Pillar Two – Key considerations for fund vehicles

Introduction – the basics

Pillar Two is an OECD initiative which implements a global minimum tax rate of 15% with the aim of preventing entities shifting profits to low or no-tax jurisdictions. At a broad level, where the effective tax rate of an entity (as computed under specific rules) is less than 15%, there are various mechanisms in place to collect additional tax to bring it up to an effective tax rate of 15%.

Our asset management team explores the Pillar Two impact to businesses and the relevant key considerations for fund vehicles in depth in the below article.

The rules

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.

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. The key considerations in assessing whether a fund vehicle is in scope are to determine:

Does the vehicle meet the requisite conditions to be considered an “investment fund” and if so, does it fall within the scope of the Excluded Entity definition?
If the vehicle is not an Excluded Entity, is it part of an MNE group or domestic group? and
If so, does the group exceed the consolidated revenue threshold?

It is important to note that not all fund vehicles will be regarded as investment funds for the purposes of the rules, so a case-by-case analysis is necessary to determine whether there is sufficient basis to regard the fund as outside the scope of Pillar Two.

Furthermore, even where a fund is considered outside the scope of the rules, its revenue may need to be taken into account in determining whether any other entity which it is part of a group with exceeds the revenue thresholds. Where a vehicle is in scope of the rules, it may have additional compliance obligations even where it does not have any additional tax obligation, which may give rise to an additional administrative burden collating the data required.

Even where a fund vehicle falls outside the scope of the rules, its revenue may nonetheless be relevant in assessing whether related parties are in scope of the rules.

Philip Murphy

Partner

KPMG in Ireland

Scoping – is the vehicle an Excluded Entity?

Where a fund vehicle is considered both an investment fund and Excluded Entity for the purposes of the rules, it will be completely outside the scope of the rules without any administration required on an ongoing basis. Therefore, most fund vehicles will first assess whether they can fall within the relevant definitions, which include each of the following:

An investment fund that is an ultimate parent entity (and is therefore considered an Excluded Entity);
An entity which is 95%+ owned by or through an Excluded Entity, subject to certain conditions in relation to the activity of the entity; and
Any entity which is 85%+ owned by or through an Excluded Entity, where the entity derives substantially all of its income from dividends or gains.

The application of these tests can therefore be broadly split between entities which are the primary investor facing / aggregation vehicles (where (a) is likely more relevant) or which are part of fund complexes (where (b) and (c) are likely more relevant). It is worth noting for completeness that certain real estate investment vehicles can also be regarded as Excluded Entities where conditions are satisfied.

Having an understanding of the relevant accounting treatment applicable to a vehicle and other entities in its investor / ownership chain is crucial when assessing Pillar Two impact.

Philip Murphy

Partner, Asset Management Tax

KPMG in Ireland

Pillar Two - key considerations for fund vehicles

Investor facing / aggregation vehicles

A vehicle which is considered an investment fund for the purposes of Pillar Two will be outside the scope of the Irish rules in respect of one of the collection mechanisms (specifically, the domestic top-up tax mechanism) – the definition of an investment fund for the purposes of the rules is included further below.

However, in order to be considered an Excluded Entity and outside the scope of the alternative collection mechanism (specifically, the income inclusion rule) further to (a) above, 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.

Vehicles which are part of fund structures

Where entities are part of a fund complex but are not themselves investment funds, there are two different scenarios under which they might nonetheless be outside the scope of the rules. The key points in the context of these two scenarios are:

In tracing whether the respective 85% / 95% rules are satisfied, it is necessary for any intermediate entities which are being traced through to themselves be considered Excluded Entities. For example, if there is an investment holding vehicle, the shares of which are exclusively held by a master holding company which is held by an investment fund, it is necessary for both the master holding company and the investment fund to be regarded as Excluded Entities in their own right;
Although the 85% / 95% tests allow tracing through intermediate entities, it is not possible to trace through certain entities which have been established to invest on behalf of pension funds;
The 95% test only applies where the entity operates exclusively (or almost exclusively) to hold assets or invest funds for the benefit of an excluded entity or carries out activities ancillary to those performed by the Excluded Entity;
The 85% test only applies where substantially all of the income of the entity is derived from dividends or gains that are excluded when calculating the income for Pillar 2 purposes.

Where there are entities which are not themselves investment funds or if there are investment funds which are consolidated into other investment funds, it will therefore be important to ensure that (i) the vehicle meets the relevant criteria to allow it rely on the 85% / 95% test and (ii) that any tracing through a fund structure is done in accordance with the specific rules, as it will not be possible to trace through certain entities (albeit where the sole investor is a feeder fund or pension fund, a look through approach may be possible).

Although there is an exemption from the rules that can apply to fund vehicles, it should not be assumed that the conditions will apply in every case.

Gareth Bryan

Partner, Head of Asset Management Tax

KPMG in Ireland

What if a fund or entity which it holds an interest in is not an Excluded Entity?

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, they 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.

Determination of consolidated revenue 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 must nonetheless needs to be included in ascertaining whether the threshold has been exceeded.

Treatment of partnerships and other vehicles

An “entity” is broadly defined for the purposes of the Irish legislation implementing Pillar Two and captures:

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

In light of this, any partnership which prepares separate financial statements would be considered an entity, even if it has no legal personality. However, in ascertaining whether the effective tax rate of a group exceeds 15%, it is possible to allocate any amount attributable to a “flow-through” entity to the owners of the flow-through entity.

This broadly requires that a vehicle such as a partnership is fiscally transparent in both its jurisdiction of formation and from the perspective of its limited partner(s). Where this is the case, the relevant income arising to the partnership is allocated to the limited partner(s) in computing the effective tax rate for the group.

In certain circumstances where a partnership is not regarded as 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.

Other considerations

The recent Finance Act includes a legislative amendment to remove standalone investment undertakings from the scope of Ireland’s domestic top-up tax.

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 domestic top-up tax, 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.

Key considerations for fund structures

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

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;
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;
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. There are specific nuances applicable in the context of partnerships and similar entities which can give rise to additional considerations for in scope groups.

There may be some circumstances whereby fund vehicles do not fall outside the scope of the rules – where vehicles are in scope, the additional compliance burden that can arise should not be underestimated.

The level of additional work required to comply with Pillar Two compliance obligations should not be underestimated – it won’t be possible to collate necessary information at short notice where required.

Gareth Bryan

Partner, Head of Asset Management Tax

KPMG in Ireland

Get in touch

We can assist with assessing any or all the contents of the above article in the context of specific structures, providing any required technical accounting input as part of the analysis, in addition to advising on the optimal approach to adopt. Reach out to our team today to discuss more about Pillar Two and the potential impact for your business.