The reforms reflect the outcome of an ambitious effort to develop a co-ordinated global response to difficulties caused by increasing digitalisation of the economy. Although there have been many moments at which it seemed that the painstaking process might never come to fruition, consensus (at least in principle) was ultimately reached in October 2021, and the first tranche of changes have effect for accounting periods beginning on or after 31 December 2023. Implementation is at an advanced stage in many jurisdictions, including the UK and a number of EU member states.
The structure and scope of the new rules are complex, and it has not been an easy task to come to terms with their detail; this has been exacerbated by the continuing development and refinement of the rules, as well as differences in their interpretation and application across different jurisdictions. However, the Pillar Two rules can no longer be considered a niche topic, and its principles and themes are becoming common parlance. Application of the rules to real world transactions and to various markets and sectors is the next challenge.
This article looks at the emerging application of the new rules to structured finance transactions.
Overview of Pillar Two
First, a quick recap on the Pillar Two rules.
Broadly, the principle of Pillar Two is that multinationals of a certain size must pay a minimum effective corporation tax rate of 15% in all jurisdictions in which they operate. This principle is relatively straightforward, but the mechanics under which it is given effect are more complex. The primary mechanism is an income inclusion rule. It is supported by an undertaxed profits rule (UTPR) and a subject to tax rule (STTR). Jurisdictions are expressly permitted to implement a qualified domestic minimum top-up tax (QDMTT or domestic top-up tax) which effectively allows the jurisdiction to impose its own income inclusion rule, and for this to be fully creditable against tax otherwise chargeable elsewhere.
The detail is set out in OECD Model Rules published in December 2021, supplemented by Commentary and Agreed Administrative Guidance. In the EU, a Directive was adopted in December 2022 and in the UK the rules are given effect by the Finance (No.2) Act 2023, as amended.
Key points on scope and application:
- The rules apply to multinational groups with annual consolidated revenues exceeding EUR750 million, based on financial accounts.
- Each jurisdiction must implement its own domestic provisions if the rules are to apply in that jurisdiction. EU member states must implement provisions in accordance with Directive 2022/2523.
- Exclusions and safe harbours apply.
- Where a group is within scope, an effective tax rate (ETR) must be determined for each jurisdiction in which the MNE operates. If the ETR is under 15% a top-up tax will apply. The starting point is that the ultimate parent entity pays the tax under the income inclusion rule, but this may be displaced by a domestic top-up tax. If any under-taxed profits are not caught by an income inclusion rule or a domestic top-up tax, then other group companies may instead be liable for the tax by way of the undertaxed profits rule.
- Companies can be secondarily liable for the unpaid top-up tax of other members of the same group.
- The income inclusion rule has effect for accounting periods beginning on or after 31 December 2023.
- The undertaxed profits rule has effect for accounting periods beginning on or after 31 December 2024.
For further detail on the development and implementation of Pillar Two rules by the OECD and its implementation by the UK, EU member states and other jurisdictions, see 20 Questions on Pillar Two and the GloBE rules and OECD Pillar Talk.
Structured finance: Pillar Two on the ground
Structured finance transactions typically involve special purpose vehicles (SPVs) and can encompass a very wide range of transaction types and products, ranging from vanilla debt re-packagings, to all different types of securitizations, issue of credit-linked notes, certain covered bonds, sukuk and other complex financing arrangements. We do not propose to provide an in-depth analysis of each of these products. However, some emerging themes can be identified, although their development across various markets is not uniform, and certain markets are further along than others in reaching a relatively stable position. These Pillar Two issues are also emerging at a time when a plethora of other issues, including high inflation, economic uncertainty and global instability, make questions of affordability and funding cost a critical issue.
Scope and the question of consolidation
As stated above, the rules apply to multinational groups with annual consolidated revenues exceeding EUR750 million, based on financial accounts. From the perspective of structured finance transactions, the question of whether the relevant SPV is consolidated with another transaction party (and its group) is key. If the SPV is not so consolidated, it is much less likely to meet the threshold and fall within scope. Consolidation is an accounting issue and cannot be equated with legal or beneficial ownership. For example, an SPV may be set up as an “orphan”1 entity, but the relevant transaction party group’s control over the finance arrangement involving that SPV may require consolidation for accounting purposes. Further, the question of consolidation of the SPV must be considered not only by reference to the relevant transaction parties on the sell-side of the structured finance transaction, but also on the buy-side by the potential purchasers of securities (ie lenders/investors in a structured finance transaction) and this must be considered both at the outset and further down the line.
The question of consolidation is therefore likely to be the most important issue and should be dealt with at the outset – will any relevant transaction party on the sell- or buy-side be required to include the SPV in its consolidated accounts? If not, Pillar Two is generally less likely to be an issue.
In this context, note that there is a difference between, on the one hand, a situation where a relevant sell-side transaction party, such as the originator or sponsor, transfers assets to the vehicle but keeps the assets on balance sheet because of a failure to meet the derecognition criteria of IFRS 9 and, on the other, a situation where an investor/lender consolidates the SPV because it has control. It may only be the latter case that produces unexpected Pillar Two liabilities.
Secondary liabilities
In the event that there is a top-up tax to pay, the primary allocation under the income inclusion rule will usually be to the ultimate parent entity. However, this is not always the case and other entities in the group may have primary Pillar Two liabilities. Further, an SPV may become subject to secondary Pillar Two liabilities relating to tax due from other members of the consolidated group under joint and several liability provisions. This unappealing uncertainty is compounded by the fact that different jurisdictions may have different approaches to visiting primary fiscal liabilities on other members of a multinational group.
Calculating the Effective Tax Rate: the surprise low-tax jurisdiction
A liability to top-up tax occurs when the group’s ETR in a jurisdiction is less than 15%. The starting point for calculating the ETR is the entries in the consolidated accounts, which are then subjected to certain additions and deductions prescribed by the Model Rules and guidance. Thus it is entirely possible, if not likely, that a group in a country with a headline tax rate over 15% could still find it has an ETR below 15% for Pillar Two purposes. The rules are complex and there is the potential for inconsistent application in different jurisdictions.
Specific issues for structured finance
In the context of structured finance transactions, there are certain specific issues to deal with, including:
Accounting volatility
Intuitively one might expect that SPVs would not earn a material profit – they often only retain a nominal cash profit each year of, say, EUR1,000 and pay tax at 20% to 25% of that cash profit. However, it is not uncommon to find they have interest-rate or cross-currency swaps that are measured at fair-value through profit and loss – thereby resulting in a volatile and unpredictable accounting profit year by year. It is this accounting profit which is the starting point for assessing whether there are under-taxed profits, even if tax is charged on the cash profit.
The arm’s length requirement
Arrangements between the SPV and other members of the same accounting consolidation must be on arm’s length terms – so for example, if the holder of the most junior tranche of securities (such as a subordinated note, profit participating note or residual certificate) consolidates the SPV then the security will need to be tested to ensure it is on arm’s length terms.
Bankruptcy remoteness
Structured finance transactions are commonly undertaken on a limited recourse basis with SPVs set up as bankruptcy-remote entities – and so any unexpected tax claim by a tax authority will be problematic. In many cases, the Pillar Two top-up tax will be imposed against the parent of the consolidated group under the income inclusion rule – potentially a problem for the parent but not necessarily for the SPV or for investors/lenders in a structured finance transaction.
However, for jurisdictions that impose a domestic top-up tax the problem would prima facie fall squarely on the shoulders of the SPV.
Corporate hybrids and Regulatory capital
There are two features of corporate hybrid and regulatory capital that may be problematic under Pillar Two.
The first is that they are often accounted for as equity instruments but in a number of jurisdictions treated as debt for tax purposes. This means that the issuer claims a tax deduction for interest which is not treated as an expense in the profit and loss account – and this difference between tax and accounting could trigger a Pillar Two top-up tax charge.
The Model Rules (at 3.2.10) provide that such amounts paid in respect of Additional Tier One (AT1) capital can be taken into account as an expense for Pillar Two purposes. Administrative Guidance subsequently issued by the OECD in February 2023 confirms that this treatment is extended to Restricted Tier One (RT1) capital issued in a similar context by insurance companies. However, this beneficial treatment does not extend to the unregulated sectors.
The second is that such instruments are often “written-down” (that is, released) in times of stress. This gives rise to an accounting profit, but one which is not often subject to tax. Again, this difference between tax and accounting could trigger a Pillar Two top-up tax charge. Although the OECD’s February 2023 guidance provided some relief, this is limited.
To address some of these risks in the UK, which has a well-established securitization industry and bespoke tax regime for securitization SPVs, the government recently published draft legislation to ensure that certain vehicles used in securitization transactions will be treated as excluded entities for domestic top-up purposes, and not part of the group for domestic top-up tax purposes (other than in calculating whether the group is over the revenue threshold) notwithstanding that they may be included in consolidated accounts. This ensures that the domestic top-up tax will not compromise the bankruptcy-remote status of securitization SPVs, and the announcement has been widely well-received. The recent draft legislation also provides that SPVs in UK covered bond structures (i.e. UK LLP cover pool owner/guarantor) will not be liable to domestic top-up tax provided that the group includes another UK entity that is not such an SPV.
Risk factors
In the context of listed structured finance transactions, there is the additional question of whether any potential Pillar Two liability should be disclosed as a risk factor in the prospectus or other offer document issued to potential investors.
Risk factor disclosure considerations will need to be assessed on a case-by-case basis having regard to the applicable listing and disclosure rules of the relevant trading venue where the structured finance transaction is seeking listing or admission to trading. In general, it will be a test of materiality (having regard to the probability of occurrence and the expected magnitude of any negative impact of any potential Pillar Two liability), and whether such disclosure is necessary information that the prospective investor would need to take into account in order to make an informed assessment of the investment. Therefore, it is for the relevant issuer to assess the materiality of any such risk factors.
Cost of compliance
Quite aside from the additional financial burden caused by a tax liability under Pillar Two, the cost of compliance must also be considered. The administrative and compliance burdens required to determine the application of the rules are hefty – even where no tax is ultimate payable. The volume of data required to run the calculations and develop a strategy is considerable and in some circumstances the data required may not be required for any other purpose. As a result, even sophisticated existing systems may be inadequate and new (and expensive) systems must be developed. Further, the data may not be readily available. Historically, accounting standards have not always required MNEs to collect data on a jurisdiction-by-jurisdiction basis. Commercial relationships may also necessitate the ongoing sharing of sensitive data – something that not all multinational groups are comfortable with, and which will require careful and nuanced documentation. This is a particular issue for SPVs in limited recourse structured finance transactions that simply will not have the cash resources to deal with this.
Can conclusions be made at this time?
The implementation of Pillar Two represents a remarkable and historic attempt to reform the international tax landscape. However, it necessitates the introduction of a complex and novel set of rules into a wide variety of transactions and markets, as well as across very different tax systems.
Perhaps the only thing that can be concluded at this stage is that this is a work in progress and, except in relation to very discrete issues, it is too early to draw conclusions. Whilst business and its tax advisers (and for that matter, tax authorities) have come a long way in digesting the detail and giving the rules effect, it is fair to say that work relating to the fair allocation of Pillar Two risk and its reflection in key documentation will continue for some time.
Footnote
1. For example, for the purposes of certain tests, including, if applicable, rating agency structured finance criteria, a securitization SPV will be set up without a corporate connection to the group of the relevant originator or sponsor in order to reinforce the ring-fencing of the relevant assets under the transaction structure and to restrict the relevant SPV’s possible exposure to unexpected liabilities.