Article 4.4.4 of the OECD Model Rules implements a recapture rule for deferred tax liabilities. This applies when the deferred tax liability has not reversed within five years of the fiscal year in which it was originally recognized.
When this recapture applies, the MNE group is required to recompute its effective tax rate (ETR) for the year the deferred tax liability was originally recognized. If there is then any top-up tax, this top-up is added to the top-up tax for the current year. See our interactive deferred tax recapture tool to simulate the application of this rule.
Certain deferred tax liabilities are excluded from the recapture rule, so they do not need to be adjusted for, even if they take more than five years for the deferred tax liability to release.
Deferred tax liabilities that are excluded from the recapture rule under Article 4.4.5 of the OECD Model Rules include:
• Accelerated depreciation on tangible assets (Note: it does not include timing differences relating to the amortization of intangibles or goodwill)
• Costs of a license or similar arrangement from the government for the use of immovable property or exploitation of natural resources that incurs significant investment in tangible assets;
• Research and development expenses;
• De-commissioning and remediation expenses;
• Movements arising from fair value accounting;
• Foreign currency exchange net gains;
• Insurance reserves and insurance policy deferred acquisition costs;
• Gains from the sale of tangible property located in the same jurisdiction as an entity that are reinvested in tangible property in the same jurisdiction; and
• Other amounts accrued as a result of accounting principle changes for the above.
Company A is subject to the Pillar Two GloBE rules. It is resident in Country A which has a 15% corporate income tax rate.
Company A provided services to another company and charges 100,000 euros payable on an instalment basis over 5 years. It, therefore, receives 20,000 euros each year.
For financial accounting purposes and under the relevant GAAP the 100,000 euros income is recognized in year 1 under the accruals basis.
However, for local tax purposes, the income is recognized when it is received. This results in a deferred tax liability in year 1 of 12,000 euros (80,000 euros * 15%). This would be:
Dr Deferred tax expense (P&L) 12,000
Cr Deferred tax liability (balance sheet) 12,000
If we assume Company A had other taxable income of 250,000 euros, its current tax in Year 1 would be 37,500 euros on the other income and 3,000 euros on the service income received. Therefore, total tax payable is 40,500 euros.
For accounting purposes, it would have income of 350,000 euros in year 1. The current tax expense is 40,500 euros ie an ETR of 11.5%.
The deferred tax expense in the P&L is 12,000 euros.
For Pillar Two purposes, adjusted covered taxes would be 52,500 euros and Pillar Two GloBE income would be 350,000 euros. The Pillar Two GloBE ETR is therefore 15% and no top-up tax is due.
If in year 6, the deferred tax liability has not reversed (eg the income has not been received), this is treated as a recaptured deferred tax liability. The year 1 ETR and top-up tax calculation have to be recalculated with the deferred tax liability in year 1 removed.
Therefore, the ETR would be 11.5% and top-up tax may be due.
Section 1 of the Fourth Set of OECD Administrative Guidance (issued on June 17, 2024) provides further details on the deferred tax liability recapture rule.
Article 4.4.4 of the OECD Model Rules implements a recapture rule for deferred tax liabilities (DTLs). This applies when a DTL has not reversed within five years of the fiscal year in which it was originally recognized.
When this recapture applies, the MNE group is required to recompute its effective tax rate (ETR) for the year the DTL was originally recognized. If there is then any top-up tax, this top-up is added to the top-up tax for the current year. See our interactive deferred tax recapture tool to simulate the application of this rule.
Certain DTLs are excluded from the recapture rule, so they do not need to be adjusted for, even if they take more than five years for the deferred tax liability to release. These are referred to as ‘recapture exception accruals’.
Determining when DTLs have reversed would not be an issue if an entity determined its DTLs based on an item-by-item basis (eg based on single general ledger (GL) items). However, this is generally not the case.
Much of the new guidance for tracking and measuring reversed DTLs arises from the fact that MNEs often aggregate DTLs related to assets and liabilities in different GL accounts.
Aggregated DTL amounts could undermine the application of the recapture rules (as, for instance, the netting off of deferred tax assets (DTAs) against DTLs would prevent the recapture rule applying to the amount of the DTL offset by the DTA or the aggregated DTL amount could include some DTLs that fully reverse within five Fiscal Years and some DTLs that do not fully reverse within five Fiscal Years).
The June OECD Administrative Guidance therefore includes further guidance addressing the application of the recapture rule to aggregated DTL amounts.
Note that unlike other changes introduced in OECD Administrative Guidance which actually amend the application of the OECD Model Rules, the changes relating to tracking DTLs for the DTL recapture rule are to assist MNEs in how to apply the model rules and commentary (with the exception of the new 5 year Unclaimed Accrual election).
The key areas of the new guidance cover:
-Tracking DTLs
-Aggregating DTLs under GloBE Rules
-Determining when a DTL reverses/amount of reversal
-Simplification for Short-term DTLs
-A new Unclaimed Accrual Five-Year election
-Impact on QDMTTs
In order to apply the DTL recapture rule effectively, MNEs will need to track DTLs to determine when they reverse. The time frame in which they reverse is not required for accounting purposes but is required for the DTL recapture rule.
The guidance notes that entities can track their DTLs according to three possible approaches:
– on an item-by-item basis, where DTLs related to each single asset or liability are tracked individually,
-on a General Ledger account (GL account) basis, where DTLs related to all the assets or liabilities encompassed in a GL account are grouped and tracked as a single DTL category, or
– on an Aggregate DTL Category basis. This is generally a category of DTLs determined in relation to two or more GL accounts that fall under the same balance sheet account or sub-balance sheet account.
Constituent Entity are allowed to use different tracking systems for different balance sheet amounts.
Aggregating DTLs under GloBE Rules
The aggregate DTL tracking basis may include Short-term DTLs and Long-term DTLs (ie DTLs that reverse before and after the 5 year recapture requirement).
In order to use the aggregate DTL tracking basis some requirements must be met, otherwise the entity cannot claim the accrual of the DTL under the aggregate basis in the computation of its Adjusted Covered Taxes:
Exclusion of certain types of GL accounts and separate tracking
The guidance provides that DTLs related to the following may be aggregated for purposes of the DTL recapture rule only up to the GL account level:
Exclusion of GL accounts that generate DTAs
An Aggregate DTL basis cannot generally include any GL account that on a standalone basis would always generate only a DTA. This is required as a GL account that generated a DTA would reduce the aggregate DTL giving the appearance that part of the DTL has reversed when it has not.
A Constituent Entity will need to be able to demonstrate that the accounting and tax timing differences in respect of the assets and liabilities in the GL accounts encompassed by the Aggregate DTL basis can only generate a DTL.
Exclusion of swinging accounts and separate tracking
A swinging account is a GL account for which variances in the accounting and tax timing rules result in a net DTA or a net DTL at different points over the life of the encompassed assets or liabilities.
Swinging accounts cannot be aggregated with other GL accounts. DTLs related to swinging accounts that are claimed in the computation of Adjusted Covered Taxes must be tracked separately for purposes of the DTL recapture rule at the level of a single GL account
Determining when a DTL reverses/amount of reversal
Determining when a DTL reverses is crucial for the application of the DTL recapture rule. However, where a DTL balance is based on a GL account or an Aggregate DTL, the netting off of DTAs to DTLs may not result in an overall reversal even if on an item-by-item basis there would have been a DTL reversal.
Therefore, the guidance includes rules to determine whether a reversal (i.e. a decrease in the ending DTL balance) relates to amounts that accrued in the preceding five Fiscal Years. In particular, the rules permit either the FIFO or LIFO basis to be used.
FIFO v LIFO
The FIFO basis can only be used where:
For any Aggregate DTL Category where the FIFO is not/cannot be used, the LIFO basis applies.
Amount of reversal
Whether the FIFO or LIFO basis applies will have an impact on the calculation of the amount of any reversal.
The amount of the reversal is referred to in the OECD guidance as the ‘Unjustified Balance’ in the current Fiscal Year (ie the fifth subsequent Fiscal Year after the year in which the DTL accrual occurred and was claimed in the Adjusted Covered Taxes) when compared with the previous year.
The Unjustified Balance is the excess (if any) of the Outstanding Balance of the DTL over the Maximum Justifiable amount for that category. The Maximum Justifiable Amount is determined differently depending on whether the FIFO or LIFO basis applies.
Under the FIFO basis, the Maximum Justifiable amount is the sum of the net increases in the outstanding DTL balance for each Fiscal Year in the five-year testing period in which there was a net increase in the outstanding DTL balance. This ensures that a net decrease in the DTL balance with a Fiscal Year is treated as reducing the net increase in DTL balance in the earliest Fiscal Year in chronological order.
Under the LIFO basis, the Maximum Justifiable amount is the greater of zero or the net amount of the DTL accruals and reversals that occurred during the five year testing period.
If the Unjustified Balance increases in the current Fiscal Year (compared with the previous year), the increase represents the DTL accrual for recapture. If the Unjustified Balance decreases in the current Fiscal Year, the amount of the decrease is treated as a reversal.
Simplification for Short-term DTLs
The guidance includes an administrative simplification where it can be shown that all of the component DTLs in a GL account or an aggregated DTL category reverse within five fiscal years.
In this case, a Constituent Entity is not required to put in place a tracking system and recapture methodology to demonstrate that the DTLs reverse within 5 years.
In order for this to apply, the Constituent Entity must be able to demonstrate ‘on the basis of objective facts’, that all of the DTLs in a GL account or an Aggregate DTL Category reverse within five fiscal years.
The guidance includes a number of examples (non-exhaustive) of where this objective requirement could be deemed to be met. For instance where DTLs relate to a deferral of tax on a gain for up to a maximum of five years under local tax law.
If an Aggregate DTL Category contains Short-term DTLs and Long-term DTLs, it is permitted to separate the GL accounts with Short-term DTLs from the GL accounts with Long-term DTLs and apply this simplification to the individual GL accounts or an Aggregate DTL Category that includes two or more of the GL accounts.
Unclaimed Accrual Election
An entity can make an annual election under Article 4.4.7 of the OECD Model Rules to exclude an increase in a deferred tax liability from the deferred tax adjustment amount if it is not expected to be paid within the five-year period.
This is known as an “unclaimed accrual”. If this is subsequently paid, it is treated as an increase in the deferred tax adjustment amount for the fiscal year of payment.
The guidance confirms that the application of the election depends on the DTL tracking approach used by the MNE.
If DTLs are tracked individually, the election must be made on each DTL on an item-by-item basis, if tracking is based on a GL account, the election must be made for all the DTLs encompassed in the GL account, if tracking is based on Aggregate DTL Category, the election must be made for all the DTLs encompassed in the Aggregate DTL Category.
Unclaimed Accrual Five-Year election
The new guidance includes a new simplification which extends the application of the Unclaimed Accrual election. Specifically, the guidance provides that a Constituent Entity may make an Unclaimed Accrual Five-Year election for an aggregated DTL category that it does not expect to prove reversed within five Fiscal Years. The result will be that the Constituent Entity will not claim those DTL accruals in determining its Adjusted Covered Taxes and therefore will not need to determine when the DTLs reverse.
This could, for instance, apply where an constituent entity does not have the ability to track DTLs for aggregated DTL category at the GL account level (so that each net DTL accrual and related reversal is excluded from Adjusted Covered Taxes).
Impact on QDMTTs
The guidance provides that QDMTTs must apply the new DTL tracking guidance for Aggregate DTL Categories as well as the new Unclaimed Accrual Five-Year Election. This could result in different DTL categories where a local accounting standard is used for QDMTT purposes, rather than the accounting standard of the UPE or other acceptable accounting standard used for standard GloBE purposes.
Article 4.4.4 of the OECD Model Rules implements a recapture rule for deferred tax liabilities. This applies when the deferred tax liability has not reversed within five years of the fiscal year in which it was originally recognized.
When this recapture applies, the MNE group is required to recompute its ETR for the year the deferred tax liability was originally recognized.
Yes, there are a number of exemptions, the main one being accelerated depreciation on tangible assets. Note: this does not include timing differences relating to the amortization of intangibles or goodwill.
On December 19, 2024, Luxembourg’s Parliament approved a law to amend its Global Minimum Tax Law to implement aspects of the OECD Administrative Guidance.
The Isle of Man has issued a domestic top up tax cessation form for entities that are located in the Isle of Man that are intending to enter liquidation, dissolution or any other form of winding up, or otherwise cease to be located in the Isle of Man for DTUT purposes
On December 13, 2024, the Tax Laws (Amendment) Act, 2024 was published in the Official Gazette. It comes into force on December 27, 2024 and includes a domestic minimum top-up tax.
On December 17, 2024, the Dutch Parliament approved a draft law to amend the GMT Law. This includes a number of amendments to implement further aspects of the February 2023 and July 2023 OECD Administrative Guidance and some aspects of the December 2023 OECD Administrative Guidance.
On December 17, 2024, the Chamber of Deputies approved Bill 3817/24 that repeats Provisional Measure No. 1,262/2024 and implements the DMT. It will be sent to the Senate.
In December 2024, the Malaysian Inland Revenue Board (MIRB) issued guidance on the interpretation and administration of the Pillar Two global minimum tax applicable from January 1, 2025.
On 12 December 2024, the Cyprus House of Representatives voted to approve local legislation to implement Pillar 2. The Law will come into effect once it is published in the official Government Gazette.
On December 15, 2024, Bahrain issued Decision no. (172) of 2024 to provide for the Executive Regulations for the DMTT law. This provides the detailed rules for the operation of the DMTT.
On December 10, 2024, the Australian GloBE legislation received Royal Assent.
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