment, or an investment entity) that (i) owns, directly or indirectly, an ownership interest in another constituent entity of the group and (ii) has more than 20% of the ownership interests in its profits held, directly or indirectly, by third parties that are not constituent entities of the group. As a result, a POPE is less than 80% held (financial rights) by the UPE and holds an ownership interest in a constituent entity;
• A Luxembourg minority-owned constituent entity (MOCE), which is a constituent entity in which the UPE has a direct or indirect ownership interest of 30% or less; or
• A Luxembourg joint venture (JV), which is a Luxembourg entity whose financial results are reported under the equity method in the consolidated financial statements of the UPE, provided that the UPE holds, directly or indirectly, at least 50% of the JV’s ownership interest.

Other types of entities may have to be identified and classified for the correct application of the Pillar Two rules, e.g., flow-through entities and investment entities.
 

Comments

While the draft is only expected to be final by the end of 2023 and clarifications of the wording provided in the Pillar Two directive and the OECD guidance may still be provided based on comments from various public and private parties, any group that includes Luxembourg entities should assess the possible impact of these new rules on their businesses, starting with the determination of whether they are in scope. Should you have any questions or need assistance in this respect, you may contact our tax professionals.