Pillar 2 GloBE rules technical series: Understanding how Pillar 2 GloBE impacts tax accounting 

Continuing our technical series on Pillar 2 GloBE, this article aims to give an overview of the relationship between tax accounting and Pillar 2 GloBE. As well as highlighting basic accounting principles, the article will summarise issues relating to the computation of the effective tax rate, top-up tax, GloBE income or loss, covered taxes and reporting obligations. A link to a more detailed version giving in-depth information, relevant GloBE rule sources and examples is available at the end of this article.

As income tax accounting knowledge forms the foundation for Pillar 2, a refresher on some tax accounting basics can help with GloBE modelling and calculations.

As a general rule, we have one set of books for an organisation that follows financial accounting principles, such as those under Generally Accepted Accounting Principles (GAAP) or International Financial Accounting Standards (IFRS).

The second set of books that we commonly refer to are tax records. Generally, tax records are determined by the financial accounting principles used after tax legislation has been applied. These records track adjustments required to financial statements that are necessary to file tax returns. 

While there are similarities between financial accounting and tax records, there are some critical differences that need to be addressed. It is therefore essential to understand key differences in the jurisdictions where an MNE does business and how the whole process flows together. 

Generally, financial accounting’s matching principle requires that the timing of the revenue and expenses incurred to produce net income, are recognised in the same period. However, different rules govern the timing of when items of revenue and expenses are recorded for accounting and tax purposes. Thus, income tax accounting must bridge the timing of taxes paid in the current period and the recognition of any future tax amounts related to the current period. The timing of recognition of amounts for tax purposes can be accelerated or deferred compared to how the amounts are recognised for accounting purposes. Assets and provisions are created to reflect these differences and financial statements include a reconciliation of the percentage of tax recorded in the financial statements to the nominal effective tax rate. Rate reconciliation compares the company’s effective tax rate (ETR) with the statutory tax rate applicable in the jurisdiction where the company is resident.

Prior to the introduction of Pillar 2, there were statutory reports supported by legal entity financial statements for various countries, and consolidated group financial statements. These included disclosures and supporting calculations to meet financial accounting standard requirements in relation to reporting tax for accounting purposes. Now, in addition to having one set of calculations dealing with adjustments to get from accounting figures to domestic jurisdiction tax liabilities, a different set of adjustments from accounting figures is required to arrive at Pillar 2 tax liabilities –  an additional set of books. Based on the June 2024 Administrative Guidance, MNE groups should now consider implementing separate books and controls to document and manage the underlying Pillar 2 book value of assets and liabilities, as well as the underlying Pillar 2 deferred taxes and tax liabilities.

Computation of ETR and top-up tax

Unlike the effective tax rate (ETR) for normal corporate tax liabilities that is reported in financial statements, the Pillar 2 ETR is calculated differently. Currently for financial statement purposes deferred tax arising from Pillar 2 tax is not reported separately, only the actual Pillar 2 tax liabilities needs to be. To calculate the top-up tax liability, the primary rule is that the income inclusion rule (IIR) or undertaxed profits rule (UTPR) should be considered at the parent entity level.

The top-up tax liability is calculated based on the top-up tax percentage (15% less the GloBE jurisdictional ETR calculation, or zero if less than 0) by the excess profit calculation (GLoBE profit less the substance-based income exclusion). The substance-based income exclusion provides a carve-out for payroll expenses and tangible assets representative of a fixed return for substantive activities within a jurisdiction applying the global rules. 

Under Pillar 2, the ETR is calculated by dividing the adjusted covered tax by the GloBE income. Therefore, it is essential to understand how to compute the adjusted covered tax and the GloBE income. It is also important to remember that GloBE income is not the same as the profit before tax in the financial statements. 

Determining GloBE income or loss

The starting point for determining a constituent entity’s (CE’s) GloBE income is the net income or loss of that entity that is included in the consolidated financial statements of the ultimate parent entity (UPE) before eliminating inter-group transactions. Once a financial accounting net income or loss of a CE is determined, adjustments must be made for certain differences between financial accounting figures and taxable figures. Certain income is excluded from GLoBE income, such as shipping income. Other adjustments are generally related to permanent differences between financial accounting and local tax rules.

Once the GloBE income has been determined, where necessary it can be allocated to permanent establishments (PEs) or flow-through entities in accordance with local tax treatment.

Dealing with adjusted covered taxes

Several safeguards are designed to protect the integrity of the ETR calculation under the GloBE rules. These safeguards include limiting the recognition of the deferred tax assets and liabilities to ensure that amounts claimed as covered taxes are actually paid within a set period. 

The current tax expense in financial statements is the starting point for determining covered taxes. Several adjustments are then made relating to temporary differences and losses that involve recasting deferred tax assets and liabilities using a 15% rate and taking account of a recapture rule. It is then a case of allocating covered taxes to specific CEs. Such allocations include controlled foreign corporation (CFC) taxes to the relevant CFC and withholding taxes, tax in respect of a permanent establishment (PE) and tax transparent or hybrid entities. In terms of subsequent adjustments to financial statement or tax figures, special rules apply to the recalculation of a Pillar 2 tax liability or ETR . For example, an adjustment leading to an increase in covered taxes in a prior year is treated for Pillar 2 purposes as an increase in covered taxes for the current year.

It’s vital that MNEs know how to deal with the required adjustments to accrued tax expenses. A number of additions and reductions can apply. Additions to covered taxes include those accrued as expenses at the pre-tax profit level in financial accounts, any amount of GloBE loss deferred tax asset used, or any amount of covered taxes paid in relation to uncertain tax positions. Other additions include credits or refunds for a qualified refundable tax credit recorded as a reduction to the current tax expense (e.g. R&D tax credit).

Reductions to covered taxes include current tax expense concerning income excluded from the computation of the GloBE income or loss, and credits or refunds related to a non-qualified refundable tax credit that is not recorded as a reduction to the current tax expense. Further reductions include current tax expenses which relate to an uncertain tax position or expenses not expected to be paid within three years of the end of the fiscal year.

However, a certain number of covered tax inconsistencies can arise in practice related to withholding taxes on interest and royalties (such withholding taxes are treated as taxes of the recipient), where there are uncertain tax positions (tax on uncertain tax positions is not treated as a covered tax until it is paid), or where there are deferred tax recognition issues. Withholding taxes on distributions are treated as taxes of the payor. It is, therefore, vital to look at situations on a case-by-case basis.  

Importance of the recapture rule

The main purpose of the deferred tax liability (DTL) recapture rule is to ensure that the ETR is not overstated by giving credit for DTLs that will not reverse within the subsequent five years. However, the rule does not apply to all DTLs or recapture exceptions accruals (REAs – these are changes in deferred tax expenses recognised in respect of things like cost recovery allowances on tangible fixed assets, licenses from the Government for the use of immovable property or exploitation of natural resources, to name a few).

In practical terms, DTL recapture means that the adjusted covered taxes and the ETR for the year in which the DTL was accrued and claimed are re-computed minus the DTL. If the ETR is below 15%, an additional top-up tax is computed for that year. MNEs will need to develop a process, in addition to their accounting process, to observe whether a DTL reversed within five years. 

It is, therefore, important that MNEs ensure the availability of a DTL breakdown as well as separate tracking of Pillar 2 DTLs to determine if the five-year reversal rule applies. In addition to being able to distinguish between short-term and long-term intangible DTL details, it will be essential for MNEs to develop a clear process to determine and collate the information required.

Reporting obligations

The U.S. Financial Accounting Standards Board (FASB) announced in February 2023 that they view the GloBE minimum tax as an alternative minimum tax (AMT), meaning Pillar 2 taxes are taken into account in current tax, but not the effect of Pillar 2 deferred tax accounting. This approach denotes a current inclusion approach, which means recognising the additional tax in the period that it is due. This period cost should be considered as part of the effective average tax rate (EATR) for the year and recorded on a quarterly basis for that period. Consideration should be given to exclusions related to discrete items and intra-period allocation relating to discontinued operations. 

Some differences in practice are beginning to emerge with respect to valuation allowance considerations. As such, additional guidance from the FASB is expected in the future. However, once an accounting policy fair value election has been made, the most critical aspect of reporting is consistency from a disclosure standpoint. While it doesn’t have to be quantified, disclosure of material impacts should be qualified and included in tax footnotes. Some companies are beginning to provide updates on expected future impact in qualitative terms and identify jurisdictions in which they have material operations that may trigger a GloBE tax liability. 

Next steps and questions to ask

By creating a clear roadmap that focuses on asking the right questions, MNEs can be best placed to ensure that their tax accounting related to Pillar 2 GloBE is fit for purpose. As a starting point, the following questions can help.

• Safe harbour rules can apply for 2024, 2025 and 2026! Have the benefits of applying for any of the GloBE Safe Harbour elections been identified?
• Does the MNE have a Pillar 2 implementation roadmap?
• Is the MNE aware of the required information to determine and compute amounts under the GloBE rules?
• Not all jurisdictions will implement the rules. Has the MNE reviewed the enactment status of the jurisdictions in which it operates?
• How will the MNE collect the required data? Is there a data strategy available? Has a data gap analysis been completed?
• Determine whether computations will be carried out at the local or group level. Also, have the data owners been identified?
• Which tool is to be used to calculate the top-up tax liability?
• Is the MNE able to complete the GloBE return?

For a more comprehensive explanation of tax accounting and Pillar 2 GloBE issues please listen to our webcast #4: Pillar 2 Technical Series: Tax Accounting Overview & Impact where you can download technical slides giving more in-depth details and examples.

You may also be interested in other webcasts in this technical series, including: 

1. Pillar 2 Technical Series: Overview & Transition Years 
2. Pillar 2 Technical Series: MNE Group Determination
3. Pillar 2 Technical Series: Complex MNE Groups

You can also contact us directly to discuss your GloBE issues.