Addressing Unwarranted Top-up Taxes: Exploring Strategies and Navigating Challenges for Multinationals under Pillar Two

The global tax landscape is in flux with the OECD's release of the Pillar Two Model Rules and their ongoing adoption worldwide. These rules aim to ensure that multinational enterprises (MNEs) pay at least a 15% tax rate in each of the jurisdictions where they operate, targeting base erosion and profit shifting. As per the Model Rules, if the effective tax rate (ETR) in a particular jurisdiction is below 15%, the so-called “top-up tax” will be levied. However, entities within an MNE group may face a situation where, due to a combination of how the jurisdictional ETR is determined and how charging provisions are applied, tax liabilities under Pillar Two potentially bear taxes that economically should be attributed to other entities or shareholders in cases of partial ownership.

Pillar Two at a Glance 

The Global Anti-Base Erosion (GloBE) Rules introduce two main components: the Income Inclusion Rule (IIR) and the Undertaxed Payments Rule (UTPR). These rules mandate a top-up tax when the ETR in a jurisdiction falls below 15%. The IIR, generally charged in the jurisdiction of the Ultimate Parent Entity (UPE), applies on a top-down basis. When the IIR is insufficient, the UTPR acts as a backstop, requiring Constituent Entities (CEs) in implementing jurisdictions to adjust their tax expense to meet the top-up tax amount allocated to that jurisdiction.

Additionally, the GloBE Rules allow for an optional domestic rule for countries to impose a Qualified Domestic Top-up Tax (QDMTT) locally before the IIR or UTPR applies, ensuring that MNE income is taxed at the minimum rate domestically.

IIR is levied by the parent jurisdiction in an amount necessary to top-up the tax of foreign subsidiaries and branches to the minimum 15% effective tax rate. QDMTT allows the top-up tax to be collected in the otherwise low-tax jurisdiction, as opposed to being collected by the parent jurisdiction on income earned in the low-tax jurisdiction. UTPR acts as a backstop mechanism where the parent jurisdiction does not impose top-up tax under an IIR. These are the GloBE charging provisions.

In all cases, the jurisdictional ETR is calculated by aggregation of the GloBE income and covered taxes—as defined in the GloBE Rules—of all the entities/vehicles considered to be in such a jurisdiction. In other words, the ETR is calculated based on a blended approach.

Scenarios Leading to Unwarranted Top-up Taxes 

This article explores tax allocation rules under Pillar Two, where tax liabilities arise in entities which—on an isolated basis—would not trigger a top-up tax but that would be subject to top-up tax due to the blended approach for the computation of the jurisdictional ETR or because of the charging provisions included in the GloBE Rules.

The easiest example is that of a "high tax" UPE liable to pay a top-up tax in relation to a "low tax" CE in another jurisdiction through the application of the IIR. Another one is that of a "high-tax" CE liable to pay QDMTT because of a "low-tax" CE in the same jurisdiction after jurisdictional blending. These scenarios can result in a top-up tax to be borne by entities that are not actually low-taxed themselves.

In the examples described above, the mismatches are triggered by the different charging provisions of the Pillar Two GloBE Rules. However, this is not the only circumstance in which these deviations could be triggered.

One other situation would be a sub-group that is not 100% owned by the ultimate parent entity. In fact, the primary IIR charging provision in the GloBE rules applies at the level of the UPE of the Group. However, if a partially owned parent entity (POPE) owns—directly or indirectly—more than 20% of the interest in any of the entities of the UPE Group, IIR is first payable by such POPE (i.e., the parent entity of a sub-group).

However, the blending approach underlying Pillar Two may result in a situation where a top-up tax is triggered by low-taxed CEs that are not part of the POPE sub-consolidated group but 100% held by the UPE.

The Pillar Two Model Rules, which are by now widely adopted, do not address the treatment of a recharge of taxes between entities, raising concerns about fairness and the recovery of excessive tax payments.

Challenges for Multinationals and Tax Sharing Agreements as a Potential Solution 

The OECD Pillar Two Model Rules, while aiming for fairer taxation, can lead to top-up taxes that misalign with an MNE Group's economic activities or ownership structures. MNEs should be well-informed and ensure that top-up taxes align with ownership structures.

Entities with tax liabilities should seek advisory support and consider options for correct tax allocation and cost management.

MNEs have identified a need for a mechanism of compensation between entities to address the misalignment of economic activities and tax liabilities. To address these misalignments, MNEs are considering tax sharing agreements (TSAs), i.e., intercompany contracts that equitably distribute tax obligations among related parties.

A TSA, being an intercompany agreement, is subject to relevant jurisdictions' transfer pricing requirements.

Corporate Tax and Pillar Two Implications of TSAs

 TSAs are not explicitly addressed in the Pillar Two rules or OECD Guidance, and, to our knowledge, there is no specific country legislation that regulates the allocation of top-up tax liability between entities of the MNE group, except in the case of QDMTT. This leaves the tax treatment of TSAs highly dependent on their design and the tax laws of the relevant jurisdictions. Depending on the country, recharges triggered by TSAs may be classified as taxable or exempt income, deductible or non-deductible expenses, dividend income, or capital contributions.

In the absence of harmonized guidelines under the Pillar Two GloBE rules, the treatment of TSAs can vary significantly across jurisdictions and is influenced by the specific charging provisions applicable in each jurisdiction. Additionally, some countries may base their approach on how recharges—whether income or expenses—are accounted for within the group.

From a technical perspective, recharges agreed between CEs within the same jurisdictional QDMTT framework could be treated differently compared to recharges of an IIR. In the latter scenario, the tax liability may fall on a single entity—such as the UPE, POPE, or other holding entity—and is not shared, at least from a purely legal standpoint, with the low-taxed CEs even though the IIR arises as a result of these CEs being low-taxed. This distinction highlights the complexities that multinational groups face when navigating the intersection of TSAs and the evolving Pillar Two landscape.

TSAs can also raise significant accounting issues, particularly when determining which entity’s standalone accounts should record top-up tax liabilities. In consolidated sub-group reporting, TSA effects are typically eliminated for entities within the consolidation perimeter. However, this treatment may differ when a TSA is implemented with a CE outside the sub-consolidation scope. Whether the recharge is recognized as tax or other expense/income depends on the rules defining the entity legally liable to the top-up tax and the specific provisions of the TSA.

The same complexities arise on a standalone basis, depending on the applicable charging provisions and the specific terms and conditions of the relevant TSA.

The accounting treatment of TSA recharges in both standalone and consolidated financial statements is crucial. These entries form the foundation for calculating GloBE Income and Covered Taxes, impacting not only taxable income for domestic corporate income tax purposes but also the jurisdictional ETR. As such, understanding the nuances of TSA accounting is essential for ensuring accurate Pillar Two compliance and effective management of global tax obligations.

As tax regulations evolve, ongoing dialogue and analysis are essential to refine the Pillar Two framework and ensure its fair application. Collaboration between the OECD, tax authorities, and MNEs is vital to balance preventing tax avoidance with maintaining an equitable tax system that accurately reflects genuine ownership structures and economic activities.

MNEs are encouraged to seek professional advice on how to address the challenges and opportunities presented by the Pillar Two rules to ensure compliance and address their tax positions.