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Tracking Deferred Tax Adjustments for Pillar Two

Contents

General

The application of the Pillar Two global minimum tax hinges on the calculation of the effective tax rate (ETR). Only when the jurisdictional ETR is below 15% will this apply. 

The ETR is based on adjusted covered taxes and Pillar Two GloBE income, both calculated under the Pillar Two rules. Adjusted covered taxes takes the current and deferred tax figures from the financial accounts and adjusts them for Pillar Two purposes. 

Multinationals will therefore need to be able to track the underlying adjustments to ensure that they are able to correctly calculate deferred tax for Pillar Two.

Some of the tracking adjustments will be relatively straightforward to apply given the information will already be in their financial accounting or ERP system. However, others will require significant adjustments to existing systems, particularly where the Pillar Two requirements differ from the treatment under current accounting standards such that the specific adjustments have not historically been tracked. 

In this article, we take a comprehensive look at what adjustments will need to be tracked and how difficult this will be. 

Summary

Before looking at the detailed rules, its useful to summarise all of the deferred tax tracking adjustments MNEs will need to have in place. 

The complete list is:

  • Domestic tax rate used for deferred tax
  • Deferred tax assets from December 1, 2o21
  • Intra-group asset transfers from December 1, 2021
  • Deferred tax related to income excluded from Pillar Two
  • Deferred tax valuation and accounting recognition adjustments
  • Disallowed and unclaimed accruals
  • Deferred tax arising from changes in the domestic corporate income tax rate
  • Deferred tax arising from tax credits
  • Deferred tax liabilities not fully reversed within five years
  • Excess losses
Brought Forward Adjustments

The first key point relates to the first year that a multinational is within the scope of the Pillar Two rules (eg when the jurisdiction enacts relevant legislation or when the turnover of the group exceeds 750 million euros and brings it within scope). 

General Rule

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.

However, this is subject to the restriction that the 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 reason for the restriction on deferred tax assets being recognised at a maximum of the 15% global minimum rate is to prevent an MNE group from 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. 

The fact that existing deferred tax attributes are recognized is good news for MNE groups as is the fact that they are not required to go back and recalculate the preexisting deferred tax entries under Pillar Two. The only adjustment is a potential recast for the tax rate used in the accounts. However, this would be a simple adjustment to track. 

Losses Arising from Permanent Differences

Whilst the above represents the general rule, there is a potential fly in the ointment. A special transitional rule in Article 9.1.2 of the OECD Model Rules applies to deferred tax assets that arise from items that are excluded from the computation of Pillar Two GloBE income. Under the OECD Model Rules, they are excluded from the MNE’s deferred tax computation where they arise from transactions after November 30, 2021.

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. 

Although the OECD Model Rules apply this special rule after November 30, 2021 (ie December 1, 2021 onwards) it may well be that specific jurisdictions will vary the application date.

Therefore MNE groups will need to ensure that domestic enacting legislation is reviewed to identify the application date. They will then need to review brought forward deferred tax assets that arose on or after December 1, 2021, and identify whether they would be excluded under the existing Pillar Two rules.

Whilst the OECD Commentary states that this does not have retroactive application, and is just to identify the treatment in the first year of Pillar Two, in practice this will be a significant burden. It is, however, essentially a one-off exercise.

A similar rule applies to intra-group asset transfers. 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.

As for deferred tax assets arising from differences between the accounting and Pillar Two treatment, this will mean MNEs will need to track intra-group asset transfers from December 1, 2021, and adjust the deferred tax entries.

Again, a burdensome, one off exercise.

Tax Rate Used in The Accounts

This needs to be tracked for two main purposes:

Firstly, 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. 

Secondly, 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 it can be shown that the deferred tax asset is attributable to a Pillar Two GloBE loss (Article 4.4.3 of the OECD Model Rules).

This would be of significant benefit to an MNE Group as without this recast top-up tax would be levied on the unwinding due to the tax rate used being less than 15%.  This is a similar adjustment as for brought forward deferred tax attributes, except it applies on an ongoing basis.

Given the preparation of the financial accounts involves a consideration of the tax rate to be used for calculating deferred tax, this should be a simple adjustment to track. 

Deferred Tax Related to Pillar Two Exclusions

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. 

The key aspects that MNEs will need to track are:

  • Excluded Dividends – generally dividends (or other distributions on shares) where the MNE group holds 10% or more of the ownership or had held full ownership for more than 12 months.
  • Excluded Equity Gains or Losses. This includes (1) Changes in the fair value of an ownership interest (eg accounting policies that apply to financial instruments which revalue assets and liabilities at their current market value) and (2) Profits or losses from an ownership interest under an equity method of accounting.
  • Policy Disallowed Expenses

In many cases, tracking these adjustments will require amendments to MNEs’ underlying ERP systems in order to adequately pull the data given the new definitions in Pillar Two.

Valuation and Accounting Recognition Adjustments

Valuation adjustments or accounting recognition adjustments for deferred tax assets are excluded under Article 4.4.1(c) of the OECD Model Rules.

The requirements under accounting standards vary but generally, in order to reflect a deferred tax asset in the balance sheet, there needs to be some likelihood that the asset will be available for future offset.

If it was not probable that the asset would be utilized then the deferred tax asset would need to be amended to reflect this.

There are broadly two ways of achieving this for financial accounting purposes.

One, the deferred tax asset could be shown in full, but then there is an associated credit in the balance sheet to reduce its value to the level that is expected to be offset.

Alternatively, the deferred tax asset could be adjusted to just show the net amount that is expected to be utilised.

These are commonly known as the ‘gross’ or ‘net’ method of reflecting deferred tax.

Under IFRS (IAS 12) the net approach is followed, while US GAAP (ASC 740) uses the gross method.

In both cases, for the purpose of the GloBE rules, they are excluded.

If the deferred tax asset isn’t recognized at all due to the requirements under the accounting standard not being yet, Article 4.4.2(c) of the OECD Model Rules, deems there to be a where a deferred tax asset.

This is a relatively straightforward adjustment to track, given this will be available directly in financial accounting preparation software.

Disallowed and Unclaimed Accruals

A disallowed actual is:

  • any movement in the deferred tax expense that relates to an uncertain tax position (where there is doubt over the tax filing position taken, such that the deferred tax amount in the accounts is adjusted to take account of the uncertainty).
  • deferred tax that relates to distributions from a constituent entity (eg relating to withholding tax).

An unclaimed accrual is an increase in a deferred tax liability that is not expected to be paid within the next five years and an election is made not to include it.

Both of these are excluded under Article 4.4.1(b) of the OECD Model Rules, given their speculative nature. 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).

The disallowed accrual is likely to be relatively straightforward to track, however, unclaimed accruals will require MNEs to assess their deferred tax liabilities to identify the likelihood of them being paid within five years. 

This does not mirror the treatment under accounting stands as under many accounting standards (eg IAS 12) deferred tax liabilities are recognised for all taxable temporary differences (subject to some limited exceptions for goodwill, business combinations and investments in subsidiaries).

Whilst this is an election, if no election is made and the deferred tax liability is not fully paid within five years, the Pillar Two recapture provisions would apply anyway (see below). Therefore, simply not applying for this to apply would not negate the requirement to track deferred tax liabilities in the five-year window.

Change in Domestic CIT Rate

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.

This is a relatively straightforward deferred tax adjustment to track given this adjustment will be contained in the financial reporting software.

Tax Credits

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 likely to be a significant adjustment to the financial accounting deferred tax figure. However, for tracking purposes it is likely to be relatively straightforward to identity and obtain the required adjustments for deferred tax arising from tax credits. 

Recaptured Deferred Tax Liabilities

Article 4.4.4 of the OECD Model Rules implements a recapture rule for deferred tax liabilities. This applies when the deferred tax liability has not reversed (ie is fully paid) within five years of the fiscal year in which it was originally recognized.When this recapture applies, the MNE group is required to recompute its ETR for the year the deferred tax liability was originally recognized. If there is then any top-up tax, this top-up is added to the top-up tax for the current year. 

If the recaptured deferred tax liability is subsequently paid, there is then a further adjustment to deferred tax under Article 4.4.2(b) of the OECD Model Rules

The recaptured deferred tax rule will be a significant tracking burden for MNEs. 

Firstly, they will need to introduce measures into their financial accounting and ERP systems to identify deferred tax liabilities that are not fully reversed within five years. This in itself is difficult. 

Secondly, there are a number of exceptions to the recapture rule under Article 4.4.5 of the OECD Model Rules (eg accelerated depreciation on tangible assets). Therefore, not only will MNEs need to identify which deferred tax liabilities aren’t paid but they will need to classify them according to whether they fall within a category that is included or excluded from the recapture requirement. 

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.

This again will be a significant burden and will require the recomputation of domestic financial accounting losses under the Pillar Two Rules to identify whether there is any additional top-up tax to be levied. 

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