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Pillar Two GloBE Income Elections

Pillar Two GloBE Income Elections

Contents

Election for Stock-Based Compensation

Article 3.2.2 of the OECD Model Rules includes an election to replace the deductible amount of stock-based compensation in the financial accounts of the constituent entity with the amount deductible in its corporate income tax return. This applies to shares/stock and options and warrants related to them.

As with a lot of the Pillar Two GloBE adjustments, the intention here is to replicate the tax treatment under domestic tax in many jurisdictions.

For financial accounting purposes, companies generally account for stock-based compensation based on the present value of the stock option at the time of issue, and amortize that amount over the vesting period.

However, for tax purposes, companies generally deduct the value of stock-based compensation based on the ultimate market value of the stock.

Eg a company may be able to deduct the present value of the stock option at the time of issue over the term of the option, and then the difference between the present value at the time of issue and the market value when the option is exercised.

If the market value of the stock increases over the life of the option, as it frequently does, the tax deduction for the company will be higher than the financial accounting expense. This isn’t a temporary difference and therefore won’t be picked up in the deferred tax calculation. This would then result in a lower Pillar Two GloBE ETR.

This election, therefore, looks to replicate domestic tax laws that allow a tax deduction based on the value of stock at the exercise date. If the election is made and a tax deduction is taken on the issue of the option (as permitted under the domestic law) but it is not subsequently exercised, the amount taken as a deduction for Pillar Two GloBE income is treated as additional Pillar Two GloBE income.

The election is a 5-year election on a jurisdictional basis (ie it applies to all constituent entities in the jurisdiction).

Stock-Based Compensation Election – Example

Whilst the treatment for both financial accounting purposes and domestic tax treatment can vary, depending on the GAAP and domestic tax regime, this simple example illustrates the key principles.

Example

MNECo1 is part of an MNE group subject to the Pillar Two GloBE rules.

In year 1 it issued 1.2 million stock options to employees with an exercise price of 20 euros per share. The current share price is 20 euros per share.

The fair value of each stock option is 10 euros per share.

The stock options vest over a 3 year period.

For accounting purposes, there will be an expense in the financial accounts in years 1-3 of 4,000,000 euros (400,000 shares * 10 euro/share). The accounting entry each year is:

Dr P&L – Stock-based compensation expense 4,000,000
Cr Balance sheet – Additional Paid in Capital 4,000,000

In year 4 the stock options vest. All of the employees exercise their options. The share price is 40 euros per share.

The accounting entry is:

Dr Cash 48,000,000
Dr Additional Paid in Capital 12,000,000
Cr Common Stock & APIC* in Shareholders Equity 60,000,000

*Additional Paid In Capital (APIC)

In this case, the APIC account is reversed when the options are exercised. Note, when the stock options are exercised there is no impact on the P&L as the entries go to the balance sheet. Therefore, the company effectively gets a deductible expense for financial accounting purposes of 4,000,000 euros per year for the 3-year period.

For tax purposes, in MNECo1 jurisdiction, the company gets a tax deduction equal to the value of the shares received by the employee at the date of exercise, less any amount paid for those shares by the employee ie 24,000,000 euros.

In this case, there would be a choice between using the accounting treatment and taking a 4,000,000 euros deduction to reduce profits for the 3 years or the tax treatment and a 24,000,000 deduction in year 4.

This is actually not the end of the matter though as there is also a deferred tax implication due to the timing difference between the recognition of the tax expense and the financial accounting expense. Let’s assume the tax rate in MNECo1’s jurisdiction is 20%.

In each of the 3 years deferred tax would be provided for as:

Dr Deferred Tax Asset (Balance Sheet) 800,000 (4,000,000 * 20%)
Cr Deferred Tax Expense 800,000

After the three years when the tax deduction is obtained, the deferred tax asset is released. In this case, this would be:

Dr Deferred Tax P&L 2,400,000
Cr Deferred Tax Asset 2,400,000

Therefore the 800,000 euro credit to the P&L for deferred tax would decrease the ETR which would offset the expense in the P&L for share-based compensation. Similarly, the release of the deferred tax asset would increase covered taxes and increase the ETR.

Election to use the Realization Method

This applies where a constituent entity uses the fair value accounting method to account for assets and liabilities it holds. Generally speaking, the fair value accounting method revalues assets and liabilities for certain financial instruments to market value for accounting purposes.

Where a domestic tax system adopts a similar approach there would be no issue. However, if a domestic tax system taxed gains on realisation of the asset there would be a divergence. The Pillar Two rules would include the fair value movements in GloBE income (and therefore potentially subject to top-up tax).  

This results in gains or losses that would be included in Pillar Two GloBE income even though they are essentially only on paper.

Article 3.2.5 of the OECD Model Rules provides for an election that replaces the fair value accounting method with the realization method so that gains and losses are only reflected in the Pillar Two GloBE income or loss when assets or liabilities are sold. This will require an adjustment to Pillar Two GloBE income to exclude any gains or losses derived from the fair value method that were reflected in the financial accounts.

This is a five-year jurisdictional election.

Election to Spread Capital Gains

Article 3.2.6 of the OECD Model Rules provides for an election that allows an MNE group to spread gains and losses on sales of local immovable tangible assets over the current year and the previous four years and to match gains with losses.

The intention behind this is to avoid volatility in the ETR calculation that could arise if one-off gains or losses reflected in the financial accounts flowed through into the Pillar Two GloBE income or loss calculation.

The election works by allocating the total gains from all sales of immovable tangible assets in the jurisdiction (aside from intra-group transfers), firstly to any net asset losses starting with the earliest year first (ie the fourth year before the year of the election).

If there are no net asset losses or the loss is insufficient to cover the gain, the remainder is carried forward and offset against the next year (eg year 3).

If any gain remains after the offset of losses, this is then simply pro-rated over the 5-year period and allocated to constituent entities based on their share of the total net asset gain in the election year.

For instance, if total gains were 10 million euros and company A had gains of 8 million euros and company B had gains of 2 million euros, a remaining gain of 5 million would be allocated as 4 million euros to company A and 1 million euros to company B, and be spread over the 5 year period.

The approach is therefore to (1) carry back the gain to a loss year in the lookback period, and then (2) prorate any remaining gain evenly over the lookback period.

Capital Gains Election – Example

Company 1 realized a loss on tangible net assets of 5,000,000 euros in 2026. In 2028 it realized a net asset gain of 25,000,000 euros on tangible assets. It made a Pillar Two GloBE election for the carryback of the gain in 2028.

The gain is carried back to 2026 first and offset against the loss. This reduces the gain to 20,000,000 euros.

This gain is then offset evenly with 4,000,000 euros being allocated to 2024,2025,2026,2027 and 2028. As a result of this 2026 would have a gain allocated to it of 9,000,000 euros and 4,000,000 would be allocated for each of the remaining years.

The ETR and top-up tax of any previous years affected by the carry back would need to be recalculated for Pillar Two GloBE purposes.

Any covered taxes that are included in the tax expense in the financial accounts must be removed from adjusted covered taxes for Pillar Two GloBE purposes if an election is made.

This is a jurisdictional election made on an annual basis.

Capital Gains Carry Back Calculator

Use our capital gains carry back calculator to see the impact of making an election to spread capital gains.

Consolidation Election

Whilst consolidated financial accounts are used for determining whether MNE groups are in scope, Pillar Two GloBE income is based on the entity-level financial accounts before any consolidation adjustments.

As such, transactions between group entities are taken into account when determining the Pillar Two GloBE income or loss of constituent entities.

However, for tax purposes, if there is a domestic group relief or consolidation regime, this may ignore in-country intra-group transactions or provide for another form of relief for sharing intra-group losses.

An election is available in Article 3.2.8 of the OECD Model Rules that adopts an amended form of accounting/tax consolidation and applies to constituent entities of an MNE group in the same jurisdiction that are included in a tax consolidation group in the jurisdiction.

If the election is made, income, expenses, gains and losses between the constituent entities are eliminated. It does not impact on the carrying value of assets.

The election does not apply to investment entities or minority-owned entities given they are treated on a standalone basis for the jurisdictional blending calculation.

Note that this election is not available for transactions between constituent entities in different jurisdictions.

This is a five-year jurisdictional election.

The aim of the election is to make the accounting (and therefore Pillar Two GloBE) treatment more aligned with the local tax treatment. The greater the disparity the greater the risk of adverse consequences under the Pillar Two GloBE rules, particularly as the tax expense in the accounts is used as a starting point and then adjusted.

For instance, if for domestic tax purposes intra-group transactions were ignored this would represent a difference in the taxable income of each constituent entity in the jurisdiction from the financial accounting income (assuming intra-group transactions and no consolidation election is made). The current tax in the P&L which flows through into adjusted covered taxes would be based on the domestic tax treatment.

This could lead to a distorted ETR depending on whether the entity was a net recipient or payee.

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