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Pillar Two and the GCC: Important Consequences for Tax Havens and Exemptions for Nationals

Aggressive tax planning combined with the digitalization of the economy has seriously amplified the risks of Base Erosion and Profit Shifting

Aggressive tax planning combined with the digitalization of the economy has seriously amplified the risks of Base Erosion and Profit Shifting in the past few years. From Starbucks to Amazon and Google, multinational companies have used loopholes of the international tax system to reduce their tax liability. Pillars 1 and 2 aim to limit this and ensure that companies around the world pay their fair share of taxes. The Gulf Cooperation Council Countries are known for being low/limited tax jurisdictions. Due to this increased attention, the Kingdom of Bahrain and the United Arab Emirates especially have been included in blacklists in several instances but managed to be removed successfully. Coupled with other favorable tax regimes across the world like the Netherlands and Ireland, the GCC countries are bound to make drastic changes in their tax policies. In this article, we explore several of the forecasted changes to these tax policies as a result of the global reform introduced by Pillars 1 & 2. 

As part of the efforts to combat the range of consequences of the digitalization of the economy and the corresponding profound increase of Base Erosion and Profit Shifting[1] (BEPS) in the last era, the Organization of Economic Corporation and Development (OECD) initiated Action 1 in 2015. The report remarkably recognizes the exacerbation of BEPS risks by the digital economy but does not propose any tax reforms specifically for the digital economy based on the early idea that it would be difficult to ring-fence the digital economy from the rest of the economy.

The main BEPS risk stems from disruptive digital transformations that, to a certain extent, render the current international tax rules obsolete. To be specific, the question arises whether the nexus and profit allocation rules developed in a “brick and mortar” environment are catching up with the pace of digital change. These digital changes can easily facilitate tax avoidance and BEPS due to the utilization of intangibles, mobility, reliance on data, and a tendency towards monopoly and volatility.

Many countries have enacted unilateral measures and taxes (for example: the Digital Services Tax “DST”) in an attempt to prevent this risk. For instance, the United Kingdom and France have both introduced digital service taxes aimed to consider user participation when allocating profits between countries. The United Kingdom has recognized the need for an international approach to the problem and continue to support the OECD’s agenda but considers that an interim solution needs to be implemented until a sustainable long-term approach is collectively concluded. A lot of political tension arose because of these Digital Service Taxes, and the United States has greatly opposed such unilateral measures and argued that these taxes profoundly and unfairly discriminate against US multinational enterprises, especially with regards to the French DST.

It was not until 2019 that the OECD released a policy note that proposes a two-pillar approach and subsequently two public consultation documents that discuss those pillars in detail. These pillars significantly move away from the rigid principles engraved in international tax around residency and source and constitute a truly remarkable reform of the international tax framework. This has triggered numerous debates on an academic level. The necessity for reform was recognized, but there was skepticism as to the practicality of implementing the pillars and the likelihood of a global endorsement.

In 2021, discussions around Pillar One and Pillar Two have picked up considerable speed following the endorsement by the G7 on 5 June 2021 and the endorsement by most of the OECD Inclusive Framework members on 1 July 2021. These endorsements have substantially increased the likelihood of reaching an international consensus.

With laws being drawn up in 2022, and an implementation in 2023, Pillar Two is right around the corner. In this article, we only analyse Pillar Two since it has the most profound impact on businesses.

What is Pillar Two?

Simply stated, Pillar Two establishes a Minimum Global Tax of 15% for businesses operating in multiple jurisdictions. Those businesses need to have a consolidated turnover in excess of EUR 750 million in order to be caught by the Global Anti-Base Erosion Rules (GloBE).

The minimum tax is achieved through the inclusion on the parent level of untaxed income of the subsidiary (the “Income Inclusion Rule”), or, as a backstop, via a rejection of the deduction of undertaxed payments (the “Undertaxed Payment Rule”).

In addition, a subject-to-tax rule applies, allowing source jurisdictions to impose a limited source taxation on certain related-party payments, which will be taxed below the 15% minimum rate.

The rules are designed to create a level playing field, canceling out income declared and taxed below the minimum effective rate of 15%, or not at all, by having to “top up” the tax. This is done on a jurisdictional basis (no consolidation between jurisdictions).

There are limited exemptions to be foreseen, which will be reserved for government entities, international organisations, non-profit organisations, pension funds or investment funds that are Ultimate Parent Entities (UPE) of an MNE Group or any holding vehicles used by such entities, organisations or funds.

Do All Countries Have to Apply It?

Technically no, but let’s call it fiscal peer pressure. Most of the Inclusive Framework members have endorsed the principles of Pillar Two. Among those are all GCC Member States, except Kuwait. The overwhelming majority of the important economies stand behind it, which means that the rest of the world is bound to follow.

What Choices do Countries Have in Terms of the Implementation?

Countries with a corporate tax system leading to an effective taxation in excess of 15% may simply implement Pillar Two in their domestic tax legislation, with the abovementioned principles to be adopted. This means they will mainly target jurisdictions with a lower corporate income tax rate (CIT) and include the top-up tax in the simplest cases.

If, however, a country has a CIT below 15%, it may consider the following actions:

• Adopt a higher tax rate compliant with Pillar 2 provisions. It will therefore collect more revenue.
• Adopt a higher tax rate compliant with Pillar 2 provisions, on a limited scale, i.e., only for businesses with a consolidated turnover in excess of EUR 750 million.
• Omit to take any action and thereby allow other countries to tax the revenue of the source jurisdiction.

A country with no corporate income tax may consider implementing corporate income tax on a limited scale or full scale.

What Will GCC Countries Do?

While arguably the UAE and Bahrain face the most important choices, with a potential (limited) implementation of CIT on a national level on the cards, Saudi Arabia, Qatar and Kuwait will also need to reform their laws. Potentially, Oman will not need to amend its legislation.

On an international level, if UAE and Bahrain start taxing income recorded in those jurisdictions at 15%, as long as the CIT rate in the parent jurisdiction is higher, the group effective tax rate[3] may overall be equal or lower, than in the case where the parent includes the income of the UAE/Bahraini subsidiary and taxes the income at the CIT rate of the parent, under the current circumstances. The UAE faces a double conundrum as well in regard to the free zones and its federal structure.

Was Doing Nothing an Option?

While the UAE and Bahrain have often been heralded for the absence of a CIT and their large double tax treaty network, they were often considered a tax haven and were therefore subject to measures taken by other countries, thereby reducing their attractivity. These measures included:

• Monitoring payments connected to tax havens.
• Denying some tax exemptions (for example: participation exemption denied for dividends received from tax havens).
• Application of Controlled Foreign Corporation rules, which include revenue recorded in tax havens in the income of the parent company in another country.
• Rejection of payments as deductible expenses in the jurisdiction of the parent.
• Imposing substance requirements on tax havens (such as those imposed under the Economic Substance Regulations in the UAE).

This means that in effect, transactions with tax havens are being targeted by other jurisdictions already today.

While Oman has been labeled a tax haven in the past for insufficiently exchanging information, and Saudi Arabia at some point as well for solely taxing non-GCC shareholders, they have been subject to these types of anti-tax haven measures much less.

Next Steps

The OECD and the BEPS Inclusive Framework Members will further develop a more granular set of rules for Pillar Two. In the meantime, governments will start exploring policy options and implement them over the course of 2022 and 2023. This harmonized set of rules needs to be accepted by all or most of the countries thereby presenting the biggest obstacle for the implementation of the pillar.

The OECD will likely develop a new multilateral treaty to implement Pillar Two in a more streamlined fashion.

Conclusion

The adoption of Pillar One (not discussed in this article in detail) and Pillar Two are undoubtedly going to have a profound impact on the international tax landscape. Simultaneously, they will place a number of governments before some policy choices, which will have an important impact at the domestic level.

Businesses can already analyse what the impact will be, at a higher or more detailed level, by following the detailed guidelines given by the OECD in regard to implementation. If prior implementation of transfer pricing or substance rules provides any lessons, it is that jurisdictions often implement new rules wholesale in their domestic jurisdictions. Businesses can therefore anticipate now what the impact will be. The overall design is not expected to change much. Some preliminary analysis and planning can already be conducted.

Some concrete steps that may be taken are:

• Mapping jurisdictions and the Effective Tax Rate under the Country-by-Country report[4], which is already required to be filed by the in-scope MNEs.
• Analysing what potential policy choices jurisdictions with a nil to low Effective Tax Rate may take.
• Analysing what measures are currently being taken by other jurisdictions in respect of tax havens, and what impact Pillar Two might have on these transactions (i.e., identifying high-risk jurisdictions).
• Calculating the financial impact of the imposition of the Global Minimum Tax on profits in terms of the net profit after tax.

[1] Base erosion and profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. Developing countries’ higher reliance on corporate income tax means they suffer from BEPS disproportionately. (See https://www.oecd.org/tax/beps/about/)

[2] According to the OECD, Zakat is considered a covered tax for GloBe purposes. Zakat is the third pillar of Islam and the most important form of financial obligation for the Muslim community. It is a financial contribution collected by the State and distributed to poor people and social security beneficiaries.

[3] The effective tax rate is the actual percentage of taxes the company pays on all of its taxable income.

[4] BEPS Action 13 requires large Multinational Groups of Entities to file a CbC Report that reflects a breakdown of the Multinational Group’s global revenue, profit before tax, income tax accrued, and some other indicators of economic activities for each jurisdiction in which the MNE operates.

Thomas Vanhee

Partner

Aurifer

Mohamed AlAradi

Associate

Aurifer