Spotlight on: Pillar 2

The rules, which are complex, are in force in Ireland for in-scope entities with fiscal years beginning on or after 31 December 2023. An Irish tax resident entity should only potentially be in scope of the rules where it is part of a multi-national (MNE) group or a domestic group which has consolidated revenue exceeding €750m for at least two of the preceding four fiscal years. Importantly, the term “entity” is broadly defined and captures:

• Any legal arrangement of whatever nature or form that prepared separate financial accounts; or
• Any legal person other than an individual

Consequently, a partnership or similar entity, such as a common contractual fund (“CCF”), which prepares separate financial statements would be considered an entity for Pillar Two purposes and could be in scope of the rules, notwithstanding that the tax transparency means such vehicles do not otherwise pay tax in Ireland.

However, there are a range of vehicles which are entirely outside the scope of the rules. For example, “investment funds” (as defined) can be considered completely outside the scope of the two main collection mechanisms however, in order to be so considered, there are prescriptive criteria which need to be satisfied.

Where a fund vehicle is nevertheless in-scope of the rules, if it is considered to be fiscally transparent in both its jurisdiction of formation and from the perspective of its investors, it can be treated as a Tax Transparent Entity for Pillar Two purposes such that the income of the entity is allocated away from the entity to the investors.

In certain circumstances where a partnership or similar entity is not regarded as tax transparent from the perspective of any investor, an election can be made where conditions are satisfied to achieve broadly the same outcome as if it were transparent from an investor perspective. Such an election can ultimately protect the tax neutrality of these vehicles.

There are three mechanisms under which tax is collected under the Pillar Two rules:

The Qualified Domestic Top-up Tax (QDTT) requires that those entities in the MNE group which are located in a jurisdiction that has adopted the Pillar Two rules but which would otherwise have an effective tax rate of less than 15%, pay additional tax in that jurisdiction. This rule ensures that the income of these entities is taxed at least at the minimum rate of 15%.

The Income Inclusion Rule (IIR) requires a parent entity pay a top-up tax on the income of its low-taxed constituent entities (i.e., those entities in the MNE group with an effective tax rate of less than 15% in which it has a direct or indirect ownership interest).

This rule ensures that the income of these entities is taxed at least at the minimum rate of 15%. The rule can only apply where the parent entity is located in a jurisdiction that has implemented the Pillar Two rules.

Generally, a parent entity should not have an IIR liability where the entities in the MNE group in which it has a direct or indirect ownership interest are located in a jurisdiction that has adopted the Pillar Two rules as the QDTT collection mechanism should ensure that their effective tax rate is at least 15%.

The Undertaxed Payments Rule (UTPR) acts as a backstop to the IIR and QDTT and applies to payments made to low-taxed entities within an MNE group. Where there are entities in the MNE group with an effective tax rate of less than 15% (taking account of any IIR paid in respect of those profits), UTPR requires that additional tax (equalling, in aggregate, 15% of those entities profits) is effectively borne be group members in jurisdictions that have implemented UTPR. This is to be done by denying tax deductions or imposing an additional charge on the in-scope group members.

The UTPR charge is allocated across the group based on the proportion of tangible assets and employees in each jurisdiction that has implemented the UTPR. This rule ensures that the income of these entities is taxed at least at the minimum rate of 15%.

Generally, a group member in a jurisdiction which has implemented UTPR should not have a UTPR charge where all other entities in the group are located in a jurisdiction that has adopted the Pillar Two or are owned directly or indirectly by entities located in a jurisdiction that has adopted the Pillar Two as the QDTT and IIR collection mechanisms should ensure that the effective tax rate is at least 15%.

In order to be considered an Excluded Entity and outside the scope of the alternative collection mechanism (specifically, the income inclusion rule) the fund vehicle cannot be consolidated on a line-by-line basis into any other entity.

In assessing this, there is also a deemed consolidation test (i.e. it is necessary to consider if line-by-line consolidation would be necessary if the investor in the vehicle prepared consolidated financial statements).

Although many funds are widely held or there are multiple investors such that they would never need to be consolidated, there are circumstances whereby a fund may need to be consolidated into an investor (e.g. where there is a significant investor or if the manager is seeding the fund for any reasonable amount of time).

Where it is possible to conclude that the vehicle is the ultimate parent entity, it is then necessary to ascertain if it falls into the relevant definition of an investment fund, which requires the fund to have all of the following characteristics:

• it is designed to pool assets (which may be financial and non-financial) from a number of investors (some of which are not connected);
• it invests in accordance with a defined investment policy;
• it allows investors to reduce transaction, research, and analytical costs, or to spread risk collectively;
• it has a main purpose of generating investment income or gains, or protection against a particular or general event or outcome;
• investors have a right to return from the assets of the fund or income earned on those assets, based on the contributions made by those investors;
• the entity or its management is subject to a regulatory regime in the jurisdiction in which it is established or managed (including appropriate anti-money laundering and investor protection regulation); and
• it is managed by investment fund management professionals on behalf of the investors.

Many investment funds should meet the above criteria however, there are circumstances where the criteria may not be clearly met.

For example, a fund-of-one which is designed as such may not be able to satisfy the criteria in relation to the pooling of assets from a number of investors.

Where a fund entity meets the above conditions but is not an ultimate parent of the group, it will not qualify to be treated as an Excluded Entity for the purposes of IIR and UTPR. However, it should be treated as an Excluded Entity for QDTT purposes.

Thus an investment fund resident in Ireland should be exempt from Irish QDTT though its investors may be subject to IIR (and other group members could be subject to UTPR) in respect of its income, depending on how Pillar Two has been implemented in the jurisdiction of its investor(s)).

This is one of the special rules that apply to a category of entities known as investment entities and which includes investment funds.

If a fund vehicle or any entity in a fund structure is not an Excluded Entity, it will potentially be in scope of the rules. In order to ascertain this, the key consideration is whether the entity is a part of a group, and the accounting consolidation position is critical in determining this.

At its most basic level, the concept of a group is determined by reference to the consolidated financial statements prepared in accordance with an acceptable accounting standard (includes IFRS and a range of local GAAPs, including GAAP of any EU Member State), where the entity is consolidated on a line-by-line basis.

However, there are a few additional points that need to be considered when determining the group for Pillar Two purposes:

• If an investor or other equity holder is not required to prepare consolidated financial statements, there is a deemed consolidation test which must be applied i.e. it is necessary to consider the position in the event the investor / equity holder was required to prepare consolidated financial statements;
• If an entity is excluded from the consolidated financial statements solely based on its size (in the context of materiality) or on the basis it is held for sale, it is nonetheless required to be included in the group; and
• There are specific rules under which joint ventures should be included in the group, where they are at least 50% owned by a group and accounted for in the group consolidated financial statements further to the equity method.

There are also additional rules which can apply to permanent establishments however they are unlikely to be relevant to most fund structures.

Once the applicable group is determined, it is then necessary to consider whether the consolidated group revenue exceeds the €750m threshold. 

The basic test is whether the consolidated revenue of the group exceeds €750m in two of the preceding four fiscal years. The threshold amount is increased or decreased on a pro-rata basis where a relevant accounting period end is more or less than 12 months.

Any revenue attributable to a vehicle or entity that is specifically excluded from the scope of Pillar Two (e.g. an Excluded Entity) nonetheless needs to be included in ascertaining whether the threshold has been exceeded. 

Another special rule applicable to investment entities (and hence investment funds) relates to how tax is computed and allocated under Pillar Two.

In general, Pillar Two applies a methodology known as jurisdictional blending which requires that the Pillar Two effective tax rate calculations be done by taking all of the income of, and taxes paid by, the members of the same MNE group that are resident in the same jurisdiction together in a single, joint calculation.

Where the effective tax rate is below 15% and, as a result, additional tax is due, the amount to be paid by each entity is essentially based on a pro rata allocation to each of the group members.

This could easily result in a disproportionately high or low allocation of Pillar Two taxes to a particular entity relative to what it would have paid if assessed independently.

However, a special rule applies to investment entities (and hence to investment funds) whereby the effective tax rate is to be calculated separately from the effective tax rate of the jurisdiction in which it is located.

These rules do not apply where the investment entity is a Tax Transparent Entity (or is treated as one by election) or where the Taxable Distribution Method applies to it (discussed on the following page). If there is more than one investment entity located in the same jurisdiction, a joint calculation is done in respect of all of the investment entities.

The most recent Finance Act included a legislative amendment to remove standalone investment undertakings from the scope of Ireland’s QDTT. As a result, where an investment undertaking, such as a unit trust, investment limited partnership, or common contractual fund is not a member of any consolidated group it may fall outside the scope of Ireland’s QDTT, even where its revenues are above €750 million.

Furthermore, it is expected that updated guidance will shortly be published by Irish Revenue which clarifies that sub-funds of umbrella funds can be regarded as separate entities for the purposes of the rules where they prepare separate financial statements.

The key considerations for funds and their underlying structures can be broken down into a number of net points:

1. Fund vehicles are not automatically outside the scope of the rules, notwithstanding that there is a carve out for investment funds. In order to be considered fully outside the scope, it is necessary to consider if the fund may be consolidated into any investor, in addition to whether it meets the relevant criteria to be an “investment fund” as defined for the purposes of the rules. It may be challenging in practice for fund-of-one type arrangements to qualify for exclusion;
2. It is possible for vehicles held by investment funds to be considered outside the scope of the rules in their own right, however it is necessary to understand the profile of each entity in the ownership chain of the structure and also whether specific conditions are satisfied by the vehicle;
3. Where an investment fund or vehicle in a structure does not fall outside the scope of the rules by virtue of the fund focused exclusions, the accounting consolidation position is crucial to understand the group for Pillar Two purposes and whether it is in scope.
4. There are specific nuances applicable in the context of partnerships and similar fiscally transparent entities which can give rise to additional considerations for in scope groups.

Where fund vehicles do not fall outside the scope of the rules, the additional compliance burden that can arise should not be underestimated.

In addition, in some cases funds will need to understand how investors treat the fund – either from an accounting consolidation perspective or in the context of whether the investor categorises the fund as opaque or transparent for tax purposes.

This may require additional information from investors as part of onboarding in certain instances, which will need to be incorporated into the subscription process for new funds.