The OECD breaks this down into three components in Article 6(2) of the Progress Report on Amount A of Pillar One:
An MNE Group has:
Revenue of 50 Billion Euros
Adjusted profits of 10 Billion Euros
Revenue sourced to jurisdiction A of 5 Billion Euros
The profitability threshold is:
10 Billion – 50 Billion * 10%
= 5 Billion Euros
The reallocation percentage is the above profitability threshold multiplied by 25%. Therefore 5 Billion * 25% = 1.25 Billion Euros
The allocation key pro-rates the profits after the reallocation percentage by the proportion of local revenue to total revenue. Therefore 1.25 Billion Euros * 5 Billion/50 Billion = 125 Million Euros.
This is the initial amount that can be reallocated to jurisdiction A.
This is intended to reduce double taxation by reducing any profit reallocation where there are physical activities within a jurisdiction that would be taxed under domestic law.
The profits after the marketing and distribution safe harbour reduction are then allocated to the relevant jurisdiction and taxed.
As the Pillar One tax is a tax on net income, it is therefore a covered tax for Pillar Two purposes.
However, the Pillar Two calculation doesn’t apply at the group level but instead calculates the effective tax rate on the group entities in a jurisdiction. This is based on the Pillar Two adjusted covered taxes and GloBE income.
When both Pillars One and Two are implemented, Pillar One will apply in priority to Pillar Two.
Therefore, when calculating the taxes incurred in a jurisdiction, tax on Pillar One profits allocated to that jurisdiction is included in Covered taxes and will increase the effective tax rate in that jurisdiction (and reduce any Pillar Two top-up tax).
The mechanics as to how this will apply have not yet been published. Most notably Pillar Two applies on an entity basis. Any top-up tax is calculated at the level of the jurisdiction but is then allocated to entities within the jurisdiction under Articles 3.4 and 3.5 of the OECD Model Rules.
If the Pillar One tax is simply calculated on reallocated profits from the MNE group there will need to be some method of allocating this to the entities in the jurisdiction for Pillar Two.
Similarly, it could be the case that entities in the jurisdiction are investment entities or minority owned entities. Both of these are treated differently for Pillar Two purposes to other group entities.
In particular, both are excluded from the standard jurisdictional blending calculation and their ETR is calculated separately (or in the case of investment entities, two or more investment entities effectively form their own separate group for the ETR calculation). In addition, the actual top-up tax calculation for investment entities is different to other entities as under Article 7.4 of the OECD Model Rules, minority owned interests are taken into account when calculating the top-up tax (ie effectively excluded). As such, the allocation of Pillar One tax could have a significant impact on the Pillar Two calculation depending on which entities it was allocated to.
As this is an after tax figure, the tax expense in the P&L needs to be added back to avoid any double taxation (as otherwise the profits that were allocated would have already been subject to tax).
The net tax expense is the total current tax expense and deferred tax expense included in the consolidated P&L.
This includes dividends or other distributions included in calculating the Financial Accounting Profit (or Loss).
Note that this does not tie into the Pillar Two exclusion for ‘Excluded Equity Dividends‘. For Pillar Two purposes, excluded dividends are generally dividends (or other distributions on shares) where the MNE group holds 10% or more of the ownership or had held full ownership for more than 12 months.
These are excluded from the Amount A adjusted profit under Article 5.2(c) of the Progress Report on Amount A of Pillar One if they were taken through the profit and loss account. If the fair value gains or losses were included in Other Comprehensive Income they would have been excluded anyway.
The equity method of accounting is a method of accounting for holdings in entities that are not subject to consolidation. Generally, this applies when the equity interest is less than 50%. These entities aren’t generally controlled by the MNE group and therefore aren’t constituent entities (aside from certain Joint Ventures).
As the equity method of accounting brings in the proportionate share of the entity’s income or loss into the parent company’s financial accounts, this needs to be excluded.
Note that this does not apply to profit or loss derived from a Joint Venture in which the MNE group has joint control. This would not be included for Pillar Two purposes.
Illegal payments, including bribes and kickbacks, are added back in the Pillar Two GloBE income calculation under Article 5.2(d) of the Progress Report on Amount A of Pillar One, just as they generally would be under a country’s domestic tax law. A payment is illegal if it is illegal under the domestic law of the country of the constituent entity or the UPE.
Fines and penalties are only added back if they are 50,000 euros or more (or an equivalent amount in local currency). Note that interest on late payment of tax is not considered a fine or penalty.
This is the same as for Pillar Two.
Just as for Pillar Two, if there was an error in the accounts (or a change in accounting policy) in a previous year that impacts on the Amount A adjusted income or loss, Article 5.2.(e) of the Progress Report on Amount A of Pillar One provides that this must be adjusted in the Amount A adjusted profit calculation.
For accounting purposes, the adjustment would generally be by way of an amendment to the opening equity in the balance sheet.
For Pillar One, Amount A purposes, the adjusted profits are amended. For instance, if deductible expenses were not included, this would be represented as a decrease in opening equity and a decrease in Pillar One adjusted profits.
Just as this would be excluded for the Pillar Two GloBE income calculation, any profit or loss of Excluded Entities is excluded from the Pillar One adjusted profit.
Where an entity values assets under a revaluation method for accounting purposes, its value in the balance sheet is revalued to the current market value (less accumulated depreciation and impairment losses).
For Pillar One, Amount A purposes, Article 5.2(g) and Schedule F of the Progress Report on Amount A of Pillar One provides that assets and liabilities that are subject to fair value or impairment accounting in the Consolidated Financial Statements are taxed on a realisation basis – not fair value basis. Therefore any gain or loss on revaluation is excluded and the carrying value is the historic cost.
It’s worthwhile noting that this is different to Pillar Two. Under Pillar Two, revaluation gains and losses are included in GloBE income, although there is a requirement to include gains and losses that are booked to other comprehensive income given they wouldn’t usually be included in the consolidated profit or loss before tax.
Pillar Two does permit an MNE group to make an election to use the realisation basis.
Article 5.2(h) and Schedule G of the Progress Report on Amount A of Pillar One provide that where an entity is acquired and it becomes a group entity, the MNE group determines its tax basis for Amount A as the carrying value of the assets in the accounts for the entity immediately before the acquisition. This applies for determining depreciation, amortisation, impairment or any gain or loss on a disposal by the MNE group.
This is different from both the standard financial accounting treatment and the default treatment under Pillar Two.
The accounting treatment generally values the transfer of assets at fair value (eg FRS 102 requires the total fair value of any consideration as well as the assets, liabilities and contingent liabilities of the acquirer to be determined).
Pillar Two generally follows the accounting treatment unless there is a GloBE reorganisation, in which case the historic carrying value can be used.
Under Article 5(2)(i) of the Progress Report on Amount A of Pillar One gains on assets or losses on assets (excluding inventory) are evenly spread between the period of disposal and the next four fiscal years.
This is unlike Pillar Two which includes the gain or loss in the fiscal year of disposal. However, an electioncan be made to carry back a capital gain to the previous four fiscal years. This is not possible under the Pillar One Amount A calculation.
These rules for Pillar One Amount A purposes have not yet been developed, but there will need to be some method of excluding these where part of the profit is allocated to non-group members. The Pillar Two rules accommodate this under the income inclusion rule (for partially-owned parent entities) and directly as part of the top-up tax calculation for investment entities.
The treatment of losses for Pillar One Amount A purposes is different to Pillar Two. Pillar Two uses the deferred tax figure in the financial accounts (subject to a number of adjustments). As such, losses are taken into account as deferred tax assets.
The Pillar One Amount A calculation does not need to bring tax (either current or deferred tax) into account and just excludes it from adjusted profits. Nevertheless there needs to be a mechanism to take losses into account when calculating adjusted profits.
Therefore, for Amount A, losses are carried forward and deducted against adjusted profits in chronological order. However, there is a restriction for pre and post implementation losses.
Post implementation losses are carried forward for 10 years. Pre implementation losses are losses incurred up to three years before the Amount A implementation and they can also be carried forward for up to ten years.
There are therefore a number of differences from the calculation of adjusted profits for Pillar One, and GloBE income for Pillar Two. Some of the adjustments that aren’t taken into account for Pillar One, but are for Pillar Two include:
However, Pillar One, has another measure of profits for the marketing and distribution safe harbour.
This is called ‘Elimination Profits’ by the OECD and is used to determine the amount (if any) that is reduced from reallocated profits due to the safe harbour.
In general though, elimination profit does include more of the adjustments that are included in GloBE income. Subject to a number of diffferences. For instance, the adjustment for stock based compensation under Schedule I (2) of the OECD Progress Report on Amount A of Pillar One is not an election as it is under Article 3.2.2 of the OECD Model Rules for GloBE income. It is complulsory.
The fact that there is no consistent overlap in the definition of profits for Pillars 1 and 2, and the fact that the adjustments are frequently calculated differently will mean that MNEs will need to have separate tracking methods for each Pillar and ensure that they are careful in their application of the separate rules.