|Bob van Kasteren
Key jurisdictions, including European Union member states and the U.K., are now working toward these rules being in place from January 2024.
The introduction of the Pillar Two rules is expected to have a significant impact on international M&A transactions. This will include new consequences for financial modeling, deal structuring and risk allocation, as well as particular intricacies for joint venture arrangements and how the new rules should be reflected in transaction documentation. Market practice for contractual tax protections is still in development.
Overview of Pillar Two Rules
Pillar Two of the OECD proposal seeks to ensure that large multinationals are subject to tax on their global income at a minimum effective tax rate of 15%, with the aim of reducing the incentive to shift profits to low-tax jurisdictions.
The Pillar Two rules apply to multinationals that have consolidated revenues of at least €750 million ($820 million) in at least two out of the previous four years.
The proposed mechanism for achieving this is complex and involves a series of interlocking rules. The Global Anti-Base Erosion Model Rules, referred to as the GloBE rules, are a key component that comprise:
- The income inclusion rule: The main rule that imposes a top-up tax on a parent entity where its subsidiaries have low-taxed income, i.e., is subject to an effective tax rate below 15%; and
- The undertaxed payments rule that acts as a backup rule to the income inclusion rule and operates where the parent jurisdiction does not impose an income inclusion rule top-up tax. Instead, the undertaxed payments rule applies to require an adjustment that increases the tax at the level of a low-taxed subsidiary, e.g., the denial of a deduction.
The GloBE rules are supported by a subject-to-tax rule, a treaty-based rule that targets risks to source jurisdictions on a defined set of payments where there are low nominal rates of taxation.
The Pillar Two rules also allow, but do not require jurisdictions to include provision for a qualified domestic minimum top-up tax, which operates to reduce the amount of top-up tax that may otherwise be due under the GloBE rules, and is payable in another jurisdiction.
Domestic implementation of the Pillar Two rules in key jurisdictions is now well underway. EU member states and the U.K. are on course for the income inclusion rule to be effective from January 2024, with the undertaxed payments rule to follow in EU member states from January 2025.
Other jurisdictions have announced plans to implement the rules, including Australia, Japan and Canada. A notable exception to this is the U.S., where it appears highly unlikely that the U.S. will implement the Pillar Two rules in this Congress, meaning that the U.S. is in wait-and-see mode until at least the next presidential election in autumn 2024.
Modeling M&A Deals
The application of the Pillar Two rules to in-scope multinationals is expected to become a key point for deal teams when modeling M&A deals, in particular where the proposed deal causes groups to move in scope of the Pillar 2 rules or results in top-up tax being payable.
For example, an in-scope group acquiring a low-taxed target could result in top-up tax being payable, which will need to be factored into the financial modeling.
Potentially more significantly, the acquisition of a high-revenue but low-taxed target could result in the acquiring group exceeding the €750 million threshold and moving to be in scope of the Pillar Two rules.
Here the bidder would need to model not only for any top-up tax that may be due in relation to the target entity, but also any other low-taxed entities that are already part of its group.
These examples also illustrate the new competitive advantages and disadvantages for bidders with different Pillar Two profiles. In both examples outlined above, bidders that are outside the scope of Pillar Two, and remain outside the scope following the acquisition, will have a competitive advantage over in-scope bidders.
Among other deal structuring points, implementation of the Pillar Two rules could make jurisdictions less attractive as the jurisdiction of residence of the acquisition vehicle or main holding company, particularly where target entities are located in jurisdictions that have not implemented Pillar Two rules, which would currently include the U.S.
In addition, the Pillar Two rules determine effective tax rates differently from domestic tax rules and commercial accounting rules. The result is that care needs to be taken where there are mismatches between domestic tax regimes and the Pillar Two rules in order to ensure that top-up tax is not triggered as a result of typical deal structuring steps. This includes post-acquisition reorganizations and certain post-acquisition intra-group financings.
Tax Risk Allocation
On tax risk allocation, an initial step is to establish the Pillar Two tax risks that need to be allocated. Due diligence exercises typically focus on the tax position of the target entity, whereas the Pillar Two position of an entity will largely depend on the Pillar Two status of other entities in the group.
As a result, specific Pillar Two tax risk protection may be sought in the form of Pillar Two targeted warranties and indemnities.
Relatedly, for deals using warranty and indemnity insurance, an insurer is typically not willing to insure a risk that is not covered in due diligence. Consequently, while this remains a developing area, it seems likely that Pillar Two exposure will be excluded from warranty and indemnity policies, although specific risk insurance may be available if a particular Pillar Two tax risk is identified.
For deals including tax risk allocation in the form of a standard tax covenant, it will need to be considered how to deal with Pillar Two issues. An area that will require particular consideration is the somewhat complex treatment of deferred tax liabilities and assets under the Pillar Two rules, which presents new tax risks not currently addressed in a typical tax covenant.
For example, these rules provide that a buildup of certain types of deferred tax liabilities needs to be recaptured if the deferred tax liability does not become an actual lability within five years.
That five-year period is reset on a change of control, meaning a buyer could effectively buy into this recapture that could trigger a cost for the buy-side if the deferred tax liability has not been fully reversed five years after acquisition. This is just one example — deal teams will need to deal with various tricky points under these rules going forward.
Other provisions in transaction documentation that may require updated drafting for Pillar Two issues include limitation of liabilities and information rights. In the case of the former, it could be appropriate to have bespoke financial and time limitations for Pillar Two tax risks.
As regards the latter, the application of the Pillar Two rules is data intensive and there may well be data required for Pillar Two calculations that is not available to the companies in the target perimeter. Thus, wider information access rights may become more standard following Pillar Two implementation.
Joint Venture Arrangements
The impact of the Pillar Two rules on joint venture arrangements is expected to be particularly acute due to a combination of the complexity of the Pillar Two split ownership rules and the vast permutations of possible joint venture structures.
Given that the Pillar Two rules operate by reference to consolidated accounts, there is a key distinction between consolidated and nonconsolidated joint ventures.
Where a joint venture investor is consolidated with a joint venture entity for accounting purposes, this could potentially bring the investor group or the joint venture itself within the scope of the Pillar Two rules. It could, positively or negatively, affect the effective tax rate of other investor group entities, due to jurisdictional blending, which we discuss here.
This puts more focus on managing whether consolidation is required, which may in turn require analysis of the joint venture's governance arrangements.
Pillar Two top-up tax is calculated on a jurisdiction-by-jurisdiction basis. For a consolidated joint venture, this means that the calculation for a particular jurisdiction will take account of and blend the results of both the joint venture entities in a particular jurisdiction and the wider group entities of the consolidating investor in that jurisdiction.
This could result in scenarios where low-taxed subsidiaries of the joint venture are effectively offset by highly taxed subsidiaries of the consolidating investor in the same jurisdiction. In such cases, other investors in the joint venture would benefit from this jurisdictional blending and the consolidating investor may seek additional value from the other investors for that benefit.
The reverse situation could equally occur where the joint venture has the high-tax operations and the consolidating investor group has the low-tax operations, in which case the discussions as to additional value would work in the opposite direction.
Care will also need to be taken with investor thresholds under the Pillar Two rules. If a joint venture is owned more than 20% by persons other than the consolidating investor group, such that it is classified as a partially owned parent entity, the liability for the top-up tax of the joint venture's low-taxed subsidiaries arises at the level of the joint venture instead of the parent entity of the consolidating investor group.
This could result in other nonconsolidating investors in the joint venture also suffering an indirect Pillar Two top-up tax.
A further example arises in the context of the participation exemption in the Pillar Two rules. In calculating the Pillar Two tax base, dividends and gains on shareholdings that carry entitlement to 10% or more of the profits, capital and voting rights of the issuer are excluded.
If a 10% investor's holding is diluted because of the issuance of additional shares to another investor, the first investor's holding will drop below the 10% level and consequently such investor would then need to include any dividends and gains received in respect of its investment in joint venture in its Pillar Two tax base.
In circumstances where there is no domestic tax on those dividends or gains due to the domestic participation exemption, for example where the threshold for the participation exemption under domestic tax rules is lower than 10%, there is a Pillar Two mismatch, with the result that there may be a top-up tax liability for this investor.
Joint Venture Agreements
The application of the Pillar Two rules will also need to be reflected in joint venture agreements. This will include reviewing governance arrangements, provisions that affect shareholding percentages, and information rights, as well as providing for potentially complex arrangements regarding the allocation of any tax costs or benefits arising from the application of Pillar Two rules.
The latter is particularly the case where there is a consolidating investor, because the top-up tax implications for the joint venture could be affected positively or negatively by the circumstances of the wider consolidating shareholder group.
With significant aspects of the Pillar Two rules due to be switched on in key jurisdictions with effect from January 2024, now is the time for multinational groups and tax advisers to become familiar with the effects of the Pillar Two rules on M&A transactions. Key considerations to take into account include the following:
- Whether a target is in scope or whether the acquisition of the target could bring the buyer in scope of the Pillar Two rules;
- Detailed modeling of Pillar Two costs for in-scope transactions;
- Scope of due diligence exercises for in-scope transactions — in particular, the extent to which this extends beyond the target perimeter;
- Protection for Pillar Two risk areas — including how to cover these risks in transaction documentation and whether warranty and indemnity or specific tax risk insurance will be available;
- Provision for coordination of the Pillar Two position with the retained seller group — in particular, wider buy-side information access rights may be appropriate; and
- For joint ventures, the application of the Pillar Two rules will need to be reflected in joint venture agreements — bearing in mind these rules could affect both new and existing joint venture arrangements.
Alison Dickie is counsel, and Bob van Kasteren and Katharina Kubik are partners, at Freshfields Bruckhaus Deringer LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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