Pillar 2 – A new “minefield” in tax due diligence and beyond

published on 20 October 2022 | reading time approx. 3 minutes

Cross-border corporate taxation is changing. Until now, taxing rights have been linked to the existence of a physical presence. In the increasingly digital economy, however, this concept corresponds less and less to actual business practices (just think of Netflix), which is why an appropriate taxation of companies and a fair distribution of tax revenue can no longer be guaranteed.

In a bid to prevent "base erosion and profit shifting", the OECD countries have now developed a two-pillar system. While Pillar 1 deals with new profit allocation frameworks, Pillar 2 addresses a global minimum level of taxation. The enormous complexity of the Pillar 2 regulations will pose new challenges not only to tax due diligence, but also to all companies involved.

What is the global minimum level of taxation?

The global minimum level of taxation affects MNE groups with an annual revenue of at least 750 million euros. The aim is to ensure that company profits are taxed at an effective rate of (at least) 15 percent. In principle, this is to be done by subsequently taxing the low-taxed income of foreign subsidiaries effectively at the level of the ultimate parent entity (UPE). But the devil is in the detail.

Furthermore, there are some ambiguities, including the question of when the new rules should be applied for the first time. According to the original OECD rules (so-called GloBE Rules) and the European Commission's draft directive of December 2021, the rules should already apply as of 1 January 2023. According to latest information, however, a postponement is expected at EU level: the rules are likely to apply for the first time to fiscal years beginning after 31 December 2023. For the majority of the affected companies, they would thus be mandatory from 1 January 2024.

However, the supposedly long time horizon until first-time application is deceptive. For affected companies, the challenge is that they have to understand and navigate this complex tax project within a very short time. Since the check whether the prerequisites for the application as of 2024 are met will be based on the previous year's financial data, it is necessary that computer units provide or generate the corresponding data already today.

The Pillar 2 rules apply if a jurisdiction is identified as a low-tax jurisdiction. For this purpose, the effective tax burden per country must be determined for all countries in which a MNE group has operations. Because such determination is done based on a dedicated template with various adjustments, the companies’ existing accounting systems will usually not be sufficient. Companies are therefore forced to find a solution as quickly as possible.

What does this mean for M&A consulting?

The affected companies must adapt their systems to the new compliance obligations imposed by the Pillar 2 rules. Tax planning and reporting must be extensively expanded and it has to be clarified whether companies will be able to use their current reporting systems for digital support or whether they will have to implement a dedicated reporting tool for that. Pillar 2 has thus already found its way into the “new” scope of tax due diligence. Although related to taxes, the Pillar 2 rules will also quite significantly affect Financial and IT Due Diligence because the quality, generation and processing of data relevant to Pillar 2 will have to be reviewed.

Pillar 2 will have a significant impact on restructuring measures. For example, mergers or demergers may cause that the consolidated revenue threshold of 750 million euros will or will not be reached. Transactions of acquiring and selling companies can also lead to situations where MNE groups may fall within or outside of certain sales thresholds. Furthermore, scoping, i.e. the classification of group companies in the calculation methodology, and the additional amount of tax may change in these cases. All these aspects should be taken into account in future transactions, e.g. by preparing a simulation.

Since the application of the global minimum level of taxation already has an effect on the current year because it is based on a check of the previous year's financial data, it is important to set the course for a tax-optimised set-up of MNE groups already today, both from an accounting and IT perspective as well as from a tax planning perspective.