One of the core commitments of the G7’s June announcement on the global minimum tax was to address any substantial risks of an uneven playing field under the “side-by-side solution”. This commitment acknowledges that although the G7 countries were satisfied that the existing US rules for ensuring a minimum level of tax is paid by US headquartered groups were sufficiently robust, differences in the design of the US rules and the Pillar Two rules create risks for unequal treatment between groups depending on where they are headquartered.
One of the main design differences that results in different outcomes under the US rules and the Pillar Two rules is that the US rules apply on a blended basis (i.e., by testing the effective tax rate across all non-US subsidiaries, blending high-taxed subsidiaries and low-taxed subsidiaries). In contrast, the Pillar Two rules apply on a jurisdiction-by-jurisdiction basis.
Differences in outcomes under the side-by-side solution
We have examined some very basic fact patterns to demonstrate that the side-by-side solution agreed by the G7 countries gives rise to different outcomes depending on where a group is headquartered. The examples (available here) demonstrate a number of things that you expect, including:
- The operation of the undertaxed profits rule (“UTPR”) means that non-US headquartered groups will, more or less, be in the same position regardless of whether or not their headquarter jurisdiction has implemented Pillar Two. The real difference is between US headquartered groups and non-US headquartered groups.
- Under a side-by-side solution, US groups with a relatively high effective tax rate (“ETR”) on a group basis would not be subject to any additional US top-up tax. In contrast, non-US headquartered groups with a similarly high ETR would generally still be subject to a Pillar Two top-up.
- The level of the Pillar Two top-up for high ETR non-US groups will vary depending on the tax profile of the jurisdictions where the group operates. The top-up can be quite significant (e.g., increase the group ETR by 5%) if the group has a good proportion of its income in low or zero tax jurisdictions.
- Groups with a lower ETR will face top-ups under both regimes. Again, though, top-ups for non-US groups would generally be higher than top-ups for US groups. Top-ups for such low-ETR non-US groups can be substantial under Pillar Two (e.g., increasing a group’s ETR by 10%) if the group operates in a mix of jurisdictions that tax at a medium rate and low or zero tax rate.
What the examples also illustrate is that one way to ensure equilibrium (or something close to equilibrium) in outcomes is if at least a medium level of tax is paid in every jurisdiction where a group operates. Although the Pillar Two concept of a qualifying domestic top-up tax (“QDTTs”) is a step in that direction, QDTTs are optional under the Pillar Two framework. Some jurisdictions may choose not to implement them, or, to abandon them, especially if it improves their ability to attract more US investment. That change in dynamic will make it far more challenging for the side-by-side solution to deliver a level playing field.
Are jurisdictions satisfied with differences in outcomes?
Media reports indicate (unsurprisingly) that countries are already raising concerns that non-US headquartered groups will be at a disadvantage compared to their US competitors. It seems even G7 members who were party to the statement (France, Germany, Italy and the UK) are concerned about the level playing field and are requesting more economic analysis on the side-by-side system. While those countries may have considered that the potential imbalance was a reasonable trade-off for the US agreement to remove section 899 from the draft US tax reform bill, the inclusion of the commitment in the G7 statement to address substantial risks to the level playing field signals the significance of the issue.
One perspective that was not represented in the development of the G7 statement is that of jurisdictions (other than the US) that have not implemented Pillar Two, such as, China, India and Brazil. Groups headquartered in those jurisdictions will still be subject to the full Pillar Two regime (because of the UTPR). It appears that some of those jurisdictions, most notably China, will seek to reopen how the Pillar Two rules apply to groups headquartered in their jurisdictions.
What are the available options?
Three potential options available to keep the playing field in the side-by-side solution level are:
- making adjustments to the US tax rules – it’s clear that there will be limited US appetite for that approach;
- making QDTTs mandatory – this would be a significant encroachment on tax sovereignty and would, in practice, be impossible to enforce; or
- realigning the Pillar Two rules so that they more closely reflect the outcomes under the US system, for example, by moving to a system that allows blending. A big question is whether countries that have so far been strong proponents of Pillar Two would be willing to stomach such changes and this may depend on whether they can tolerate their industrial champions being more highly taxed on their worldwide operations than their US competitors. Previous comments of the German Chancellor calling for the suspension of Pillar Two indicate that there may be appetite for change in some quarters even though those comments were quickly walked back by the German Finance Minister.
Concluding remarks
The impact of the side-by-side solution on the level playing field will be one of the most important aspects of the upcoming negotiations on Pillar Two. It could have a meaningful impact on the level of top-up taxes payable by non-US headquartered groups under a revised Pillar Two framework. Groups headquartered outside the US and the industry bodies that represent them have a pressing interest in ensuring their perspective is understood by their own governments so that it may be represented in the negotiations.
Should you have any questions on developments under Pillar Two, please speak to your usual Matheson contact or to any of our Tax partners.