Following international agreement on the key components of the OECD’s Pillar 2 proposal to introduce a global minimum tax, attention has turned to domestic implementation. Key jurisdictions, including EU Member States and the UK, are now working towards these rules being in place from January 2024.
The introduction of the Pillar 2 rules is expected to have a significant impact on international M&A transactions, including new consequences for financial modelling, deal structuring and risk allocation, as well as particular intricacies for joint venture (JV) arrangements and how the new rules should be reflected in transaction documentation, with market practice for contractual tax protections still in development.
With domestic implementation round the corner, now is the time for multinational groups to become familiar with the key impacts of the Pillar 2 rules on M&A transactions.
A panel of our international tax partners recently hosted a client webinar discussing these issues in further detail. Highlights from this discussion are set out below.
Pillar 2 rules: a refresher
Pillar Two of the OECD proposal seeks to ensure that large multinationals are subject to tax on their global income at a minimum effective tax rate (ETR) of 15%, with the aim of reducing the incentive to shift profits to low tax jurisdictions. The Pillar 2 rules apply to multinationals that have consolidated revenues of at least EUR750 million in at least two out of the previous four years.
The proposed mechanism for achieving this is complex and involves a series of inter-locking rules. The 'GloBE rules' are a key component which comprise the 'income inclusion rule' (IIR), the main rule that imposes a top-up tax on a parent entity where its subsidiaries have low-taxed income (that is, is subject to an ETR below 15%), and the 'undertaxed payments rule' (UTPR) which acts as a back-up rule to the IIR and operates where the parent jurisdiction does not impose an IIR top-up tax and instead the UTPR applies to require an adjustment that increases the tax at the level of a low-taxed subsidiary (for example, the denial of a deduction).
The GloBE rules are supported by a 'subject-to-tax rule' (STTR) which is treaty-based rule that targets risks to source jurisdictions on a defined set of payments where there are low nominal rates of taxation. The Pillar Two rules also allow (but do not require) jurisdictions to include provision for a qualified domestic minimum top-up tax (QDMTT), which operates to reduce the amount of top-up tax that may otherwise be due under the GloBE rules and payable in another jurisdiction.
Domestic implementation of the Pillar 2 rules in key jurisdictions is now well underway. EU Member States and the UK are on course for the IIR to have effect from January 2024, with the UTPR to follow in EU Member States from January 2025. Other jurisdictions have announced plans to implement the rules including Australia, Japan and Canada. A notable exception to this is the US, where it appears very unlikely that the US will implement the Pillar 2 rules in this Congress, meaning that the US is in ‘wait and see’ mode until at least the next Presidential election in Autumn 2024.
Financial and structural modelling of M&A deals
The application of the Pillar 2 rules to in-scope multinationals is expected to become a key point for deal teams when modelling M&A deals, in particular where the proposed deal causes groups to move in scope of the Pillar 2 rules and/or results in top-up tax being payable. For example, an in-scope group acquiring a low-taxed target could result in top-up tax being payable, which will need to be factored into the financial modelling. Potentially more significantly, the acquisition of a high-revenue but low-taxed target could result in the acquiring group exceeding the EUR750 million threshold and move to being in scope of the Pillar 2 rules – in such case the bidder would need to model not only for any top-up tax that may be due in relation to the target entity, but also any other low-taxed entities that are already part of its group.
These examples also illustrate the new competitive advantages and disadvantages for bidders with different Pillar 2 profiles. In both examples outlined above, bidders that are outside the scope of Pillar 2 (and remain outside the scope as a result of the acquisition) will have a competitive advantage over in-scope bidders.
Other deal structuring points include that implementation of the Pillar 2 rules could make jurisdictions less attractive as the jurisdiction of residence of the acquisition vehicle and/or main holding company, particularly where target entities are located in jurisdictions that have not implemented Pillar 2 rules – which would currently include the US. In addition, the Pillar 2 rules determine ETRs differently from domestic tax rules and commercial accounting rules, with the result that care needs to be taken where there are mismatches between domestic tax regimes and the Pillar 2 rules to ensure that top-up tax is not triggered as a result of typical deal structuring steps, including post-acquisition reorganisations and certain post-acquisition intra-group financings.
Tax risk allocation
On tax risk allocation, an initial step is to establish the Pillar 2 tax risks that need to be allocated. Due diligence exercises typically focus on the tax position of the target entity, whereas the Pillar 2 position of an entity will largely depend on the Pillar 2 status of other entities in the group. As a result, specific Pillar 2 tax risk protection may be sought in the form of Pillar 2 targeted warranties and indemnities. Relatedly, for deals using warranty and indemnity (W&I) insurance, an insurer is typically not willing to insure a risk that is not covered in due diligence. Consequently, while this remains a developing area, it seems likely that Pillar 2 exposure will be excluded from W&I policies, although specific risk insurance may be available if a particular Pillar 2 tax risk is identified.
For deals including tax risk allocation in the form of a standard tax covenant, it will need to be considered how to deal with Pillar 2 issues. An area that will require particular consideration is the somewhat complex treatment of deferred tax liabilities (DTLs) and assets under the Pillar 2 rules, which presents new tax risks not currently addressed in a typical tax covenant. By way of example, these rules provide that a build-up of certain types of DTLs needs to be ‘recaptured’ if the DTL does not become an actual lability within five years. That five-year period is reset on a change of control, meaning a buyer could effectively buy into this recapture that could trigger a cost for the buy-side if the DTL has not been fully reversed five years after acquisition. This is just one example – deal teams will need to deal with various tricky points under these rules going forward.
Other provisions in transaction documentation that may require updated drafting for Pillar 2 issues include limitation of liabilities and information rights. In the case of the former, it could be appropriate to have bespoke financial and time limitations for Pillar 2 tax risks. As regards the latter, the application of the Pillar 2 rules is data intensive and there may well be data that is needed for Pillar 2 calculations that is not available to the companies in the target perimeter, hence wider information access rights may become more standard following Pillar 2 implementation.
The impact of the Pillar 2 rules on JV arrangements is expected to be particularly acute due to a combination of the complexity of the Pillar 2 split ownership rules and the vast permutations of possible JV structures.
Given that the Pillar 2 rules operate by reference to consolidated accounts, there is a key distinction between consolidated and non-consolidated JVs. Where a JV investor is consolidated with a JV entity for accounting purposes, this could potentially bring the investor group and/or the JV itself within the scope of the Pillar 2 rules or it could (positively or negatively) affect the ETR of other investor group entities (due to jurisdictional blending – as discussed below). This puts more focus on managing whether consolidation is required, which may in turn require analysis of the JV’s governance arrangements.
Pillar 2 top-up tax is calculated on a jurisdiction-by-jurisdiction basis. For a consolidated JV, this means that the calculation for a particular jurisdiction will take account of and 'blend' the results of both the JV entities in a particular jurisdiction and the wider group entities of the consolidating investor in that jurisdiction. This could result in scenarios where low-taxed subsidiaries of the JV are effectively offset by highly taxed subsidiaries of the consolidating investor in the same jurisdiction. In such cases, other investors in the JV would benefit from this jurisdictional blending and the consolidating investor may seek additional value from the other investors for that benefit. The reverse situation could equally occur where the JV has the high-tax operations and the consolidating investor group has the low-tax operations, in which case the discussions as to additional value would work in the opposite direction.
Care will also need to be taken with investor thresholds under the Pillar 2 rules. For example, if a JV itself is owned more than 20% by persons other than the consolidating investor group (so that it is classified as a ‘partially owned parent entity’ or ‘POPE’), the liability for the top-up tax of the JV’s low-taxed subsidiaries arises at the level of the JV – as opposed to the parent entity of the consolidating investor group – with the result that other (non-consolidating) investors in the JV may also suffer an indirect Pillar 2 top-up tax.
A further example arises in the context of the participation exemption in the Pillar 2 rules. In calculating the Pillar 2 tax base, dividends and gains on shareholdings that carry entitlement to 10% or more of the profits, capital and voting rights of the issuer are excluded. If a 10% investor's holding is diluted because of the issuance of additional shares to another investor, the first investor's holding will drop below the 10% level and consequently such investor would then need to include any dividends and gains received in respect of its investment in JV in its Pillar 2 tax base. In circumstances where there is no domestic tax on those dividends or gains due to the domestic participation exemption, for example where the threshold for the participation exemption under domestic tax rules is lower than 10%, there is a Pillar 2 mismatch, with the result that there may be a top-up tax liability for this investor.
The application of the Pillar 2 rules will also need to be reflected in joint venture agreements. This will include reviewing governance arrangements, provisions that impact on shareholding percentages, information rights as well as providing for potentially complex arrangements regarding the allocation of any tax costs or benefits arising from the application of Pillar 2 rules. The latter is particularly the case where there is a consolidating investor, because the top-up tax implications for the JV could be affected positively or negatively by the circumstances of the wider consolidating shareholder group.
A word on the US position
As mentioned above, domestic implementation of the Pillar 2 rules in the US is currently very uncertain. There are, however, a number of US domestic laws that overlap with the policy goals and conceptual mechanics of P2, including the book minimum tax enacted in the Inflation Reduction Act 2022 as well as the global intangible low-taxed income (or ‘GILTI’) regime (which is essentially a 10.5% global minimum tax on worldwide profits). But these rules do not mesh perfectly with the Pillar 2 rules and there may be scenarios where US-headed multinationals are subject to an inefficient result when the Pillar 2 rules are switched on outside the US. Going forward, US bidders will need to assess whether being in a non-Pillar 2 jurisdiction is an advantage or a disadvantage in any particular transaction which will need to be assessed on a case-by-case basis, including the potential for double taxation as a result of QDMTTs or UTPRs as it is unclear whether US foreign tax credit will be available in respect of such Pillar 2 tax charges.
The points outlined above were recently discussed in more detail and illustrated with examples during a client webinar exclusively available to our contacts. A recording of this webinar is available – please contact Joanne Price at email@example.com for further details. Otherwise, please get in touch with your usual Freshfields Tax contact to discuss any of these issues in further detail.