Foreign Tax Credit for GloBE Top-Up Tax
The nature of the GloBE rules means that they apply after the application of the jurisdictional domestic tax regime. If a domestic tax regime provided a foreign tax credit for any tax imposed under an Income Inclusion Rule (IIR) or Under-Taxed Payments Rule (UTPR) this would then give rise to circularity issues since those taxes have already been determined prior to applying the Qualified UTPR or IIR.
As such, top-up tax under the GloBE Rules won’t benefit from a foreign tax credit in domestic regimes.
Substitute Loss Carry-Forwards
Article 2.8 of the February 2023
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. For more information, see:
Tax Credits & Substitute Loss Carry Forwards.
Foreign 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.
This includes deferred tax arising from tax credits granted in a jurisdiction due to a tax liability imposed in another jurisdiction or imposed on profits distributed by another entity such as foreign tax credits.
As such, any movement in deferred tax expense arising from the generation and use of such tax credits is excluded from the computation of Adjusted Covered Taxes for Pillar Two GloBE purposes. For example, when an excess foreign tax credit carry-forward is generated, the deferred tax asset associated with the carry-forward will not reduce Adjusted Covered Taxes.
Similarly, when the foreign tax credit carry-forward is used in a subsequent Fiscal Year, the use of the deferred tax asset (ie the Dr to the P&L account) will not result in an increase to Adjusted Covered Taxes.
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 a 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 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.
Allocation to a Permanent Establishment
For GloBE purposes permanent establishments (PEs) are treated as separate constituent entities, and their GloBE income and adjusted covered taxes are taken into account for jurisdictional blending purposes.
Therefore, covered taxes arising in the Main Entity in respect of the PE income need to be computed.
If the PE income is subject to tax separately from other income of the Main Entity, the tax rate applicable to the included income can simply be multiplied by the amount of the income inclusion.
However, if the PE income is mixed with the Main Entity’s other income this complicates the calculation slightly.
In this case the Main Entity’s pre-foreign tax credit tax liability on all the income needs to be determined and allocated between the PE income and the rest of the Main Entity’s taxable income. In most cases, a pro rata allocation will be appropriate.
Similarly, the tax credit (if any) allowed in respect of taxes paid by the PE needs to be calculated. In many cases, the total credit allowed in respect of these income inclusions will be easily determinable from the Main Entity’s tax returns. In some cases, however, the creditable Taxes of PEs may be included in a broader base of foreign income that includes other foreign income of the Main Entity.
In these cases, the amount of the foreign tax credit attributable to the PE income has to be determined based on the rules of the jurisdiction and using reasonable assumptions.
The amount of covered taxes paid on PE income that is then allocated to the PE is then the excess of the tax liability arising from the PE income over any credit allowed for the PE’s taxes on its income.
For example, Company 1 is a resident of Country X where the tax rate is 25%. It has a PE in Country Y where the tax rate is 10%.
The PE generates taxable income of 10 Million Euros and suffers tax in Country Y of 1 Million Euros. Company 1 is taxed on this income at 25% in Country X (ie a pre FTC tax liability of 2.5 Million Euros).
However, a foreign tax credit applies in Country X to offset the 1 Million tax incurred in the PE in Country Y. Therefore the tax liability in Country X is 1.5 Million euros.
This is the amount allocated to the PE as this is the actual liability on the PE income.
