Pillar Two in Luxembourg: a game changer for accountants

Introduction

On 22 December 2023, the Luxembourg parliament passed a law to enforce the EU Council Directive 2022/2523, established on 15 December  2022. The law, also known as the Pillar Two law, sets a global minimum tax rate of 15% for Multinational Enterprise (MNE) groups and large-scale domestic groups within the European Union. The law is applicable from the fiscal year starting on or after 31 December 2023, affecting various businesses, such as commercial entities, banks, insurance companies, and alternative structures.

The assessment and adoption of the Pillar Two law necessitate the understanding of taxation principles and consolidated financial statements requirements, further emphasizing the effects of accounting on taxation. It also brings attention to the crucial role that accountants may have when working along with tax specialists. Therefore, cultivating new tax accounting awareness and skills is becoming critical for a smooth adoption of the new Pillar Two accounting impacts.

Scoping - Understand & apply consolidation requirements

The calculations for Pillar Two are based on consolidated financial statements. In Luxembourg, these accounts usually guide tax payments and returns, although this isn't the case in all jurisdictions.

The law of Pillar Two apply to constituent entities established in the Grand Duchy of Luxembourg, which are part of either a:

• Multinational Enterprise group (a MNE group means at least one entity or permanent establishment outside the Ultimate Parent Entity’s jurisdiction) or,
• Large-scale domestic group (a group whose constituent entities are all located in Luxembourg); and which, in the consolidated financial statements of their Ultimate Parent Entity (UPE) have an annual turnover of at least €750 million  for at least two out of the last four years.

Financial statements must comply with an acceptable accounting standards. To form a group, entities and other legal arrangements must be financially consolidated on a line-by-line basis. If a consolidation exemption applies under acceptable accounting standards, Pillar Two rules are generally not applied. For groups with complex ownership structures, such as private equity or investment funds, this can be a complex issue.

In Luxembourg and more generally across the European Union (EU), national laws dictate if, and when consolidated accounts must be prepared by an EU undertaking, while International Financial Reporting Standards IFRS (as endorsed by the EU) or Lux Generally Accepted Accounting Principles (GAAP) outline how these consolidated accounts should be prepared.

As a part of the Pillar Two scoping assessment and UPE identification, accountants clarify consolidation requirements and exemptions under Luxembourg Accounting law. They also help with applying critical definitions, such as "investment entity" and "control" under IFRS 10, or "private equity fund exemption" and "turnover" under the Luxembourg Accounting law and the Commission des Normes Comptables (CNC). Leveraging their extensive knowledge of IFRS and Lux GAAP, accountants aid in determining entities for line-by-line consolidation, crucial for calculation turnover thresholds under Pillar Two law.

Top-Up Tax - Support with deferred taxes and identify the right accouting framwork

The objective of Pillar Two is to ensure that the Effective Tax Rate (ETR) is at least 15% tax in each jurisdiction where the MNE group operates. If the 15% minimum tax rate is not achieved in a jurisdiction, the Top-Up Tax rule applies, levying additional tax (the Top-Up Tax) via three new taxes: the Income Inclusion Rule (IIR), the Undertaxed Profits Rule (UTPR) and the Qualified Domestic Top-Up Tax (QDMTT). Therefore, each constituent entity may owe an additional amount of tax in Luxembourg. 

The determination of the Top-Up Tax starts with calculating the ETR for each jurisdiction, per fiscal year, as follow:

Accountants and tax specialists work together to compute the adjusted covered taxes for each entity, following  specific rules aimed at determining the amount of taxes to be considered. They focus on deferred taxes, primarily to identify adjustments related to:

• Any deferred tax that arose on excluded items;
• The effect of a valuation allowance or accounting recognition adjustment for deferred tax assets that must be disregarded (these need to be considered for the total deferred tax adjustment amount, even if not recognized and booked);
• The unrecognized deferred tax assets and deferred tax liabilities reflected or disclosed in the financial accounts of all constituent entities in a jurisdiction for the transition year.

One of Pillar Two’s Top-Up Taxes is the QDMTT. Based on proposed amendments to the draft law submitted by the Luxembourg government to the parliament on 13 November 2023, related to Pillar Two, to determine the QDMTT of the Luxembourgish entities, their net qualifying income or loss of those entities must be computed using a financial accounting standard applicable in Luxembourg for statutory filing purposes (Luxembourg GAAP or IFRS).

If Luxembourg entities within the MNE group use different financial accounting standards, the Luxembourg QDMTT computation should be based on IFRS.¹ Alternatively, if all use Lux GAAP, then the Luxembourg QDMTT will be calculated under Lux GAAP. Otherwise, or if the fiscal years of the Luxembourg entities differ from the consolidated financial statements of the MNE group, the Luxembourg QDMTT should be computed based on the accounting standard used for the consolidated financial statements.  

Qualifying Income - Tracing & application of specific accounting adjustments

The Pillar Two law establishes the parameters for calculating the net qualifying income or loss for each Constituent Entity², a crucial step in determining the Effective Tax Rate (ETR) calculation process. The data is expected to come primarily from the accounting department.

The calculation begins with the net income or loss used in the UPE's consolidated financial statements, excluding intra-group transactions. This is based on the UPE’s accounting standard, though exceptions may apply (see paragraph above on the QDMTT considerations).

To derive qualifying income or loss, mandatory and optional accounting adjustments are required. These include excluding equity gains or losses, including revaluation method gains or losses, adjusting errors from previous periods, and changes in accounting principles. The adjustments require data from individual subsidiaries across jurisdictions, often necessitating assistance from both accountants and appropriate reporting tools. These adjustments are made prior to those eliminating intra-group transactions.

Accountants play a pivotal role in aiding tax specialists to understand transitional adjustments from local GAAP to relevant GAAP under Pillar Two. Nuances related to GAAP adjustments, late adjustments, consolidation adjustments, purchase price adjustments, and centrally booked items will require detailed examination.

Pillar Two enforces the ecosystem between tax and accounting and other departments including IT and Legal, not just during the transition to Pillar Two but also afterward. Entities should involve their accounting, tax, and legal experts early in transaction structuring, to grasp implications on their income tax and Pillar Two.

Disclosures requirements
 

In May 2023, the International Accounting Standards Board (IASB) announced limited amendments to IAS 12 – “Income Taxes”, offering temporary respite from accounting for deferred taxes linked to the implementation of Pillar Two model rules. Furthermore, the IASB introduced a disclosure requirement for entities under Pillar Two. It stipulates that such entities must disclose any known or reasonably estimated information aiding financial statements users in assessing their Pillar Two-related tax responsibilities during enacted or significantly enacted periods, even if not yet effective.

Under Lux GAAP, deferred tax disclosures are limited, mainly for consolidated financial statements and undertakings under Lux GAAP-fair value option regime. Management's discretion dictates Lux GAAP’s disclosure on the company’s tax environment (true and fair value principle). Notably, in response to the IASB guidance on the market, the CNC released 2 additional doctrines at the beginning of the year:

• The Q&A 24/031 addresses Pillar Two Law’s impact on LuxGAAP or LuxGAAP-FV annual and consolidated accounts, recommending IFRS-like disclosures;
• The Q&A 24/032 concerns Pillar Two Law and the option to disclose deferred tax assets and liabilities in the 2023 annual account notes. Given uncertainty from Article 53, paragraph 2 of the Pillar Two law, disclosing such assets in Luxembourg standalone account notes (including unrecognized deferred taxes related to unused tax losses) is strongly advised to mitigate validity debates of these tax attributes/deductible for Pillar Two purposes.

The Frequently Asked Questions (FAQ) issued by the Luxembourg tax authorities on 25 March 2024 confirms that the relevant financial statements for the purpose of disclosing Pillar Two Deferred Tax Assets and Deferred Tax Liabilities could be either the standalone annual accounts of the Luxembourg constituent entity and/or the consolidated financial statements of the UPE. For the latter, it's crucial to ensure traceability to the Luxembourg entity.

Those qualitative and quantitative requirements will oblige the Luxembourg accountants to compile sophisticated tax accounting data, to work jointly with tax specialists and to set a up a robust data collection process involving various jurisdictions, tax specialists and stakeholders considering the potential impacts on financial reporting.

Conclusion
 

No doubt, the Pillar Two Law is a game changer for accountants in Luxembourg. Until now, the concepts of tax accounting and deferred tax scheme were most likely scrutinized for the elaboration of group reporting or IFRS financial reporting. The rules have changed and the  integration of (trained) tax accountants in this process from the start is essential for a smooth transition to the fulfillment of Pillar Two's requirements.

To learn more about these changes and their implications, we invite you to join our webinar, "Pillar Two in Luxembourg: A Game-Changer for Accountants," on June 12 2024, from 11:00 a.m. to 12:00 p.m. (CEST).

Register now to gain insights from Deloitte Luxembourg’s tax and accounting specialists.

¹ Pillar Two draft law — Revised draft legislation released | Deloitte Luxembourg

² A Constituent Entity is an Entity included in a Group or a Permanent Establishment of a Main Entity.