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The Impact of the Different ETR Calculation for Investment Funds

The Pillar Two effective tax rate (ETR) calculation for investment entities is similar to the standard ETR calculation, however, there is an important twist. 

ETR Calculation, Generally
Generally, the ETR is calculated as Adjusted Covered Taxes/GloBE Income. This is then deducted from the 15% global minimum rate to calculate the ‘top-up tax percentage’.  
 
GloBE income is then reduced by any Substance-Based Income Exclusion and the initial top-up tax is calculated by applying the top-up tax percentage.  There is then a further adjustment for any additional top-up tax (eg from a previous year) or any tax imposed under a qualifying domestic minimum top-up tax. 
 
Importantly, when calculating the ETR, the adjusted covered taxes and GloBE income are not reduced for any minority interest. For example, if a UPE held 90% of the interest in a low-taxed subsidiary, there is no reduction for the 10% interest held by the minority owner and 100% of the tax and income attributable to the entity are used to calculate the Pillar Two ETR. 
 
The reason for this is that the minority interest is taken into account when the top-up tax is allocated to another group entity for payment of the top-up tax under the income inclusion rule or under-taxed payments rule. In the example above, for instance, the UPE would be allocated 90% of the top-up tax. 
 
Investment Entity ETR Calculation
 
However, this does not apply to investment entities as minority interests are taken into account when calculating the ETR and the top-up tax. 
The adjusted covered taxes for an investment entity is comprised of: 
 – the MNE groups allocable share of covered taxes of the investment entity
 – the MNE groups allocable share of covered taxes of the investment entity owners
 
Covered taxes of the investment entity owners can be allocated to the investment entity in certain circumstances, such as where the investment entity owners are subject to tax under a CFC regime or where withholding tax on dividends is incurred (which is allocated to the paying company, unlike other withholding tax that is taken into account in the recipients covered tax calculation).
 
The MNE groups allocable share is calculated as:
 
GloBE Income of the Investment Entity – Amounts Attributable to Other Owners
               GloBE Income of the Investment Entity
 
Globe Income and the Substance-Based Income Exclusion are similarly based on the amount of the MNE Groups allocable share.
 
Note the special ETR calculation for investment entities does not apply if they have made a tax transparency or taxable distribution method election.
 
Importantly, when it comes to allocating the top-up tax for payment (eg to the UPE to account for the tax under an IIR) the top-up tax determined for the investment entity needs to be taken into account. As noted above, usually the parent entity is allocated its allocable share of the top-up tax. However, as this has already been adjusted for in the investment entity’s top-up tax calculation, all of the top-up tax can then be allocated.
Example 1: Investment Company ETR
A UPE owns 90% of an intermediate parent company. The remaining 10% is held by non-group members. The intermediate parent entity owns 100% of an investment entity.
image showing group structure for investment entities ETR example

The investment entity has GloBE income of 10 million euros and incurs tax of 500,000 euros.

It has local tangible assets of 1 million euros.

The intermediate parent company incurs tax of 500,000 euros under a CFC regime in respect of the investment entity (note we assume the CFC pushdown limitation is not relevant).

The top-up tax is calculated as:

Adjusted Covered Tax=

Tax incurred by investment entity =500,000* 90% = 450,000 euros

CFC tax pushed down = 500,000* 90% = 450,000 euros

GloBE income = 10 million * 90% = 9 million euros

The ETR is therefore 10%.

The top-up tax percentage is 5% (15%-10%).

The substance-based income exclusion is (1 million * 5%* 90% ) = 45,000 euros.

Top-Up tax is therefore (9 million – 45,000) * 5% = 447,750 euros.

If we assume the UPE is in a jurisdiction that applies an income inclusion rule, the UPE would account for the top-up tax of 447,500 euros.

There is no reduction for the minority interest as it has already been taken into account.

In this case, there would be no effective difference between the position of an investment entity and any other entity. The method of calculating the top-up tax would be different but the eventual outcome would be the same (ie if the entity was not an investment entity, the top-up tax would be 497,500 and the UPE would be allocated 90% of the tax (447,750)).

However, this will not always be the case.

For instance, what if the UPE held the investment company via a partially owned parent entity (POPE)?

A POPE is a constituent entity, other than a UPE, that owns (directly or indirectly) an ownership interest in another constituent entity in the same group, and the right to more than 20% of its profits are held by persons that aren’t part of the MNE group.

There’s a departure here from the standard top-down rule for POPEs as even if a UPE applies an IIR, if there is a POPE that owns an interest in a low-taxed entity it will also need to apply the IIR. 

Example 2: Investment Company ETR

If we adjust the example above so that the UPE owns 75% of Parent Co and the remaining 25% is held by non-group members, the structure would be:

group structure for example 2 showing the ETR for investment entities

Parent Co would be a POPE and would apply an IIR (assuming it is located in a jurisdiction that applies an IIR). 

It would be allocated tax based on its allocable share, which in this case would 100%.

Therefore, 447,750 would be allocated to the POPE. The UPE would also apply an IIR but the IIR offset mechanism would reduce any top-up tax allocated to it by the amount paid by the POPE.

If the low-taxed entity wasn’t an investment entity the top-up tax allocated to the POPE would be 497,500.

For information on the jurisdictional blending implications of investment companies, see Non-Tax Transparent Investment Funds 

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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