The European Commission has published its proposal for a Directive to implement the OECD Pillar Two Global Anti-Base Erosion rules (the “OECD GloBE Model Rules”).

We have previously considered the OECD Pillar Two proposals twice before, and they can be found here and here. Here, we provide an overview of the general architecture of the Directive, in particular by reference to the aspects of the Directive that track, or divert from, the OECD GloBE Model Rules.

It is worth noting that only the Income Inclusion Rule (“IIR”) and its “backstop,” the Under Taxed Payments Rule (“UTPR”), will be implemented by the Directive. As the Subject to Tax Rule (“STTR”) is a treaty-based rule that allows source jurisdictions to impose source taxation on certain related party payments that are subject to tax below a minimum rate, the European Commission considers that the STTR is naturally suited to be addressed in bilateral tax treaties, instead of in a Directive.

The Directive (generally) tracks the OECD GloBE Model Rules

As the Directive aims to implement the OECD GloBE Model Rules, the Directive follows the OECD GloBE Model Rules closely.

As with the OECD GloBE Model Rules, the Directive only applies to groups of multinational enterprises (“MNE”) that have a combined annual group turnover of at least EUR 750 million based on consolidated financial statements, although the Directive further extends its scope to cover purely domestic groups of the same scale (see further below). The following entities are excluded from the scope of the Directive: governmental entities, international organisations, non-profit organisations, pension funds and, provided that they are at the top of the group structure, investment entities and real estate investment vehicles.

Consistent with the OECD GloBE Rules, the IIR works by imposing a “top-up tax” on a parent entity in respect of the low-taxed income of the constituent entities in the same group. The UTPR acts as a backstop to the IIR and allocates “top-up tax” to all eligible constituent entities across the MNE group where there is no qualifying IIR in the jurisdiction of the parent entity or where a low level of taxation arises in the jurisdiction of the parent entity. The “top-up tax” is due in respect of each of the constituent entities in a jurisdiction if the “effective tax rate” of the constituent entities computed together as one in this jurisdiction falls below the minimum tax rate (i.e., 15%).

Departures from the OECD GloBE Model Rules

In order to ensure compliance with the EU fundamental freedoms (so as to avoid any risk of discrimination between cross-border and domestic situations), the Directive departs from the OECD GloBE Model Rules in the following ways:

• The Directive extends its scope to large-scale purely domestic groups, while the OECD GloBE Model Rules do not.
• The Directive requires the EU Member State of a constituent entity applying the IIR (which is usually the jurisdiction of the parent entity) to ensure effective taxation at the minimum agreed level not only of foreign subsidiaries but also of all constituent entities resident in that EU Member State and permanent establishment of the MNE group established in that EU Member State. The OECD GloBE Model Rules provide that the jurisdiction which applies the IIR takes into account the effective tax rate of only foreign constituent entities.

Interaction with the U.S.’s implementation of Pillar Two

We have reported in our earlier article how the Biden administration proposes to satisfy its obligations under Pillar Two.

The Directive sets out conditions which will enable the European Commission to assess whether third country systems (e.g., the U.S.’s GILTI) are equivalent to the content of the OECD GloBE Model Rules (and in particular to the IIR) and to include the jurisdictions which fulfil the relevant conditions in a list annexed to the Directive.

This is important because whether a jurisdiction has a “qualifying IIR” plays a key role in determining how the “top-up tax” is allocated under the IIR or the UTPR.

Going forward

The Directive will require the unanimous approval by all 27 EU Member States. However, it is worth noting that all EU Member States (except Cyprus) are members of the OECD Inclusive Framework and therefore have already agreed on the main aspects of Pillar Two and committed to apply the OECD GloBE Model Rules. The Government of Cyprus has, however, confirmed that it does not oppose the content of the Statement by the Inclusive Framework.

Once adopted, EU Member States will be required to implement the Directive by 31 December 2022, and to apply the IIR and the UTPR from 1 January 2023 and 1 January 2024, respectively.