L-Day: UK UTPR and other amendments to the UK Pillar Two rules

Detail on the UK undertaxed profits rule and amendments to existing UK Pillar Two rules, including an election for non-material entities

Undertaxed profits and Pillar Two changes

On 18 July 2023, the Government published draft legislation to amend the recently enacted Finance (No.2) Act 2023, which introduced the Multinational Top-up Tax and Domestic Top-up Tax. These taxes are the UK’s adoption of the income inclusion rule and domestic minimum top-up tax rule as referenced in the OECD’s Pillar Two Global Anti-Base Erosion (GloBE) rules. The amendments published include the UK’s proposed adoption of the backstop undertaxed profits rule (UTPR) and other amendments to keep UK legislation consistent with the GloBE rules. The Government noted that further amendments may be introduced in the future to reflect subsequent Administrative Guidance released by the Inclusive Framework/OECD. In this article we unpack the key aspects of this draft legislation.

Undertaxed profits rule (UTPR)

The UTPR works as a backstop to ensure that any amounts of multinational top-up tax that are not collected under an Income Inclusion Rule (IIR) will still be collected. For example, this could apply to a US parented multinational group where the US Effective Tax Rate (ETR) is below 15 percent.

In that situation, the relevant jurisdiction below the US which has implemented the Pillar Two rules could use the UTPR to collect additional tax in respect of the US. The expectation is that the UTPR will apply in the UK from 2025 onwards.

This follows the OECD publication on 17 July 2023 of updated Administrative Guidance which includes a UTPR transitional safe harbour. Broadly, this will apply where a jurisdiction’s headline tax rate is at least 20 percent. In that case, the UTPR should not apply. This is notably not included in the Government’s package of amendments to the existing UK domestic legislation, but may be updated in due course. This would provide some temporary relief from the impact of the UTPR in earlier years.

The OECD also published a consultation document on Amount B under Pillar One, model rules in respect of the Subject to Tax Rule (STTR) including modifications to the 2021 STTR proposals, and further details on the GloBE information return. Please refer to KPMG International commentary for further details.

Non-material constituent entity safe harbour election

As noted above, the draft legislation also included other amendments to keep UK legislation consistent with the GloBE rules including the rules around partnerships, flow through entities, etc.

The most significant of these is the proposed introduction of a non-material constituent entity safe harbour election in an effort to simplify the application of the rules. Broadly, this election can be made on an entity-by-entity basis and can apply where an entity is not included in the consolidated financial statements on the grounds of size or materiality.

Where a valid election is made, it uses data from the Country-by-Country Report (CbCR) so that the adjusted profits and covered tax balance of non-material members do not need to be separately calculated. In particular, the adjusted profits for the entity are equal to the revenue of that member (instead of applying the various adjustments to underlying profits) and the covered tax for that entity is taken to be the income tax accrued by that member.

As with the transitional safe harbours, the revenue and income tax data must be derived from qualifying financial statements. Financial statements will be qualified if they are: (a) prepared in accordance with CbCR guidance of the relevant territory; and (b) determined by the group external auditor to be non-material. If the revenue exceeds EUR50 million, they must be prepared in accordance with an acceptable or authorised financial accounting standard.

The election must be made for the first accounting period in which the Pillar Two rules apply to that member and may be revoked at any time (albeit cannot be made again once revoked).

This is a welcome amendment which should aid simplification of the compliance and data gathering process. However, care must be taken to assess whether using revenue instead of profits will detrimentally impact the ETR of a particular jurisdiction, although on the basis this only relates to smaller entities, this may not have too negative an impact overall.

Amendments to existing legislation

There are a number of refinements to the enacted legislation. These include a definition of ‘Revenue’, essential for groups close to the EUR750 million Pillar Two threshold, and the creation of a ‘special foreign tax asset’ where domestic losses have to be offset against foreign, e.g. overseas permanent establishment, income that generates covered tax.

Key takeaways

The UTPR transitional safe harbour published by the OECD is a welcome development which, assuming it is reflected in UK and other domestic legislation in due course, will provide some comfort to especially USA and China HQ groups Although it’s worth remembering that this is only applicable for a short period of time.

The non-material constituent entity safe harbour election is extremely helpful for those groups who were grappling with producing the necessary data to calculate accurate ETRs for non-material entities. Although, as noted above, given the substitution of profits for revenue, it will be important to assess the impact this could have on the ETR of any particular jurisdiction before making the election given it can only be made once. Availability of complete and accurate data continues to be the single biggest challenge multinational groups are currently facing.

The draft legislation is open for consultation until 12 September 2023.