The European Commission has repeatedly expressed its ambition to implement the Two-Pillar agreement in a coherent and consistent way across Member States. On December 22, 2021, a mere two days after the Inclusive Framework released its Pillar Two package, the EC proposed a Directive to implement Pillar Two for large multinational groups operating in the European Union. The Directive would implement the GloBe Model rules only, leaving Pillar One for another time.
The proposal sets out how the effective tax rate will be calculated per jurisdiction, and includes binding rules that will ensure large groups in the EU pay a 15% minimum rate in every jurisdiction in which they operate. The design elements of the Directive consist of the OECD Model rules and the -still to be released-Commentary and detailed implementation guidance. The Commission proposes that the Directive be finalized by the middle of 2022 and transposed into national law in Member States and effective on January 1 ,2023. The timetable envisaged by the Commission is ambitious and raises an issue with regard to the OECD process. Indeed the explanatory Commentary is not scheduled to be released by the OECD before January or February and the implementation guidance will not be available until then end of 2022 or even early 2023.
It remains to be seen whether the EU is overly ambitious particularly in light of the fact that the US legislation that would implement Pillar Two is delayed and uncertain.
The starting point of the draft Directive is the OECD Model Rules with some legally required adjustments to comply with EU Law (see below).
The proposed rules will apply to any large group, both domestic and international, including the financial sector, with combined financial revenues of more than €750 million a year, and with either a parent company or a subsidiary situated in an EU Member State.
Also, in line with the OECD/G20 Inclusive Framework agreement, government entities, international or non-profit organizations, pension funds or investment funds that are parent entities of a multinational group will not fall within the scope of the Directive on the OECD Pillar Two.
The effective tax rate is established per jurisdiction by dividing taxes paid by the entities in the jurisdiction by their income. If the effective tax rate for the entities in a particular jurisdiction is below the 15% minimum, then the Pillar Two rules are triggered and the group must pay a top-up tax to bring its rate up to 15%. This top-up tax, known as the ‘Income Inclusion Rule’, applies irrespective of whether the subsidiary is located in a country that has signed up to the international OECD/G20 agreement or not. In the OECD/G20 Inclusive Framework agreement, a consistent and simplified way of calculating the effective tax rate was agreed by all 137 countries involved. This is reflected in the proposed Directive. The calculations will be made by the ultimate parent entity of the group unless the group assigns another entity.
If the global minimum rate is not imposed by a non-EU country where a group entity is based, Member States will apply what is known as the ‘Undertaxed Payments Rule’. This is a backstop rule to the primary Income Inclusion Rule. It means that a Member State will effectively collect part of the top-up tax due at the level of the entire group if some jurisdictions where group entities are based tax below the minimum level and do not impose any top-up tax. The amount of top-up tax that a Member State will collect from the entities of the group in its territory is determined via a formula based on employees and assets.
The Commission proposal follows closely the international agreement with the necessary adjustments to ensure compliance with EU law. The Directive expands the scope of Pillar Two to include purely domestic groups. While Pillar Two is limited to multinational (MNE) groups, this expansion was necessary in order to comply with the EU fundamental freedoms included in the EU Treaty, specifically the freedom of establishment.
The OECD Model Rules allow jurisdictions the option to apply a qualifying domestic minimum tax. The Commission proposal will also allow EU Member States to exercise the option to apply a domestic top-up tax to low taxed domestic subsidiaries. This option will allow the top-up tax due by the subsidiaries of the multinational group to be charged locally, within the respective Member State, and not at the level of the parent entity.
Within the OECD/Inclusive Framework, the rules have been agreed under what is known as a ‘common approach’. This would mean that Inclusive Framework members are not required to adopt the rules, but if they choose to do so, they will have to implement and administer the rules in a way that is consistent with the agreed outcome under Pillar Two. This also means that Inclusive Framework members will have to accept how other members apply the rules. In practice, multinational groups with subsidiaries in countries that operate a rate below the agreed minimum rate will ultimately also have to face the consequences of Pillar Two. The rules test the effective tax rate per jurisdiction and apply a top-up tax to companies in the low-tax jurisdictions. As a result of either the Income Inclusion Rule or the Under Taxed Payments Rule, a Member State will collect the top-up tax due at the level of the entire group if some jurisdictions where entities are based impose tax below the minimum level and do not impose any domestic top-up tax. In other words, failing to apply the Pillar Two rules will not protect jurisdictions from effectively being subject to tax at least at the agreed minimum rate.
The fundamentals of the Model Rules are therefore taken over by the Directive. However, the OECD Model Rules leave open technical questions such as the clarification of “Excluded entity,” substantially”, “mainly owned”. Those questions, among others, will most likely be addressed in the draft Commentary and will be discussed during the public consultation planned by the OECD in February. The OECD Implementation Framework (including administrative procedures, Safe Harbours and conditions for US GILTI co-existence) is not expected before the end of the year.
In the light of the timetable, there is today no guarantee that the ongoing OECD work and the EU Directive (and the Member States laws…) will be fully converging.
Member States will need to unanimously agree the Directive in Council. The European Parliament and European Economic and Social Committee will also need to be consulted and give their opinion. EU members of the OECD Inclusive Framework are already supporting the global agreement that the Commission proposal is implementing. The only EU Member State that is not a member of the Inclusive Framework, and as such has not formally committed to the agreement, is Cyprus. The Commission expects Cyprus to support the Directive. Moreover, given that the US legislation that would implement Pillar Two, the “Build Back Better Act”, has stalled in Congress, it remains to be seen whether one or more Member States will use the delay in US legislation to delay approval of the Directive. The EC made a quick exit from the starting gate. Time will tell whether the rest of the world will keep up the pace.