Pillar Two: impact on corporate transactions

The start of 2024 has seen many major jurisdictions – including the UK and most EU Member States – implement the OECD’s “Pillar Two” minimum tax initiative. The minimum tax is likely to have a pervasive effect on many large businesses, including on M&A transactions. This note provides an overview of just some of the M&A issues we are beginning to see in practice.

Recap: the GloBE Rules

Pillar Two aims to ensure that large MNE groups pay a minimum effective tax rate of 15% on their profits on a country-by-country basis. This is to be achieved by countries implementing the GloBE Rules, under which they will charge top-up taxes in respect of MNE groups’ low-taxed profits.

In short, there are two top-up tax rules:

  1. the income inclusion rule (IIR) – this is the primary top-up tax rule, under which parent companies will be charged top-up taxes in respect of any low-taxed profits of their subsidiaries; and
  2. the undertaxed profits rule (UTPR) – this is a backup rule, under which any implementing jurisdiction in which a group has a presence may collect top-up tax in respect of any low-taxed profits that are not picked up by the IIR.

The GloBE Rules apply to groups with entities in more than one jurisdiction that have consolidated revenues of more than €750m per annum in two of the previous four accounting periods. In the UK, the IIR applies to accounting periods starting after 31 December 2023, with the UTPR expected to be introduced in relation to accounting periods starting on or after 31 December 2024.

Alongside the GloBE Rules, many implementing countries have chosen to introduce qualified domestic minimum top-up taxes (QDMTTs). These are taxes that impose the 15% minimum effective tax rate (ETR) on domestic profits, thereby ensuring any additional tax is collected by the QDMTT-implementing jurisdiction (and not by another jurisdiction under the GloBE Rules).

The UK has introduced a QDMTT (known as “domestic top-up tax”) for accounting periods starting after 31 December 2023. Notably, domestic top-up tax applies to both multinational and wholly domestic groups that meet the €750m revenue threshold.

Impact on M&A

Pillar Two is still relatively new, and a market-standard approach (for example, in relation to the technical drafting of tax covenants) has not yet emerged. However, the underlying commercial issues that Pillar Two may give rise to are becoming clearer. Below, we have outlined some of the issues we are seeing in practice, and how they might be addressed.

  • Blended effective tax rates (ETRs)

Under the GloBE Rules ETRs – and therefore top-up taxes – are calculated based on jurisdictional blending. Each jurisdiction’s ETR is calculated by comparing the aggregate profits earned by all group members located in that jurisdiction to the aggregate of all the taxes paid on those profits by those members. This permits a degree of sheltering: a group member with an ETR below 15% may not be exposed to top-up tax provided there are other group members in the same jurisdiction with profits taxed sufficiently above 15% to ensure that the overall jurisdictional ETR is above 15%.

There is therefore a potential tax benefit to high- and low-taxed companies being members of the same group. Buyers that are in-scope of Pillar Two may therefore realise a tax synergy as a result of an M&A transaction while, conversely, in-scope sellers may lose such a synergy.

This is a contextual point, but worth being mindful of given the effects may be significant and could materially change the tax profile of one or both parties to a transaction.

  • Conduct

The GloBE Rules are complex – effectively they represent a second corporate income tax system that applies to in-scope groups. Like other tax systems they include optionality and elections and come with significant reporting requirements.

We have seen several transactions in which in-scope sellers have sought to safeguard their position by including specific wording in sale documents to govern the buyer’s conduct relating to Pillar Two that might affect the seller for example:

  1. specifying the buyer’s responsibilities to assist the seller with Pillar Two compliance obligations that might fall on the seller post-completion; or
  2. making provision for how the buyer should (or should not) make elections that could affect the top-up tax position of the seller.

We expect to see such wording become increasingly common in deals where at least one of the parties is in scope of Pillar Two.

  • Tax covenant operation

A basic question is whether, and to what extent, tax covenants need to provide specifically for post-completion Pillar Two taxes that should economically fall on the seller, and pre-completion Pillar Two taxes that should fall on the buyer.

Under the GloBE Rules a target entity ceases to be a member of the seller group (and therefore to affect the seller’s top-up tax position) at the point the seller ceases to consolidate it for accounting purposes (or, if later, when the seller ceases to recognise it as “held for sale”). Likewise, a target becomes part of the buyer group at the point the buyer begins to consolidate it for accounting purposes. Generally, these events occur simultaneously on completion.

This is simpler than with other UK tax grouping rules and should mean that top-up tax relating to the target often falls on the appropriate party. Therefore, existing pre-completion tax indemnity wording may often work. However the position will often be more complicated, such as where the deal pricing is by reference to a set of “locked box accounts” rather than completion accounts, so that the date on which the economic benefit of the target business transfers from seller to buyer does not align with when tax liabilities transfer.  

  • Who is liable?

A fundamental design feature of the GloBE Rules is that they impose top-up tax charges on entities in respect of other group members’ profits. That could, for example, mean that, post-completion:

  1. a buyer entity in a parent jurisdiction becomes liable for post-completion top-up tax in respect of the target (rather than that tax falling on the target itself);
  2. a seller entity has a residual liability for pre-completion top-up tax relating to the target; or
  3. more unusually, the target has a residual liability for pre-completion top-up tax relating to the seller.

This is not unprecedented – existing Controlled Foreign Company (CFC) taxes operate similarly, and there are also parallels with “secondary liability” rules.

Under Pillar Two, we may see these fact patterns more often, which will require careful consideration. However, this may be mitigated by countries introducing QDMTTs (which will ensure top-up taxes are paid by the entities to which they relate).

  • Insurance

Warranty and indemnity insurers do not yet appear to have appetite to cover Pillar Two taxes in their policies. Therefore, on deals with a £1 liability cap, any liability for Pillar Two taxes or compliance obligations will either need to be carved out of the cap or left unprotected.

We expect that the availability of insurance cover is likely to change as Pillar Two implementation progresses and these new tax liabilities become more familiar to the market.

The areas outlined above give a flavour of the issues which we are seeing in practice, but this list is not exhaustive and there will be other points for the parties to address. This might include, for example, the impact of Pillar Two on deal pricing, how best to deal with the allocation of deferred tax recapture risk, and the need for the transaction documentation to deal appropriately with information sharing.

If you would like to discuss any of the points raised in this note, or the impact of Pillar Two more generally, please get in touch with Jeremy Moncrieff or Bezhan Salehy.