A Review of the UK Draft Pillar Two Legislation


The UK published draft legislation on July 20, 2022 to implement Pillar Two for accounting periods beginning on or after December 31, 2023. 

The draft legislation runs to 110 pages with another 239 pages of explanatory notes. 

As you’d expect, in general the effect of the draft legislation produces the same outcome as the OECD Model Rules, but there are differences. 

The UK draft legislation is a mixed bag. For certain provisions it pretty much copies the wording in the OECD Model Rules (eg for the definition of investment funds).

In other cases it deconstructs the OECD approach and implements the effects of the Model Rules via a different mechanism (eg the top-up tax calculation in relation to the offset of Qualifying Domestic Minimum Taxes). 

It’s also worth noting that the draft legislation is not complete. There are a number of placeholder texts that cover key areas such as the GloBE Loss Election and purchase accounting adjustments

At this stage the UK is just implementing the income inclusion rule, which it refers to as the ‘Multinational Top-Up Tax’.  

Implementing the under-taxed payments rule (of which no details were provided) would allow the UK to collect tax revenue from UK resident subsidiaries and permanent establishments where top-up tax wasn’t collected under an income inclusion rule in another jurisdiction.

The reason the draft legislation is as lengthy as it is (when compared to the OECD Model GloBE Rules for instance which are around 70 pages), is it clarifies a number of areas that weren’t specifically addressed in the Model Rules, but were in the subsequent OECD Commentary (for instance on when an alternative accounting standard could be used and whether the information in the accounts is reliable). 

In this article we look at some of the key aspects of the UK draft Pillar Two legislation, with a particular focus on areas that differ from either the OECD approach or the Model Rules. 

This includes:

Election to Spread Capital Gains

The Model Rules include an election that allows an MNE to spread jurisdictional capital gains over a lookback period.

This is defined as the current year plus the previous four years.

I won’t go into details of how the election operates here, but if you’re interested, we have analysis here and a tax tool that illustrates the operation of the carry back here.

In essence the capital gain is offset first against jurisdictional losses (starting with the earliest year). If any gain then remains it is prorated amongst the group entities that had capital gains. 

The OECD Model Rules are clear that the lookback period is 5 years. This means any remaining gain after the offset of losses is allocated over the current year and the previous 4 years. 

However, the UK draft legislation doesn’t look to apply this.

It adopts a lengthy ten-step approach to applying this election, but after the offset of losses it then divides the gain by four, and prorates it amongst the previous 4 years.

The legislation is clear that the lookback period is the previous 4 years. 

There is therefore a divergence between the UK’s approach and the OECD’s approach.

The OECD’s approach would result in some of the gain still being charged in the current year, but with less prorated to earlier periods, whilst the UK would eliminate any current year gain and carry it back over the previous 4 years.

Given that a carry-back to previous years may well result in additional top-up tax being payable for those years (and interest on underpayments), it could be that this would increase compliance burdens on MNEs. 

Additional Tax and the Domestic Minimum Tax Offset

The UK adopts a different approach to the OECD in the top-up tax calculation. 

The OECD Model Rules simply calculate the initial top-up tax by multiplying the top-up tax percentage by the GloBE income (as reduced by the substance-based income exclusion). Then additional tax is deducted and finally any qualified domestic minimum tax is deducted. 

Additional tax can arise either in certain loss situations or as a result of a prior year amendment. 

The UK splits out the calculation. There is the standard top-up tax calculation which is the top-up tax percentage multiplied by the profits (after the substance-based income exclusion).  Then additional tax is addressed separately. This means that the tax credit for domestic minimum tax is also addressed separately. 

The UK does this by a so-called ‘QDT Credit’. In most cases its straightforward and the domestic minimum tax is offset to the extent it doesn’t exceed the top-up tax.

However, where there is a top-up tax and additional tax that is less than the amount of domestic minimum tax it is necessary to prorate the QDT credit between the initial top-up tax and the additional top-up tax to achieve the offset. 

The draft legislation puts it (not so succinctly) as:

‘…the QDT credit for those members for that period is equal to the proportion of the sum of amounts of qualifying domestic top-up tax payable by those members for that period that is equal to the proportion of the sum of the result of Step 6 in subsection (1) and that collective additional amount that the result of that Step represents.’

Therefore, the QDT is split between the two.

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