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.
In May 2020, the KSA announced an increase in the standard VAT rate from 5% to 15% effective from 1 July 2020. Transitional rules for supplies spanning the date of the VAT rate change (1 July 2020) were introduced. In brief, these transitional rules state that if you entered into a contract prior to 11 May 2020 for supplies to be made after 1 July 2020, the 5% rate would still apply until the end of the contract, the contract renewal date or 30 June 2021 (whichever occurs first), if the customer is entitled to recover the VAT charged by the supplier in full, or if the customer was a government entity.
These transitional rules were optional, and even if the conditions were met, you could choose to apply VAT at 15% from 1 July 2020. B2C supplies were simply immediately subject to 15% VAT, as were imports of goods.
Meanwhile, the other GCC countries which implemented VAT, i.e. the UAE, Bahrain and Oman continue to apply 5% and have no plans currently to increase the VAT rate. The average VAT rate applied in the EU is approximately 21%. KSA therefore still has a relatively reasonable rate.
End of transitional period
Businesses currently applying the transitional regime, will no longer be able to avail it, and need to be mindful to apply 15% VAT for supplies rendered as from 1 July 2021.
You may still be making supplies under a contract entered into prior to 11 May 2020, where this contract has continued and was not subject to renewal, i.e. there was no cessation or renewal of the contract to trigger the end of the application of the 5% rate. In this case, where you are still charging VAT at 5%, this must end on 30 June 2021. For goods or services supplied before 30 June 2021 the 5% rate can still apply, however for all supplies made from 1 July 2021 the VAT rate of 15% must apply.
Action to be taken
Where business are currently still applying 5%, this will need to be increased as of 1 July 2021. The boxes in the VAT return where 5% output or input needs to be reported, may remain for some time. Tax payers may need to issue credit notes for initial supplies subject to 5%, and the recovery of input VAT can be done during a period of 5 years.
For businesses that had been availing the transitional regime, the cash flow impact will be significant. Caution needs to be taken as well as to expense invoices, as invoices with the wrong VAT rate will not be claimable.
Where do we go next
The Crown Prince of KSA, H.E. Mohammed Bin Salman (“MBS”), announced recently that the 15% VAT rate is a temporary measure that may last only for the coming 5 years. Increasing the VAT rate was necessary to help the ambitious government toward realizing its KSA 2030 vision.
MBS stated that the rate will reduce to a rate of 10% or even 5%. Undoubtedly, there will be new transitional provisions then.
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Since the inception of VAT in the UAE in January 2018, the Federal Tax Authority (FTA) had put in place a strict penalty regime. It was much stricter than its neighbour Saudi Arabia, which implemented VAT at the same time. In terms of the types of penalties, it was not the harshest, since both Bahrain and Oman later imposed prison sentences for what are often considered administrative oversights.
The tax authorities were also very active from the start in 2018, mostly imposing automatic penalties, as our survey back then showed (https://aurifer.tax/news/vat-survey-shows-fta-is-very-active/?lid=482&p=14). However, the authorities also imposed their so-called 2-4-1 penalties for late payment, which were the most impactful. A business making a mistake and being audited would be subject to a fixed penalty of up to AED 5,000, but also a penalty of up to 356% of the unpaid tax. The predicted pushback in terms of litigation followed, as scores of tax payers challenged penalties, on whatever basis they could find. The litigation was potentially mainly in the interest of litigators.
The Federal Cabinet listened to the concerns of tax payers, and now decided to act and to reduce the penalties, but also propose a penalty amnesty for penalties applied under the old regime. Cabinet Decision No. 49 of 2021 amends provisions of the Cabinet Decision on Penalties (No. 40 of 2017) and enters into effect 60 days after the issuance, i.e. 28 June 2021.
In most circumstances, the new regime will be more beneficial. It should be noted as well, that there is still an FTA Decision to be expected to implement the changes.
First off the FTA would like to give all tax payers a clean slate. Tax payers having outstanding penalties under the old regime, i.e. imposed on 27 June 2021 or before, can benefit from a 70% waiver, provided they settle the penalties on or before 31 December 2021. This is surely to add substantial cash to the Federal budget.
What is currently not clear, and might be in the announced FTA Decision, is how to handle penalties against which tax payers have filed a reconsideration, have gone before the Tax Disputes Resolution Committee (“TDRC”), or have gone before the administrative courts. Insofar as we know, the FTA has not been open to negotiated settlements for these types of litigation, but perhaps this is an opportunity for tax payers and the FTA to agree on a settlement, even if they are already before court.
As a comparison, KSA until recently was offering a full waiver of all penalties for voluntary disclosures. The Cabinet has not opted for the same approach, though it offers a partial amnesty.
New penalty regime
What’s new in the new penalty regime then? A number of fixed penalties have been lowered (e.g. late registration, late deregistration, filing incorrect tax return, …). However, the paradigm shift came in the late payment penalties.
Where before, a tax payer was subject to the 2-4-1 penalties, i.e. 2% for paying one day late, 4% for paying a week late and 1% per day after one month, the monthly penalty is now only 4% (in addition to the 2% penalty which remains).
However, and this is probably the most fundamental change, in case of a voluntary disclosure or a tax assessment, the late payment penalty only starts to run as from 20 business days after the date of submission of the voluntary disclosure or receipt of the assessment. While this position was advocated before the UAE Federal Court of Cassation, the highest court had ruled that the FTA was correct in applying a penalty since the time of supply (UAE Court of Cassation 14 October 2020, Appeal No. 227 of 2020). The Federal Cabinet now decided that it is the right approach to start calculating late payment penalties after the submission of the voluntary disclosure, and not as of the initial supply.
In other words, under the new penalty regime, if the tax payer pays within 20 days, there is no late payment penalty due.
That does not mean he is completely off the hook as a proportional penalty is due ranging from 5 to 40% calculated on the difference between the tax calculated and the tax that should have been calculated. The range depends on the period elapsed between the error and the date on which the voluntary disclosure was submitted.
There is a substantial difference in the calculation of the penalty. Where the previously law had ambiguity around what constituted “payable tax”, the new regime is clear that any situation will be penalized where there is a difference between the tax calculated, and the tax that should have been calculated. Especially for tax payers in a constant refund position, this may constitute a higher penalty bill.
In order to compare the effect of the amendments in the regime, let us have a look at a few examples.
Example 1 - Supply in January 2018
Company A in January 2018 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company A comes to this conclusion on 15 June 2021. Company A has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company A is subject to a penalty for submitting an incorrect tax return.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 4,500.00
Late Payment Penalties AED 45,600.00 AED 0.00
Total AED 49,350.00 AED 5,500.00
It is clear that Company A has a real benefit in waiting for the new regime to be in force. However, as illustrated below, because of the dynamics triggered by the tax amnesty, depending on when the mistake is made, business may need to try and have the penalties imposed before or on 27 June 2021.
Example 2 - Supply in January 2021
Company B in April 2021 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company B comes to this conclusion on 15 June 2021. Company B has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company B is subject to a penalty for submitting an incorrect tax return.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 750.00
Late Payment Penalties AED 900.00 AED 0.00
Total AED 4,650.00 AED 1,750.00
Waiver AED 3,255.00 N/A
Net AED 1,395.00 AED 1,750.00
Company B has an incentive to voluntary disclose the transaction before the new regime enters into force so that the penalties are imposed under the old regime.
Example 3 - Supply in January 2021
Company C in January 2021 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company C comes to this conclusion on 15 June 2021. Company C has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company C is subject to a penalty for submitting an incorrect tax return. Company C is in a constant refund position, and even after correcting the January 2021 supply, it remains in a refund position.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 750.00
Late Payment Penalties AED 0.00 AED 0.00
Total AED 3,750.00 AED 1,750.00
Waiver AED 2,625.00 N/A
Net AED 1,125.00 AED 1,750.00
Company C has an incentive to voluntary disclose the transaction before the new regime enters into force. Note that we have observed here that the FTA had not applied penalties under the old regime for these kinds of mistakes. However, we would have expected it to treat an over claimed amount in the same way as an underpaid amount.
Example 4 - Failure to register
Company D in January 2021 made supplies worth AED 400,000 but failed to register for VAT purposes. On 15 June 2021 it discovers it had to register for VAT purposes already back in January 2021.
Old regime New regime
Fixed Penalties AED 20,000.00 AED 10,000.00
Waiver AED 14,000.00 N/A
Net AED 6,000.00 AED 10,000.00
Company D has an incentive to make use of the old regime to register for VAT purposes, before the new regime enters into force.
Audit and enforcement
When we conducted our survey back in 2018, we saw a very active FTA. With the additional resources it has gained over the years, it has conducted a great number of additional audits. Especially refund audits have been very prevalent. More regular audits have happened as well, although these often focused on entertainment expenses and non-compliant invoices. In 2023, transactions conducted in 2018 will be statute barred, so we may see additional activity by the FTA to ensure compliance before that date.
Tax payers have consciously being disclosing non compliant transactions and reporting under the old regime, and were hit with penalties, which then often spilled over into litigation.
Once the liabilities are final, or the court case ruled, the file would eventually end up in enforcement. The advantage the FTA had in litigation is the application of the “pay and claim” principle. If the tax payer lost the case, the litigious amount was already paid.
In situations where there was no Tax Disputes Resolution Committee litigation, the liabilities sometimes remained outstanding (with no additional penalty being added), or for businesses in a refund position, the refund was compensated bit by bit by the penalty amount.
Since 2018, the FTA did take a number of steps to encourage compliance and try and move tax payers towards settling their liabilities.
It had for example suspended the application of the automatic reverse charge mechanism for businesses with a customs number and a VAT number which were linked. The only impact of this decision was negative cash flow.
In addition, in early 2021, the UAE appointed judicial officers which have the powers to seize assets. This was seen as a step up in terms of the enforcement in the UAE.
Rather than stepping up enforcement under its tax procedures law (see our article on the FTP law (https://www.aurifer.tax/news/the-uae-publishes-more-detail/?lid=482&p=19) and on the FTP law lacking director’s liability (https://www.aurifer.tax/news/dawn-of-a-new-tax-era--corporate-perspectives/?lid=482&p=14), the UAE has chosen to make it easier to correct mistakes.
It has taken a substantial turn with the newly implemented policy, which will surely have a very beneficial impact on the tax compliance climate in the UAE. While the penalties are still there as a deterrent, there is now a real motivation in most cases to voluntary disclose and to build a more horizontal and transparent relation with the FTA. The move is without doubt a benefit to businesses, in terms of reduced penalties applied for errors made, and a benefit to the FTA, in terms of increased compliance and perhaps additional revenues from this increased compliance and the amnesty.