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TAX - A SHAKE-UP LOOMS

Herbert Smith Freehills LLP
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OECD March 20 2024

Few developments in the tax world have an impact on a truly global scale, but
the so-called 'Pillar Two' rules – essentially a global minimum corporate tax –
is one of them.

Pillar Two arose from the Organisation for Economic Co-operation and
Development's (OECD) Base Erosion and Profit Shifting (BEPS) project. Agreed in
principle in 2021 by around 140 countries, Pillar Two is designed to end the
'race to the bottom' for corporate tax rates and remove the advantages of
shifting profits to low-tax jurisdictions.

The rules operate by ensuring that large multinationals (those with consolidated
annual revenue exceeding €750 million) pay a minimum 15% effective corporate tax
rate in every jurisdiction in which they operate. This is achieved through a
series of inter-locking international rules (to be implemented through domestic
legislation in adopting countries) which essentially levy a 'top-up tax' on
income which is taxed below this level. If the profits of a multinational are
taxed at below 15% in one country, other countries are able to charge a top-up
tax. The tax is most often payable by the ultimate parent company of a group but
may also be levied at a lower level in the group structure. The rules include an
optional domestic top-up tax, which means that wholly domestic groups may also
be affected by the new regime. Ultimately, in the longer term, it is likely that
most, if not all, jurisdictions will implement domestic minimum 15% top up taxes
(the rationale being that if the profits are going to be taxed anyway, better
that they are taxed domestically).

The OECD has produced a detailed set of 'Model Rules', which form a template for
consistent and co-ordinated domestic legislative implementation by participating
jurisdictions. Many jurisdictions, including the UK, the majority of EU member
states, Australia, Canada and Japan, are amongst the first wave of countries to
implement the rules for accounting periods beginning on or after 31 December
2023, with the first returns and payments due in June 2025. Others are at later
stages of implementation, with many set to bring the minimum tax online from
2025. Notably, a number of significant jurisdictions that signed up to the 2021
agreement, including the US, India and China, have yet to announce their
implementation timetables.

As for the economic impact of the new rules, in addition to compliance costs,
the OECD forecasts that multinationals will pay an additional US$155-192 billion
of corporate tax annually. Jurisdictions defined by the OECD as 'investment
hubs' (ie those where inward foreign direct investment accounts for more than
150% of GDP, including Ireland, the Netherlands and Singapore) are forecast to
benefit most from additional tax revenues in the short-term. However, this
position may change in the longer-term, as business investment decisions become
less influenced by available tax rates due to a levelling of the playing field
in this regard.

For businesses undertaking M&A, Pillar Two will create a new, potentially
significant, consideration, both in terms of planning and structuring a
transaction, as well as documenting and negotiating protection for historical
Pillar Two risks.

> “For businesses undertaking M&A, Pillar Two will create a new, potentially
> significant, consideration, both in terms of planning and structuring a
> transaction."

With regard to transaction planning, financial and tax modelling will need to
take account of Pillar Two implications arising as a consequence of a
transaction. For example, an acquisition may lead to the resulting combined
group exceeding the €750 million financial threshold and therefore falling
within the scope of the rules. Alternatively, if a group operating exclusively
in jurisdictions that have not implemented Pillar Two acquires a target in a
territory that has implemented the rules, this will bring the entire combined
group within scope of the regime, and in these circumstances an asset deal may
be considered more attractive than a share deal, from a Pillar Two perspective.

When it comes to allocating and documenting pre-Completion Pillar Two risks,
challenges may in particular arise due to the way that Pillar Two liabilities
are calculated within a jurisdiction (broadly by reference to income, profits
and gains and tax rates of the whole group in that jurisdiction). Determining
Pillar Two liabilities may therefore require parties to look beyond the entities
that they are buying or investing in, with tax liabilities in one vehicle (which
may be the target of an acquisition or a joint venture vehicle) potentially
arising because of the tax rate paid by another related entity that is otherwise
unconnected with the transaction in question. Complex issues relating to
allocation of Pillar Two risks and liabilities, as well as access to information
and conduct of disputes, will therefore need to be considered (with, at least
initially, little in the way of market practice).

Our teams of tax experts, located across multiple jurisdictions, will be able to
guide you through the complexities of the new regime and help parties to
transactions to sensibly deal with the issues that Pillar Two will create.

The Pillar Two rules are still in their infancy and remain very much a work in
progress as the OECD continues to publish guidance and an increasing number of
jurisdictions implement their own regimes. But Pillar Two is certainly here to
stay, and it is a game-changer for the international tax landscape.

Herbert Smith Freehills LLP - William Arrenberg, Toby Eggleston, Andrea Gott and
Howard Murray

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