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Pillar Two: Transitional Rules for Deferred Tax

Pillar Two Deferred Tax Transitional Rules

Contents

Why Transitional Rules are Required

There needs to be a mechanism to deal with pre existing losses and other timing differences otherwise an MNE group could be subject to an artificially low ETR in the periods the GloBE rules apply. 

For example, if an entity had trading losses of 10 million euros that were incurred before it was subject to the GloBE rules, these may be offset against future taxable profits after it is subject to the GloBE rules.

This would result in a nil effective tax rate and Pillar Two top-up tax. This applies irrespective of the fact that the low ETR has arisen due to the offset of losses. 

The Pillar Two rules don’t include specific provisions for the carry forward of losses.  Instead they rely on the deferred tax provision in the accounts to take account of this.

When the losses are incurred a deferred tax asset is created.

As this is released there is a debit to the deferred tax provision in the P&L account to increase the tax charge.

This then reduces or eliminates the low effective tax rate issue. 

Similarly, the reversal of a deferred tax liability after a company was subject to the GloBE rules (eg in a case where income was recognised in year 1 for financial accounting purposes but included in taxable income over a number of years) could also lead to a low effective tax rate.

The release of the deferred tax credit would be a credit to the deferred tax provision in the P&L and reduce the tax charge. 

Therefore the OECD Model Rules needed to reflect deferred tax on transactions before an entity was subject to the Pillar Two GloBE rules. They do this in a number of ways 

Deferred Tax Recognition

The general rule under Article 9.1.1 of the OECD Model Rules, is that in the transition year, deferred tax assets and liabilities of the entity are recognised at the lower of:

  • the domestic tax rate used in the accounts;  and
  • the 15% global minimum rate. 

The restriction on deferred tax assets being recognised at a maximum of the 15% global minimum rate prevents an MNE group reducing top-up tax by creating large releases to the P&L  on the utilisation of a high tax deferred tax asset.

However, deferred tax assets that arise from losses can be recast from a rate lower than 15% to the 15% rate providing the loss would have been a GloBE loss for entity had it been subject to the Pillar Two rules when the loss was incurred. 

The recasting of the loss to 15% is important as this means that this can totally eliminate any top-up tax. 

Example – Deferred Tax Loss Recast

An entity had a loss of 10 million euros in year 1.

The tax rate is 10%.

A deferred tax asset of 1 million euros is created. 

In year 2 the entity became within the scope of the Pillar Two GloBE rules.

It had GloBE income of 10 million euros.

There is no tax payable as the loss is brought forward and fully offset against profits. 

If there was no recast there would be a top-up tax liability even if the deferred tax asset was recognised.

This is because the 1 million euros deferred tax asset would be released to the P&L (Dr Deferred Tax P&L, Cr Deferred Tax Asset) and increase the tax charge to 1 million euros.

The effective tax rate would 10% (1 million/10 million) and the top-up tax percentage would be 5%.

Therefore, top-up tax would be 500,000 euros. 

If the deferred tax asset was recast to 15%, the release of this to the P&L would be 1.5 million euros, which would then equate to a 15% effective tax rate, eliminating any Pillar Two top-up tax. 

There is, though, a price to be paid for this.

Whilst the aim of the transition rules is generally to try and prevent an MNE having to go back and perform GloBE calculations for periods it was not within the scope of the rules, this is only partially correct for a recast loss.

The MNE group can only recast if the loss would have been a GloBE loss.

Therefore, the MNE would need to go through the Pillar Two calculation for the loss year to determine the GloBE loss, as opposed to the accounting loss. 

Note that if a GloBE loss election is made this does not apply (as it does not need to). 

Losses Arising from Permanent Differences

A special transitional rule in Article 9.1.2 of the OECD Model Rules applies to deferred tax assets that arise from permanent differences that are included in calculating taxable income but not Pillar Two GloBE income.

Note that this can apply to both timing differences and permanent differences where they aren’t reflected in Pillar Two GloBE income.

This will frequently arise from a permanent difference.

A permanent difference is a difference between the tax and accounting treatment that won’t reverse out over time.

Typical examples are many of the tax-specific deductions that don’t apply for accounting purposes, such as a specific enhanced tax deduction.

If they aren’t taken into account for Pillar Two GloBE income then this rule can apply.

Where the deferred tax asset is created in a transaction that takes place after 30 November 2021 it is not included in adjusted covered taxes.

This means that on the release of the asset there is no debit to the deferred tax charge in the P&L and no increase in covered taxes. 

This applies to any deferred tax asset, although the key application in practice will be losses. 

Example – Loss Arising from Permanent Differences

In 2024, Company A had profits of 10 million euros and is located in Country X.

It purchased qualifying assets in 2024 for 10 million euros.

In 2025 it became subject to the Pillar Two GloBE Rules. 

For tax purposes it can claim 100% of the cost as an expense.

However, in addition to the 100% immediate tax relief, Company A is also entitled to a super-deduction of 20 million euros for tax purposes.

In this case there would be a tax loss of 20 million euros. The deferred tax asset of 20 million euros arising from the loss is excluded from the calculation of adjusted covered tax in 2025.

This means that if the deferred tax asset was released (eg if profits of 20 million euros were earned) the 5 million debit to the P&L (25% * 20 million) would not be included in adjusted covered taxes.

 Intra-Group Asset Transfers

The Pillar Two treatment of intra-group asset transfers generally follows the financial accounting treatment.

This generally values the transfer of assets at fair value.

Therefore any gain or loss recognised for accounting purposes would also flow through to the GloBE income calculation.

However, the Article 9.1.3 of the OECD Model Rules provides that if an asset is transferred between group entities after November 30, 2021 and before the first year the GloBE rules apply to the group, the asset is recorded at its historic cost providing the entities would have been subject to the Pillar Two GloBE rules had they been in-scope.

The reason for this is to prevent an uplift in the base cost of assets (with potentially additional tax relief and reduced gains on a future disposal) when any original gain on the intra-group transfer was not taken into account for Pillar Two GloBE purposes as the group was not subject to the rules.

This would also mean that any deferred tax assets or liabilities would also need to be recast to the historic value (eg if tax relief for the assets was given over a shorter period than for financial accounting purposes).

Note that under the Model Rules this applies to ‘assets’ not just fixed assets.

This would, therefore, include current assets, however, stock is specifically excluded.

FAQs

The general rule under Article 9.1.1 of the OECD Model Rules, is that in the transition year, deferred tax assets and liabilities of the entity are recognised at the lower of:

  • the domestic tax rate used in the accounts;  and
  • the 15% global minimum rate. 

The restriction on deferred tax assets being recognised at a maximum of the 15% global minimum rate prevents an MNE group reducing top-up tax by creating large releases to the P&L  on the utilisation of a high tax deferred tax asset.

A special transitional rule in Article 9.1.2 of the OECD Model Rules applies to deferred tax assets that arise from permanent differences that are included in calculating taxable income but not Pillar Two GloBE income

Where the deferred tax asset is created in a transaction that takes place after 30 November 2021 it is not included in adjusted covered taxes.

This means that on the release of the asset there is no debit to the deferred tax charge in the P&L and no increase in covered taxes. 

The Pillar Two Commentary makes it clear that this is not a retrospective rule in that it doesn’t apply the GloBE rules to the 2021 fiscal year, but it does effect how the rules apply from the first year an MNE is subject to them.

 

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