UK publishes draft Pillar Two legislation

In brief

For inclusion in Finance Bill 2022/23, the United Kingdom has released draft legislation to introduce the OECD’s Pillar Two Model Rules into UK law. The draft legislation includes an Income Inclusion Rule (IIR), to be known in the UK as the Multinational Top-up Tax, which will apply to accounting periods beginning on or after December 31, 2023. The UK government also stated its intention to introduce an Undertaxed Profit Rule (UTPR), although the final decision on its timing will be confirmed at a later date. The overall approach to drafting the legislation has been to closely follow the intent of the Model Rules, while also adapting the structure and drafting in places to achieve clarity. Noted below are a few areas where the draft legislation potentially differs from the Model Rules or the associated commentary.

Actions to consider: Although further changes may be made to the UK Pillar Two rules, the draft legislation provides an opportunity to assess the impact and prepare a roadmap to be Pillar Two ready. Also note that transitional rules will apply to transactions undertaken now and therefore the draft legislation should be considered as part of any analysis relating to current transactions.

Addressing these issues at an international level would promote consistency across implementing jurisdictions and the reduction of risks for disputes and uncertainty. The government subsequently notes that it will remain open to resolving some issues domestically in order to avoid disproportionate and unintended outcomes, provided that this does not challenge the common approach, produce risks to the Exchequer, or risk double taxation to business.

While the draft UK legislation closely follows the intent of the Model Rules, there are some areas where the legislation could be interpreted to differ, in particular by reference to the Commentary associated with the Model Rules. For example:

• Intra-group transfers: the UK legislation, like the Model Rules, states that the general position on an intra-group transfer is to follow the accounting treatment (under the standard of the consolidation). The legislation however does not include an equivalent of paragraph 64 of the Chapter 3 commentary which states that intra-group transfers are to be treated in the same manner as transactions with third parties. This appears to mean that under the UK legislation there could be different Pillar Two outcomes depending on the GAAP used for consolidation if different GAAPs allow different treatments for intra-group transactions (e.g., transfer value or historic cost). This is particularly relevant where US GAAP does not provide for a step up in the base cost of assets transferred intra-group, whereas there is a choice under IFRS. This could lead to differences in the ETR for Pillar Two purposes between US GAAP and IFRS.
• Intra-group financing arrangements: The UK legislation follows the Model Rules but does not appear to be limited to situations where the relevant tax attribute would not otherwise have been used (as suggested by the Commentary to the Model Rules).
• Deferred Tax Assets on transition into the regime: the UK legislation refers to amounts reflected in the consolidated accounts at the start of the regime whereas the Model Rules refer to amounts reflected or disclosed in the accounts. It will need to be established whether this is a deliberate narrowing of the rule. 

Takeaway

What are the issues to address in getting Pillar Two ready?

• Initial impact assessments have identified significant operational impacts and some unanticipated Top-up Tax in high-tax territories, such as the United Kingdom, United States, Netherlands and India.
• Key operational issues identified are the availability of data, some of which is very granular accounting data, to do the necessary calculations and also the incremental time and processes that will be added onto the existing reporting cycle (to accommodate the necessary Pillar Two calculations).

Why start now given the start date for the rules for accounting periods commencing on or after December 31, 2023?

• The calculation creates operational complexity requiring new data points and revisions to existing systems and processes. Changing systems and processes can take time, including time taken obtaining the necessary support and approvals within the organization to undertake such projects.
• Transitional provisions mean that intra-group asset transfers undertaken now can potentially have ongoing Pillar Two consequences. Further, the transitional provisions can require the tracking of specific attributes that are created between December 1, 2021 and commencement of the rules..
• Reorganizations and group simplifications that can be undertaken in a tax neutral manner today, may in some instances give rise to Pillar Two Top-up Taxes if implemented once the rules are fully in place. Taxpayers therefore, should carefully consider the timing of such transactions. Furthermore, certain structures and attributes can potentially result in double taxation under the Pillar Two rules. MNEs need sufficient time to identify these structures and attributes and address any appropriate restructuring.