Pillar Two – how it works

The OECD (Organisation for Economic Cooperation and Development) Pillar Two framework seeks to address the tax challenges arising from the digitalisation of the economy with wide-reaching implications for many international businesses. The main purpose is to reduce incentives for base erosion and profit shifting by limiting tax competition among countries. 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.

Contents

You will find everything you need to know about Pillar Two, its implementation in the UK and how to respond, in this article. You can use the links here to jump to specific sections that are more important to you.

Which businesses do OECD Pillar Two rules apply to? 
What are the Pillar Two Rules?
When is Pillar Two applicable from?
Disclosures in financial statements
How we are supporting groups

Which businesses do OECD Pillar Two rules apply to?

The rules apply to multi-national enterprises (MNEs) with annual consolidated revenues of at least €750 million in at least two out of the prior four accounting periods. They apply for accounting periods commencing on or after 31 December 2023, and therefore the first period in scope of the rules will depend upon the accounting period of the group. Common structures likely to be impacted are those involving:

• Tax havens, low-tax jurisdictions and jurisdictions with territorial regimes
• Notional interest deduction regimes
• IP (Intellectual Property) boxes and other similar incentives regimes including tax holidays
• Certain tax credit regimes
• Low-taxed financing, IP and global centralisation arrangements.

Every global organisation with global revenues of €750m or more will need to act to be compliant with Pillar Two. In addition, organisations that are close to the threshold will need to actively monitor whether they continue to fall outside of scope and, if on a growth trajectory, take action to prepare for Pillar Two compliance when they cross the revenue threshold.

The impact of M&A activity may bring groups or entities in scope, or take them out of scope, immediately and the impact if this will need to be considered in transactional documentation and processes, such as due diligence.

Do you have a Pillar Two plan in place?

Pillar Two will have both short and long-term impacts. In scope MNEs should expect a significant increase in their compliance burden as the calculations needed are complex and many of the data points required may not currently be tracked, requiring updates to your systems and changes to existing compliance processes.

We have a dedicated global team made up of International Corporate Tax, Tax Accounting and Tax Technology experts who can advise and assist you and your business with planning for Pillar Two impact, training, compliance and reporting. Through our global network, we can provide consistency and a joined-up approach to Pillar Two.

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What are the Pillar Two Rules?

The OECD’s Pillar Two framework aims to ensure MNEs with global revenues above €750 million pay a minimum effective tax rate on income within each jurisdiction in which they operate. Commonly referred to as BEPS (Base Erosion and Profit Shifting) 2.0, the framework imposes a Top-Up Tax on profits arising in jurisdictions where the effective tax rate (ETR) is below 15%.

What are the core components of the rules? 

The core elements of Pillar Two are: 

• An Income Inclusion Rule (IIR) 
• An Undertaxed Profits Rule (UTPR) 

Under the IIR, where an entity’s ETR in any jurisdiction is below the minimum 15% rate, the ultimate parent entity is primarily liable for a ‘top-up tax’ to bring the rate up to 15%. 

As a backstop, the UTPR can apply, through allocation of a top up tax to a sibling entity in respect of profits which are not subject to the charge under an IIR. 

A country may also choose to implement a Qualified Domestic Minimum Top-up Tax (QDMTT), alongside the IIR. This would enable the relevant territory to retain taxing rights in respect of low taxed profits (rather than the relevant profits being taxed in the parent entity’s jurisdiction under IIR or a sister jurisdiction under UTPR). Most territories are seeking to implement a QDMTT.

The calculation mechanism for determining the effective tax rate is broadly the same under all three elements. It blends elements of current and deferred tax in determination of the ETR and, therefore, requires understanding of international tax principles as well as deferred tax accounting in undertaking the calculations. 

What is the Subject to Tax Rule Multilateral Instrument (STTR MLI)? 

In addition to the above, a multilateral instrument on the subject to tax rule (the STTR MLI) was recently adopted by the OECD Framework to facilitate the implementation of the Pillar Two STTR rule. This is a treaty-based rule which allows the source (or payor) jurisdictions to impose additional tax on several categories of cross-border intragroup payments when such payments are subject to a nominal corporate income tax rate of below 9% in the residence (or payee) state and is expected to be most beneficial to developing countries.  

The MLI will allow the STTR rule to be included within the existing bilateral agreement without the need to make any amendments to those treaties provided that both jurisdictions to the treaty sign up to the MLI. The MLI is currently open for signature, and it is yet to be seen how many jurisdictions will sign up to it.  

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When is Pillar Two applicable from? 

The timing of implementation for each element varies by territory. Most territories have opted to implement the IIR and QDMTT first with the earliest movers having legislated for implementation from 1 January 2024 (accounting periods beginning on or after 31 December 2023). Implementation of the UTPR is expected to follow from 1 January 2025 at the earliest.

Has the UK implemented the rules?  

The Pillar Two rules are included within Finance Act (no.2) Act 2023 and came into effect for accounting periods beginning on or after 31 December 2023. The UK government has sought to follow the intent of the Model Rules as closely as possible, both from a policy perspective, and to ensure that the UK’s regime is recognised as a ‘qualifying’ regime by other territories introducing the rules. 

The enacted legislation includes the IIR, referred to as the ‘multinational top up tax’ or MTT, and a QDMTT, referred to as ‘domestic top up tax’ or DTT. Both MTT and DTT will apply to MNEs with global revenues exceeding EUR 750m in two of the previous four years, for accounting periods beginning on or after 31 December 2023. The DTT is applicable to wholly domestic UK groups and to a standalone UK entity if it meets the revenue threshold test.

Draft legislation has also been published to include the UTPR, which was announced in the Autumn Statement 2023, and which will come into effect from accounting periods beginning on or after 31 December 2024. 

The enacted legislation also includes the safe harbour provisions in line with the OECD rules such as the temporary Country by Country reporting (CbCr) safe harbour provision, QDMTT and UTPR including a simplified calculation approach for non-material and non-consolidated entities. 

You can also find more about the implementation of Pillar Two around the world. 

The enacted legislation also sets out the following reporting framework: 

• A one-time requirement for relevant groups, the ultimate parent entity or a filing member, to register with HMRC within six months of coming into scope of the rules – for example, groups with a 31 December year end who already meet the turnover requirement must register by 30 June 2025.
• An annual domestic information return/overseas return notification, to confirm entities’ UK top-up tax liabilities, to be submitted to HMRC within 15 months after the end of the accounting period (extended to 18 months for a group’s first return).
• Payment of the UK top-up tax liability in a single instalment due 15 months after the end of the accounting period (18 months for a group’s first return). 

It should be noted that other territories have differing registration, filing and payment requirements and associated timelines, and in scope groups will need to monitor these timelines across their territories of operation.

Irrespective of whether any top-up tax becomes payable, the compliance burden for affected organisations will be significant, as there are many data points that will be required to be incorporated into determination of the effective tax rate of a territory under the rules.


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Disclosures in financial statements

Disclosures in financial statements for periods before the rules are in force 

It should be noted that while the rules are effective for accounting periods commencing after 31 December 2023, “in scope” groups are required to include disclosures of the expected Pillar Two impact within their financial statements for the periods in which the rules are substantively enacted but not yet in force.

Disclosures in financial statements for periods once the rules are in force 

For periods once the rules are in force, it is no longer only a disclosure obligation from a reporting perspective; any tax arising under Pillar Two will need to be quantified in the tax provision.

From a current tax perspective, tax arising under Pillar Two should be accounted for as an income tax, with the one potential exception at entity level where a company is taxing profits other than their own, where uncertainty remains.

The accounting framework requires disclosure of the expected impact of the Pillar Two rules in periods in which the rules are substantively enacted but not yet in force. Once the rules are in force, the requirement switches to disclosure of the top-up tax with potentially a reduced narrative / qualitative disclosure obligation. However, many multinational groups will now experience several periods of flux where some entities are fully in the scope of the rules, with others are in territories which are either yet to legislate at all or where the rules have been substantively enacted, but no tax can yet fall due. This patchwork brings with it both complexity in terms of where any additional tax will be levied in these ‘in between’ years and the need to still include disclosures for those territories yet to come ‘on line’, as well as an estimate of any tax due for those already in force.

In estimating Pillar Two liabilities, groups need to expect a greater level of scrutiny from their auditors as amounts are being recognised in the accounts and not only disclosed.  This also applies where groups are stating there is no liability to account for. The following are our observations in this respect:

The importance of data

• Auditors will be as interested in the source of the data used in the estimates, as the estimates themselves. Groups may find it difficult to obtain sufficiently granular data for the current period and therefore use the previous period’s data to arrive at the estimate. This is potentially acceptable but auditors will want assurance and may test that no one off events or changes in the underlying business mean that the past position is not indicative of the current period. 
• Many groups are using Country-by-Country Reporting (CBCR) data to underpin their estimates through reliance on the CBCR transitional safe harbour, where such data exists or can be forecast.  The CBCR transitional safe harbour provides for a much-simplified determination of whether top-up tax is due in a territory where the Country-by-Country Report (CbC Report) is “qualifying” for a territory. It is a generally sensible approach to seek reliance on this safe harbour, but in some cases it has not been possible to easily evaluate whether they are able to produce a CbC Report that is ‘qualifying’ under the relevant rules. To be ‘qualifying’ means to meet certain requirements on how the CbC Report is compiled and the data sources used.  This will need to be tested, and assurance obtained. In periods prior to the rules coming into force, many groups were able to state to their auditors an intent to ‘fix’ the process for the first reporting period where the rules apply. However, in periods where the rules apply, auditors will want to understand the work that groups have undertaken to satisfy themselves that their CbC Report is qualifying for each jurisdiction where they intend to rely upon it, what issues were identified and what remedial work is underway. 

Moving goalposts

• The OECD continues to issue guidance to clarify, and in some cases amend or augment, the Pillar Two framework. Countries are then legislating and issuing guidance at different paces. It remains possible that we will see significant practical divergence from what should be a ‘model’ set of rules due to the approach of different legislatures and competing domestic requirements.  
• Groups will need to demonstrate their responses to the evolving developments A recent example was the divergence of Belgium from the OECD recommended timeline for registration for Pillar Two reporting processes, with the Belgium authorities requiring a significant amount of information on the global group (not just Belgium operations) at short notice. We expect to see more such deviations from the OECD suggested approach as time passes.

Find out more about the latest developments in the implementation of Pillar Two around the world.

UK only groups are not fully exempt from the rules

• One of the perhaps surprising outcomes from a set of rules that is designed to tax multinational groups is that UK only groups are not exempt from the entire framework if they breach the turnover threshold. The DTT, which is designed to ensure that the UK retains the taxing rights over UK income, applies to such groups – and hence they also need to demonstrate they are paying an effective rate of more than 15% under the rules to avoid an additional charge, with the same disclosure obligations in the accounts. Further, even a very small UK subsidiary of a large multinational group will be in scope of the DTT and must take action to comply.

It is not just a compliance and reporting matter

• While there are undoubtedly compliance and reporting challenges associated with Pillar Two, it must be remembered that it is a live tax. That means that the Pillar Two consequences of any transaction, restructuring or event should be analysed in parallel to the Corporate Tax, VAT or stamp duty consequences prior to implementation. This will need to be built into group tax governance processes, and appropriate training provided to workers to be able to identify potential Pillar Two impact and to seek support where needed.

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How we are supporting groups

We support “in scope” groups by undertaking impact assessments which broadly involves a review of the safe harbours/de minimis limits and their application to the group as an initial phase, and determination of ETR and the resulting top up tax on a jurisdictional basis as the next phase, where the safe harbours are not applicable or a group chooses not to rely upon the safe harbours. A key part of this work is review of the CbCR process itself and testing whether it produces a “qualifying” CbC Report in territories where the group intends to rely upon the CbCR transitional safe harbour. We are supporting many groups with this review, and the ground-up design or re-design of the CbCR process itself.

This will allow the correct disclosures to be made in financial statements and will also provide a working assessment of future Pillar Two tax exposures. Additionally, it will also identify and address data gaps that will be required to complete the full calculations, either where a safe harbour is not applicable (or not elected for) or post expiry of the current temporary safe harbours.  

We are supporting group with the identification and implementation of technology solutions to streamline compliance and reporting processes.

We are also supporting UK subsidiaries and sub-groups of over overseas parented groups by reviewing and leveraging any work that has been undertaken by the overseas parent to assess impact on the UK subgroup. In some instances, no work may have been undertaken in the parent jurisdiction as some notable countries, such as the US, are not currently progressing with implementation of the Pillar Two rules.

We have a dedicated global team made up of International Corporate Tax, Tax Accounting and Tax Technology experts who can advise and assist you and your business with planning for Pillar Two compliance. Through our global network, we can provide consistency and a joined-up approach to Pillar Two.


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