Pillar Two draft law—Phase two: Demystification of the top-up tax

At a glance

On 4 August 2023, the Luxembourg government submitted to the Luxembourg parliament the draft law (“the draft”) for the implementation of Council Directive (EU) 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 (DGs) within the EU (“Pillar Two directive”). The draft still needs to complete the legislative process but must be implemented by 31 December 2023 to comply with the EU deadline.

According to the draft, when an MNE group or DG is in the scope of the Pillar Two rules (as discussed in our phase one article), an additional amount of tax (top-up tax) would be required to be paid in relation to each jurisdiction in which the effective tax rate (ETR) is below the agreed 15% minimum level of taxation. The amount of top-up tax determined would be levied through the application of what the draft presents as three new taxes. These new taxes relate to the income inclusion rule (IIR), the undertaxed profits rule (UTPR), and the qualified domestic top-up tax (referred to as the QDMTT based on the acronym used by the OECD). Special rules have been included in the draft to potentially delay the application of the Pillar Two rules to some in-scope MNE groups and DGs. These rules would provide certain exclusions from the application of the Pillar Two rules, based either on the group being in its first phase of expansion, or on a specific parameter (e.g., revenue or profit).

A closer look

Our previous article issued on 7 September 2023, “Pillar Two draft law—Phase one: To be or not to be in scope of Pillar Two,” summarizes the main principles driving the determination of the scope of application of the Pillar Two rules and provides a practical approach that may be followed to assess the Pillar Two Luxembourg perimeter.

The purpose of this article is to help groups that are within the scope of Pillar Two to assess whether an amount of top-up tax would be required to be paid under the Pillar Two rules and to determine how, to which jurisdictions, and to which entity the tax should be allocated, as the second phase of their Pillar Two journey.

Practical approach

Determining the additional amount of tax to be paid in Luxembourg by each constituent entity in an in-scope MNE group or DG would require the following main steps.

Step 1: Consideration of available temporary/partial exclusions

The draft provides for various exclusions to apply at different stages of the application of the Pillar Two rules. At step 1, the “initial phase of exclusion from IIR and UTPR” and the “transitional safe harbor” may allow the MNE group or DG to avoid the computation of top-up tax at a jurisdictional level. Further exclusions would be available at later steps, i.e., the “IIR de minimis” exclusion and the “QDMTT safe harbor.” The first two exclusions are further described in step 1, while the remaining two are described in steps 3 and 4, respectively.

Initial phase of exclusion from IIR and UTPR

The draft provides for a potential five-year delay in relation to the application of the IIR and UTPR for MNE groups (first case) and DGs (second case).

The top-up tax due based on the IIR tax from (i) a low-taxed Luxembourg ultimate parent entity (UPE) in respect of itself and its low-taxed Luxembourg constituent entities, or (ii) a low-taxed Luxembourg intermediate parent entity (IPE) (when the UPE is an excluded entity, as defined in the draft) in respect of itself and its low-taxed Luxembourg constituent entities could be deemed to be zero for a five-year period. The period would be the first five years (i) of the initial phase of the international activity of the MNE group (in the first case), or (ii) starting from the first day of the fiscal year in which the DG falls for the first time within the scope of the Pillar Two rules (in the second case).

The rules would not grant any temporary exclusion at the level of the Luxembourg UPE or IPE of an MNE group from the mandatory computation based on the IIR in relation to low-tax constituent entities (LTCEs) in other jurisdictions. An LTCE generally would be a constituent entity located in a low-tax jurisdiction (a jurisdiction with an ETR lower than 15%).

Where the UPE of an MNE group is located in a non-EU jurisdiction, the top-up tax due by a constituent entity in Luxembourg under the UTPR would also be deemed to be zero in the first five years of the initial phase of the international activity of the MNE group.

An MNE group would be considered to be in its initial phase of international activities if it has constituent entities in no more than six jurisdictions and the sum of the net book value of the tangible assets of all constituent entities of the MNE group located in all jurisdictions other than the reference jurisdiction (i.e., the jurisdiction in which the MNE group has the highest total net book value of tangible assets in the fiscal year in which the MNE group originally falls within the scope of the rules) does not exceed EUR 50 million.

Transitional safe harbor (TSH)

The draft provides for a TSH rule, in line with guidelines issued by the OECD/G20 Inclusive Framework on BEPS in December 2022. The TSH is an optional short-term measure to exclude an MNE group or DG’s operations in “lower-risk” countries from the requirement to prepare a full Pillar Two calculation during fiscal years starting on or before 31 December 2026 and ending on or before 30 June 2028. This is expected to reduce compliance and administration costs and improve tax certainty for MNE groups within the scope of the rules.

The TSH mechanism would be based on data from the group’s country-by-country (CbC) report and qualifying financial statements and provides for three tests to determine if a jurisdiction would qualify for a temporary exclusion from the top-up tax computation. For the purposes of the TSH, it should be noted that the CbC report would have to be prepared and filed using qualified financial statements (“qualified CbC report”).

The tests would apply on an alternative basis, i.e., in a case where one of the tests is met by a certain jurisdiction, the top-up tax for the jurisdiction would be deemed to be zero.

The tests are the following:

• De minimis test: The MNE group or DG’s total revenue for the jurisdiction is less than EUR 10 million and its profit before tax is less than EUR 1 million based on its qualified CbC report for the tested tax year. This test is not expected to apply to DGs falling within the scope of Pillar Two.
• Effective tax rate test: The MNE group or DG’s simplified ETR for a jurisdiction is equal to or greater than the “transition rate” for the year, i.e., 15% for fiscal years beginning in 2024, 16% for fiscal years beginning in 2025, and 17% for fiscal years beginning in 2026. For the computation of the simplified ETR, the covered taxes (excluding uncertain tax positions) reported in the qualified financial statements of the entities of the jurisdiction would be divided by the profit before tax of the jurisdiction reported in the qualified CbC report (a net unrealized fair value loss on an ownership interest would be excluded from profit/loss before income tax if that loss exceeds EUR 50 million in a jurisdiction).
• Routine profits test: The profit before tax in a jurisdiction based on the qualified CbC report is equal to or less than the “substance-based income exclusion amount” as calculated under the Pillar Two rules, as explained below.

The TSH should not be considered as automatically applicable to all entities within a group or to all groups. For instance, it would not apply to stateless entities, or to multi-parented MNE groups where a single qualified CbC Report does not include the information of the combined group. The TSH also would not apply to jurisdictions that did not benefit from the TSH in a previous fiscal year in which the MNE group or DG was subject to the Pillar Two rules, unless the MNE group or DG did not have any constituent entities in that jurisdiction in the previous year (“once out, always out approach”).

Special rules also would apply to joint ventures (JVs), entities held for sale, tax neutral UPEs, and investment entities, as defined in the draft.

Step 2: Computation of the effective tax rate (ETR)

If an MNE group or a DG cannot rely on the initial phase exclusion for Luxembourg or on the TSH for any jurisdiction, the additional amount of tax to be paid in Luxembourg by each constituent entity would have to be determined, starting with the computation of the jurisdictional ETR.

According to the draft, the computation of the ETR and top-up tax would be made for each fiscal year, on a jurisdiction-by-jurisdiction basis.

The ETR for each jurisdiction would be computed based on the ratio between the aggregate amount of adjusted covered taxes of all constituent entities in a jurisdiction and the aggregate amount of net qualifying income of all constituent entities in the jurisdiction.

The amounts of net qualifying income and adjusted covered taxes would be computed starting with the values in the financial statements used for consolidation purposes, before any elimination of intragroup transactions, and would be adjusted according to specific rules provided in the draft. The computation of the net qualifying income and adjusted covered taxes will be covered in our next article.

More than one ETR computation might be necessary for a jurisdiction, depending on the Pillar Two perimeter, e.g., in the case of the presence of minority-owned subgroups (i.e., a subgroup constituted by entities in which the UPE has a direct or indirect ownership interest of 30% or less).

Step 3: Computation of potential jurisdictional top-up tax

If the jurisdictional ETR is lower than the 15% minimum ETR, a top-up tax would have to be computed. In such a case, a top-up tax percentage for the jurisdiction would be calculated as the difference between the 15% minimum ETR and the jurisdictional ETR.

The jurisdictional top-up tax would be determined by multiplying the jurisdiction’s top-up tax percentage by the excess profit, adding any additional top-up tax and deducting any qualified domestic top-up tax (as determined in accordance with the draft and described below).

The excess profit would be determined by reducing the net qualifying income by the substance-based income exclusion, an amount computed based on a 5% fixed percentage (during a transition period lasting until 2032, temporary higher rates declining gradually over the period would apply, as specified in the draft) on the employment costs and the net tangible asset value of the jurisdiction.

Additional top-up tax would arise in various situations based on, e.g., the mandatory recomputation of an ETR for a prior fiscal year, or on the amount of losses. This concept will be discussed in our next article.

As mentioned above, the draft provides for a permanent exclusion called the “IIR de minimis” exclusion. Under the exclusion, subject to a (yearly) election, the jurisdictional top-up tax would be equal to zero to the extent that (i) the average qualifying revenue of all constituent entities located in the jurisdiction is less than EUR 10 million, and (ii) the average qualifying net income/loss of all constituent entities located in the jurisdiction is less than EUR 1 million. The averages would take into account the tested fiscal year and the two preceding fiscal years. This exclusion would not apply to investment entities or stateless constituent entities, as defined in the draft.

Should there be a positive jurisdictional top-up tax, it should then be allocated to each constituent entity located in such jurisdiction that has reported a positive qualifying income in a given fiscal year. The allocation would be based on the ratio of each constituent entity’s qualifying income to the total amount of qualifying income of all constituent entities in the jurisdiction that have reported a positive qualifying income in that fiscal year.

Step 4: Allocation of top-up tax

After the computation of the top-up tax of a constituent entity under step 3, it would be necessary to determine how, to which jurisdictions, and to which entity the amount should be allocated. The draft provides for three different taxes to levy the top-up tax of a constituent entity: the QDMTT, the tax based on the IIR, and the tax based on the UTPR. Considering that the interaction of the three different taxes might lead to some confusion in terms of priority, the draft provides for a clear-cut path to follow.

The top-up tax for a constituent entity not located in Luxembourg could be levied by Luxembourg through the IIR or the UTPR. If Luxembourg is itself considered a low-tax jurisdiction, an LTCE located in Luxembourg first would be subject to the domestic top-up tax, which should, in principle, be considered a QDMTT.

The first rule to apply would be the QDMTT, which would give Luxembourg the primary right to tax an LTCE located in Luxembourg.

The second rule to apply would be the IIR. Any Luxembourg parent entity (UPE, IPE, or partially owned parent entity (POPE)) that has an ownership interest in an LTCE would apply the IIR in respect of the top-up tax corresponding to its ownership interest in the qualifying income of the LTCE, unless the QDMTT safe harbor (detailed below) applies to the jurisdiction.

The last rule to apply would be the UTPR, which would only come into effect to cover any top-up tax that has not been captured by the IIR (and indirectly by the QDMTT).

A description of each of the new three taxes is provided below.

QDMTT

The domestic top-up tax provided for in the draft would allow Luxembourg to collect the top-up tax in relation to Luxembourg LTCEs that are part of an MNE group or a DG.

The domestic top-up tax included in the draft is intended to be considered as a QDMTT, since it could be considered as being implemented and administered in a consistent way with the outcomes provided under the EU Pillar Two directive, the OECD Pillar Two model rules, the related commentary, and the administrative guidelines. The determination of the Luxembourg QDMTT would generally follow the rules set forth to compute LTCE’s top-up tax.

The QDMTT would also be applicable to Luxembourg JVs and their subsidiaries, which would be considered as a separate group.

QDMTT safe harbor

In line with the EU Pillar Two directive, the draft provides that when the QDMTT is computed based either on the UPE’s acceptable financial accounting standard that is used for the group’s consolidation purposes or on International Financial Reporting Standards, there would be no need to compute top-up tax based on the IIR and UTPR, as it would be considered that LTCEs in the jurisdiction that imposes such a QDMTT have been sufficiently taxed through the QDMTT mechanism. The draft does not include any provisions on a QDMTT safe harbor that is based on local financial accounting standards, as permitted by the administrative guidance released by the OECD in July 2023. Given that the draft was published before the issuance of the administrative guidance, the expectation is that a QDMTT safe harbor in relation to local GAAP could be taken into consideration during the legislative process.

In the event that the newly released guidance is not reflected in the final legislation, in a case where the QDMTT is not computed based on the UPE’s acceptable financial accounting standard that is used for the group’s consolidation purposes or based on International Financial Reporting Standards, the top-up tax computed for LTCEs in the jurisdiction to be allocated under the IIR would be reduced by the amount of the QDMTT imposed at a national level.

IIR

Under the IIR, the constituent entity top-up tax would be payable by parent entities, based on their allocable share of income of LTCEs.

This means that Luxembourg parent entities would be required to pay the top-up tax calculated for their LTCEs, in proportion to their ownership interest in the qualifying income of each LTCE.

In addition to the top-up tax calculated for foreign LTCEs, parent entities located in Luxembourg would be required to pay the top-up tax calculated for themselves and for other Luxembourg constituent entities, to the extent that Luxembourg itself is considered a low-tax jurisdiction and to the extent that the QDMTT does not cover the entire amount of the top-up tax (this could apply, for example, if the QDMTT safe harbors under the July 2023 administrative guidance from the OECD are not incorporated in Luxembourg law).

In practice, the IIR would be applied by three types of Luxembourg parent entities (as detailed in our phase one article): ultimate parent entities (UPEs), intermediate parent entities (IPEs), and partially owned parent entities (POPEs).

The draft contains rules applicable in a case where several parent entities could potentially apply the IIR in relation to the same portion of top-up tax calculated for an LTCE. The rules follow a “top-down” approach, in the sense that the UPE generally would have priority in applying the IIR with respect to its share of top-up tax computed for its LTCEs. Accordingly, any IPEs would not be required to apply the IIR where the UPE is already required to apply the IIR.

However, if the UPE is an excluded entity (as defined in the draft), or if it is located in a jurisdiction that has not implemented the global anti-base erosion (GloBE) rules, IPEs in the group would be required to apply the IIR unless a controlling interest (as defined in the draft) in the IPE is held by another IPE. In that case, the highest IPE in the group’s structure would apply the IIR. An exception to the rule of the UPE’s priority would apply when there are POPEs in the group that are required to apply the IIR. In that case, the top-down approach would not apply, as the POPE would have priority to apply the IIR, regardless of whether the UPE is also applying the IIR. The rationale behind this rule is to capture the excess amount of top-up tax that would remain unpaid in a case where third parties that have an interest in the POPE would not apply the Pillar Two rules. A POPE would not be required to apply the IIR if it is wholly owned (directly or indirectly) by another POPE required to apply the IIR (i.e., the highest POPE in the group’s structure would apply the IIR).

If, after considering the rules described above, there is still more than one parent entity required to apply the IIR for the same portion of the top-up tax calculated for an LTCE, an offset mechanism would ensure that the amount of top-up tax already paid by a parent entity would be deducted from the top-up tax payable by a parent entity higher up in the group’s structure.

UTPR

The UTPR would apply as a secondary (backstop) tax whose purpose is to capture any outstanding amount of top-up tax that has not been covered by the application of the IIR (and indirectly by the QDMTT). For instance, the UTPR would apply where the UPE of the group is located in a jurisdiction outside the EU that has not implemented a qualified IIR, where the UPE is an excluded entity, or where the UPE is located in an EU member state that has opted for a deferred application of the IIR and UTPR.

The UTPR would be applicable by all constituent entities located in Luxembourg, except for investment entities (as defined in the draft). The UTPR top-up tax would be equal to the total of the top-up tax calculated for every low-tax jurisdiction in the MNE group or DG, reduced by the amount of top-up tax already covered by the application of the IIR.

The allocation of UTPR top-up tax among different jurisdictions would be made through the application of a substance-based formula, which would take into account the number of employees and the net book value of the tangible assets. Through the application of the substance-based formula, each jurisdiction applying the UTPR would be allocated a portion of the UTPR top-up tax, in proportion to its substance within the group. The jurisdiction in which the group has the most substance would have the highest amount of top-up tax allocated to it under the UTPR mechanism.

The EU Pillar Two directive offers two possibilities to levy the adjustment equal to the UTPR top-up tax, either through a denial of a deduction or through a top-up tax. Based on the draft, Luxembourg has opted to apply a top-up tax.

We will address the method of payment of the UTPR in an upcoming article.

UTPR safe harbor

The current draft does not include a provision to establish a UTPR safe harbor similar to the one provided for in the administrative guidance released by OECD in July 2023. Under such a safe harbor, relief from the UTPR top-up tax could be provided to UPE jurisdictions with a nominal statutory corporate income tax rate of at least 20%. However, given that the draft was published before the issuance of the OECD administrative guidance, the expectation is that a UTPR safe harbor could be taken into consideration during the legislative process, since it is critical for the business relationships Luxembourg has with certain countries (e.g., the US).

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 is within the scope of Pillar Two should assess whether an amount of top-up tax would be required to be paid under the Pillar Two rules and determine how, to which jurisdictions, and to which entity the tax should be allocated. Should you have any questions or need assistance in this respect, you may contact our tax professionals.