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Pillar Two Tracker

Tax Credits & Substitute Loss Carry Forwards

Contents

Tax Credits and Deferred Tax

Under Article 4.4.1(e) of the OECD Model Rules, deferred tax expenses arising from the generation and use of tax credits are ignored for the purposes of calculating covered tax. Therefore, any deferred tax assets or liabilities and the impact of them unwinding are removed from covered taxes.

This is necessary as the deferred tax attributes arising from tax credits could distort the Pillar Two GloBE ETR.

Example: Deferred Tax and Tax Credits

Company A has taxable income of 1 million euros and suffers tax at 20% in year 1.

This would equate to corporate income tax of 200,000 euros. If we assume the Pillar Two GloBE tax base is the same as the domestic tax base and there are no other taxes, this would also equate to adjusted covered taxes of 200,000 euros.

The jurisdiction provides an investment tax credit of 100,000 euros, however, this is restricted to 50,000 euros in year 1 with the remainder being carried forward to year 2. In year 2, Company A receives the same taxable income, and the tax rate is unchanged.

In both years, the adjusted covered tax is 200,000 less 50,000 = 150,000 euros. This equates to a Pillar Two GloBE ETR of 15%.

However, if the investment tax credit had given rise to a deferred tax asset, in year 1, the 50,000 euros that was carried forward to year 2 would have been a Dr to deferred tax assets of 50,000 euros and a Cr to deferred tax expense in the P&L of 50,000 euros.

This would have reduced the adjusted covered taxes in year 1 to 100,000 euros, resulting in a Pillar Two GloBE ETR of 10%, which would then have triggered the top-up tax provisions.

In year 2, the unwinding of the deferred tax asset would be Dr deferred tax expense in the P&L 50,000 euros and a Cr to deferred tax on the balance sheet of 50,000 euros.

This would increase the adjusted covered tax in year 2 to 200,000 and increase the Pillar Two GloBE ETR to 20%.

It is for this reason that deferred tax assets relating to tax credits are not taken into account under the Pillar Two GloBE rules.

Substitute Loss Carry-Forwards
Article 2.8 of the OECD Administrative Guidance provides for the inclusion of deferred tax in the GloBE deferred tax adjustment amount for ‘Substitute Loss Carry Forwards’.
 
This arises due to the differing tax treatment of foreign source income amongst jurisdictions.
 
If a jurisdiction permits tax on foreign source income to be offset with foreign tax credits (FTCs) in a year with a domestic loss, a loss will generally be generated that can be carried-forward.
 
If the jurisdiction required the domestic loss to first offset foreign source income before FTCs are used, no loss or a reduced loss would be generated compared to the above.
 
In this case, jurisdictions generally permit future domestic source income to be
recharacterized as foreign source, up to the amount of the prior year domestic source loss, to allow the use of FTCs in lieu of the loss that was not generated.
 
However, the GloBE rules do not include deferred tax arising from foreign tax credits in the calculation of covered taxes.
 
Therefore, when FTC carry-forwards are used to offset tax on domestic source income in future years, Top-up Tax could arise even though the economics are the same as the scenario where a loss carry-forward has been provided for.
Example
Company A is resident in country X. Country X has a 20% tax rate. It has a subsidiary (Subco) in country Y which has a 25% tax rate.
 
Company A is taxed on the profits of Subco under a CFC regime.
 
In 2024 Company A incurs a loss of 10 million euros and generates profits of 10 million euros in Company B. Subco pays tax of 2.5 million euros. 
Domestic Loss Offset
 
If Company A was required to offset its 10 million euro loss against the 10 million loss of Subco there would still be no tax for Company A in year 1. 
 
If the domestic loss is not set against Subcos profits, Company A has a loss of 10 million euros. If we assume that that the domestic tax base exactly matches the GloBE base, Company A would have a deferred tax asset of 1.5 million euros (ie the 10 million loss recast to 15%). 
 
In future years when there are profits, the deferred tax asset would be released to the P&L to increase the tax expense and adjusted covered taxes for GloBE purposes (thus increasing the GloBE ETR).
 
No tax is payable on the 1 million profit of Subco captured as a CFC for Company A, as the 2.5 million tax paid by Subco would qualify as a foreign tax credit and offset any tax levied by country X.
No Domestic Loss Offset
 
If Company A was required to offset its 10 million euro loss against the 10 million loss of Subco there would still be no tax for Company A in year 1. 
 
However, the 2.5 million foreign tax credits cannot be used in year 1. If Country X permits them to be carried forward then they could be offset against future income. 
 
However, for GloBE purposes, the deferred tax asset arising from the foreign tax credit carry forward wouldn’t be reflected in the deferred tax adjustment amount.
 
As such the reversal of the deferred tax asset when the foreign tax credits are utilised would not see the increase in the deferred tax adjustment amount of 1.5 million euros. This would lower the GloBE ETR and potentially lead to top-up tax. 
 
As such, the Administrative Guidance provides for a Substitute Loss Carry Forward.
 
The deferred tax expense attributable to the Substitute Loss Carry-forward deferred tax asset is included in the entity’s Total Deferred Tax Adjustment Amount in the year that it arises and in the year(s) it reverses.
 
A Substitute Loss Carry-Forward deferred tax asset arises where:
 
  • the jurisdiction requires that foreign source income offset domestic source losses before foreign tax credits may be applied against tax imposed on foreign source income;
 
  • the Constituent Entity has a domestic tax loss that is fully or partially offset by foreign source income; and
 
  • the domestic tax regime allows foreign tax credits to be used to offset a tax liability in a subsequent year in relation to income that is included in the computation of the Constituent Entity’s GloBE Income or Loss
 
Where the above conditions are met, the deferred tax expense attributable to the Substitute Loss Carry-forward deferred tax asset is included in the Constituent Entity’s Total Deferred Tax Adjustment Amount to the extent the foreign tax credit that gave rise to the Substitute Loss Carry-forward deferred tax asset is used to offset a tax liability on income included in the Constituent Entity’s GloBE Income or Loss.
 
The Substitute Loss Carry-forward deferred tax asset is equal to lower of:
 
  • the amount of the foreign tax credit in respect of the foreign source income inclusion that the domestic tax regime allows to be carried forward from the year in which the Constituent Entity had a tax loss (before taking into account any foreign source income) to a subsequent year; and
 
  • the amount of the Constituent Entity’s tax loss for the tax year (before taking into account any foreign source income) multiplied by the applicable domestic tax rate.
Picture of Lee Hadnum

Lee Hadnum

Lee is a qualified Chartered Accountant and Chartered Tax Adviser. A former Senior Tax Analyst at Bloomberg Tax, Lee began his career in Ernst & Young's Entrepreneurial Services department and has 20 years of international tax planning experience. Lee's books have been recommended by The Times, The Guardian and The Telegraph.

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