Pillar Two and the prognosis for UK tonnage tax

The UK has dusted down its tonnage tax rules post Brexit. But will the Pillar Two rules dilute the benefits of tonnage tax?

The UK has dusted down its tonnage tax rules post Brexit.

Our main article this week, ‘Supporting the Pillar’, covers the UK’s general approach to Pillar Two implementation. This note for shipping companies highlights the tension between the BEPS Pillar Two concept of international shipping and the boundaries of the UK tonnage tax regime. We locate a desert island in this definitional sea: some businesses may find themselves marooned there with an extra tax bill for reading material.

The UK tonnage tax regime exempts shipping profits and instead taxes a notional base (which is generally much lower) at normal tax rates. The effective tax rate (ETR) resulting may be around 1-2 percent. A multinational enterprise (MNE) Group with turnover over €750 million will need to consider what impact Pillar Two may have on companies within UK tonnage tax.

The Pillar Two Model Rules exclude International Shipping Income from Global Anti-Base Erosion (GloBE) Income. The definition of International Shipping Income in Article 3.3 of the model rules is modelled closely on Article 8 of the OECD model treaty and commentary. The key is that voyages must cross borders. Article 3.3.6 of the Model Rules goes on to impose a requirement that for a Constituent Entity to qualify for the Article 3.3 exclusion, the strategic and commercial management of all relevant ships must be effectively carried on in the jurisdiction where the Constituent Entity is located.

A UK tonnage tax company whose vessels are engaged in international traffic clearly should satisfy the above tests. UK tonnage tax also includes a requirement for qualifying ships to be strategically and commercially managed in the UK, thus Article 3.3.6 should be met. The company’s net income from International Shipping should therefore be excluded from the GloBE Income or Loss calculation. The fact that only a minimal amount of UK corporation tax is paid in respect of this income should thus not lead to any Top-up Tax being payable.

However, it is possible for a company to qualify for UK tonnage tax without engaging in international traffic. Transport at sea between UK locations can qualify assuming the other tonnage tax conditions are met. Examples are:

  • Ferries between islands;
  • Other sea routes between UK ports; and
  • Certain types of operation in the UK Continental Shelf area.

These activities will not satisfy the definition of International Shipping Income. If tonnage tax applies and only minimal UK corporation tax is paid in respect of such income this could lead to Top-up Tax becoming payable. However, for this situation to arise a UK tonnage tax company would first need to satisfy the conditions of being in an MNE Group with turnover of €750m or more.

As Pillar Two takes shape in the UK and more widely, the situation should be kept under review. An MNE with over €750m turnover which has UK subsidiaries benefiting from UK tonnage tax treatment in respect of UK domestic shipping activity may be impacted.