Pillar 2 of the two-pillar solution to international tax reform
On October 8, 2021, 136 out of the 140 countries of the OECD/G20 Inclusive Framework (“IF”) on Base Erosion and Profit Shifting (“BEPS”) announced that they have agreed to the two-pillar solution to international tax reform.
Within the scope of this article, we only focus on analyzing Pillar 2. To learn more about Pillar 1, please refer to our previous article at the following link: https://www.lexology.com/library/detail.aspx?g=ccb774d3-5ecd-4c5f-a69f-051bed43e19c
To assist in the implementation of Pillar 2, on December 20, 2021, the OECD published the Pillar Two model rules, which define the scope and set out the mechanism for the so-called Global Anti-Base Erosion (“GloBE”) rules under Pillar 2, which will introduce a global minimum corporate tax rate set at 15%. The minimum tax will apply to Multinational Enterprises (“MNEs”) with revenue above EUR 750 million.
What are GloBE rules?
The GloBE rules are designed to ensure MNEs pay the minimum level of tax on income arising in each of the jurisdictions in which they operate. The rules create a “top-up tax” to be applied on profits in any jurisdiction whenever the effective tax rate (“ETR”), determined on a jurisdictional basis, is below the minimum 15% rate.
The GloBE rules consist of two interlocking domestic rules, which are:
1) The Income Inclusion Rule (“IIR”): This rule imposes a top-up tax on a parent entity in respect of the low-taxed income of a constituent entity (“CE”); and
2) The Undertaxed Payment Rule (“UTPR”): This rule denies deductions or requires an equivalent adjustment to the extent the low tax income of a CE is not subject to tax under an IIR.
The GloBE rules will have the status of a common approach. This means that IF members are not required to adopt the GloBE rules, but they must accept the application of the GloBE rules by other IF members. IF members that choose to adopt the rules must administer them in a way that is consistent with the outcomes provided for under Pillar 2.
What are the main contents of the Pillar 2 model rules?
The model rules are organized into 10 chapters that deal with the scope of the rules, the general charging provisions, the rules for calculating the income (or loss) on a jurisdictional basis, the rules that determine the tax attributable to such income, the computational rules for determining the ETR of jurisdictions in which the MNE operates and for determining the top-up tax for a low-tax jurisdiction, etc.
The model rules also address the treatment of acquisitions and disposals of group members and include specific rules to deal with particular holding structures and tax neutrality regimes.
Finally, the rules address administrative aspects, including information filing requirements, and provide for transitional rules for MNEs that become subject to the global minimum tax.
However, the model rules were designed to accommodate a broad range of tax systems and business structures, therefore many of the specific provisions may not apply to all jurisdictions or in-scope MNEs.
What is the scope of application of the GloBE rules?
Regarding the scope of application, the rules apply to CEs that are members of an MNE group with annual revenue of EUR 750 million or more in the Consolidated Financial Statements of the Ultimate Parent Entity (“UPE”) in at least 2 of the 4 years immediately preceding the test year. Government entities, international organizations, non-profit organisations, pension funds or investment funds that are UPEs of an MNE group are excluded entities that are not subject to the GloBE rules, but this exclusion does not affect the MNE Group owned by such entities, which will remain in the scope of the GloBE rules if the group as a whole otherwise meets the consolidated revenue threshold.
An MNE group refers to a group that is generally consolidated for financial accounting purposes that include at least one entity or a permanent establishment that is not located in the jurisdiction of the UPE. An entity can be an MNE group if it has one or more permanent establishments in other jurisdictions and is not part of another MNE group.
A CE refers to any entity within an MNE group or a permanent establishment of an entity within an MNE group. Permanent establishments are treated as separate entities for the purposes of the GloBE rules, such that a company with 2 permanent establishments would be treated as 3 separate CEs.
How to determine an MNE’s top-up tax liability?
Regarding the mechanism to determine an MNE’s top-up tax liability, the model rules establish a five-step process:
1) Step 1 – CEs within the scope: Identify MNE groups within the scope and the location of each CE within the group.
2) Step 2 – GloBE Income or Loss: Determine the income of each CE.
3) Step 3 – Covered taxes: Determine the pre-GloBE taxes attributable to the income of a CE.
4) Step 4 – ETR and top-up tax: Calculate the ETR of all CEs located in the same jurisdiction and determine resulting the top-up tax.
The amount of covered taxes calculated in Step 3 is divided by the GloBE income calculated in Step 2 to determine the ETR for each jurisdiction. Each entity considered stateless is treated as a single CE located in a separate jurisdiction.
When the ETR is below the minimum 15% rate, the top-up tax percentage for the jurisdiction must be calculated. This is computed by subtracting the ETR from the minimum rate (e.g., if the ETR is 10%, the top-up tax percentage is equal to 15% – 10% = 5%).
The top-up tax percentage is applied to the GloBE income for the jurisdiction after accounting for the substance-based income exclusion. This amount of top-up tax is then reduced by any qualifying domestic minimum tax.
A de minimis exclusion will apply to deem top-up tax as nil where the average revenue and profit for a jurisdiction for the current and 2 preceding years are less than EUR 10 million and EUR 1 million respectively.
5) Step 5 – IIR and UTPR: Impose top-up tax under IIR or UTPR in accordance with the agreed rule order.
The top-up tax is first imposed under the IIR on a parent entity with an ownership interest in the low-taxed CE.
- If any residual amount of top-up tax remains unallocated after the IIR applies, the UTPR allocation mechanism shall come into play.
How will Pillar 2 affect Vietnam?
The application of Pillar 2 is expected to bring many opportunities, but at the same time, it also contains many challenges for Vietnam.
First and foremost, Vietnam’s competitiveness in attracting foreign investors may be affected by this new tax policy. In fact, Vietnam attracts foreign investment mainly through the application of preferential tax rates, exemption and reduction of corporate income tax (“CIT”).
When Pillar 2 is applied, MNEs enjoying tax incentives with ETR lower than 15% in Vietnam will be subject to top-up tax in the country where their head office is located. That reduces the effect of tax incentives that their CEs have or will enjoy in Vietnam, leading to the risk of a decrease in the quantity and also the quality of foreign investors investing in Vietnam.
From a macro perspective, this could have an impact on the country’s industrial development goals, as well as the growth of Vietnam’s exports and foreign exchange reserves.
In addition, applying Pillar 2 will lead to Vietnam having to amend its legal system on CIT, which is already quite complicated. This amendment is not only limited to the Law on CIT, but the Law on Investment and its guiding documents also need to be revised accordingly.
What does Vietnam need to do to adapt to the new context?
In order to adapt to the effects that Pillar 2 can bring to Vietnam, especially in the context that countries are speeding up to apply the new global tax policy, Vietnam needs to quickly implement the following tasks to ensure that it keeps pace with the general trend of the world:
Firstly, research to amend the current regulations related to CIT, specifically:
The Ministry of Finance and the Ministry of Planning and Investment need to quickly review the Vietnamese legal system on CIT, assess the specific impact of Pillar 2 on the system of regulations and on the effectiveness of foreign investment in Vietnam, thereby proposing appropriate plans to amend the legal system and supplement policies to ensure foreign investment. Such agencies need to be able to answer the question of whether Vietnam should impose this tax rate, if so, what is the roadmap for applying it, and how to organize the implementation to ensure feasibility, and efficiency and at the same time limit possible disputes.
In addition, the tax authorities also need to review tax policies to submit proposals for amendments to the regulations and tax declaration process in accordance with the BEPS action standards for issuance of amended policies as soon as possible before Pillar 2 comes into effect, and at the same time need to have communication plans on these new policies and set up training sessions for officers and enterprises to grasp and properly implement the newly revised regulations.
Second, Vietnam needs to consider learning from the experiences of developed countries in the world and in the region to limit the negative impacts of new policies on the economy of Vietnam. Although the impact of the new global tax policy on foreign investment in Vietnam is undeniable, it must be remembered that tax incentives are not only Vietnam’s tool to attract foreign investment, but this is also a tool of many other countries in the world and not to mention tax havens. Instead of targeting tax incentives, Vietnam can change its investment attraction policy towards focusing on improving competitiveness from factors such as business environment, labor resources, infrastructure, etc. which are the basic factors when making business investment decisions. On the positive side, this will be an opportunity for Vietnam to build and develop a more comprehensive business environment, instead of just focusing on tax incentives to attract foreign investment.