Pillar Two and Australian real estate Pillar Two and Australian real estate Pillar Two and Australian real estate

The 130 members of the Organisation for Economic Cooperation and Development (OECD)/G20 Inclusive Framework on BEPS approved a statement on 1 July 2021 which provides a framework for reform of the international tax rules.

The agreement has two components which are referred to as Pillar 1 and Pillar 2:

• Pillar One reallocates a portion of the profits of certain very large multinational enterprises (MNEs) with a global turnover above 20 billion euros to market countries, irrespective of whether the MNE has a physical presence in that country.
• Pillar Two is a global minimum tax for MNEs with a global turnover of more than 750 million euros. The rate is to be “at least 15 percent” and the assessment of whether the minimum tax has been incurred will be done on a country by country basis.

For the purposes of this article, we have focused on some preliminary thoughts in relation to the potential application of the global minimum tax rules in Pillar Two with respect to Australian real estate investments.

For present purposes, we have assumed that Australian real estate is unlikely to be a relevant issue for an entity impacted by Pillar One.

The analysis below is based on the following assumptions:

• Very few Australian real estate vehicles invest offshore and, as such, there will not be many instances where the Pillar Two rules need to be applied at an Australian level.
• Listed and widely held Australian real estate funds are unlikely to be consolidated into an upstream entity for financial accounting purposes such that there is unlikely to be any application of the Pillar Two rules in respect of such entities.
• The exception to the effective exclusion of widely held funds may be those funds which are deemed to be widely held for MIT purposes but are, in fact, closely held by a designated investor (which is considered a proxy for a widely held outcome) such that the fund is consolidated with the investor for financial accounting purposes.

In the first instance, the application of Pillar Two will depend upon whether the jurisdictions where the parent fund and/or the investors are based decide to enact these rules (they are not obliged to do so).   

Let’s assume the rules are in place in one or more relevant jurisdiction (remembering that the rules are applicable on a top-down basis) and that there is a financial accounting consolidation outcome in that jurisdiction.

We haven’t focused on the factors around consolidation outcomes in this note but note in passing that IFRS 10 might provide an exemption for Investment Entities which meet its qualifying conditions.

 There are a number of threshold issues which need to be considered:

• are the entities in scope? Note the Euro 750m threshold and that countries can choose to adopt a lower threshold for inclusion in the scope of the rules.
• are the investors themselves exempt? Based on what has been released to date, we anticipate that sovereign wealth funds and sovereign pension funds investors (and their holding vehicles) should (mostly) be exempt (subject to them not carrying on a trade or business).
• are the funds themselves exempt? The July 2021 Statement from the Inclusive Framework seemingly endorses the fund exemption outlined in more detail in the 2020 OECD Blueprint document. Based on that we might anticipate that most regulated, managed investment funds (and their wholly owned holding vehicles) should be exempt, provided they do not carry on a trade or business.

We need to wait for confirmation of the exemption and some further analysis of the “trade or business” language.

It seems unlikely that the rules would adopt the Australian domestic (Division 6C) trading business test to determine what is a trade or business and perhaps the rules will leave it up to the implementing country to make a final decision on the scope and interpretation of this test.

 A number of interesting questions arise in an Australian context including those below:

• How would these rules apply in the context of a fund which carries on significant development activity, as many Australian funds do?
• What is the treatment of a stapled entity – it would seem that the trust might qualify for the exemption, but the stapled company might not. Would the entities be treated as separate entities for the purposes of these rules or as one economic entity? If they are treated as a single vehicle, how are they characterised?  What if the stapled entities are effectively required to be consolidated for Australian accounting purposes?  However, the relevant question based on the above assumptions is whether they are consolidated into an upstream entity and what does the inclusion of the corporate side mean for the trade or business analysis?
• What is the treatment of a non-wholly owned vehicle? It is not unusual to see non-wholly owned entities in the chain, such entities being set-up as co-investment structures with one or more investors. These entities might not fall under the exemption for the particular fund and may have to be considered on a stand-alone basis. Again, the threshold question is whether such entities would be consolidated into an upstream entity?
• How much work will a fund need to do to ensure that they can provide impacted investors with any necessary information? This might be relevant both for existing investors to whom the rules apply and might be a due diligence point for potential investors. 

Let’s put the threshold issues to one side and consider the possible mechanics of the operation of the rules in an Australian context.

The headline tax rate is generally 15 percent (10 percent for a clean building managed investment trust MIT) but this rate is applied only to taxable income, which can be materially different from accounting income. 

The major difference is that IFRS based accounting income is (unless the entity decides not to make a fair value election) calculated treating investment properties on a mark-to-market basis whereas taxable income works from cost and allows for depreciation.

Assuming a rising property market, accounting income will be usually be significantly higher than taxable income due to property revaluations which generally flow through the P&L and which will need to be excluded from the Pillar Two calculations in order to avoid significant tax being paid on unrealised gains.

We understand that OECD is aware of the mark to market accounting issue but not specifically in the property context and it would seem sensible to make sure that this issue is properly considered, especially if the scope of the fund exemption is not all encompassing.

Another way of dealing with this issue might be to allow a credit for the deferred taxes given that the gains are currently unrealised and will eventually be subject to tax i.e. it is a genuine timing mis-match not a difference arising from the non-taxation of the gain or the operation of a specific tax incentive.

However, most Australian property trusts do not currently recognise deferred tax as they are flow through vehicles, rather it is the holding entities that may recognise any deferred taxes.

Some other items which will need to be considered include:

• capitalised interest (which is deductible for tax purposes) – where a development period for an asset is longer than 6 months, interest can be capitalised which again means that accounting income may be higher than taxable income
• lease incentives which do not result in an asset owned by the Lessor (eg depreciable fit-out) will generally be expensed over the terms of the lease rather than claimed outright as they might be for tax purposes. Again, this will result in a difference in the timing of recognition of accounting and tax income which may mean that accounting income exceeds taxable income
• there are also complicated accounting rules dealing with financial arrangements and especially derivatives which are beyond the scope of this article but which will need to be considered.

 If these structural issues can be dealt with then, leaving aside ordinary timing differences, the main issue will generally be tax deprecation.

It would seem a little unusual if the impact of the rules is to reverse such depreciation (especially where is it based on a useful life calculation rather than being an accelerated tax incentive) and it would seem that the proposed rules recognise this in relation to physical assets insofar as they suggest that you can use tax depreciation instead of book depreciation.

It would be sensible to confirm that this outcome persists where the tax depreciation rate is incentivised rather than being simple useful life outcomes.

The headline tax rate here will generally be 30 percent and subject to the issues relating to the accounting treatment of properties referred to above, one might expect that the Effective Tax Rate would be above 15 percent.