Unpacking Pillar Two: a period of transition (Pillar Two safe harbour explained)

On 20 December 2022 the OECD published a document titled "Safe Harbours and Penalty Relief", which sets out the design by the Inclusive Framework countries of a transitional safe harbour from the GloBE minimum tax.

The transitional safe harbour is the first addition to the substantive charging rules since the Model GloBE Rules were published exactly a year earlier on 20 December 2021. It is likely to be of immediate relevance to most groups that are expecting to be in scope of the GloBE Rules when countries, including the UK, start to implement them from the end of 2023.

What is the objective of the transitional safe harbour?

Many businesses have raised concerns that they will find it difficult to implement new GloBE reporting processes on the same timetable that countries are implementing the Rules. That is particularly so given that the GloBE calculation relies on information that is not currently gathered for any other purpose.

The transitional safe harbour is a response to those concerns. It aims to alleviate the administrative burden of complying with the GloBE Rules in the early years of implementation. It does that by deeming the top-up that is due in respect of a jurisdiction to be zero in situations where one of three simplified tests show there is a low risk of top-up tax being due.

How does it work?

The safe harbour deems the amount of top-up tax due in respect of a jurisdiction to be zero if one of the following three tests is met.

  • The de minimis test, which is met if the revenues and profit before tax (PBT) reported in the group’s Country-by-Country Report (CbCR) in respect of the jurisdiction are less than €10m and €1m respectively.
  • The simplified ETR test, which is met if the ETR calculated by comparing the Covered Taxes reported in the group’s accounts for a jurisdiction to the PBT reported for that jurisdiction in the group’s CbCR is less than 15% (rising to 16% for 2025 and 17% for 2026 onwards).
  • The routine profits test, which is met if the PBT reported in the group’s CbCR for a jurisdiction is less than the GloBE Substance-based Income Exclusion (SBIE) for that jurisdiction.

The tests all correspond to features of the full GloBE Rules. However, they employ simplified calculations under which groups may rely on the jurisdictional profits and revenues reported in their CbCRs (subject to minimal adjustments) rather than making the myriad of adjustments necessary to calculate their GloBE Income according to the Model Rules.

The transitional safe harbour will apply to Fiscal Years beginning on or before 31 December 2026. For GloBE purposes the fiscal year for all entities is determined by the accounting period of the group’s Ultimate Parent Entity. A UK-parented group with a calendar accounting year will therefore potentially be able to access the safe harbour for three years: 2024, 2025 and 2026.

How does the safe harbour affect groups’ transition to the full GloBE Rules?

The objective of the safe harbour is to simplify the GloBE compliance process. The OECD was therefore careful to avoid an outcome in which groups would be saved from having to do full calculations during the safe harbour period but then made to do the same calculations later to work out their position (for example in relation to deferred tax assets) under the full GloBE Rules. The safe harbour prevents that by deferring the point at which the GloBE Rules take effect in relation to a given jurisdiction until after the safe harbour has ceased to apply – it is only at that point that the first-year transitional provisions in the GloBE Rules take effect.

The OECD has also designed the safe harbour so that it takes a “once out, always out” approach: if the safe harbour does not apply to a jurisdiction for a year, it will not apply to that jurisdiction for any subsequent year. This is necessary to avoid having potentially complex mechanics to deal with groups that might otherwise repeatedly move between the safe harbour and the full GloBE Rules. It can also be seen as part of a risk-based approach – if a jurisdiction fails all three safe harbour tests for one period, the Rules see it as proportionate to require the group to make a full GloBE calculation for that jurisdiction for all subsequent years.

How helpful is the transitional safe harbour?

Groups are likely to still be faced with a significant new compliance burden, however the transitional safe harbour is a welcome addition to the GloBE Rules. We expect it will provide a valuable saving by removing the need to do a full GloBE calculation for many high tax jurisdictions during the period that it applies.

That saving primarily arises because the simplified calculations make use of the profit figures that a group will already be determining for its CbCR instead of requiring a calculation of fully adjusted GloBE Income.

While the routine profits test requires groups to determine their GloBE SBIE, which is a completely new concept, that should be a relatively self-contained exercise. The routine profits test also provides a useful shortcut: if a group reports a net CbCR loss for a jurisdiction, the test must be met.

Is the safe harbour always beneficial?

Generally, the safe harbour will benefit groups: either it applies, in which case no top-up tax is due, or it does not, in which case the group must apply the normal GloBE calculation and is no worse off.

There are, however, some limited circumstances in which the safe harbour may be unfavourable. For example, if a group transfers assets between two group entities resident in different jurisdictions during a period in which the safe harbour applies, then article 9.1.1 of the Model Rules will apply. That rule disregards any step-up in the base cost of the assets, which might differ from the tax treatment under the relevant domestic tax systems and could reduce the group’s ETR in the acquiring jurisdiction. This issue would not arise if the full GloBE Rules applied.

The newly published safe harbour rules do not explicitly provide for groups to elect in or out of the transitional safe harbour. However, that is the approach contemplated in the holding text for safe harbours in article 8.2 of the Model Rules, and the explanatory text in the latest document suggests that is what is envisaged. Some groups may therefore need to consider whether they want the safe harbour to apply to all jurisdictions that might qualify for it.

Are there other points to watch out for?

All three of the simplified tests rely on the jurisdictional profit reported in a group’s CbCR, with only minimal adjustments. Notably, there is no adjustment to remove intra-group dividends that would be excluded from GloBE Income. Including those dividends in the profit figure would tend to depress a group’s simplified ETR, reducing the likelihood that the safe harbour applies.

The most recent CbCR guidance published by the OECD in November 2019 indicates that intra-group dividends are not to be included in a group’s CbCR profit. Such dividends should effectively therefore be excluded from the simplified ETR calculation automatically, preventing any distortion.

However, that guidance was issued to address uncertainty in the OECD’s original CbCR guidance, which was silent on this point. That led to some jurisdictions and some MNE Groups taking the view that intra-group dividends should be included in CbCR profit. Some groups may therefore need to consider whether they (or the jurisdictions in which they are located) are following the most up-to-date practice.

What next?

The design of the transitional safe harbour has been agreed by the OECD Inclusive Framework countries, so it is now effectively part of the Model GloBE Rules that implementing countries have agreed to follow. We expect that the UK will update its draft GloBE legislation to add safe harbour provisions before it is included in the expected Spring Finance Bill. Likewise, the EU Pillar Two directive refers to the OECD’s work on safe harbours and we expect Member States will give effect to the safe harbour in their domestic implementation of the rules.

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