OECD publishes further Administrative Guidance for Pillar 2 Model Rules

On December 18, 2023, the Organisation for Economic Co-operation and Development (OECD) published further Administrative Guidance on the Pillar 2 Model Rules (December AG).

Following previous Administrative Guidance documents published in February and July 2023, respectively, the December AG contains further clarification on Transitional Safe Harbor rules, including guidance with respect to the treatment of so-called hybrid arbitrage arrangements.

Within the guidance document, the OECD introduces anti-hybrid rules into the Transitional Safe Harbor rules, addressing OECD observations that certain arrangements were put in place to allow companies to meet the Transitional Safe Harbor thresholds. In principle, these rules will have retroactive effect until December 15, 2022 – the date of issuance of the Safe Harbor and Penalty Relief document by the OECD – unless jurisdictions are not constitutionally allowed to implement the guidance retroactively, in which case these rules will apply as of December 18, 2023.

As with all guidance, the OECD expects jurisdictions to adopt the December AG into existing or proposal domestic Pillar 2 legislation on a dynamic interpretation basis.

See below a short summary of the key components of this new December AG.

Purchase price accounting adjustments in Qualified Financial Statements

Chapter 1 introduces changes to the 2022 OECD Safe Harbor and Penalty Relief document (2022 SH report) to clarify that a constituent entity may use financial accounts that include the effect of purchase price accounting (PPA) adjustments in the computation of Profit (or Loss) before Tax for Transitional CbCR Safe Harbor purposes under certain conditions, which include having consistently filed CbC reports taking into account the PPA adjustment.

It was unclear whether PPA adjustments needed to be removed for purposes of the Transitional CbCR Safe Harbor due to the interplay of Article 3.1.2 (and its Commentary) and the previous definition of Qualified Financial Statements (and its previous guidance)

Further guidance on the Transitional CbCR Safe Harbor

Chapter 2 provides additional guidance with respect to the application of the Transitional CBCR Safe Harbor of the 2022 SH report. For many companies, the assessment to determine whether the Transitional CbCR Safe Harbor rules apply has been a key focus as part of initial preparation for Pillar 2 implementation. This section of the new guidance also contains previously announced additional guidance on certain hybrid arbitrage arrangements. Below, we provide an overview of some of the key pieces of additional guidance in relation to the CbCR Safe Harbor, which we expect to have practical implications for many taxpayers:

Qualified financial statements

Based on the 2022 SH report, companies must use so-called Qualified Financial Statements and a Qualified CbCR report in order to apply the Transitional Safe Harbor rules. The new guidance clarifies that, for any given jurisdiction, the relevant financial data in the CbCR report should, in principle (there are some exceptions – for instance, if data is only available at the level of the consolidated accounts), be drawn from the same Qualified Financial Statements for that jurisdiction (eg, PBT, Income tax expense, payroll expense and carrying value of assets). Other data in the CbC report, which is not relevant for the Transitional Safe Harbor calculations, may be drawn from any other source permitted under the CbC reporting rules.

The guidance further clarifies that the classification as a “Qualified” CbC report is determined on a jurisdiction-by-jurisdiction basis – hence, a CbC report can be qualifying for certain jurisdictions and used for the Transitional Safe Harbor calculation, while that same CbC report may not be considered a Qualified CBC report for other jurisdictions.

Using different accounting standards in the same CbCR report

The guidance clarifies that different accounting standards may be used for the preparation of a Qualifying CBC report. Of course, the accounting standards used should be Qualified Accounting Standards, which typically means accounts drawn up under either the accounting standard of the ultimate parent entity or under an acceptable local accounting standard.

Adjustments to Qualified Financial Statements

In principle, any adjustments to Qualified Financial Statements – even if meant to more closely align the financial statements with the GloBE Rules – would disqualify the resulting CbCR Safe Harbor calculations for that jurisdiction unless such adjustments are explicitly required under the Commentary or AG.

Redeemable preference shares

Similar to treatment under the GloBE Rules, the new guidance indicates that, for purposes of the Safe Harbor calculations, and irrespective of the tax treatment, an intra-group payment should not be excluded from the income of a recipient if the payer treats the intra-group payment as an expense for financial statement purposes and the recipient treats the payment as income. The OECD specifically refers to the treatment of dividends in the context of so-called redeemable preference shares, which may be treated as income/expense for financial statement purposes but qualify as an equity instrument for tax purposes (dividend).

This guidance now clarifies that, for the Transitional Safe Harbor calculations, no adjustments to financial statements will be required/allowed, even if there is a difference in accounting versus tax treatment. It is important to read this provision in conjunction with the new guidance in relation to the treatment of hybrid arbitrage arrangements.

In light of the December AG, a redeemable preference share may qualify as a hybrid arbitrage arrangement, resulting in a so-called deduction/non-inclusion situation. As a result, the tax deduction at the level of the payer in relation to redeemable preference shares would need to be adjusted (ie, eliminated) for the purposes of the Transitional Safe Harbor calculations and, as a result, not increase the Simplified ETR in the jurisdiction of the issuer of the redeemable preference share.

MNE Groups not required to file CbCR

The new guidance clarifies that an MNE that is not required to file a CbCR may still rely on the transitional Safe Harbor calculations, provided it produces qualifying financial statements to enable the calculations.

Qualified financial statements for permanent establishments

Although a PE should have its own Qualified Financial Statements in principle, the OECD recognizes that such financial statements may not be available. As a result, more flexibility is given with respect to the financial statements used for PEs (including separate financial statements prepared by the main entity for financial reporting, regulatory, tax reporting, or internal management control purposes).

Simplified ETR computation

The current language in the 2022 SH document defines Simplified Covered Taxes as a jurisdiction’s income tax expense after eliminating any taxes that are not Covered Taxes and uncertain tax positions reported in the MNE Group’s Qualified Financial Statements. However, in a further statement, the SH document suggests that adjustments to prior-year income tax expense provision (other than those related to uncertain tax positions) would not be included in Simplified Covered Taxes.

The new guidance aims at clarifying the inconsistency related to uncertain tax positions, prescribing that, where the income tax expense includes an adjustment (generally referred to as a return to provision), the effect of any uncertain tax position reflected in that adjustment must be removed. This compliance exercise should not be especially burdensome, according to the December AG, as the income tax expense and uncertain tax positions are recorded in distinct line items in an MNE Group’s trial balances, making them easy to identify.

Covered taxes on income of PEs, CFCs, and hybrid entities

The new guidance specifies that, when the parent or main entity determines their Simplified ETR, the following principles should apply:

• The income tax expense in the jurisdiction in which the PE is located on the PE’s income must be allocated exclusively to the PE’s jurisdiction and can only be included in the Simplified ETR Test for the PE jurisdiction. That income tax expense shall not be included in the Simplified ETR Test for the main entity’s jurisdiction.
• Taxes paid under a CFC Tax Regime or a taxable branch regime do not need to be adjusted (ie, excluded and allocated) in the Simplified ETR for the jurisdiction of the constituent entity-owner or main entity, although they are also taken into account for purposes of determining the GloBE ETR of the CFC, PE, or hybrid entity.

Routine profit test

In calculating a Tested Jurisdiction’s Substance-based Income Exclusion (SBIE) amount, an MNE should use the transitional rate for the applicable fiscal year set out in Article 9.2 of the GloBE Rules.

Treatment of hybrid arbitrage arrangements under the cbCR Safe Harbor

In relation to the CbCR Safe Harbor, the Inclusive Framework has become aware of certain arrangements qualified as “hybrid arbitrage arrangements.” MNEs have considered these arrangements to enable a constituent entity to qualify for the Safe Harbor in order to avoid the full GloBE calculations and potential connected top-up taxes that would otherwise have been triggered.

• A deduction/non-inclusion arrangement under which:

a. There is no commensurate increase in the revenue or gain in the financial statements of the constituent entity counterparty or

b. The constituent entity counterparty is not reasonably expected over the life of the arrangement to have a commensurate increase in its taxable income.

• A duplicate loss arrangement under which:

a. The expense or loss is also being included as an expense or loss in the financial statement of another constituent entity or

b. The arrangement also gives rise to a duplicate amount that is deductible for purposes of determining the taxable income of another constituent entity in another jurisdiction.

• A duplicate tax recognition arrangement under which more than one constituent entity is including part or all of the same income tax expense in its:

a. Adjusted covered taxes or

b. Simplified ETR for purposes of applying the Transitional CbCR Safe Harbor

A Tested Jurisdiction’s Safe Harbor calculation must be adjusted by:

• Excluding any expense or loss arising as a result of a deduction/non-inclusion arrangement or duplicate loss arrangement from the Tested Jurisdiction’s PBT and
• Excluding any income tax expense arising as a result of a duplicate tax recognition arrangement from the Tested Jurisdiction’s income tax expense.

The Inclusive Framework has agreed that any hybrid arbitrage arrangements entered into after December 15, 2022 will trigger the adjustment under the anti-hybrid rules for the purposes of calculating the Simplified ETR. This date may be shifted to December 18, 2023 for jurisdictions that are not constitutionally able to provide retroactive effect.

Application of GloBE Rules

Chapter 3 provides needed clarification on the definition of revenues set out in Article 1.1. Because the GloBE Rules apply to MNE Groups that have revenues equal to or in excess of the EUR750 million threshold based on the CbCR rules, what constitutes revenue is determined under financial accounting standards and taken from the consolidated profit and loss statement of an MNE Group.

As a result, whether certain elements (eg, extraordinary income and gains from investment activities) are included in that threshold can vary among financial accounting standards and UPE jurisdictions. In fact, a consolidated income statement prepared under some financial accounting standards may present some gains and losses on a net basis or report the gains and losses separately. These discrepancies in financial reporting practices and requirements would cause the application of the threshold to vary and create a lack of uniformity. For this reason, the Inclusive Framework has determined that, in order to increase certainty in the application of the GloBE Rules, the definition of revenues for the purpose of Article 1.1 should be clarified.

Article 10 of the Commentary will be amended to include that, for purposes of Article 1.1, revenue will comprise:

the inflow of economic benefits arising from delivering or producing goods, rendering services, or other activities that constitute the MNE Group’s ordinary activities. The revenue amounts shall be determined in line with the relevant accounting standard, which may allow for netting for discounts, returns and allowances, but in any event before deducting cost of sales and other operating expenses.

If different types of revenue are separately presented in the consolidated profit and loss statement of the consolidated financial statements, it is clarified that they must be aggregated for purposes of Article 1.1.

In addition, the definition of revenue shall include net gains from investments (whether realized or unrealized) reflected in the profit and loss statement and income or gains separately presented as extraordinary or non-recurring items. If the MNE Group’s consolidated profit and loss statement presents gross gains from investments and gross losses from investments separately, the MNE Group shall reduce revenues by the amount of such gross losses to the extent of gross gains from investments in determining revenues for purposes of Article 1.1. With this, the December AG aims to ensure that an MNE Group is not disadvantaged in the application of the threshold test by adopting a financial accounting standard that requires gains and losses to be presented separately in the profit and loss statement.

Chapter 3 also addresses the situation in which the financial accounts of some constituent entities are based on a different fiscal year than the UPE’s fiscal year. Paragraph 13 of the Commentary will provide that, in such cases, MNE Groups may apply different accounting conventions in the preparation of the consolidated financial statements depending upon the rules of the financial accounting standard used in the consolidated financial statements – for example, by either incorporating the constituent entity’s financial accounting results for its fiscal period into the consolidated financial statements or by segregating the income of the constituent entity based on the UPE’s fiscal year and combining the amounts from the constituent entity’s two fiscal years that straddle the UPE’s fiscal year.

Further administrative guidance on the allocation of Blended CFC Taxes

Chapter 4 provides further guidance on the allocation of Blended CFC Taxes, addressing the following three issues:

Computing an entity’s blended CFC allocation key when multiple GloBE jurisdictional ETRs are computed for a jurisdiction

If an MNE Group computes multiple GloBE jurisdictional ETRs for different blending groups of entities located in the same jurisdiction (such as in the case of a joint venture or where there are minority-owned constituent entities or investment entities located in the jurisdiction), the Blended CFC Allocation for an entity shall be calculated using the GloBE Jurisdictional ETR that is applicable to the blending group to which such entity belongs. The sum of all Blended CFC Allocation Keys includes those computed for all of the entities located within the jurisdiction, notwithstanding that some may have been computed based on different GloBE Jurisdictional ETRs.

Computing an entity’s Blended CFC Allocation Key when it is not required to compute an ETR under Article 5.1

For a Tested Jurisdiction for which the MNE Group elects the simplified ETR test under the Transitional CbCR Safe Harbor, the MNE Group shall use that Tested Jurisdiction’s Simplified ETR, as calculated under the Transitional CbCR Safe Harbor guidance in lieu of the GloBE Jurisdictional ETR when determining the Blended CFC Allocation Key for entities in that Tested Jurisdiction. This shall result in a Blended CFC Allocation Key of zero for the entities in the blending group.

If an MNE Group elects the de minimis test or the routine profits test for the Tested Jurisdiction under the Transitional CbCR Safe Harbor, the MNE Group shall calculate the Tested Jurisdiction’s Simplified ETR following the guidance set forth in the Transitional CbCR Safe Harbor document as well as any Agreed Administrative Guidance that relates to the application of the Transitional CbCR Safe Harbor. Under this approach, MNE Groups that qualified for the Transitional CbCR Safe Harbor under the routine profits or the de minimis test would need to obtain additional data points to perform their Blended CFC Tax allocation, whose data points should be easily accessible.

If an MNE Group computes multiple Simplified ETRs for a jurisdiction under the Transitional CbCR Safe Harbor, the Blended CFC Allocation Key for an entity shall be calculated using the Simplified ETR that is applicable to the blending group to which such entity belongs.

For a jurisdiction in which the MNE Group has elected the QDMTT Safe Harbor, the GloBE Jurisdictional ETR shall be determined based on the taxes and income used to determine the ETR for the jurisdiction pursuant to the jurisdiction’s QDMTT, except that any creditable QDMTT payable in the jurisdiction for the fiscal year shall be added to the taxes in the numerator for the ETR computation.

For this purpose, a QDMTT is creditable only if the Blended CFC Tax Regime allows a foreign tax credit for the QDMTT on the same terms as any other creditable Covered Tax.

The guidance indicates that, in cases where an MNE Group computes multiple ETRs for a QDMTT jurisdiction, the Blended CFC Allocation Key for an entity shall be calculated using the ETR, as determined under the QDMTT that is applicable to the blending group to which such entity belongs. Any Blended CFC Tax allocated to an entity in the QDMTT jurisdiction shall not affect the ETR calculation under the QDMTT because CFC taxes and Blended CFC taxes are excluded for the purposes of the QDMTT.

Under both the Transitional CbCR Safe Harbor and the QDMTT Safe Harbor, scenarios may arise in which some of the entities located in a jurisdiction are not eligible for the Safe Harbor (ie, investment entities or joint ventures). In those scenarios, an ETR would be computed under Article 5.1 for the blending group that includes the entities that are ineligible for the Safe Harbor, and this ETR shall be used to determine the GloBE Jurisdictional ETR and the Blended CFC Allocation for those entities.

Computing a non-GloBe entity’s Blended CFC Allocation Key when multiple GloBE jurisdictional ETRs are computed for a jurisdiction

To the extent a constituent entity is subject to a Blended CFC Tax Regime with respect to the income of non-GloBE entities (ie, entities that are not constituent entities, joint ventures, or JV subsidiaries) in which it has a direct or indirect ownership Interest, an amount of tax imposed under the Blended CFC Tax Regime must be allocated to such non-GloBE entities to ensure such tax is properly excluded from the Adjusted Covered Taxes of the constituent entities, joint ventures, or JV subsidiaries of the MNE Group for GloBE purposes.

Such non-GloBE entities should compute a Blended CFC Allocation Key using the GloBE Jurisdictional ETR for the blending group in the same jurisdiction that has the largest aggregate amount of attributable income of entity and shall include its Blended CFC Allocation Key in the sum of all Blended CFC Allocation Keys.

The guidance explains that this approach is simpler than requiring the MNE Group to determine which blending group the non-GloBE Entity would belong to if it were not a non-GloBE Entity. It also avoids an additional ETR computation that would have been required if the non-GloBE Entity had formed a separate blending group.

Transitional filing deadlines for MNE Groups with short reporting fiscal years

Chapter 5 amends paragraph 32 of the Commentary to Article 9.4.1. to provide relief (like the CbCR relief provided in 2016) so that MNE Groups do not need to file General Information Returns or notifications before June 30, 2026.

This amendment avoids the 30-month window that MNE Groups and tax administrations have for preparing and activating their filing systems – being shortened, for instance, for MNE groups that have a short reporting fiscal year in the transitional year.

Simplified calculation Safe Harbor for non-material constituent entities

The last chapter of the guidance addresses concerns raised by the business community regarding significant additional compliance costs in bringing the financial accounts (and financial accounting systems) of subsidiaries excluded from the consolidated financial statements due to the expectation that the omission of the subsidiary’s financial data would not influence the decisions made by primary users of the financial statements (so-called materiality test).

In response to these concerns, the IF agreed on providing simplified income, revenue, and tax calculations for non-material constituent entities (Simplified Calculations for NMCEs) as part of the Simplified Calculations Safe Harbor.

For the purposes of the Simplified Calculations for NMCS, an NMCE is defined in this Agreed Administrative Guidance as an entity that is not consolidated in the ultimate parent entity’s (UPE) consolidated financial statements, but which is considered a constituent entity in accordance with Article 1.2.2 (b) of the GloBE Rules and meets following conditions:

• Consolidated financial statements have been prepared in accordance with an Acceptable Financial Accounting Standard or an Authorized Financial Account Standard adjusted to prevent material competitive distortions
• An external auditor has agreed that such entity does not meet the materiality standards and has been excluded from the consolidation process on those grounds.

An entity with revenue exceeding EUR50 million will only qualify as an NMCE if the entity’s financial accounts are prepared in accordance with an Acceptable Financial Accounting Standard or an Authorized Financial Accounting Standard.

Furthermore, this Agreed Administrative Guidance provides for Simplified Calculations for NMCEs as part of the Simplified Calculations Safe Harbor described in Chapter 2 of the Safe Harbours and Penalty Relief Document issued in December 2022. The Simplified Calculations for NMCEs is composed of simplified income, revenue, and tax calculations.

In the case of the simplified income calculation, instead of computing the GloBE income or Loss of an NMCE (ie, the financial accounting net income or loss adjusted in accordance with the GloBE Rules), the MNE Group will determine the MNCE’s GloBE Income based on its total revenue as determined under the CbCR.

An NMCE’s GloBE revenue will also equal the total revenue of such entity as determined under the CbCR, meaning that the GloBE income and the GloBE revenue will be the same under the simplified income and revenue calculations.

Similarly, Simplified Tax Calculations will be based on the information used by the MNE Group to prepared its CbCR. The adjusted covered taxes of the constituent entity under this calculation will be the entity’s accrued income tax within the current year, which excludes any deferred tax expenses, adjustments for non-current items, and provisions for uncertain tax liabilities.

The Simplified Calculations Safe Harbor for NMCEs is an annual election and is made for each NMCE individually.

Assuming that the Simplified Calculations for NMCEs are the only Simplified Calculations elected by the MNE Group in the Tested Jurisdictions for the fiscal year, the MNE Group shall apply the regular GloBE Rules (including the Simplified Calculations Safe Harbor) for all other constituent entities of the Tested Jurisdictions, other than NMCEs, and shall apply the Simplified Calculations for NMCEs in accordance with the new released guidance.

For more information, please contact the authors.

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