In this publication, our experts explore the effective tax rate (ETR) considerations for indirect investments held by institutional investors under Pillar 2. Indirect investments can include private equity, real estate and infrastructure fund investments, as well as club deals and joint ventures. Such investments are typically reported under IFRS as either (1) “financial assets” or as (2) “associates and joint ventures”. This publication focuses on financial assets.
 
The considerations in this publication are based on the OECD’s Pillar 2 Model Rules and Transitional CbCR Safe Harbour. This publication is relevant for investors that are in scope of Pillar 2, which typically concerns insurance companies, but can also include sovereign wealth funds, pension funds, REITs and investment funds that are not fully carved-out.
 
The EU is implementing Pillar 2 effective 1 January 2024. Other jurisdictions are expected to follow.

1.    BASICS FIRST

Before digging into the specifics for financial assets, let’s recap the basics of the Pillar 2 Model Rules, Qualifying Domestic Minimum Top-up Taxes and Transitional CbCR Safe Harbour.

1.1    GloBE Rules

The OECD’s Pillar 2 Model Rules - also referred to as the Anti Global Base Erosion Rules (GloBE Rules) - are in essence a system of top-up taxes to ensure that multinational enterprises (MNEs) pay at least 15% tax in the jurisdictions where their ETR is lower. An overview of the GloBE Rules is included in our publication ‘Pillar 2: REITs and Real Estate Funds’.

1.2    Qualifying Domestic Minimum Top-up Tax

Most jurisdictions will be implementing Qualifying Domestic Minimum Top-up Taxes (QDMTTs) to safeguard against any top-up tax being levied by another jurisdiction under the charging mechanisms included in the GloBE Rules. This means that a cross-check against domestic implementations of Pillar 2 is becoming increasingly relevant. QDMTTs are allowed to have variations in design compared to the standard GloBE Rules as long as the incremental tax liability is at least the same. To ensure that QDMTTs meet this requirement, we’re seeing jurisdictions generally applying the same computation mechanics as the GloBE Rules.

1.3    CbCR Safe Harbour

The OECD’s Transitional CbCR Safe Harbour is a temporary measure for fiscal years ending before 1 January 2027 aimed at excluding MNEs from the scope of the GloBE Rules in lower-risk jurisdictions. Under the CbCR Safe Harbour, the top-up tax in a jurisdiction will be deemed zero - removing the need for more detailed computations under the general GloBE Rules - when at least one of the following tests is met:

• De minimis test: The revenue of the MNE in a jurisdiction is lower than EUR 10 million and the profit before tax is lower than EUR 1 million. This assessment needs to be based on the MNE’s (qualifying) CbCR.
• Routine profits test: The MNE reports a loss in its (qualifying) CbCR or a profit that does not exceed the so-called substance-based income carve-out based on the GloBE Rules. This carve-out is calculated as a mark-up percentage on eligible payroll costs and tangible assets.
• Simplified ETR test: The MNE has a jurisdictional ETR of at least 15 percent in fiscal year 2024, 16 percent in 2025 and 17 percent in 2026. The simplified ETR needs to be calculated using the profit (or loss) before tax as included in its (qualifying) CbCR and the income tax expense reflected in the (qualifying) financial statements of the entities in that jurisdiction.

The CbCR Safe Harbour is tested based on simplified jurisdictional revenue, income and tax data included in an MNE’s (qualifying) CbCR and financial accounts. The CbCR Safe Harbour also contains specific rules to address differences and maintain a level of alignment with the GloBE Rules.

2.    FINANCIAL ASSETS

The Pillar 2 considerations in this section are based on indirect investments that are not consolidated under IFRS, but reported as financial assets. Such investments typically concern fund investments in which an investor, roughly speaking, holds a stake of less than 20%. In case an investor’s stake is 20% or more, the IFRS classification typically shifts to “associate” which will be discussed in the second part of this Pillar 2 series that focuses on indirect investments.

2.1    IFRS and Financial Assets

Under IFRS, financial assets that are not subject to significant influence or control are typically reported at fair value. Fund investments that qualify as such are then revalued at the end of each reporting period whereby changes in fair value, although unrealised, are reported in the profit and loss. Upon disposal, a gain (or loss) is recognised broadly equal to the difference between the sales proceeds and the carrying fair value. Distributions received from a fund investment are reported in the profit and loss.

It is required to recognise a deferred tax asset (DTA) or liability (DTL) for temporary differences between the tax and IFRS carrying value (if any). Temporary differences can, for example, exist when the fund investment is valued at cost for tax purposes. When a future gain (or loss) is tax-exempt, this does not constitute a temporary difference and therefore should not lead to the recognition of a DTA or DTL.

2.2    GloBE Rules, QDMTT and Financial Assets

The GloBE ETR is in principle calculated on a jurisdictional basis by dividing the GloBE taxes by the GloBE income of the entities in that particular jurisdiction. The starting point for determining the GloBe income is the IFRS statement of profit or loss, which would include the net income and (un)realised gains or losses derived from fund investments. The starting point for computing the GloBE taxes is the current tax expense reported under IFRS, which includes any deferred taxes. These mechanics would also apply for QDMTTs.

To arrive at the final GloBE income and GloBE taxes, there are various exclusions, adjustments and ring-fencing rules to consider: 

• Excluded dividends: Distributions derived from fund investments and taxes due on such distributions are excluded from the GloBE income and GloBE taxes, unless received from a short-term portfolio shareholding. The qualification of a fund investment as a short-term portfolio shareholding should be tested at the date of each distribution. It applies when an interest of less than 10% is held and such interest is held for less than one year.
• Excluded gains or losses: Gains (or losses) derived from fund investments and taxes due thereon are excluded from the GloBE income and GloBE taxes when arising from changes in fair value or as a result of a disposal provided an interest of at least 10% is held.
• DTL recast: DTLs for latent gains on fund investments should in principle be recast at the GloBE minimum tax rate of 15%. This rule exists to prevent deferred tax amounts from sheltering unrelated GloBE income.
• Recapture exceptions: A recapture exists for certain amounts claimed as DTLs that are not paid within five years. An exception exists for DTLs that relate to unrealised gains resulting from fair value accounting.
• Realization election: An election is available to disregard fair value and connected DTL movements related to fund investments from the GloBE income and GloBE taxes by applying the so-called realization method. Under this election, gains (or losses) are only recognized when the fund investment is disposed. Such election applies to all assets and liabilities in the jurisdiction to which the election applies.
• Capital gains spread election: Another election is available that allows a disposal gain to be spread out over the election year (generally the year of the disposal) and the prior four fiscal years, which then requires a recalculation of the ETRs and any top-up taxes.
• DTA recast: DTAs should be recast to 15% if the DTA is recorded at a lower rate and relates to a GloBE loss. This rule exists to ensure that a loss of 100 shelters 100 of income under the GloBE Rules. It is allowed to make an election for a simplified approach whereby the DTA is calculated at 15% of the loss as determined under the GloBE Rules.
• (Insurance) investment entity: If the entity that holds the fund investment qualifies as an investment entity (IE) or insurance IE, the ETR is calculated separately from any other entity in the same jurisdiction that does not qualify as an (insurance) IE. This rule exists based on the notion that (insurance) IEs are ‘often subject to little or no tax at the entity level’ and thus to prevent an MNE from ‘blending this low-taxed income’ with other income to improve its ETR on investment income.

There are various reasons for the above adjustments and ring-fencing rules. They mainly serve to safeguard the integrity of the ETR computations under the GloBE Rules and to address some of the most common global book-to-tax differences (e.g., participation exemption regimes).

2.3    CbCR Safe Harbour and Financial Assets

There are no specific rules for financial assets in the CbCR Safe Harbour. Income and gains (or losses) from fund investments are included in the revenue and profit before tax figures for the various tests included in the CbCR Safe Harbour. 

The current tax expense for the CbCR Safe Harbour (i.e., for the simplified ETR test) is derived from the entities’ financial statements, which in principle includes the current taxes due over the net income and gains, as well as any deferred taxes over latent gains (or losses) attributable to the relevant fiscal year.

An (insurance) IE is excluded from the benefit of the CbCR Safe Harbour meaning that the ordinary GloBE Rules should be applied to determine whether any top-up tax arises.

3.    A&M SAYS

Pension funds, sovereign wealth funds and investment (fund of) funds should generally be carved-out from the scope of Pillar 2, which leaves insurance companies as the main category of institutional investors for whom these considerations are relevant. To be clear, fund investments are treated as separate entities under the GloBE Rules irrespective of their tax classification for corporate income tax purposes (i.e., tax transparent or opaque). 

For financial assets we can broadly distinct between fund investments in which an investor holds a stake of (a) 10% or more, or (b) less than 10%.

10% or more - The conclusion can be drawn that interests held in fund investments of at least 10% lead to a complete exclusion of the income from distributions, (un)realised gains (or losses) and connected taxes from the GloBE ETR computation. This means that such investments should not adversely impact the ETR of the investing entity under Pillar 2. 

Any costs related to such investments that can be charged to the profit or loss under IFRS would lower the overall GloBE income of the investing entity. This could therefore positively influence the GloBE ETR computation of that entity. Although local tax rules typically disallow deductions for expenses associated with income that is excluded from taxable income (e.g., participation exemption regimes), this is not the case under the GloBE Rules.

Less than 10% - For interests below 10%, distributions derived from fund investments in the first year and connected taxes should be included in the GloBE ETR computation by virtue of qualifying as a short-term portfolio shareholding, whereas income from distributions and connected taxes after that first year would be excluded. In other words, the GloBE ETR would only be affected in that first year, especially if no tax is due on any distributions received from the fund. 

Based on the latest Administrative Guidance, an election should be available for an entity to optionally include income from distributions after that first year in its GloBE ETR computations, which could be interesting if such income is high-taxed and would help shelter low-taxed income under the GloBE Rules.

Capital gains (or losses) and connected taxes should be included in the GloBE ETR computation. The (lack of) taxation of such gains (or losses) at the level of the investing entity will likely be relevant to determine preferences for the realization election and capital gains spread election.

(Insurance) IEs - To be complete, the CbCR Safe Harbour cannot apply to (insurance) IEs and there are ETR ring-fencing rules for (insurance) IEs under the standard GloBE Rules. Whether an investment-owning entity within the overall structure of an insurance company qualifies as an insurance IE is strongly dependent on the facts. 

How can A&M help?

A&M can help with assessing, modelling and managing the impact and practical implications of the GloBE Rules and CbCR Safe Harbour for your structure(s). For more information, please feel free to get in touch with your usual A&M adviser, Roel de Vries or Nick Crama.