Introduction to Pillar Two
Pillar Two, also known as the global minimum tax, is an OECD initiative that, in broad terms, aims to ensure that multinational enterprises (MNEs) pay a minimum effective tax rate (ETR) of 15% on income in each jurisdiction in which they operate. Pillar Two is not just one rule but is made up of a series of interlocking rules.
The primary rule under Pillar Two, the income inclusion rule (or IIR), applies if the ETR of a group (as calculated for the purposes of the Pillar Two rules) that is in scope is below 15% in a particular jurisdiction. If so, the IIR imposes a top-up tax to ensure a minimum 15% corporation tax rate. This tax is generally charged to the ultimate parent entity or an intermediate parent entity (e.g. if the ultimate parent is not in a jurisdiction that has implemented the IIR). Jurisdictions can also implement a domestic version of the top-up tax and, provided that the domestic rules meet certain criteria, that tax is credited against IIR that would otherwise be payable in respect of that jurisdiction. As such, domestic top-up taxes effectively take priority and are likely to be important in practice.
These rules are supplemented by the undertaxed payment rule (UTPR) which applies where the parent entities are in jurisdictions where the IIR has not been implemented. This means that other companies lower down the group where the UTPR has been implemented can collect the top-up tax due, either by way of additional tax or denial of deductions. Pillar Two also includes a subject-to-tax rule, which is a treaty-based rule dealing with related party payments, but this is less likely to be relevant in a JV context.
The rules apply to groups with revenue of at least EUR750 million and the starting point is the consolidated accounts. Not all entities are in scope and entities which are excluded for most Pillar Two purposes include governmental agencies, international organisations, pension funds, and certain investment entities.
Impact of Pillar Two on JVs
At the most basic level, if the JV is subject to top up tax itself, or top-up taxes are imposed at the investor level in respect of the JV, this will clearly affect the economic profile of an investment. The compliance obligations of the JV and its investors can also be affected, sometimes significantly. The impact of Pillar Two on a JV cannot be assessed in isolation from its investors. Where the JV group is consolidated with an investor for accounting purposes, this has a number of implications, including: (i) revenues are combined in considering the EUR750m threshold; (ii) tax liabilities are determined on a jurisdictional basis across both the MNE group and the JV group (so-called “jurisdictional blending”); (iii) who is liable for the tax will depend on which jurisdictions are involved and what ownership interests the investors have; (iv) compliance obligations will be intertwined and (v) the potential for secondary liabilities of the MNE group being assessed on the JV group and vice versa.
Even where the JV group is not consolidated with an investor, if an investor holds a 50% or more interest in the JV and uses the equity method to account for its JV interest, the Pillar Two rules on joint ventures can apply. Where these specific joint venture rules apply, top-up tax liabilities are determined looking at the JV group broadly on a standalone basis with the JV company as the ultimate parent entity. These liabilities are then allocated to any investors in the JV who have interests of 50% or more, broadly in accordance with their ownership interests. The basic position is that top-up tax is collected from investors under the IIR, but if investors are not in jurisdictions that have implemented the IIR, then the UTPR may kick in. That said, there is less interdependency between the JV and its investors in this scenario, with less scope for secondary liabilities, and no aggregation of revenues or jurisdictional blending across the JV and investor groups.
Domestic top-up taxes take priority over multinational top-up taxes and this may mean that in practice top-up tax is collected at the level of the JV and borne by investors in proportion to their relative interests, with credit given for such tax under the IIR. The impact of domestic top-up taxes varies by jurisdiction, but they should generally mirror the multinational top-up tax calculations.
What are POPEs and why are they particularly problematic in a JV context?
The classification of a JV as a Partially Owned Parent Entity (POPE) raises significant issues. A POPE is a JV that is consolidated with an investor who holds less than 80% of the ownership interests in the JV. Where the JV is a POPE, the IIR charging mechanism shifts to the JV entity based on its ownership interests in the JV subsidiaries (but not in respect of the JV entity itself – this entity’s top-up tax still needs to be collected by the majority investor). This can bring in tax in relation to the portion of the JV held by the minority investor which might not have been subject to Pillar Two tax had the JV company not been a POPE. In addition, there can still be jurisdictional blending between the majority investor’s MNE group and the JV group and, if this is the case, then the position of the majority investor could potentially lower or raise the ETR for a particular jurisdiction, with knock on effects on the amount of Pillar Two tax payable in respect of JV entities.
What are we seeing in terms of JV contractual protections in relation to Pillar Two?
We are not yet seeing standard drafting for Pillar Two risks, primarily because the position is very fact-specific, and will depend on factors such as which jurisdictions are involved, which entities have low-taxed income, what ownership rights are involved and/or whether there is consolidation with an investor, not to mention more general points such as the relative bargaining position of the parties.
Whilst minority investors may seek indemnities for tax liabilities caused by low-taxed amounts in the majority investor's group, majority investors may also ask for compensation for tax benefits in the JV as a result of high-taxed entities in their group. Mutual cross-indemnities based on with-and-without calculations may be considered. Thought should be given as to who should give and receive any indemnity and how any payments under the indemnity will be taxed. Is the drafting broad enough to cover secondary liabilities? What exclusions are appropriate? The practical implications of enforcing such an indemnity should also be considered.
Ongoing information requirements
Pillar Two binds JV entities and investors in an unprecedented manner. The parties will need access to information both to comply with their own filing obligations as well as to verify the impact of Pillar Two on the JV (including for the purposes of enforcing any indemnity provisions). This may require access to sensitive data, potentially raising confidentiality and antitrust concerns. The compliance burden of Pillar Two can be onerous: who will bear the cost of collecting the requisite data and doing the necessary computations? Cooperation will be needed in terms of making (or not making) Pillar Two elections, allocation of income to JV entities, filing returns, and dealing with audits and disputes.
Importance of factoring Pillar Two in early consideration
Pillar Two can affect the financial returns from the JV, which will impact the financial modelling and may justify changes to the JV structure such as the location of holding companies. Early consideration can help avoid odd results, for instance under the UTPR, and ensure appropriate indemnities are in place where needed.
Specific considerations for U.S.-headed multinationals
There are a number of ways that the Pillar Two rules interact with U.S. tax rules that could lead to unexpected results. For instance the treatment of basis step-ups under U.S. tax rules may not be respected for Pillar Two purposes. Whilst there are exceptions provided for in the rules which may assist, their application is limited and often unclear.
Final thoughts
Pillar Two is a complicated beast. It involves new, rapidly developing legislation, across multiple jurisdictions with potentially diverging interpretations. Pillar Two’s reliance on accounting concepts and the interplay with new legal rules and evolving commentary present novel challenges. The recent U.S. elections may also have an impact on the future direction of Pillar Two globally. Early and thorough consideration of the relevant issues is essential to navigate these challenges effectively.
