Making Sense of the OECD Pillar 2 Rules (Part 3)

Source: Gemini

This is the third series in my discussion of this topic. As noted in my previous piece, while the OECD Pillar 2 Rules seek to ensure that large multinational enterprises (MNEs) pay a minimum level of tax across their various operating jurisdictions, the process is not cast in stones. This is so in view of the operational flexibilities and complexities involved in their implementation. Recall that in the second series of this article, I simplified some important concepts. Therefore in this third series, I will discuss a few more concepts such as De Minimis Exclusion, Carve-outs, Income Inclusion Rule etc. as follows:

1. De Minimis Exclusion

This is a rule that allows companies to avoid the Pillar 2 minimum tax in certain countries where they have very small amounts of profit or operations. If a company’s revenue or profit in a country is below a certain threshold, the minimum tax rules may not apply there. The idea is to reduce the burden of complying with the rules when there’s not much income to tax. For instance, the De Minimis Exclusion may apply to a jurisdiction where the net income is below 1million EUR and revenue below, 10million EUR.

2. Transitional Safe Harbours

Safe harbours are temporary rules that give companies some relief or protection from certain tax requirements during the initial implementation period of Pillar 2. These transitional safe harbours are designed to ease companies into compliance with the new rules by offering simplified calculations or relaxed standards for a limited time. For instance, for the first few years of the Pillar 2 implementation, companies might be allowed to use simplified financial information or lower compliance thresholds to determine if they meet the minimum tax requirements, giving them time to adjust their systems and reporting methods.

3. Carve-out

A carve-out is like an exception to a rule. When computing global minimum tax for a location, certain amounts of income or operations are “carved out,” meaning they are not subject to the minimum tax rule. The carve-out usually applies to companies that have real, tangible business activities (factories, offices, etc.) in a country. This ensures that businesses that contribute economically to a country are not unfairly taxed. For instance, if a company builds a manufacturing plant in a country and creates jobs, the profit linked to that plant might be “carved out” from the minimum tax requirements. This incentivizes real business activities over just having money parked in low-tax jurisdictions.

4. Substance-Based Income Exclusion (SBIE)

In making sense of Carve-out, you need to understand substance-based income exclusion. This is a rule that allows a portion of a company’s profit to be excluded from the minimum tax if it’s tied to real, physical business activities (substance), such as having employees or tangible assets in a country. This rule ensures that companies that genuinely invest in a country by employing people or setting up factories are not unfairly taxed. Similar to the example I gave earlier. If a company has a factory in Country A and hires 1,000 workers, a portion of its profits related to this factory might be excluded from the minimum tax calculation under the SBIE. For instance, if 5% of the value of the factory and payroll costs can be excluded, that profit would not be subject to the top-up tax.

According to a December 2021 OECD Commentary on the GloBE Rules and more recently June 2024 FAQS on GloBE rules, the exclusion will apply at a fixed percentage of each jurisdiction’s payroll sum and tangible asset balance. The rules provide for a 10-year transition period to allow for the impact of the rules on the existing investment incentives. The transition period begins with 10% carve-out for payroll and 8% for tangible assets. These exclusion rates are however expected to reduce over time till they reach 5% each.

In a simple income tax sense, the deductions or exclusions are like tax reliefs as a reward for actual business presence in the said countries.

5. Income Inclusion Rule (IIR)

This rule applies to the parent company of a multinational group. Under the IIR, if a subsidiary in a low-tax jurisdiction pays less than the minimum 15% tax, the parent company must include that low-taxed income in its own taxable income and pay the top-up tax to the tax authority of the parent’s country. It is like a way for the parent company to “collect” and “remit” the tax that wasn’t paid by its subsidiaries. For instance, if Company X’s subsidiary in Country B only pays 10% tax, the parent company in Country A must include that income in its tax calculation and pay an additional 5% tax to the home country to meet the 15% minimum. This especially applies where Country B does not subscribe to QMDTT commitment.

6. Top-Up Tax Allocation (Global Blending vs. Jurisdictional Blending)

The Pillar 2 rules require that tax be calculated per jurisdiction (country by country) rather than averaging (blending) taxes across all countries. This is called jurisdictional blending. If companies could blend taxes globally, they could average out low-tax profits with high-tax profits across different countries. Instead, each country’s effective tax rate must be calculated individually, and top-up taxes apply country by country.

This marks the end of concept definition bit in this this series. In the final lap of this series (Part 4, that is), I will examine the real-world implications of Pillar 2 rules especially the policy spaces where African governments can shape outcomes to protect national interests and boost investment. If you need a specific clarification, drop me a comment or mail via goodsalam@gmail.com and I will get back to you on same.