The OECD’s Pillar II initiative has ushered in a new area of corporate taxation. In-House Perspective assesses what this means for deals and for counsel around the world.

Digitalisation has had many positive effects on the global economy. It has aided entrepreneurial innovation, boosted productivity and helped drive regional economic growth. It’s perhaps no wonder, then, that the World Bank has called digitalisation ‘the transformational opportunity of our time’.

It has created challenges too, though, such as how to tax organisations operating in that digital economy so they don’t use globalisation as a means of moving profits to lower-tax jurisdictions. Which is why, as of the beginning of this year, the Organisation for Economic Cooperation and Development (OECD) introduced a new tax framework. Known as Pillar Two, the regime was first mooted in 2020, with the OECD at the time calling it ‘a ground-breaking plan to update key elements of the international tax system which is no longer fit for purpose in a globalised and digitalised economy’. More than 130 countries signed up to the regime, which at its simplest level requires multinational organisations with turnover of over €750m to pay minimum corporate taxes of 15 per cent in each of the countries in which they operate.

But, while the EU and countries including the UK have already implemented Pillar Two, others, such as South Africa and Australia, are still grappling with the legislative process and many more – the US among them – have yet to even get to that stage. For the businesses the system affects, the picture is therefore a complex one. As Barbara den Exter, a lawyer at UK firm Bird & Bird, says, ‘Pillar Two is not just a tax reform – it’s a global tax revolution that will disrupt the business landscape and will require new levels of tax strategy from CFOs [chief financial officers] and tax directors.’

The marriage of tax and accounting

Though the imposition of a blanket tax rate may seem like a tax simplification, Gouri Puri, Membership Officer, Asia Pacific, on the IBA Taxes Committee and a tax partner at Shardul Amarchand Mangaldas & Co in New Delhi, says it’s ‘definitely the most complicated piece of legislation or set of tax rules that has ever come out’. In part, that’s because so many different countries, with a wide variety of existing tax regimes, are involved.

‘In trying to address each and every nuance in every situation – and trying to keep everyone happy – it’s become super complex,’ she says. ‘I have to go and read it every few months to refresh on it because unless you’re practising it every day it’s too complex. It’s an area of tax that is very accountancy-driven and in several areas of tax you don’t really need to have a strong sense of how accounts and financial numbers work, but because Pillar Two is so deeply tied with what financial statements look like – it marries tax and financial accounting together – it has to be dealt with by someone with a strong handle on accountancy.’

Ana Lucia Ferreyra, LPD Council Liaison Officer on the IBA Taxes Committee and tax counsel at Latin American energy company Pluspetrol, says this will lead to massive upheaval within the multinational organisations that fall within Pillar Two’s scope. The challenge for in-house tax lawyers and others in this area is to communicate the impact of the new rules within their organisation, she explains.

‘The issue is that we used to have two different sets of records – accounting records and tax records – and the first was handled by the accounting team and the second by the tax people’, she says. ‘Pillar Two is like a mixture or combination of the two of them – it’s a third different set of rules and set of records. It is a tax-oriented measure but, with the purpose of having something universal, it’s based on accounting rules. There are a lot of tax adjustments to the accounting rules and that puts you in the middle of the two. It’s not pure tax and it’s not pure accounting, it’s something else – it’s Pillar Two. That creates a lot of challenges from an administrative perspective because it’s a new set of rules.’

Another challenge, adds Ferreyra, is that formerly there were accounting advantages that didn’t have any tax impact at all. Adjustments that used to be pure accounting adjustments will now have a particular impact under Pillar Two in that they’ll have an effect on cash tax payments.

As if that wasn’t complicated enough, Ferreyra says that, because Pillar Two only applies to companies with revenues of €750m or more, it could also have the unintended consequence of giving non-Pillar Two organisations a competitive advantage in M&A transactions.

‘Not all the companies in the world are subject to Pillar Two so if you end up in a competitive process you may end up competing with a company that Pillar Two is not a concern for,’ she says. She gives the example of entering a process in Paraguay to buy a company in a tax-free zone with no corporate income tax. ‘If one of the bidders is part of a multi-national entity that is subject to Pillar Two on the valuation of the entity you have to add the Pillar Two impact because it will be paid by the ultimate parent company’, she explains. ‘If one of your competitors is not subject to Pillar Two then it won’t be part of the valuation so the competitor will be willing to pay more for the company because the Pillar Two impact does not affect them. That creates a big challenge on M&A transactions.’

Rosie Marriott, a lawyer at UK law firm Macfarlanes, says the rules allow for ‘jurisdictional blending’ that could help ease that concern, but adds that it’s nevertheless something that organisations are going to have to be alive to. ‘Effective tax rates are calculated based on jurisdictional blending and each jurisdiction’s [rate] is calculated by comparing the aggregate profits earned by all group members located in that jurisdiction to the aggregate of all the taxes paid on those profits by those members,’ she says. ‘This permits a degree of sheltering – a group member with an effective tax rate below 15 per cent may not be exposed to top-up tax provided there are other group members in the same jurisdiction with profits taxed sufficiently above 15 per cent to ensure that the overall jurisdictional rate is above 15 per cent. There is therefore a potential tax benefit to high- and low-taxed companies being members of the same group.’

Buyers that are in-scope of Pillar Two may therefore realise a tax synergy as a result of an M&A transaction while, conversely, in-scope sellers may lose such a synergy. ‘This is a contextual point, but worth being mindful of given the effects may be significant and could materially change the tax profile of one or both parties to a transaction,’ says Marriott.

The Swiss example

Ross Robertson, an international tax partner at accountancy company KPMG, says one of the driving forces behind the introduction of Pillar Two was to prevent multinational corporations shifting profits from high-tax jurisdictions to low-tax ones in order to lower their overall tax burden. ‘The main purpose is to reduce incentives for base erosion and profit shifting by limiting tax competition among countries,’ he says. ‘This is to be achieved through ensuring that large multinational groups pay a minimum level of tax on the profits arising in each jurisdiction in which they operate.’

However, Aron Liechti, a lawyer at Swiss firm Bär & Karrer, says that has implications for the many corporates that have chosen to locate themselves in countries such as Switzerland specifically due to the tax incentives they receive there. ‘Switzerland is a hub for business and multinational entities,’ he says. ‘It has big advantages like political stability, a tax environment that has been very attractive, and employer rights. Switzerland wants to keep those advantages but at the same time it has to be compliant. It was clear from the outset that Switzerland was going to implement Pillar Two – we need to offer legal certainty – and in a public vote about 80 per cent of people voted in favour of it. That’s very high.’

Yet, in common with Puri and Ferreyra, Liechti says the advantages that have historically made Switzerland an attractive place to do business are now being tempered by the additional burdens Pillar Two has brought. ‘The big burden is that you now have to draft separate financial statements based on acceptable reporting standards, such as IFRS [the International Financial Reporting Standards], for each business entity,’ he says. ‘Those are reporting standards for consolidated financial statements and multinational entities would not typically make a standalone statement per entity. Then, of course, you have to have the Pillar Two tax return drafted and submitted. Depending on how many constituent entities you have that can be quite burdensome and costly.’

He adds however that the largest impact for Switzerland is because companies have corporate income tax below 15 per cent. There are some incentives that lead to even lower corporate income tax rates, and these will be affected. ‘The incentives will stay in place because all the other organisations that don’t qualify for Pillar Two can still get the incentive and it can lead to a good outcome tax-wise’, says Liechti. ‘They are also still available for multinational entities under the Pillar Two rules but it leads to a higher top-up tax so there isn’t a positive outcome. Switzerland will seek to implement subsidies – it will invest the proceeds from Pillar Two top-up taxes in other incentives to maintain the attractiveness of Switzerland.’

Working out how those supplementary taxes should operate has not been an easy process, though. Rules to levy the top-up tax came into effect at the beginning of 2024, but only for entities that are based within Switzerland – for international subsidiaries the top-up will be applied at a later, yet to be determined, date. Though it’s seen as a fix that will help maintain Switzerland’s competitive edge, Deloitte partner Thomas Hug says it has made a hugely complex situation even more difficult to navigate.

‘Swiss corporations and permanent establishments of Swiss multinational groups [have been] subject to the new national top-up tax from 1 January 2024,’ he says. ‘This will result in a significant administrative burden and, depending on the individual case, additional taxes. As the tax base of the national top-up tax differs significantly from that of the Swiss corporate income tax, it cannot be automatically concluded that companies in high-tax cantons such as Zurich or Bern do not have to pay top-up taxes or vice versa. As the revenue threshold is defined in euros and the Swiss franc tends to strengthen against the euro, privately owned groups and family offices will be increasingly affected by this new tax.’

The fairness puzzle

Given the complexity involved in dealing with top-up taxes, it’s perhaps unsurprising that other countries that offer low corporate tax rates haven’t yet moved to implement Pillar Two. Puri notes that, as an emerging economy, India offers a range of different tax incentives designed to help certain sectors develop. Against that backdrop, and despite being a participating partner of the OECD, it hasn’t yet taken plans for Pillar Two forward.

‘India has not yet announced its Pillar Two rules either in draft form or intent,’ she says. ‘The expectation is that we should come up with rules in our domestic law but that hasn’t occurred yet. This is an election year in India so I would expect that, once a government is formed, we will hear the plan on how to get on board with Pillar Two.’

‘From an Indian point of view, we’ve had very high corporate tax rates in the past’, explains Puri. ‘At the moment it’s between 22 per cent and 30 per cent depending on incentives and turnover.’ She highlights that India has set up a new International Financial Services Centres Authority, which offers tax holidays that mean profits are exempt. There are political concerns about what happens to those incentives in light of Pillar Two, she adds, and there remain questions about whether developing countries really want to come on board with this.

‘India doesn’t really have too many companies that will fall within the realm of Pillar Two due to the revenue threshold, but multinationals that are operating in India will be covered if India adopts this’, she says. ‘The concern of developing countries is that we don’t have the resources within our tax administrations to focus on this – there are other issues on our policy agendas.’

According to Puri, the EU has been ‘gung-ho’ about Pillar Two and has forced ‘everyone to do it’, resulting in the initiative being pushed forward. However, she believes that developing countries feel the framework doesn’t cater to their needs. ‘For many developing countries tax holidays and incentives have been a way to attract investment. With Pillar Two coming in place we’ll have to rework some of that but if three quarters of the world signs up to something it’s hard for others to stay behind’, she adds.

Ferreyra agrees and suggests the rules governing Pillar Two will need further development in order to ensure it’s applied equitably around the world. ‘There are a lot of tax policy issues because, for example, a developing country like Paraguay might want to provide a particular incentive to a certain industry that could mean an effective tax rate of zero per cent. But, under these rules, if the company is a subsidiary of a Spanish parent company a 15 per cent tax on the revenues of that Paraguay company has to be paid in Spain.’ She further explains that if the tax has to be paid it’s preferable for the developing country to put it in place and collect the money that’s needed for the basic needs of a developing country. ‘But, at the same time, you don’t want to increase the tax burden because it will create a disincentive to investment’, adds Ferreyra.

Describing the issue as ‘a huge challenge’, Ferreyra says she hasn’t seen any substantial developments in this area. However, she believes that change will happen eventually because ‘it’s not fair that the tax applicable for revenues arising in a poor country has to be paid in a developed country. I would expect that developing countries will start analysing the matter and try to find a solution, but sometimes there are so many urgent matters in a developing country that it’s not a top priority. If they don’t move forward in this regard, though, they could be losing investments or tax revenues.’