Unpacking Pillar Two: EU implementation

18 May 2022

It might have been thought that EU Member States would be early adopters of the global minimum tax. All, apart from Cyprus, are part of the OECD Inclusive Framework and as Cyprus had welcomed the OECD agreement it too was expected to support rapid EU implementation. However, negotiations on the way in which EU Member States will adopt the OECD Model Rules have not been straightforward and agreement has yet to be reached.

What is the plan?

The European Commission wants any agreement on a global minimum tax to be implemented by an EU directive.  This will enable coherent and consistent implementation across the EU and ensure that the new rules comply with EU law. Without the discipline of a directive, the Commission fears that the scale, detail, and technicalities of the Pillar Two rules could fragment the EU internal market, creating mismatches and distorting fair competition.

A first draft EU Directive was published in December 2021, a mere two days after the OCED published its Model Rules. There was no prior public consultation on the text of the directive or accompanying economic impact statement. The treaty-based "subject to tax rule" of Pillar Two (which permits source jurisdictions to withhold tax on certain types of related party payments when these payments are not subject to a minimum rate of tax) will be for jurisdictions to implement individually and is not part of the EU package.

What does the draft directive do?

The intention is to implement the OECD agreement in full with only necessary adjustments to ensure compliance with EU law. This means EU Member States must introduce domestic legislation that implements the OECD’s income inclusion rule (IIR) and its backstop, the under taxed payments rule (UTPR), and the method of calculating effective tax rates. The substance carve-out, de minimis, transfer pricing, and transitional rules must be duplicated. The treatment of flow-through entities, and permanent establishments must also replicate the treatment set out in the Model Rules. Member States may use OECD commentary and guidance to determine how the Pillar Two rules should be interpreted and applied. Compliance should be strictly enforced with EU Member States required to introduce ‘dissuasive’ penalties for any breaches.

The major modification is that EU Member States will be required to apply the global minimum tax rules to large domestic groups (those with a combined group turnover of at least €750m) as well as large multinationals where either the ultimate parent company (UPE) or a constituent entity of the group is resident in an EU Member State. This modification is necessary to meet the requirements of EU law - notably the principle of freedom of establishment and the CJEU judgment in Cadbury Schweppes.  

The OECD Model Rules allow jurisdictions to enact domestic minimum tax regimes. Such regimes are prioritized under OECD rules and enable a jurisdiction to keep any top-up revenue for itself rather than being charged and collected in the jurisdiction of the UPE. Subject to European Commission notification requirements, the draft directive will allow EU Member States to apply a qualified domestic top-up tax to low-taxed constituent entities located within their territory. A number of non-EU jurisdictions are contemplating domestic minimum tax regimes, and there is likely to be a similar level of interest within EU Member States.

What is causing the hold-up?

Taxation is the last EU policy area that exclusively relies on unanimous decision-making. Unanimity is seen as a way of protecting fiscal sovereignty but has the corollary that a single Member State may block tax measures that are agreed on by all the others. In the case of implementing the Pillar Two rules, consensus was initially prevented by concerns over the speed of the implementation timetable and Member States with few affected UPEs reluctance to be required to introduce rules. There was also a desire on the part of some Member States to link EU legislation on Pillar Two to global progress on Pillar One.

In an effort to reach agreement, two compromise texts were published in March 2022. These made a number of significant changes to the original draft including:

  • a one-year extension to the date for the transposition of the directive into Member State’s national law, meaning that that Member States will only be required to apply the IIR from 31 December 2023 and the UTPR from 31 December 2024; and
  • a temporary deferral for Member States with fewer than 12 in-scope UPEs located in their jurisdiction - these States can elect not to apply the directive for six consecutive fiscal years provided they notify the European Commission of their intention to exercise this opt-out right before 31 December 2023.

The Council would also re-affirm the EU’s commitment to a two-pillar solution with successful implementation of Pillar One.

All Member States apart from Hungary appear to have accepted this compromise. Czechia now presides over the EU Council and it intends to continue negotiations over the summer with the hope of reaching unanimous agreement at the October 2022 ECOFIN meeting. The European Parliament must be consulted but the Parliament has already given its broad support to the December draft of the Directive.

What if unanimity can’t be achieved?

It is technically possible for the market distortion provisions in the EU Treaties to be used to end a prolonged veto. This would enable the majority to overrule the objections of a single Member State, but there are long-standing concerns that these provisions are not an appropriate basis for tax legislation. Were they to be used, a challenge in the European Courts by the aggrieved State would be a likely outcome.

The "enhanced cooperation" procedure is another option. This permits a minimum of nine Member States to agree rules that are only binding between themselves. The enhanced cooperation procedure is deemed "last resort" but has been used before when it was not possible to achieve unanimity - most recently in 2013 as part of the effort to progress a European Financial Transaction Tax.  In that instance, the process took so long that some Member States took it upon themselves to enact domestic financial transaction taxes unilaterally.

Unilateral action by an EU Member State is also a possibility for Pillar Two implementation and this could include legislation for a domestic minimum tax regime. Any unilateral regime would have to cover domestic as well as cross-border situations to avoid falling foul of EU law.  

Where does this leave the UK?

The UK is no longer an EU Member State so can proceed with Pillar Two implementation without regard to EU machinations. The UK government has produced draft legislation relating to the IIR which it intends to include in Finance Bill 2022-23. The legislation would have effect from 31 December 2023 meaning UK rules would be in force at the same time as that proposed for EU Member States. Given the number of technical issues on Pillar Two that have yet to be ironed out, this is a prudent move by the UK government presumably concerned that being ahead of competitor countries is not necessarily advantageous. Assuming the schedule is kept to this still places the UK and the EU in the implementation advance guard.

Keep up to date with the latest developments and other useful information on our OECD BEPS 2.0 hubpage