Podcast transcript: What Oceania multinationals must know about the Pillar Two model rules

Tony Merlo

Hello everyone and thank you for joining this edition of the EY Oceania BEPS 2.0 podcast series where we discuss the latest developments and our subject-matter professionals from around the EY organization provide their practical insights.

My name is Tony Merlo and I'm the Tax Policy Leader for Oceania at Ernst & Young in Australia.

Joining me today are Dean Madsen, an International Tax Partner who leads the International Tax and Transaction Services team at Ernst & Young Limited in New Zealand, and Andrew Nelson, an International Tax Partner in the Perth office of EY Australia.

Dean and Andrew are both deeply immersed in assisting business navigate their way through the Pillar Two rules, so I'm looking forward to hearing about some of the practical issues facing business.

So let's get right into it, Dean, who do these rules apply to, and when do they start?

Dean Madsen

Yeah, thanks Tony.

The OECD suggestion is that rules the rules start applying for tax years commencing on or after 1 January next year (being 2023).

So far, we haven't heard anything contrary from either the ATO in Australia or the IRD in New Zealand, albeit the local legislation process is still to commence and my suspicion is that there are going to be some unpleasant surprises around the amount of detail and complexity required.

To be honest with you, the people on the calls and these podcasts that you're listening to have probably spent more time than anyone thinking about the detail and every time we get together to facilitate a discussion, we're finding new and complex issues.

I can only imagine what that's going to be the case when the legislature gets their hands on this.

In terms of coverage, it's supposed to be the big end of town and a revenue threshold the same as the Country-by-Country Reporting threshold at €750 million per year has been suggested. As with anything, there's a little bit of complexity there too, because they use a rolling average of the previous four years to check whether or not a taxpayer qualifies for that.

In terms of exemptions, they're very limited and that makes sense, because if you accept the principle that low tax paying jurisdictions are bad, then it should be equally self-evident that it's not really possible or appropriate to find industries the whom that is not a bad thing, and we should encourage low taxpaying.

Therefore, the industry coverage is very broad and exemptions are limited to what you'd typically expect to see. And by that, I mean governmental, charitable agencies and some investment funds where those funds really are only look through between your investor and the underlying investees, which themselves will probably be subject to these rules.

Merlo

Andrew, is it true that if a business operates in a high tax jurisdiction that these rules can still apply?

Andrew Nelson

Yeah, thanks Tony, that's a really good question that we hear a lot from clients.

I think a lot of clients are operating on the assumption that they're paying taxes in a high tax jurisdiction and don't need to worry about these rules. That's not true for two reasons.

One is the question of whether these rules can apply to actually trigger a tax payable amount in these jurisdictions, and secondly, what it takes to prove that position.

I think on the second, we'll hear from Dean again, just on what clients are doing around proving up their position.

But just on the 1st issue on whether tax could be payable in a high tax jurisdiction, I can make a few observations.

First of all, the measurement of whether a company is paying tax at a certain rate is not based on a national rate, it's an effective rate, so you may be operating in a high tax jurisdiction, but local incentives, tax concessions etc. have to be taken into account to determine the effective rate.

Depending on the industry, of course, those types of local concessions that could be available could take the form of tax holidays, territorial regimes (Singapore and Hong Kong come to mind) or incentives focused on specific industries (the financial resources sector, IP related incentives etc.).

But in all those situations, to the extent that the local operation is benefiting from some concession, then that may well reduce the actual rate down below the minimum rate of 15%.

I think the second issue is that jurisdictional blending applies, and what that means for those of you listening who haven't followed this closely. The effective tax rate for a jurisdiction is required to be determined, and that requires combining all of the operations in that jurisdiction, whether they're in separate legal entities, etc.

So, you may find that in a particular client’s circumstances, a particular company, maybe under a regime where a high-tax rate is applied, but another company in that jurisdiction may well be availing itself of an incentive, reducing its rate and the effect of combining the two may or may not result in an overall tax rate that's below or above the 15% minimum.

Another observation to make is that leaving aside the question of incentives, it may well be the case that a company operating in a high-tax jurisdiction may not be paying any cash taxes in a year.

Now there are many reasons for that, of course, unrelated to incentives, depending on the industry. But by and large, what we're talking about here is timing differences that result in a deferral of tax, particularly relevant for high-capital intensive industries and the mining industry, etc. We do have a separate podcast just exploring this in a bit more detail for those industries.

But at a very high level, the key issue here is that there's been a matter of some contention how companies that are not paying cash taxes should be treated under these rules. 

What we have is a deferred tax system now, which is different than where their rules were originally heading, which involved a credit system.

But we have a deferred tax system at least recognizes in principle, that if you're not paying cash taxes in a year, but you have a substantial deferred tax liability, then you shouldn't be penalized and pay a top-up tax.

That's all good in principle. The issue is that it's very, very nuanced.

There are anomalies with these rules. There are some ambiguities with these rules, but at a very high level, a company that is not paying any cash taxes needs to look at its deferred tax position to determine its overall tax expense. That should be good, but we ourselves are aware of many circumstances where anomalous outcomes can arise, that may mean a company that is not paying cash taxes may nonetheless, notwithstanding the deferred tax position, still have a top up tax liability.

And, leaving aside that question of the technical application of the rules, the systems challenges that that presents in tracking deferred tax at a local subsidiary level are significant.

It's going to take a substantial effort for companies to present, develop if it has not already been done so a deferred tax balance sheet for a local subsidiary, and use this as the basis for tracking the effective tax rate calculation in those situations, particularly in those situations where cash taxes are lower than the 15% rate in order to prove that the overall tax rate is above 15.

So company operating in a high tax jurisdiction, Tony, may well be subject to these rules, particularly where the effective tax rate is lower than 15% due to local incentives etc.

If cash taxes are lower than 15%, you would hope that deferred tax will be OK, but that's certainly something that needs to be worked through in detail.
There are anomalous outcomes, detailed calculations required, and notwithstanding the requirement to actually apply a tax effect accounting systems approach in order to determine that effective tax rate. So can be quite challenging to prove this up.

Back to you, Tony.

Merlo

That’s a very important point, Andrew. So no free pass just because you operate in a high tax jurisdiction.

What about those groups that have tax losses? What should they be thinking about?

Nelson

Yeah Tony, that's a particularly concerning issue for many of our clients that we're talking to and have been talking to as these rules have been developing because you would expect that a company with tax losses should not be penalized to the extent those losses are used to shelter income once these rules start, resulting in no or low tax.

Now that is broadly the intent of these rules. There are measures to recognise losses on transition.

However there are circumstances where despite these measures, there can be top up tax in a jurisdiction. For example, where a company either has existing tax losses, even the existence of a very small permanent difference reducing taxable income, for example, arising from research & development credits or, say, a non-taxable incentive, can result in top up tax, which is quite a perverse result. And there are other examples too. These fall into the territory where the rules throw up anomalous outcomes, but what the rules I think are intending to do is establish that an opening deferred tax balance sheet should be created to recognise those losses, and when those losses are used that would be recognized as an increase in the effective tax rate to the extent the deferred tax asset in relation to those losses are used.

So broadly, the answer is losses should be recognized. They're not recognized at an accounting level; they’re recognized at a tax level. So it's a tax loss that's recognized irrespective of the accounting loss.

The other notable issue for clients is that there are elections, and in particular an election in relation to losses that can be made for losses incurred after the commencement of the rules.

So I think broadly, Tony, the rules recognize that losses should be taken into account and not penalize a group. But again, the message I think is that it’s not straightforward. It becomes a deferred tax accounting issue, and again, a systems issue with the overlay with losses that there is an election to be considered, so certainly not a case of these rules taking care of themselves.

Clients really do need to work through and understand their position and take some proactive action to understand the impact, do the required accounting adjustments etc. and make any appropriate elections.

The final observation I would make is that we're talking about high tax jurisdictions. In those situations where a group operates in a jurisdiction where the rate may not necessarily be substantially higher than 15%, and there are many jurisdictions in the low 20s, for example, then the other consideration for groups is that there are many adjustments that need to be made to the taxes paid and the income used in determining the effective tax rate.

Those adjustments are both complex and not necessarily intuitive. There are various adjustments that need to be made to recognize equity investments, adjustments for consolidation, adjustments for intragroup transactions not at arm’s length, and various amounts that are removed from income (for example, dividends received, non portfolio companies etc.). I won't go into that here, but the final tax calculation may result in a substantial change in the effective tax rate from what prima face would be the expectation based on the nominal rate in that jurisdiction.

This becomes particularly relevant for those groups where the tax rate may straddle this 15%, and those adjustments suddenly become very material.

So I think overall it's a modeling exercise. It's an accounting exercise, overlaying a technical framework, and I think the first of those categories, the modeling and the accounting become particularly relevant the closer this calculation comes to 15%.

Merlo

Thanks Andrew, that sounds like there's a lot of preparatory work to be done.

Dean, what are we seeing clients doing now? And more importantly, given that fermenting the application of these rules is just around the corner, what should our listeners be prioritizing right now?

Madsen

Yeah look this is going to sound like a pretty self-serving comment from a tax advisor, but in my view there's plenty of work going out in the market around education and deeper understanding around the rules, which is great, but probably not enough around confirmatory procedures around answering that threshold question as to whether or not one is within the rules.

As Andrew’s made pretty clear, the concept of high versus low tax is pretty clear, but the detail behind it is not.

Self-identifying outside of the rules is going to prove very challenging. It's going to require a lot of work, and in many cases, it's going to require a lot of adjustment to systems which frankly weren't built with this in mind (and nor should they have been).

We really do need to move the dial, particularly with the implementation date being as soon on the horizon as it's currently expected to be. And I really feel that we are not seeing enough movement away from their education to that answering the question piece.

We are starting to see some work around adjusting tax systems, particularly given the complex deferred tax reporting or understanding required at a granular territorial level.

That is fairly nascent, but are starting to ramp up and I feel that is going to be an area where we're going to and we should see a lot of activity in the next one to six months, because that really is going to be absolutely key to being able to credibly answer whether or not these rules should cause you a problem or have any economic impact.

And I guess the last one (and this is an area where I am seeing a little bit of action with some local clients) is less a technical and more strategical practical issue, was multinationals operate in myriad countries. And even though the rules are about standardizing the rules and standardizing the process, enforcement still falls locally to humans, so enforcement is still subject to the vagaries and inconsistencies around human behavior.

And multinationals know, typically challenging countries and typically challenging personnel and the tax authorities in those countries. And what we are speaking to our clients and starting to see some movement on is really identifying the countries that they expect are going to prove particularly challenging, and looking to take a bespoke approach to those territories so they can minimize fallout and really front-foot the issue.

I think that is as, if not more important than, some of the technical and systems questions, given that it is very, very personal to individual taxpayers and individual tax models, and again an area where I expect to see a real ramp up in activity in the intermediate period.

Probably one last thing from me, and throwing back to you, Tony, just on that topic around divergence of individual countries and approach here, probably also noting that we are actually seeing some countries looking to augment the mandated OECD provisions with some additional local legislation, particularly in this interesting form and concept of a Domestic Minimum Text or DMT.

Tony, I wonder if you could potentially say something about that, using Singapore as an example that I know you're quite familiar with.

Merlo

We're certainly seeing many countries, including the UK and Switzerland amongst others, and most recently Singapore, as you say, considering implementing a domestic minimum tax to protect their domestic tax base.

And that's going to have a significant impact on where tax is paid, and therefore consequently how compliance systems will need to be adapted.

Madsen

Thanks Tony and that's an interesting concept because the intention behind a Domestic Minimum Tax and what it should do, is that it should guarantee from a local country perspective that everything, at least up to that 15% level, is trapped in the HQ country rather than individual countries risk this whole process having the effect of reallocating taxing rights offshore.

Merlo

Thanks Dean, so a lot to think about and certainly explains why many businesses are taking a deeper dive into how they're impacted by these rules and what they need to do to comply.

But there's still a lot more to come, not just from the OECD but also from individual countries, as we've just heard, as they proceed to implement the model rules in practice.

So we'll continue to explore these and other developments with other subject matter professionals in future sessions.

In the meantime, thank you to Dean and Andrew for your thoughtful insights. Thank you all for joining us and until next time, take care.