For EU Member States, the complexity of Pillar Two has been compounded by the decision to implement through an EU directive that can only be amended unanimously. That was very apparent in the recent negotiations on the side-by-side package when the implementing framework operated as a straitjacket for EU Member States. Although, the European Commission came-up with a workaround to implement the package, it is unlikely to be the last time EU Member States face the same dilemma.
Apart from the legal constraints inherent in the implementing framework, other EU law risks that are unique to the EU legal system might impact the operation of Pillar Two in the EU. The undertaxed profits rule (“UTPR”) is already facing one legal challenge at the Court of Justice of the European Union (“CJEU”). A separate action for the annulment of the Pillar Two Directive was deemed inadmissible by the CJEU late last year on the basis that the party bringing the challenge lacked legal standing. It seems possible that other aspects of the Pillar Two Directive, including the legal basis for the directive, may also be litigated.
In this update we consider some of those legal challenges and the broader impact on EU tax policymaking.
Legal challenge to UTPR
The CJEU is expected to hear a challenge under EU law to the UTPR before the end of the year. That challenge has been brought by the American Free Enterprise Chamber of Commerce (“AmFree”), a US trade organisation. The action was initiated before the exemption from the UTPR for US groups was agreed under the side-by-side package.
AmFree argues that the UTPR is incompatible with rights and principles protected by the Charter of Fundamental Rights of the European Union, the European Convention on Human Rights and the Treaty on the Functioning of the European Union.
The challenge focuses primarily on the design of the UTPR. In particular, AmFree contends that, because the UTPR may be imposed on any group entity regardless of that entity’s own financial position, the rule may jeopardise that entity’s financial stability and thereby interfere with its right to property. AmFree also argues that, because the amount of any UTPR liability cannot be determined until after the end of the relevant financial year, the rule creates uncertainty for both taxpayers and third parties dealing with them. On that basis, it is said to interfere with the freedom to conduct a business and the general principle of legal certainty. In addition, the proceedings question the extraterritorial effect of the UTPR, which AmFree argues is inconsistent with the principle of fiscal territoriality.
The case is expected to be heard towards the end of the year. There is currently no indication that the introduction of the side-by-side package will lead to the proceedings being withdrawn. That may be because the side-by-side safe harbour applies only from 1 January 2026, leaving US groups potentially exposed to the UTPR in 2025.
If the challenge were successful, it could preclude the application of the UTPR by the entire EU. That could leave just ten jurisdictions (Australia, Canada, Indonesia, Japan, Korea, New Zealand, Norway, Thailand, Turkey and the UK) enforcing the UTPR out of the more than 140 jurisdictions that agreed to implement Pillar Two.
Possible challenge to legal basis of Pillar Two Directive
Separate from the AmFree proceedings, there may also be scope for a challenge to the legal basis of the Pillar Two Directive itself. One possible route arises from comments made by Advocate General Kokott, one of the independent legal advisers to the CJEU, in her Opinion in a case concerning the Belgian implementation of the Anti-Tax Avoidance Directive (“ATAD”). In that Opinion, she expressed doubt as to the extent of the EU’s competence to legislate in the field of direct taxation, particularly where the stated objective of the legislation is harmonisation.
Kokott observed that the EU’s competence in the area of direct taxation is limited to measures that directly affect the functioning of the internal market, for example by removing restrictions on the exercise of the fundamental freedoms within the EU. In her view, that threshold is not met merely because a legislative measure pursues harmonisation as its objective. In that respect, she thought it was unclear whether ATAD directly affected the functioning of the internal market to a sufficient degree to provide an adequate legal basis for EU tax legislation.
Because the Pillar Two Directive relies on the same legal basis as ATAD, it may be vulnerable to challenge on similar grounds. If such a challenge were successful, the directive could be annulled, with the result that its provisions would cease to have legal effect, with retroactive effect if it were held to be void ab initio. So far as we are aware, no challenge has yet been taken against the Pillar Two Directive on this basis.
Concluding remarks
The decision to implement the Pillar Two rules through a directive introduces EU‑specific legal constraints and litigation risk. As a consequence, the EU is now attempting to operate a global standard through a legal framework that both complicates its application and limits its adaptability. That rigidity will likely be problematic if the international consensus on Pillar Two continues to evolve.
More fundamentally, the Pillar Two Directive experience has longer-term implications for EU tax policymaking. By increasing legal uncertainty and constraining flexibility, Member States may be more cautious about agreeing future direct tax measures at EU level. In that sense, progress on Pillar Two may come at a cost: the European Commission’s use of a directive for Pillar Two may ultimately restrict its ability to set the future direction of EU tax policy.
Should you wish to discuss Pillar Two or how it applies to your business, please contact any of our Tax partners or your usual Matheson contact.