How manufacturers can conquer Pillar 2 tax

“This gives the entity’s home jurisdiction, which might have been a low-tax jurisdiction, a strong incentive to top up taxes to 15%.”

Christopher H. Summer

Grant Thornton International Tax Services Partner

As a result of the Pillar 2 project, many jurisdictions have chosen to adopt a Qualified Minimum Top-Up Tax (QDMTT). The QDMTT essentially allows the adopting jurisdiction to collect a "top-up” tax on the adopting jurisdiction’s domestic entities, preventing any other jurisdiction from imposing Pillar 2 taxes on that same income. QDMTTs vary, but generally are designed to impose tax to ensure a minimum effective rate of 15% applies on all domestic income. Under OECD administrative guidance, entities subject to a QDMTT in their jurisdiction may enjoy a safe harbor from other Pillar 2 taxes. “This gives the entity’s home jurisdiction, which might have been a low-tax jurisdiction, a strong incentive to top up taxes to 15%,” noted Grant Thornton International Tax Services Partner Christopher Summer.

Controlled Foreign Corporation (CFC) tax regimes (US GILTI and Subpart F rules) will generally still apply, meaning the controlling shareholder’s taxing jurisdiction may seek to tax certain types of income derived through CFCs. Generally, taxes imposed under a QDMTT regime are thought to be creditable for purposes of CFC taxation. Guidance in the US supports this approach.      

As a backstop to ensure remaining pockets of low-taxed income are taxed, the Pillar 2 rules include the IIR and UTPR. The IIR imposes a top-up tax on the ultimate parent entity based on the earnings of its foreign subsidiaries. The UTPR extends this concept one step further, by allowing brother-sister jurisdictions to impose taxation if low-tax income exists within a group, even after the IIR rule is applied.

The result is an intricate and complex set of interlocking rules designed to target low-taxed income and ensure a 15% minimum rate is achieved. Consider a hypothetical low-tax jurisdiction with a 10% statutory rate. In a simple example, one of the top-up taxes would add an additional 5%. Applying the rules and determining who collects that tax, and how it impacts tax determinations in other places, is a much broader challenge for companies reacting to these rules.

“Think about manufacturers that operate in a global manner … Are you following a consistent policy, from a transfer pricing perspective, that will help you understand the potential impact?”

Samit Shah

Grant Thornton Transfer Pricing Principal

“Think about manufacturers that operate in a global manner,” offered Grant Thornton Transfer Pricing Principal Samit Shah. “Supply chains are integrated. You may have contract R&D somewhere. You may have contract service providers. You may have limited-risk distributors and contract manufacturers. Are you following a consistent policy, from a transfer pricing perspective, that will help you understand the potential impact?”

For example, are all of your contractors and entities earning cost plus 10%? Are all of your limited-risk distributors earning a 5% EBIT margin? If these are not consistent, that could cause some variation — and that variation could complicate your Pillar 2 calculations.

“While this is an informational filing, it needs to be treated as an official filing. It needs that level of attention and governance.”

Brandon Joseph

Grant Thornton International Tax Solutions Partner

Of course, CbCR reporting has its own demands. “While this is an informational filing, it needs to be treated as an official filing,” said Grant Thornton International Tax Solutions Partner Brandon Joseph. “It needs that level of attention and governance.” That means rigorous and thorough reporting. Eligibility is determined by qualified financial statement reporting which, in this case, is the consolidated reporting reflected in the UPE financial statements. Some reporting from constituent entities is often excluded from such statements. This is permitted, if they follow acceptable financial accounting standards.

Entities can qualify under one of three exemptions. “Since you cannot claim an exemption once you have been denied it, it’s smart to pursue as many as possible, as soon as possible,” Joseph said.

Three ways to achieve the CbCR Safe Harbor

1. De minimis: This looks directly at revenue as reported on a jurisdictional basis. The threshold is €10 million of revenue and €1 million of profit before income tax. 
2. ETR: The ETR test focuses on the ratio of the tax expense recorded on the qualifying financial statements to the pre-tax book income or loss. If it’s above 15% for fiscal years beginning in 2023 or 2024, the exemption applies. That 15% number escalates every year.
3. Routine profits: If the income is below the substance-based income exclusion amounts of 8% of fixed asset net book value and 10% of payroll, the exemption applies.

While it does not require country-by-country reporting, the Simplified Calculation Safe Harbor uses similar tests, with similar calculations. There are also a few noteworthy differences. The de minimis test looks at an average qualifying revenue. The ETR test threshold of 15% is fixed, not escalating. 

There are two other safe harbors that should be mentioned. The Transitional UTPR Safe Harbor, which offers an out when the UPE jurisdiction has a corporate tax rate of at least 20%, is limited by its short window. It only applies to fiscal years that begin on or before Dec. 31, 2025, and end on or before Dec. 31, 2026. The QDMTT Safe Harbor provides that jurisdictions that meet certain requirements are deemed to have a top-up tax rate of zero.