Over the coming twelve months, the EU must confront some challenging Pillar Two issues, including addressing the G7 ‘side-by-side’ deal on Pillar Two before the end of December and defending legal challenges to the EU implementation of Pillar Two in the Court of Justice (“CJEU”) later in 2026.
These issues are unique to the EU legal system and will have to be tackled in tandem with the broader politics inherent in the on-going revision of Pillar Two. This briefing addresses the current state of the ‘side-by-side’ workstream at EU-level and our next briefing will focus on the EU legal challenges to Pillar Two.
OECD negotiation of the side-by-side solution
The current OECD negotiations on Pillar Two are focussed on the implementation of the ‘side-by-side’ deal announced by the G7 countries in June 2025. Under this deal, the G7 committed to work at OECD-level with countries that have implemented Pillar Two (including many EU Member States) to deliver: (i) an exclusion for US groups from the income inclusion rule (“IIR”) and the undertaxed profits rule (“UTPR”); (ii) a simplified reporting system for groups operating in jurisdictions with high effective tax rates; and (iii) alignment of the Pillar Two treatment of non-refundable substance-based tax credits with refundable tax credits.
Those involved in the OECD negotiations are quite optimistic when speaking publicly about the prospects of reaching a resolution before the end of December. That timing is important as a number of EU safe harbours which shelter groups (including US groups) from Pillar Two taxes are due to expire at the end of 2025.
Revisiting the EU Pillar Two Directive
European Commission (the “Commission”) officials also seem optimistic about the possibility of implementing any OECD agreed resolution at EU-level without amending the EU’s Pillar Two Directive (the “Directive”). Although amending the text of the Directive itself seems like the obvious next step once agreement is reached at OECD-level, it is not one that the Commission is enthusiastic about. A Commission official publicly commented that, if the Directive was reopened, it might never be closed again. This anxiety is borne out of the effort required in 2022 to reach agreement on the Directive itself.
Getting agreement on the Directive in 2022 took almost a year of negotiating, with numerous iterations of the text being required to finally get all EU Member States to unanimous consent. Hungary had been one of the most vociferous opponents of the proposal, maintaining its veto until the eleventh hour. When Hungary was finally persuaded to support the Directive (possibly encouraged by the financial support included in the EU Recovery Plan for Hungary agreed at the same time), Poland then announced, presumably to the deep frustration of the Commission, that it needed more time to analyse the proposal. Although the Commission ultimately managed to get EU Member States to unanimously adopt the Directive, it is not an experience anyone is keen to revisit.
A bruised EU proposes a novel approach to implementation
Rather than reopening the Directive, the Commission is proposing to implement whatever is agreed at OECD level through the Directive’s existing safe harbour provision. That provision deems the top-up tax due by a group in a jurisdiction to be zero if the jurisdiction fulfils the conditions of a ‘qualifying international agreement on safe harbours’ which all EU Member States consent to. The Commission is of the view that whatever is agreed at OECD level would be a qualifying international agreement. Without reopening the Directive, the Commission would ask EU Member States to unanimously consent to extending the EU safe harbour to reflect what is agreed at OECD level.
Although preferable to amending the Directive, getting EU Member States to unanimously consent to extend existing safe harbours will not be without its own challenges. Estonia has been vocal in its position that the treatment that is offered to the US under the G7 ‘side-by-side’ deal should be available to smaller EU Member States. Most recently Estonia proposed that smaller EU Member States should be permitted to opt-out of the Directive or that it should be suspended or repealed.
Even if unanimous agreement on extending safe harbours can be reached at EU level before the end of the year, that will not leave enough time for EU Member States to update their domestic law to implement the changes. As a result, Pillar Two taxes (under the IIR and UTPR) might continue to accrue under domestic laws of EU Member States into 2026 or, at least, taxpayers might be required to provision for those Pillar Two top-up taxes during 2026 until domestic laws are updated. In response, the Commission has suggested a novel approach: to document whatever is agreed under the safe harbour provision as a ‘notice’ of the decision of EU Member States which would be published in the EU’s Official Journal. The Commission is of the view that such a notice would have ‘direct effect’ under EU law, meaning that it would be binding on EU Member States and would preclude them from collecting Pillar Two top-up taxes under the IIR and UTPR in the circumstances covered by the notice.
The EU concept of ‘direct effect’ is based on case law of the CJEU dating back to the 1960’s. Various instruments of EU law, including directives and decisions of the EU institutions, can have direct legal effect in EU Member States provided the instrument (i) is sufficiently clear and precise; (ii) is unconditional and (iii) does not require further implementing measures whether domestically or by the EU. These requirements will demand a legal rigour of what is published in the EU’s Official Journal. For example, it may not be sufficient for the notice to merely describe the characteristics of an eligible side-by-side system without identifying the specific jurisdictions that are understood to be covered.
Can the safe harbour change the treatment of tax credits?
While the Directive’s existing safe harbour provision arguably may be broad enough to legally allow the extension of safe harbours at EU level (items (i) and (ii) of the current negotiation), it is unclear to us whether the existing safe harbour could be used to address item (iii) of the negotiation, i.e., to change the Pillar Two treatment of non-refundable substance-based tax credits.
The treatment of qualified refundable tax credits as income is expressly legislated for in the Directive. If non-refundable substance-based tax credits are also to be treated as income, we struggle to see how the safe harbour provision could achieve that, given it is designed only to deem top-up taxes in particular jurisdictions to be zero rather than re-characterising a tax credit as income.
Concluding remarks
While there is no doubt that Pillar Two is a complex regime, it is becoming increasingly clear that the implementation of the rules through the Directive has brought another layer of legal and political complexity for the 27 EU Member States. There may well be a degree of buyer’s remorse amongst EU Member States at their decision to implement the rules via an EU law instrument. For now, however, there is a broad expectation that a short-term solution will be reached before the end of December. That will mark only the beginning of the EU’s work to unravel and redesign the EU rules to respond to the US and OECD developments in a way that is capable of garnering unanimous support and that can be delivered within the EU legal framework.
In our next update we will discuss a looming EU lawsuit that is challenging the UTPR as well as a broader legal risk that could threaten the legal basis on which the Directive was agreed.
Should you wish to discuss how Pillar Two and the ongoing OECD and EU negotiations impact your organisation, please speak to your usual Matheson contact or to any of our Tax Partners.