As international efforts to create a more equitable and transparent corporate tax base intensify, international tax rules for multinationals are changing. Under the proposed evolving Pillar 1 and 2 approaches, organizations will need to navigate a complex set of considerations and variables to get ready.
Many chemical companies drive their business and operational transfer pricing models based on traditional concepts: fully-fledged risk-taking versus routine operations, based on supply and value chain considerations.
Within that remit, many companies in the chemicals industry have set up 'Principal' models, usually in low taxing jurisdictions. These Principal models typically have a centralized and risk-taking entrepreneur with functions, risks, and assets centralized in a jurisdiction. In contrast, local group entities (in higher tax jurisdictions) have limited functions and risks concerning manufacturing, procurement or sales and distribution, therefore a limited tax base. However, Pillar 1 and 2 tax considerations (along with ESG trends) compel them to re-think these models, including how value and profit are allocated through the supply chain.
It's a challenging area subject to new and emerging rules. This article focuses on the Pillar 2 (minimum taxation) rules and the potential impact on chemical companies operating on this basis.
Overview of Pillar 2
In December 2021, the Model Rules for Pillar 2 were released under the OECD Inclusive Framework and a proposal from the European Commission based on them. The Model Rules form part of the so-called BEPS 2.0 Project and provide governments with a template for implementing the Pillar 2 agreement reached in October 2021 by 137 jurisdictions in the OECD/G20 BEPS Inclusive Framework.
Although the BEPS 2.0 Project was initially aimed at the digital economy, there are much broader implications for most large international groups. The rules could drive up cash tax costs and reduce earnings per share. Their interaction with withholding and other taxes could affect invoicing, cash flows, and reporting administrative processes.
Multinational enterprises ('MNEs') with a consolidated group revenue exceeding EUR 750M in two out of the four previous fiscal years are in scope for these so-called GloBE ('Global anti-Base Erosion') rules. Generally speaking, these rules are a global minimum tax regime, a system of top-up taxes that brings the total amount of taxes paid on excess profit in all jurisdictions by an MNE with so-called Constituent Entities up to the minimum rate of 15 percent. Constituent Entities are those group entities subject to the operative provisions of Pillar 2.
Under these rules, the effective tax rate ('ETR') should be calculated in the jurisdiction where an MNE has a taxable or deemed taxable presence. To the extent the jurisdictional ETR is below 15 percent, Top-up Tax for that jurisdiction will be due. The starting point for calculating the effective tax rate is an entity's financial accounts, but amendments are needed to calculate the ETR under Pillar 2 rules. It's a complex process.
The Pillar 2 rules include an Income Inclusion Rule ('IIR') and an Under-Taxed Payment Rule ('UTPR') that applies as a backstop in the case and to the extent that Top-up Tax is not charged under the IIR rules. The starting point is that jurisdictional Top-up Tax is charged under the IIR to the Ultimate Parent Entity ('UPE') of the MNE Group. To the extent this Top-Up Tax is not effectively charged, which could be the case if, for example, the jurisdiction of the UPE has not implemented the GloBE rules, jurisdictions that have adopted the UTPR rules may charge a portion of the Top-up Tax to entities (including permanent establishments) of the MNE located in their jurisdiction. The size of this portion depends on the number of employees and the value of the MNE's tangible assets in that jurisdiction relative to the total number of employees and the total value of the MNE's tangible assets in all UTPR jurisdictions.
As a preliminary comment, this article is by no means meant to be an exhaustive overview of the rules. We aim to concentrate on elements most likely to affect the chemicals sector. We won't cover other issues such as provisions regarding Excluded Entities (e.g., governmental entities, NGOs, pension funds, investment funds, etc.), De Minimis Exclusion (jurisdictions with revenue below EUR 10M and GloBE Income below EUR 1M), and Safe Harbors (yet to be developed). Neither will we go into detail about how Top-up Tax will need to be allocated and remitted, administrative matters (the first GloBE returns may become due from 1 July 2025), potential fines for non-compliance, the Subject to Tax Rule (which is proposed to apply to certain payments including interest and royalties where the nominal tax rate on a payment falls below a minimum rate of 9 percent) or transitional rules. If you are interested in any of those areas, please feel free to reach out to us separately!
Pillar 2 and the chemicals sector
The impact of the Pillar 2 rules on chemicals companies may be significant; given the nature and size of many chemicals businesses, a significant number are likely to meet the EUR 750M revenue threshold and fall within the scope. Given that chemical companies vary significantly in terms of their business structures, tax structures, and the level of taxation to which they are subjected - which may include incentives or similar tax benefits - the rules could have a range of different effects and result in higher or lower taxation relative to companies outside the sector.
Let's get into some of the key relevant considerations.
1. Tax provisioning in financial statements
Depending on whether the jurisdiction will implement the rules from 2023, tax provisions or valuation allowances may already need to be recorded in the FY22 financial statements. This would typically be the case if, based on a review of the impact, it becomes clear that, in FY23, the MNE would need to pay more taxes because of Pillar 2. This may lead to complex discussions and calculations with external auditors. To illustrate, the OECD expects the BEPS 2.0 proposals to increase global company income taxes by US$150 billion per year, principally through the introduction of Pillar 2. However, as we'll turn to next, a possible postponement of the rules could remove the need to book a provision in the financial statements for FY22. So, it is certainly advisable to stay updated on developments.
Postponement of rules?
In March 2022, the OECD commented on its rules and opened a consultation period on its implementation. Meanwhile, in April 2022, the EU Council of Finance Ministers ('ECOFIN') failed to reach a political agreement on the draft EU directive to implement the Pillar 2 rules coordinated across the EU. A compromise text tabled by the French EU Presidency and published after the ECOFIN meeting shows some changes compared to the version from December 2021 — the most important one being a one-year deferral of their entry into force. The rules would, in principle, apply to tax years starting from 31 December 2023 (instead of 1 January 2023). The French EU Presidency is expected to continue to press forward with this, aiming to reach an EU agreement before the end of June 2022.
The question is what the OECD will do regarding the postponement of the implementation of Pillar 2. At the time of writing, it remains unclear whether the OECD will also seek a delay. If it does, it could have a hard time convincing certain jurisdictions (notably Australia, Canada and the UK) who have already announced that they may implement the rules from 2023. If these countries (or any other country) implement from 2023, MNEs with Constituent Entities in these jurisdictions will need to comply, especially if the UTPR is also implemented.
2. GloBE ETR vs. statutory tax rate vs. accounting ETR
Chemical companies need to understand that they are not necessarily safe under the GloBE rules if they only operate in high-tax jurisdictions with a statutory tax rate exceeding 15 percent. In a jurisdiction with a statutory rate of 15 percent or higher, the GloBE ETR can still drop below the required minimum of 15 percent, and the ETR in the financial statements of 15 percent or higher may also not be the same as the ETR under the GloBE rules.
This is because the Pillar 2 GloBE rules adjust the components for calculating the effective tax rate. The ETR is calculated on an annual basis, and per jurisdiction, by dividing the so-called 'Adjusted Covered Taxes' of each Constituent Entity in a jurisdiction by the 'Net GloBE Income' of the MNE in that jurisdiction.
Adjusted Covered Taxes
Without going into exhaustive detail, the definition of Adjusted Covered Taxes involves many adjustments to the financial accounts to determine (based on the financial statements) what amount of tax is deemed to be due by the MNE in a jurisdiction under Pillar 2. One example of such an adjustment is deferred taxes, which are recast to 15 percent for these rules. So, a deferred tax asset in the financial accounts for a net operating loss (NOL) recognized at a statutory tax rate of 25 percent will be adjusted to the minimum rate of 15 percent. Accordingly, if an entity in a jurisdiction is in an overall profitable position in a year, whereas it does not pay corporate income tax in that jurisdiction due to utilization of losses (for which a deferred tax asset was recorded in the accounts at 25 percent), such an adjustment for deferred tax at 15 percent may have a negative effect. In addition, where a deferred tax liability is included in a Constituent Entity's Adjusted Covered Taxes, if it does not reverse within five years (i.e., the tax is not paid by that time), then this must, in principle, be reversed out (certain exceptions apply). Further, a deferred tax expense due to uncertain or deferred tax positions relating to income or losses excluded from GloBE Income may not be considered for calculating the GloBE ETR.
Looking at the chemicals sector specifically, with volatility in commodity prices and sometimes declining demand in certain markets, combined with increased costs of raw materials and high energy prices due to the war in Ukraine, which cannot always be passed on to clients and customers, companies may be compelled to make other choices in procuring feedstock, raw materials, and production techniques, which may push companies into new value offerings and innovative business models to avoid significant fluctuations in returns going forward. Significant investment, development, or restructuring costs may occur, leading to NOLs and related deferred tax assets in relevant jurisdictions for which this discount on deferred tax assets under the GloBE rules can become relevant. Such mechanisms create additional complexities with tracking carry-forward losses and excess taxes for each jurisdiction.
Net GloBE Income
The Net GloBE Income of a jurisdiction can only be a positive amount and equals the GloBE Income -/- GloBE Losses of all Constituent entities in that jurisdiction. In order to calculate the GloBE Income or Loss, the Pillar 2 rules take the Constituent Entity's Financial Accounting Net Income or Loss as a basis and require adjustments to be made to arrive at the final result. One example is Excluded Equity Gain or Loss, which requires a 10 percent shareholding to exempt a gain on disposal. Accordingly, countries that (currently) have a participation exemption regime that requires a lower shareholding percentage than 10 (many jurisdictions require a 5 percent shareholding) may be sanctioned with a lower ETR under the GloBE rules for allowing an exemption on disposal of shareholdings between 5 percent and 10 percent.
The above examples are just two out of many outcomes that could lead to a GloBE ETR that may be lower (or higher) than the actual statutory tax rate in a jurisdiction or the ETR in the financial statements. Proper modeling of the impact of the Pillar 2 rules is essential.
3. Complexity in ownership structures
The IIR is the primary rule that leads to the imposition of a Top-up Tax. Under the IIR, a parent entity within the MNE group will pay tax, in its jurisdiction of tax residence, regarding its allocable share of the Top-up Tax of a low-taxed Constituent Entity. In this regard, the IIR bears similarities to Controlled Foreign Corporation (CFC) rules.
Under the top-down approach, for income inclusion and the imposition of Top-Up Tax, as a general rule, priority is given to the parent entity at the highest point in the ownership chain. Therefore, in a multi-tiered structure, where the ultimate parent entity (UPE) of the MNE group is subject to a qualified IIR (i.e., one conformant to the GloBE rules design), it will pay the IIR tax in respect of the Top-up Tax of a low-taxed Constituent Entity, rather than an intermediate parent entity. Where the UPE is not subject to a qualified IIR, IIR taxing rights will 'drop' down to the jurisdiction of the intermediate parent entity beneath it, to the extent it applies a qualified IIR and so on down the chain of ownership.
In this respect, there is still a question of whether the US will amend its global intangible low-taxed income (GILTI) rules and/or whether the Pillar 2 rules will recognize the US GILTI rules as a qualifying IIR. While the OECD has released the Model Rules and Commentary, it has still to address co-existence with the US GILTI rules. The US Administration has proposed modifications to the GILTI rules, which are currently based on global blending. The Pillar 2 rules apply blending on a jurisdiction-by-jurisdiction basis. The prospects for changes to the GILTI rules to align with Pillar 2 remain uncertain at the time of writing.
4. Substance-based Income Exclusion
One relevant aspect of the GloBE rules specific to the chemicals sector is the Substance-based Income Exclusion, based on the return to payroll and tangible assets. The Substance-based Income Exclusion is subtracted from the local profit (Net GloBE Income) in a jurisdiction so that it may increase the ETR. This substance-based carve-out allows a jurisdiction to continue to offer tax incentives that reduce taxes on routine returns from investment in substantive activities. Payroll and tangible assets are designed to support both labor and capital-intensive industries, such as chemicals.
The payroll component is based on determining the payroll costs of employees of the relevant MNE entity. A broad concept of employees is adopted. The tangible asset component is based on the carrying value in the financial accounts of plant, property, equipment, land use rights and land (excluding land held for development). There are special rules for self-constructed assets, natural resources, and leased assets that aim at equal treatment.
The amount of the Substance-based Income Exclusion is the sum of a percentage applied to the payroll and tangible asset components. The rate starts at 10 percent for the payroll component and declines by 0.2 percentage points per year for the first five years to 9 percent, and then by 0.8 percentage points per year to reach 5 percent after ten years. For the tangible asset component, the percentage starts at 8 percent and declines by 0.2 percentage points per year for five years to reach 7 percent and then by 0.4 percentage points for five years to reach 5 percent after ten years.
Chemical companies can benefit from this Income Exclusion.
5. Data requirements and management
To become Pillar 2 compliant, MNEs will likely require a great deal of data, including non-financial information from across the group. But this information may not always be easy to extract and analyze. Furthermore, data submitted centrally and processed under IFRS or US GAAP to carry out the necessary analysis and calculations to determine the GloBE income, covered taxes and the GloBE ETR may not always align with existing local financial statements under local GAAP. Some information will be readily available as regular accounting information. Still, other data will not be available through existing processes. They will need to be separately gathered (for example, the extended definition of payroll, which includes certain types of independent contractors to determine the Substance-based Exclusion Income). It will be necessary for organizations to ensure they have sufficient people and appropriate technology/data analytics resources to address these aspects of Pillar 2.
6. Principal structures – considerations
As outlined above, many chemical companies currently have a Principal structure established in a jurisdiction that creates a potential tax benefit. As already announced by some jurisdictions, the expectation is that these jurisdictions will increase their tax rate or introduce a Qualifying Domestic Top-up Tax which would allow them to levy an additional tax, as a result of which the GloBE ETR for that jurisdiction would increase. As a result, it would reduce or fully eliminate the Top-up Tax that could otherwise be charged under the IIR by the Ultimate Parent jurisdiction to the Ultimate Parent or by the UTPR jurisdictions to Constituent Entities of the MNE in those jurisdictions. Such Qualifying Domestic Top-up Tax would avoid ‘giving away’ taxing rights to other jurisdictions in case of insufficient taxation locally. As a result, chemical companies would lose the tax benefit gained through these principal structures (which benefit, in principle, they would already lose anyway due to the application of the Top-up Tax under the GloBE rules).
We therefore expect — and are already seeing — that some MNEs are contemplating a restructuring of their operations and value chains. A common area of focus is jurisdictions that are high on the cost of living index. If a large workforce is in place, this may lead to a reassessment of the value chain.
If a potential restructuring is being considered, it will likely be important to thoroughly assess the related exit taxation, especially if valuable (amortized) IP needs to be transferred, which has a large built-in gain. In addition, both the OECD Pillar 2 rules and the proposed EU Directive contain a special provision that denies a stepped-up basis under the GloBE rules for calculating the depreciation on assets that have been transferred between group entities after 30 November 2021 and before the start of the year when the GloBE rules enter into force for the MNE group. Suppose, for local tax purposes, a stepped-up basis is provided, which is denied under GloBE Income calculation rules. In that case, this could have a negative impact on the ETR calculation for GloBE purposes.
Certain jurisdictions, housing Principal entrepreneurs that currently benefit from a low effective tax rate, may look to provide new benefits to certain businesses. This could take the form of subsidies and grants rather than (effective) corporate tax rates below 15 percent. However, the question is what effect this will have on the ETR for GloBE purposes. In addition, under both the OECD and EU rules, granting subsidies or other incentives may disqualify a Domestic Minimum Top-up Tax. We expect IIR and UTPR jurisdictions to monitor and possibly challenge these policy developments and charge IIR (or UTPR) accordingly. In this respect, it should be noted that the GloBE rules do not provide for an arbitration mechanism or similar remedies against potential ‘double Pillar 2 taxation’.
EU Regulation on distortive subsidies
It is also important to note that the EU will likely introduce a Regulation to combat distortive subsidies and create a level playing field. The EU Commission published a proposal for the Regulation on 5 May 2021. The Commission will have the power to investigate financial contributions granted by non-EU governments to companies active in the EU. If the Commission finds that such financial contributions constitute distortive subsidies, it can impose measures to redress their distortive effects.
The Regulation proposes the introduction of three tools:
- A notification-based tool to investigate concentrations involving a financial contribution by a non-EU government, where the EU turnover of the company to be acquired (or of at least one of the merging parties) is equal to or higher than €500 million and the foreign financial contribution is at least €50 million;
- A notification-based tool to investigate bids in public procurements involving a financial contribution by a non-EU government, where the estimated value of the procurement is equal to or higher than €250 million; and
- Tools to investigate other market situations, smaller concentrations, and public procurement procedures. The Commission can start on its initiative (ex-officio) and may request ad-hoc notifications.
While this is a very technical subject area, we hope that this high-level summary will have given you some valuable insights as you and relevant colleagues assess Pillar 2 impacts and related strategic considerations. Although Pillar 2 is yet to be implemented in local laws, it may come as early as next year in some jurisdictions. Time is of the essence. We recommend that modeling of the impacts should start as soon as possible if it hasn't been done so already.
How KPMG is helping chemicals organizations
KPMG firms can provide comprehensive support to organizations to model Pillar 2 impacts and preparations for Pillar 2 going live. This typically involves assistance in explaining the complex rules, modeling the impact, and developing a strategy to become compliant, including gap analysis of data sourcing and management. Although MNEs have 15 months following the first year of implementation to submit their first GloBE return, experience already tells us that it can be challenging to get the right data out of the organization, and the impact of the rules is sometimes underestimated. We can also assist with strategic tax and value chain analysis and modeling if any restructuring is being considered.
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BEPS 2.0 is aimed at dealing with the tax challenges arising from the digitalization of the economy, but the proposals will impact multiple sectors.
BEPS 2.0 is aimed at dealing with the tax challenges arising from the digitalization of th