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The Treatment of Tax Transparent Entities Under Pillar Two

Contents

What is the Issue?

Tax transparency is a feature of many domestic tax regimes as a means of applying a single layer of taxation. Tax transparent entities are also used by MNEs for a variety of tax (and non-tax) reasons, not least the ability to maximize double tax relief. 

A key feature of the GloBE rules is to try and reflect key features of domestic tax regimes, particularly in the calculation of GloBE income. As such, in many cases, a tax transparent entity would be treated for Pillar Two purposes in the same way as it is for domestic tax purposes, subject to some specific GloBE adjustments (eg to reflect income of non-group members or permanent establishments).

However, where the tax transparent entity is itself the Ultimate Parent Entity (UPE) of the group, this poses some problems in the application of the GloBE Rules.

Income can’t be allocated to the owners, as they would not be within the scope of the Pillar Two GloBE rules. In addition, tax paid by the UPE may be minimal given tax is payable on the income by its owners. This could lead to very low effective tax rates for a tax transparent UPE and substantial top-up tax obligations.  

Therefore, the Model Rules include a number of special rules to deal with these situations. 

What is a Tax Transparent Entity Under Pillar Two?

Under the Model GloBE Rules, a flow-through entity is either a tax transparent entity or a reverse hybrid entity. 

 The starting point is therefore whether an entity is a flow-through entity or not. If it isn’t it won’t be a tax transparent entity. Under Article 10.2.1 of the Model Rules, in order to be a flow-through entity it must be fiscally transparent in the jurisdiction where it was created unless it is tax resident and subject to a covered tax on its income or profit in another jurisdiction.
 
A tax transparent entity is further defined in Article 10.2.1(a) of the Model Rules as an entity that is fiscally transparent in the jurisdiction where its owner is located. 
 
Therefore, just because a jurisdiction treats an entity as transparent for tax purposes does not mean that it would necessarily be treated as fiscally transparent for GloBE purposes. In particular if it was not treated as fiscally transparent in another jurisdiction where it was tax resident and was taxed on its income it wouldn’t be a flow-through entity (and therefore not a tax transparent entity) for Pillar Two purposes. 
 
A good example would be a US LLC. This may be treated as tax transparent for US tax purposes but would be treated as opaque for UK tax purposes. It would therefore simply be another constituent entity for Pillar Two purposes and would be subject to the jurisdictional effective tax rate (ETR) and top-up tax calculation just as for other constituent entities. 
 
Once it’s determined that an entity is a flow through entity, in order to be a tax transparent entity, it would need to be treated as tax transparent in the jurisdiction of its owners. For instance, a Cayman Islands Limited Partnership with UK resident partners would be treated as a tax transparent entity as the UK treats a Cayman Islands Limited Partnership as tax transparent

GloBE Treatment of Tax Transparent Entities

The key difference between tax transparent entities and other constituent entities for Pillar Two purposes relates to the allocation of GloBE income and covered taxes
For domestic tax purposes, the income of transparent entities is taxed on the underlying owners. However, for accounting purposes, these entities would generally have their own financial accounts.
 
Given the Pillar Two GloBE rules rely on financial accounting information, specific additional rules are provided in Article 3.5 of the OECD Model Rules to correctly allocate the income of transparent entities in a way that reflects most domestic tax treatment.
 
The GloBE income of the tax transparent entity is reduced by any amounts due to non-group members and permanent establishments under Article 3.5.1 of the Model Rules. The remainder is then allocated to the owners of the tax transparent entity in proportion to their ownership interests unless the tax transparent entity is the Ultimate Parent Entity (UPE) of the group (in which case the GloBE income is allocated to the UPE). 

Example – Tax Transparent Entity Allocation

Consider this example:
Group structure - tax transparent
Sub1 is a tax transparent entity and has GloBE income of 10 million, with 5 million attributable to the PE. Firstly, Sub1’s GloBE income is reduced by amounts due to minority holders (10M * 40% = 4 million). The remaining 6 million is then allocated, firstly the PE (3 million) then the UPE (3 million), as Sub1 is a tax transparent entity. 
 
As such, providing the tax transparent entity isn’t the UPE the GloBE income simply passes up to the ownership chain in the group in line with most domestic tax treatment.
 
Similarly, Article 4.3.2(b) of the Model Rules also provides that covered taxes included in the financial accounts are also allocated to the owners to match the income with the associated tax. 
 
This treatment flows up the chain. Therefore, if a tax transparent entity was held by another tax transparent entity, the allocation of GloBE income and covered tax would flow up the chain. If all entities were tax transparent the end result would be that GloBE income would be allocated to the UPE. 

UPE as Tax Transparent

There are special rules to UPEs that are tax transparent, as the UPE owners are not constituent entities of the MNE Group and would not be required to apply the GloBE Rules.
 
As such, the GloBE income of a tax transparent UPE is allocated to it. 
 
However, the ETR of the UPE may be very low or even nil if it is a tax transparent entity given tax on the income would be incurred by the owners of the UPE and not the UPE itself. Therefore, without further provisions this would lead to a substantial top-up tax obligation for tax transparent UPEs even though the income maybe subject to significant tax in the hands of the owners. 
 
The difficulty here is identifying the tax that the owners incur. Simply allocating taxes to the UPE on the UPE income that was accrued by the owners that are outside an MNE Group would be extremely difficult to apply. 
 
As for the standard allocation rules for tax transparent entities, the amount allocated to the UPE is reduced by any amount attributable to a PE or to non-group interests. 
 
However, Article 7.1 of the Model Rules then provides for a number of reductions in the GloBE income of the UPE. The broad intention is that if the owners of the UPE pay tax at or above the 15% minimum rate, the UPEs GloBE income should also be reduced. 
 
The GloBE income of the UPE is reduced in three situations:
  • the holder is subject to tax on its share of the GloBE income at a nominal rate that is at least 15% or if the UPE can demonstrates that it is reasonable to expect that its income will be subject to tax at a rate of at least 15%;
  • the holder is a natural person that is a tax resident in the UPE jurisdiction and holds ownership interests that, in the aggregate, are less than 5% of the UPE; or
  • the holder is a Governmental Entity, an International Organisation, a Non-profit Organisation, or a Pension Fund and holds ownership interests that, in the aggregate, that are less than 5% of the UPE.

These three safe harbour provisions can be useful for UPEs.

The GloBE income reduction for natural persons, for instance, recognises that whilst identifying the tax position of minority owners may be difficult for a UPE, individuals are generally not subject to special tax regimes for income from a tax transparent entity.

As such, it is reasonable not to require the UPE to determine the tax position of a natural person that holds an ownership interest of less than 5% of the profits or assets of the UPE. This means that a UPE would be required to identify the tax position of no more than 19 individuals. 

Article 7.1.3 of the Model Rules also requires the UPE to reduce its covered taxes, pro-rata to the GloBE income reduction calculated above (eg a 50% reduction in GloBE income would result in a 50% reduction in covered taxes). It may be that there are no or at least minimal covered taxes anyway if the entity was tax transparent for domestic tax purposes. 

Example – Individuals and a Tax Transparent Entity

Group structure tax transparent partners
Assume the Australian LP has GloBE income of 100 million. 60 million is attributable to the Australian partners and 40 million to the UK partners. 
 
If the Australian partners are all individuals that hold less than 5% of the profits/assets of the UPE and are tax resident in Australia, the 60 million attributable to them is deducted from the UPEs GloBE income under Article 7.1.1(b) of the Model Rules
 
If the UK partners are taxed at a rate of 15% or above (as would be expected) the 40 million attributable to them would also be deducted from the UPEs GloBE income under Article 7.1.1(a) of the Model Rules
 
As such the GloBE income of the UPE would be nil. 

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