Pillar 2 GloBE rules technical series: Navigating adjusted covered taxes 

The sixth article of our series on Pillar 2 GloBE model rules focuses on how to identify the key principles of adjusted covered taxes. Adjusted covered taxes is the numerator in the formula for determining the effective tax rate under the main Pillar 2 rules.

As well as discussing points such as the definition of covered tax expense and the exclusion of certain taxes and qualified refundable imputation taxes, the article will also address blended controlled foreign company (CFC) taxes, deferred tax adjustments, and the GloBE loss election.

The formula for calculating adjusted covered taxes is:

Covered Tax Expense (financial accounting net income or loss (FANIL) current tax expense) + Additions/Reductions to Covered Tax Expense + Total Deferred Tax Adjustment Amount (DTAA) + Increases/Decreases for OCI/Equity Items.

The first step in navigating adjusted covered taxes requires an understanding of a covered tax expense. This includes taxes recorded in the financial accounts of constituent entities (CEs) with respect to income or profits, including those in which a CE has an ownership interest. Covered taxes should also include  taxes on distributed profits or deemed profit distributions, and non–business expenses imposed under an eligible distribution tax system. In addition, it includes taxes imposed in lieu of generally applicable corporate income tax and taxes levied by reference to retained earnings and corporate equity, including tax on multiple components based on income and equity. Examples of covered taxes include the corporate income taxes and similar taxes levied on the entity’s income by the jurisdiction or where it has a Permanent Establishment (PE), as well as any withholding taxes imposed on payments received by an entity.

Qualified imputation taxes are also included in covered tax expense. This is an arrangement where shareholders who receive a dividend also can receive a tax credit for corporate taxes paid by the CE and it is included in the adjusted covered tax expense, to the extent that that tax is not part of a foreign tax credit (FTC) regime. When the beneficial owner receives that dividend, a tax equal to or greater than the minimum rate of 15% is payable or the beneficial owner is located in the same jurisdiction as the CE and the dividend will be taxed as ordinary income.

It is also important to understand that covered taxes do not include the standard Pillar 2 GloBE taxes, such as taxes pursuant to the Income Inclusion Rule (IIR), Undertaxed Profits Rule (UTPR), or Qualified Domestic Minimum Top-Up Tax (QDMTT). Taxes paid by an insurance company relating to returns to policyholders or disqualified refundable imputation taxes included are also not included. Disqualified refundable imputation taxes are broadly those initially imposed on the income of a CE but when that income is distributed by way of dividend to the owners of the CE, the Tax is refunded to the CE or the owner or creditable against a tax liability of the owner other than a tax liability arising from the dividend.

The ultimate goal is to see what adjustments are needed to covered taxes to be consistent with any adjustments made to GloBE income. The computation is designed to conform to the GloBE income and loss base and ensure covered taxes are not taken into account more than once. 

Understanding the allocation of cross-border current taxes and blended tax regimes

The Pillar 2 rules require elements of covered taxes to be allocated to particular constituent entities.  For example, covered taxes attributable to permanent establishments are allocated to those permanent establishments.  Taxes of tax transparent entities with respect to GloBE income allocated to a constituent entity owner under Pillar 2 rules are allocated to that CE owner. Controlled foreign company (CFC) covered taxes of the owner of the interest in the CFC are allocated to that CFC.

There are several regimes which operate cross-crediting mechanisms for CFC taxes. The US, in particular, has a very complicated CFC regime which acknowledges separate basket regimes and doesn’t fit within the GloBE model rules. As a result, a mechanism for the allocation of blended CFC regime taxes (such as the US global intangible low-taxed income or GILTI regime) was outlined in the June 2024 OECD administrative guidance. That guidance outlines a four-step methodology for allocating the blended CFC charge from the constituent entity owner to its overseas CFCs for fiscal years that begin on or before 31 December 2025, but not for those that end after 31 December 2027. The methodology takes into account foreign source income taxed by the main entity, allocable covered taxes that are residual taxes paid by the main entity after considering the foreign tax credit and uses allocation keys to apportion the tax to the CFCs . 

This simplified allocation of the blended CFC tax to entities in low-tax jurisdictions where the applicable tax rate is less than 15% is available for a limited time period, being for years beginning on or before 31 December 2025. This approach is designed to accommodate blended CFC regimes for a limited period, and it will be interesting to see how the OECD responds to the current approach of the US to Pillar 2 taxes. 

Additions and reductions to covered taxes

There are additions and reductions to covered taxes to consider. Additions are designed to ensure all covered taxes are properly captured and attributed to a CE relative to GloBE income or loss. Common additions that we see are taxes that are included in pre-tax book income. It is possible to make a GloBE Loss election (see further below), which will apply different adjustments in respect of GloBE losses to the standard covered tax adjustments. The GloBE loss election is generally expected to be of most use as a simplification in jurisdictions that do not impose a corporate income tax or impose one at a very low rate.  This is because when the election is made, temporary differences may result in top-up tax under the normal calculations will not arise. The election can be made separately for different jurisdictions.

Taxes provided on uncertain tax positions (UTPs) are also taken into consideration. Additions to covered taxes include any amount of covered taxes on UTPs paid in the fiscal year where the amount has been treated for a previous fiscal year as a reduction to covered taxes under Article 4.1.3(d). However, it does not include penalties or accrued or paid interest that is not included as an addition or an unpaid current tax expense related to a UTP.

A credit or refund for a qualified refundable tax credit (QRTC) that is recorded as a reduction to the current tax expense is added back. This would require a corresponding adjustment to FANIL to treat the QRTC as income in the year the entitlement to the credit accrues.

Reductions to covered taxes for a CE is the sum of:

• the amount of current tax expense with respect to income excluded from the GloBE income or loss computation;
• a credit or refund relating to a non–QRTC not recorded as a reduction to the current tax expense;
• any amount of covered taxes refunded or credited to a CE that is not treated as an adjustment to current tax expense in the financial accounts, with the exception of QRTCs;
• any amount of current tax expense accrued in respect of a UTP;
• any amount of current tax expense not expected to be paid within three years of the last day of the fiscal year. Here, Article 4.6.4 can apply where more than €1m of the amount accrued by a CE as current tax expense and included in adjusted covered taxes for the fiscal year is not paid within three years.  In that case, the ETR and top-up tax for the year in which those amounts were originally included, must be recalculated excluding unpaid adjusted covered taxes.

Understanding DTAA and steps to allocate cross-border deferred tax expense

A total deferred tax adjustment amount (DTAA) outlined in Article 4.4 addresses the temporary differences to the tax expense for GloBE purposes. The first step is to compare the applicable tax rate to the minimum rate of 15% for the fiscal year in question. An adjustment is then made if the applicable tax rate is lower or higher than the minimum rate. A DTAA is also subject to certain adjustments and exclusions related to covered taxes under the following Articles:

• Article 4.4.2: where disallowed or unclaimed accruals paid in the year and recaptured deferred tax liabilities (‘DTL’) result in increases, while amounts  attributable due to a  deferred tax asset (‘DTA’) for a current-year loss, is not recognised due to accounting criteria not met will result in reductions) .
• Article 4.4.3: where  DTA’s attributable to GloBE losses are recognised in the financial statements at rates lower than the minimum rate). The effect of revaluing the DTA at the minimum rate may create additional top-up tax in certain instances.

A five-step methodology approach can be helpful when allocating a cross-border deferred tax expense (for example to a CFC or a PE). Specific steps include:

1. Categorisation of DTAs and DTLs recorded in parent entity (PE) or main entity accounts related to assets and liabilities of CEs or PEs.

2. Deconsolidation of any net basis DTAs or DTLs from any FTCs.

3. Allocation of deferred tax expense or benefit related to non-GloBE income of foreign PE or CE (which serves as an exclusion).

4. Allocation of deferred tax expense or benefit for non-passive GloBE income (to assess the impact of FTCs on the expense or benefit).

5. Allocation of deferred tax expense or benefit for passive GloBE income (note CFC taxes above the 15% minimum rate remain covered taxes of the parent entity and are not allocated).

The GloBE loss election and computation of adjusted covered taxes

Introduced in Article 4.5, this jurisdictional election creates a GloBE Loss DTA each year where there is a net GloBE loss for the elected jurisdiction. It permits the GloBE loss DTA to be carried forward and used in subsequent fiscal years as an addition to covered taxes (under Article 4.1.2). However, once the GloBE loss DTA is used in a subsequent fiscal year, the DTA must be reduced. Additionally, the GloBE loss DTA is a jurisdictional attribute of the MNE group that made the election, and is not transferable if, for example, a CE transfers to another MNE group.

GloBE loss is a one–time election and must be filed with the first GloBE information return (GIR) of the MNE group with a CE located in the jurisdiction where the election is made. It does not apply to jurisdictions with eligible distribution tax systems. Also, while a GloBE loss election can be revoked, any remaining GloBE loss DTA must be reduced to zero upon revocation. A GloBE election can be made for flow-through ultimate parent entities (UPEs) but only with respect to the UPE and not other entities in the UPE jurisdiction.

Finally, any increases or decreases to covered taxes that are not included in the current or deferred tax expense, but are recorded in equity or OCI, will require an adjustment when the amounts of income or loss to which such taxes relate are considered in the computation of GloBE income or loss. For example, CE subject to tax on gain/loss considered under OCI pursuant to revaluation method for Plant, Property and Equipment under Article 3.2.1(d) will require an adjustment.

For a more comprehensive explanation of GloBE adjustments please listen to our webcast #6: Pillar Two Technical Series: Computation of Adjusted Covered Taxes where you can hear more in-depth analysis and download technical slides giving examples.

For a recap of previous topics covered, please refer to previous articles:

1. Pillar 2 GloBE rules technical series: Getting to know top-up taxes and safe harbours
2. Pillar 2 GloBE rules technical series: Understanding MNE group structures through the lens of the GloBE rules
3. Pillar 2 GloBE rules technical series: Addressing MNE group complexities under Pillar 2 GloBE
4. Pillar 2 GloBE rules technical series: Understanding how Pillar 2 GloBE impacts tax accounting
5. Pillar 2 GloBE rules technical series: unpacking and applying GloBE model rule adjustments

You can also contact us directly to discuss the above topics or other GloBE issues.