Distribution Tax Regime Election

What is a Distribution Tax Regime?

Article 7.3.1 of the OECD Model Rules permits a constituent entity to to make a Distribution Tax Regime Election. 

A distribution tax regime is a tax regime that doesn’t levy a tax charge on taxable income when it is generated, but when it is distributed. Estonia, which levies a 20% corporate income tax charge when profits are distributed is a good example of this.

In order to ensure that expenses that are not deductible for tax purposes are also taxed, non-business expenses are treated as a deemed distribution and would also be subject to the distribution tax. 

What is the Issue?

Some aspects of a distribution tax regime fit in with the Pillar Two GloBE Rules nicely. For instance, the Estonian distribution tax relies on the financial accounts, just like the GloBE Rules. There are limited book-to-tax adjustments unlike in most traditional corporate income tax regimes. However, the issue with distribution tax regimes relates to the timing of income and tax suffered for the purpose of calculating the GloBE ETR.

As such, ensuring that a distribution tax regime is accommodated by the Pillar Two GloBE Rules requires some specific adjustments to the general rule. Article 7.3 of the OECD Model Rules implements this. 

A key issue is that a company may not distribute profits for a number of years. They would have GloBE income but no or limited tax suffered on that income which would lead to a sizeable Pillar Two top-up tax liability.  In the years that profits were distributed and a distribution tax charge was incurred, the tax levied may be substantial compared to the income for the year, resulting in no top-up tax. The tax suffered does not, therefore, tie in with annual taxable income. 

How Does Pillar Two Treat Distribution Tax Regimes?

The way that the Model Rules incorporates distribution tax regimes is by deeming an amount of tax to have been suffered on the income to the lower of:

• the amount that would have been suffered under the 15% global minimum rate; and 
• the amount of distribution tax that would have been paid if the Constituent Entities in the jurisdiction had distributed all of their income during the fiscal year.

This then limits the deemed distribution tax to the actual tax on the income.

After doing this, a Deemed Distribution Tax Recapture Account is created. This tracks the amount of the deemed distribution tax, and reduces it for distributions and any losses.

If the Deemed Distribution Tax Recapture Account is not reduced to zero (on a rolling basis) within four years after the year of creation, the Pillar Two top-up tax calculation for the year of creation must be recalculated, taken into account the balance of the Deemed Distribution Tax Recapture Account. 

This ensures that the top-up tax liability in the year of creation is the same as if the distribution tax paid in the following four years had actually been paid in the year of creation. 

For more information, including a worked example, see Distribution Tax Regimes.