Pillar Two and the GCC – Important consequences for tax havens and exemptions for nationals
The same thing is happening with Pillar One and Pillar Two as with BEPS. Initially, it seemed to be a topic for insiders, tax administration officials and a handful of academics, but eventually it became a topic for everyone.
Discussions around Pillar One and Pillar Two have picked up very considerable speed since the endorsement by the G7 on 5 June 2021, and the endorsement by most of the Inclusive Framework members on 1 July 2021.
With laws being drawn up in 2022, and an implementation in 2023, Pillar Two is right around the corner. In this article we analyse Pillar Two. We will leave an analysis of Pillar One for next month’s article.
What is Pillar Two?
Simply said, Pillar Two establishes a Minimum Global Tax of 15% for businesses operating in multiple jurisdictions. Those businesses need to have a consolidated turnover in excess of 750M EUR though in order to be caught be the Global anti-Base Erosion Rules (GloBE).
The minimum tax is achieved through the inclusion on the parent level of untaxed income of the subsidiary (the Income Inclusion Rule), or, as a backstop, via a rejection of the deduction of undertaxed payments (the Undertaxed Payment Rule).
In addition, a subject to tax rule applies, allowing source jurisdictions to impose a limited source taxation on certain related party payments, which will be taxed below the 15% minimum rate.
The rules are designed to create a level playing field, canceling out income declared and taxed below the minimum rate of 15%, or not at all, by having to “top up” the tax. This is done a jurisdiction basis (no consolidation between jurisdictions).
There’s an additional so-called “substance carve-out” for businesses, in jurisdictions where staff and tangible assets are used.
There are limited exemptions to be foreseen, which will be reserved for Government entities, international organisations, non-profit organisations, pension funds or investment funds that are Ultimate Parent Entities (UPE) of an MNE Group or any holding vehicles used by such entities, organisations or funds.
Do all countries have to apply it?
Technically no, but let’s call it fiscal peer pressure. Most of the Inclusive Framework members have endorsed the principles of Pillar Two. Amongst those are all GCC Member States, except Kuwait. The overwhelming majority of the important economies stand behind it, which means that the rest of the world is bound to follow.
What choices do countries have in terms of the implementation?
Countries with a corporate tax system leading to an effective taxation in excess of 15% may simply implement Pillar Two in their domestic tax legislation, with the abovementioned principles to be adopted. This means they will mainly target jurisdictions with a lower Corporate Income Tax rate, and include the top up tax in the most simple cases.
If a country however has a Corporate Income Tax below 15%, if may consider the following reforms:
- Adopt a higher rate compliant with Pillar 2 provisions. It will therefore collect more revenue.
- Adopt a higher rate compliant with Pillar 2 provisions, on a limited scale, i.e. only for businesses with a consolidated turnover in excess of 750 M EUR.
- Do nothing – this will entail that other countries will tax the revenue of the source jurisdiction.
A country with no corporate income tax, may consider implementing corporate income tax, on a limited scale, or full scale.
What will the GCC countries do?
While arguably the UAE and Bahrain face the most important choices, with a potential (limited) implementation of corporate income tax on a national level on the cards, Saudi Arabia, Qatar and Kuwait will also need to reform their laws. Potentially, Oman will not need to amend its legislation.
On an international level, if UAE and Bahrain start taxing income recorded in those jurisdictions at 15%, as long as the corporate income tax rate in the parent jurisdiction is higher, the ETR may overall be equal or lower, than in the case where the parent includes the income of the UAE/Bahraini subsidiary and taxes the income at the CIT rate of the parent, under the current circumstances. The UAE faces a double conundrum as well, in regards to the free zones and its federal structure.
Was doing nothing an option?
While the UAE and Bahrain are often heralded because of the absence of the application of corporate income tax, and their large double tax treaty network, because they were often considered a tax haven, they were subject to measures taken by other countries, therefore reducing their attractivity.
The measures taken by other jurisdictions could be:
- Monitoring payments with tax havens
- Denying participation exemption for dividends received from tax havens
- Controlled Foreign Corporations rules which include revenue recorded in tax havens in the country of the parent
- Rejection payments as deductible expenses in jurisdiction of the parent
- Imposing substance requirements on tax havens (such as those imposed under the Economic Substance Regulations)
This means that in effect today already transactions with tax havens are being targeted by other jurisdictions.
While Oman has been labeled a tax haven in the past for insufficiently exchanging information, and Saudi Arabia at some point as well for solely taxing non GCC shareholders, they undergo much less the same types of measures.
The OECD and the IF Members will further develop a more granular set of rules for Pillar Two. In the meantime, governments will start exploring policy options, and implement them over the course of 2022 and 2023.
The OECD will likely develop a new multilateral treaty to implement Pillar Two. There’s bound to be some transitional rules as well.
The adoption of Pillar One, not discussed here, and Pillar Two, are undoubtedly going to have a profound impact on the international tax landscape. Simultaneously, it will put a number of governments as well before some policy choices, which will have an important impact on a domestic level.
Businesses can already analysis what the impact will be, at a high level, or on a more detailed level, by following the detailed guidelines given by the OECD in regards to the implementation. If prior implementation of transfer pricing or substance rules provides any lessons, it is that jurisdictions often implement them wholesale in their domestic jurisdictions. Businesses can therefore anticipate now already what the impact will be. The overall design is not expected to be changed much, and therefore analysis and planning can already be conducted now.
What concrete steps could be taken are:
- Mapping the jurisdictions and the ETR under the Country by Country report which is already required to be filed by the same businesses.
- Analyse what potential policy choices the jurisdictions with a nil to low ETR may take.
- Analyse what measures are currently taken by other jurisdictions in respect of tax havens, and what impact Pillar Two might have on these transactions (i.e. identify “high risk jurisdictions”).
- Calculate the financial impact of the imposition of the Global Minimum Tax on profits in terms of the net profit after tax.