Deferred Tax and Pillar Two

Deferred Tax Under the Pillar Two GloBE Rules

Deferred tax is an element of covered taxes and therefore directly influences the effective tax rate (ETR) of an MNE.

For instance, an MNE may pay covered taxes of $1,000,000. If it recognizes a deferred tax liability of $500,000, this is added to the covered taxes to increase the covered taxes to $1,500,000. This will (other things being equal) increase the ETR of the MNE for that year.

The deferred tax liability is then released as the liability unwinds and the $500,000 is deducted from covered taxes in relevant future period(s), reducing the ETR. This is provided for in various accounting standards (eg IAS 12).

Covered taxes used for calculating the Pillar Two GloBE ETR are effectively the current tax expense accrued in the financial accounts and adjusted for the “Total Deferred Tax Adjustment Amount”.

The starting point for this adjustment is the deferred tax expense accrued in the financial statements.

However, Article 4.4.1 of the OECD Model Rules requires both deferred tax assets and liabilities to be valued at the lower of the 15% minimum rate and the applicable tax rate. This prevents additional upfront credits for deferred tax liabilities to offset other income in a year.

Impact of Deferred Tax on the Pillar Two ETR: Example

Company A buys plant and machinery in 2023 for $100,000, which will be depreciated over 10 years. For tax purposes, it gets a 100% first-year allowance (FYA). The tax rate is 25%.

In 2023, Company A’s profit before tax is $120,000 (after the $10,000 depreciation).

Company A’s current tax expense is $7,500 ($130,000 profit (including the $10,000 addback for non-deductible depreciation), less the $100,000 FYA, multiplied by the tax rate 25% tax rate).

Company A’s ETR based on the current tax would be $7,500 divided by $120,000, or 6.25%. Because this is below the 15% global minimum rate, a top-up tax would be due.

However, given the FYA represents a timing difference, deferred tax should be considered.

The timing difference in 2023 is the $100,000 FYA minus $10,000 depreciation, which is $90,000.

The deferred tax liability is $90,000, multiplied by 15% (recast to the global minimum rate), which is $13,500.

The total tax expense is now the $13,500 deferred tax liability plus the $7,500 current tax expense, equaling $21,000. The ETR is then $21,000/$120,000, equaling 17.5%, which is above the global minimum tax rate.

In 2024, assuming the same profits ($120,000), the current tax would be $130,000 x 25%, or $32,500. The ETR based on the current tax expense would be $32,500/$120,000, or 27%.

Again, there is a timing difference of $80,000 (as the accounts reflect $10,000 depreciation for 2024). Therefore, the deferred tax liability is $80,000 x 15%, or $12,000.

The deferred tax liability released to the profit and loss account is $1,500 ($13,500 from 2023 minus $12,000 from 2024), which would be a credit (i.e., a negative tax entry) in the account.

Total tax would therefore be $32,500 minus $1,500, or $31,000.

The ETR, accounting for deferred tax, would be 25.8% ($31,000/$120,000).

This pattern would continue each year until the deferred tax liability was fully released.

Exclusions

A number of deferred tax movements that may be included in the deferred tax calculation for accounting purposes are specifically excluded for Pillar Two GloBE purposes.

These include:

• Just as for the current tax expense, Article 4.4.1(a) of the OECD Model Rules provides that any deferred tax expenses relating to items excluded from the Pillar Two GloBE income or loss are excluded from covered taxes;

• Deferred tax expenses relating to disallowed accruals and unclaimed accruals (essentially deferred tax movements relating to an uncertain tax position or distributions from an entity) are excluded under Article 4.4.1(b) of the OECD Model Rules, given their speculative nature;

• The impact of a valuation adjustment or accounting recognition adjustment for deferred tax assets is excluded under Article 4.4.1(c) of the OECD Model Rules.

For financial accounting purposes, if it’s not certain that a deferred tax asset may be utilized in the future, a valuation or recognition adjustment may be made (eg if it’s not expected that sufficient profits would be available to offset any losses).

This would either reduce the deferred tax asset in the financial statements or provide for an offsetting liability to reduce the amount of the deferred tax asset. This would then be reversed in the future if the deferred tax asset was likely to be offset.

See our Pillar Two Deferred Tax Calculator for a simple illustration of how deferred tax interacts with Pillar Two.

For Pillar Two GloBE purposes, accounting valuation and recognition adjustments are ignored and the deferred tax asset would therefore be increased by this amount for covered tax purposes;

• Deferred tax expenses arising from a change in the domestic tax rate are excluded under Article 4.4.1(d) of the OECD Model Rules as they have no impact on the tax charge on the current profits.

However, although a change in domestic tax rates is not taken into account in the current year, this could have deferred tax implications for previous years. For more information, see Post-Filing Adjustments; and

• 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.

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 an investment 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 investment 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.

Adjustments

The deferred tax expense in the financial accounts is then subject to a number of Pillar Two specific adjustments:

• Article 4.4.2(a) of the OECD Model Rules provides that it is increased for any disallowed accrual or unclaimed accrual (see below) paid during the relevant fiscal year.

As discussed above they are not taken into account when accrued given they are speculative. However, once paid they are included. The tax paid would be included in the current tax expense, and the unwinding of a deferred tax liability would offset this (as this would be a credit to deferred tax in the P&L and reduced taxes).

A disallowed accrual should be excluded from the deferred tax expense anyway so no further adjustment is required. This therefore mainly applies to unclaimed accruals;

• It is increased by the amount of any recaptured deferred tax liability (see below) that was treated as a reduction in covered taxes, but which is subsequently paid during the fiscal year (Article 4.4.2(b) of the OECD Model Rules); and

• It is reduced, under Article 4.4.2(c) of the OECD Model Rules, where a deferred tax asset has not been recognized as the accounting recognition criteria was not met (i.e., a deemed deferred tax asset is generated).

A deferred tax asset that has been valued at a rate lower than the 15% minimum rate may be revalued at the 15% rate if the entity can show that the deferred tax asset is attributable to a Pillar Two GloBE loss (Article 4.4.3 of the OECD Model Rules).

This would then reduce the deferred tax expense for Pillar Two GloBE purposes in the fiscal year of revaluation just as for any standard increase in a deferred tax asset.

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.

Excess Losses

General deferred tax accounting concepts apply to losses, and a loss would therefore be a deferred tax asset. This means covered taxes are reduced in the year the deferred tax asset is recognized (i.e., when the local tax loss arises), and are subsequently increased as the deferred tax asset is released and the loss is utilized.

A special rule in Article 4.1.5 of the OECD Model Rules identifies the amount of losses that would have been available in the jurisdiction if the deferred tax asset were based on the Pillar Two GloBE Rules rather than local tax rules. A loss in excess of this is treated as additional top-up tax for that year.

The reason for this is that the loss could have arisen from permanent differences due to specific features of a jurisdiction’s tax rules (e.g., enhanced tax deductions for certain expenses).

This rule aims to prevent excessive relief when the loss arises from a permanent difference.

Transitional Rules

Certain transitional rules apply to the first fiscal year that an MNE group comes within the scope of the Pillar Two GloBE Rules in a jurisdiction.

Article 9.1 of the OECD Model Rules provides that the MNE group can take into account all the deferred tax assets and deferred tax liabilities in the financial accounts for relevant entities in a jurisdiction for that year.

These must be taken into account at the lower of the 15% minimum rate or the applicable domestic tax rate. However, losses or other deferred tax assets that would have arisen under the Pillar Two GloBE Rules can be revalued to the minimum rate from a lower domestic rate.

The net effect of this is that timing differences that began before an MNE is subject to the Pillar Two regime are effectively treated as though Pillar Two was in place when the timing difference began.

However, as an anti-avoidance measure, deferred tax assets that arise from items that are excluded from the computation of Pillar Two GloBE income are excluded from the MNE’s deferred tax computation where they arise from transactions after November 30, 2021.

This is to discourage tax-motivated transactions to generate deferred tax assets that would subsequently increase covered taxes in years when the deferred tax asset is released.

Similarly, where there is a transfer of assets (other than stock) between relevant entities after November 30, 2021, but before the first year the MNE group is subject to Pillar Two in that jurisdiction, the asset value is the transferor’s carrying value of the assets, with deferred tax assets and liabilities, also determined on that basis.