Global Ant-Base Erosion (GloBE) Model Rules Pillar Two and Its Implications

The GloBE rules pillar two has been designed to reduce profit shifting and tax competition among countries racing to the bottom. It has also been developed as part of the solution for addressing the tax challenges of the digital economy. As a background Organization for Economic Cooperation and Development (OECD) Pillar 1 and 2 statement was made on July 2021, followed by OECD Model rules being published on December 2021 with commentary on the rules published early 2022 and OECD Implementation framework is to be published by December 2022.

To determine a top up tax liability for an MNEs (Multinational Enterprises) then the following process needs to be kept in mind;

Identify Constituents Entities Within Scope

Chapter 1 Pillar 2 model rules outlines the criteria for in scope groups. The criteria include;

  • MNEs groups with revenue exceeding EUR 750 M
  • Operating in two or more jurisdictions
  • Member groups comprising constitute entities
  • Excluded entities to include; Government Entity, International organizations, Non-profit organizations, pension fund, Investment fund, Real estate investment vehicle and certain holding entities.

Allocate income and taxes to constituent entities under Chapter 3

The main rules that underpin the allocation of income and taxes include; follow the jurisdiction of the income with which they are associated, covered taxes assigned to the jurisdiction of an entity may be imposed not only by its tax jurisdiction but also by another tax jurisdiction (WHT-withholding tax), taxes imposed on a shareholder under a CFC regime are assigned to the jurisdiction of the distributing entity or Controlled Foreign Companies (CFC).

Chapter 3 and 4 of the GloBE models rules touches on computation of GloBE income or loss and adjusted covered taxes. The allocable procedure for income and taxes include;

  • Calculate Constituents Entity’s GloBE income: The starting point is usually the UPE consolidated financial statements. Adjustments include net tax expense, excluded dividends, excluded equity gains or losses, policy disallowed expenses and finally Accrued pension expenses. The other things to note is that qualified tax credits are treated as income, arm’s length adjustment is paramount in cases of related parties and lastly exclusion of international shipping income.
  • Calculate constituent entity’s adjusted covered taxes Articles 4.1 and 4.2: The covered taxes include;
    • Any compulsory, unrequited payments due to general government, imposed on entity’s income or profits
    • Any taxes imposed in leu of a generally applicable income tax, as well as taxes imposed on distributed profits, retained earnings and corporate equity.
    • Only taxes imposed on the net, therefore taxes on gross income or revenue without any deductions (a tax on turnover) are not considered income tax unless they are in lieu of income tax.
  • Excluded taxes include; Consumption and sales taxes, Digital service taxes, Stamp duty and other transfer taxes and Property taxes.

Effective tax rate (ETR) and top up tax calculation under chapter 5

It involves Calculation of the Effective Tax Rate of all Constituent Entities located in the same jurisdiction and in the event an MNE is subject to an effective tax rate below 15% in any jurisdiction then top up tax in respect of that low tax jurisdiction shall be arrived at after taking into account a substance-based carve-out. The substance carves outs include payroll and tangible asset components eligible for deductions.

Article 5.3 reads that the policy rationale behind a formulaic, substance-based carve-out, based on payroll and tangible assets is to exclude a fixed return for substantive activities within a jurisdiction from the application of the GloBE Rules. The use of Payroll and Tangible Assets as indicators of substantive activities is justified because these factors are generally expected to be less mobile and less likely to lead to tax-induced distortions.

However, simplifications measure has been sorted for calculating jurisdictional ETR. Article 5.5.1 provides two conditions for a jurisdiction to be eligible for the de minimis exclusion.
The first condition requires the Average GloBE Revenue of the MNE Group in that jurisdiction to be less
than EUR 10 million, while the second condition requires the Average GloBE Income or Loss of the MNE
Group in that jurisdiction to be a loss or less than EUR 1 million.

Application of charging provisions

The GloBE rules contain two charging mechanisms under chapter 2 and they include;

  • Primary charging mechanism
    • Income Inclusion Rule (IIR): This rule imposes top up tax to the parent entity in respect of low taxed income in one of the subsidiaries. It applies to the MNE groups with gross revenue exceeding EUR 750 M.
      • Basic Rule
        • The ultimate parent entity (UPE) must hold ownership interest in LTCE (Lower Tax Constituent Entities) at some point in fiscal year and be in IIR jurisdiction
        • The parallel Intermediate Parent entity charge (IPE) must hold ownership interest in LTCE) at some point in fiscal year and be in IIR jurisdiction.
      • Special Partially Owned Parent Entity rules (POPE)
        • Constituent entity not an UPE must holds an ownership interest in another constituent entity and more than 20% of it is held by third parties.
        • IIR charge on POPE that holds an ownership interest in LTCE at any time in a fiscal year
    • Switch-Over-Rule (SOR): The rule removes treaty obstacles to the application of the IIR in relation to certain branch structures.
  • Secondary charging mechanism
    • Undertaxed Payment Rule (UTPR): The rule kicks in where it is not being possible to collect all of the top up tax under the primary charging mechanism and that will impose the top up tax on other entities within the group. It applies to the MNE groups with gross revenue exceeding EUR 750 M.
    • Subject to Tax Rule (STTR): The rule allows the source jurisdiction to impose limited source taxation on certain related party payments where they are subject to tax below a minimum rate and this will be limited where the source country is a developing country. In addition, it applies to covered payments between connected persons or entities.

In conclusion, the GloBE rules apply a system of top up tax that brings the total amount of taxes paid on an MNEs excess profit in a jurisdiction up to the minimum rate of 15%. The GloBE rules use a standardized base and definition of covered taxes to identify those jurisdictions. It then imposes a coordinated tax charge that brings the MNE’s effective tax rate on that income up to the minimum rate (after taking into account a substance-based carve-out). The design of the GloBE Rules as a top-up tax facilitates the coordinated application of the GloBE Rules.

As an implication and implementation, IIR and UTPR shall be implemented by a way of changes to domestic laws. Countries like Kenya will need to agree on a rule order through a new multilateral convention.

On Double Tax Avoidance Agreement (DTAA), STTR and SOR shall require changes to existing DTAs which could be implemented through bilateral negotiations and amendments to individuals’ treaties and existing multilateral instruments.

Kenya like other developing countries should therefore seek to implement STTR rule in its legislation coupled with Pillar one amount A and actively participate in the current developments.

Author: Eddie Opiyo