In this publication, our experts Roel de Vries and Nick Crama explore the effective tax rate (ETR) and top-up tax considerations for direct real estate investments under Pillar 2. Such investments are reported under IFRS as “investment property”.
 
The considerations in this publication are based on the OECD’s Pillar 2 Model Rules. 

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 real estate investment funds that are not fully carved-out. The carve-outs for REITs and real estate funds are discussed in our publication ‘Pillar 2: REITs and Real Estate Funds’.
 
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 investment property, let’s recap the basics of the Pillar 2 Model Rules and Qualifying Domestic Minimum Top-up Taxes. The Transitional CbCR Safe Harbour will not be discussed in this publication.

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 QDMTTs

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.

2. INVESTMENT PROPERTY

The Pillar 2 considerations in this publication are based on direct real estate investments that are reported as investment property under IFRS. The investment property is assumed to be held by an entity that is consolidated under IFRS and subject to “standard” corporate income tax (CIT) in the jurisdiction where the property is situated. Examples are a Dutch BV, Italian SRL and Spanish SLU.

2.1 IFRS AND INVESTMENT PROPERTY

Under IFRS, the entity that holds the investment property will report the net income and connected current year tax expense in its profit and loss.

Such entities generally apply the fair value model for IFRS purposes. Under this model, investment property is 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. 

The entity can be required to recognize a deferred tax asset (DTA) or deferred tax liability (DTL) for any temporary differences between IFRS and tax. When established, DTAs are recorded as a negative tax expense (i.e., income tax benefit) whereas DTLs are recorded as a tax expense. When a DTA or DTL reverses it will reverse at the same amount and rate.

The most common temporary difference for investment property in recent years is the usually lower tax carrying value of the investment property (based on the cost model) versus a higher IFRS carrying value (based on the fair value model). This would lead to a DTL for CIT due over latent gains. DTAs typically relate to tax attributes such as tax losses and interest credits that are carried forward.

2.2 CIT AND INVESTMENT PROPERTY 

The applicable statutory CIT rates on net income and gains derived from directly held investment property are usually higher than the GloBE minimum tax rate of 15%. 

Most European jurisdictions apply the cost model for CIT accounting purposes. Under this model, investment property is generally measured at cost less accumulated depreciation and any accumulated impairment losses. Upon disposal, a gain or loss is recognised broadly equal to the difference between the sales proceeds and the carrying value under the cost model.

2.3 GLOBE RULES, QDMTT AND INVESTMENT PROPERTY

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 net income included in the IFRS statement of profit or loss. 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 ETR and top-up tax, there are various exclusions, adjustments and ring-fencing rules to consider for investment property: 

• DTL recast: DTLs for latent gains on investment property 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. This policy rationale is based on the OECD’s view that considering DTL movements at nominal rates as part of the GloBE taxes could lead to the sheltering of other low-taxed income from top-up tax under the GloBE Rules.
• 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 and for DTLs that relate to gains for which roll-over relief is claimed for CIT purposes.
• 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. There are a number of cases when making a simplified GloBE loss election would be beneficial (e.g., when a jurisdiction does not levy corporate income tax or there is no system of deferred tax).
• Realisation election: An election is available to disregard fair value and connected DTL movements related to investment property 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 investment property is disposed. This election also applies to impairment losses (and gains). Such election applies to all assets and liabilities in the jurisdiction to which the election applies. The GloBE carrying value of the investment property already in possession under this election would be the IFRS carrying value at the beginning of the year for which the election is made. For investment property acquired after the election the GloBE carrying value would be the IFRS carrying value at the time the asset was acquired or when the DTL was incurred, if the DTL is incurred after acquisition. These carrying values can differ from the CIT carrying value. 
• 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. The OECD’s policy justification for this election is that the increase in value of certain assets likely accumulated over a period of years and spreading the gain over a period of up to a maximum of five years provides a better measure of whether the MNE has been subject to a minimum level of tax in that jurisdiction.
• (Insurance) investment entity: If the entity that holds the investment property 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. Whether an entity qualifies as an (insurance) IE is strongly dependent on the facts.
• Substance-based income carve-out: A substance-based income carve-out can be applied to reduce the exposure to GloBE top-up tax. This carve-out consists of a mark-up that can be deducted from the GloBE income that is subject to the jurisdictional top-up tax percentage. The carve-out is broadly based on the payroll costs and tangible assets of an entity. A specific rule requires that the carrying value of investment property is excluded from the eligible tangible assets, therefore reducing the scope of the income carve-out. Entities that qualify as an IE are excluded from this substance-based income carve-out facility altogether.

3. A&M SAYS

As is often the case when it comes to real estate, the tax rules - in this case the GloBE Rules - are specific. Although unlikely in Europe, GloBE ETRs on investment property could possibly fall below the GloBE minimum rate of 15%. This a direct consequence of IFRS-to-tax differences when calculating current year tax expenses and the recasting of certain deferred tax positions to the GloBE minimum rate of 15%. Examples of such differences are depreciation, accelerated depreciation, immediate expensing of costs that are amortized under IFRS, additional investment deduction facilities and (interest) deduction limitations.

An example to illustrate this: 

• A Dutch BV purchases an investment property for 25 million euros on 1 January 2024.
• The investment property has a fair value of 25.5 million on 31 December 2024.
• For tax depreciation purposes, the investment property has a residual value of 7 million euros (including land value) and an economic lifespan of 30 years.
• The investment property is financed at a 75% loan-to-value and against an interest rate of 3%.
• The Dutch CIT rate is 25.8% with a reduced rate of 19% for the first 200,000 euros of taxable profit.

These calculations will always be very case specific. The above examples are realistic and show the impact of the realisation election. The realisation election can be applied on a jurisdiction-by-jurisdiction basis, and then applies to all assets and liabilities attributable to that jurisdiction. This requires careful consideration given the effects illustrated above.

It is also good to keep in mind that immediate expensing for CIT purposes of (for example) costs incurred to attract financing which are amortized over the term of the loan under IFRS or claiming investment tax deduction incentives (e.g., the EIA in the Netherlands for solar panels) would typically push the GloBE ETR down, as these deductible costs for CIT purposes are not (fully) reflected in the profit and loss under IFRS.

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.