THE POLICY LAB (TPL) - 56
DECEMBER 23, 2024

By J B Mohapatra

A: IN 2021, 135 members of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (the inclusive framework) concurred with the broad terms of the 'Statement on the Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy' (the Two-Pillar Solution) for ensuring that MNEs pay an equitable share of tax wherever they choose to operate and refrain from cashing in on the tax arbitrage opportunity in the tax rates among the tax jurisdictions. Pillar two of the inclusive framework outlines the minimum effective tax rate and its rules lays down the methodology how MNE constituent entities with effective tax rate below the minimum in any tax jurisdiction will be required to disgorge a top-up tax. In October 2024, the OECD released a report to the G20 Finance Ministers and Central Bank Governors outlining developments on proposed tax reforms including on pillar two, stating inter alia that 45 jurisdictions have introduced or are finalizing laws to implement the global minimum tax per pillar two starting in 2024 or 2025. While countries such as Australia, France, Germany, Greece, UK, Netherlands etc have already have the requisite legislation on pillar two adopted, some such as Spain or Cyprus have put out draft legislations, and some other such as Hongkong and UAE have announced their intention to legislate.

B: Thrust of the model rules for pillar two is for ensuring in general 15% minimum tax assessed through a top-up tax that is imposed on a country to country basis for companies in scope of pillar two. Top-up tax in any jurisdiction is determined with reference to the effective tax rate (ETR).

In article 5.1 of the rules, ETR is defined as below:

"The effective tax rate of the MNE Group for a jurisdiction with net GloBE (global anti-base erosion) income shall be calculated for each fiscal year. The effective tax rate of the MNE Group for a jurisdiction is equal to the sum of the adjusted covered taxes of each constituent entity located in the jurisdiction divided by the net GloBE income of the jurisdiction for the fiscal year. For purposes of chapter 5, each stateless constituent entity shall be treated as a single constituent lntity located in a separate jurisdiction."

Adjusted covered taxes are defined in the rules as below:

"Article 4.1.1 The adjusted covered taxes of a constituent entity for the fiscal year shall be equal to the current tax expense accrued in its financial accounting net income or loss with respect to covered taxes for the fiscal year adjusted by:

(a) the net amount of its additions to covered taxes for the fiscal year (as determined under article 4.1.2) and reductions to covered taxes for the fiscal year (as determined under article 4.1.3);

(b) the total deferred dax adjustment amount (as determined under article 4.4); and

(c) any increase or decrease in covered Taxes recorded in equity or other comprehensive income relating to amounts included in the computation of GloBE income or loss that will be subject to tax under local tax rules.

Article 4.1.2: The additions to covered taxes of a constituent entity for the fiscal year is the sum of:

a) any amount of covered taxes accrued as an expense in the profit before taxation in the financial accounts;

b) any amount of GloBE loss deferred tax asset used under article 4.5.3;

(c) any amount of covered taxes that is paid in the fiscal year and that relates to an uncertain tax position where that amount has been treated for a previous fiscal year as a reduction to covered taxes under article 4.1.3(d); and

d) any amount of credit or refund in respect of a qualified refundable tax credit that is recorded as a reduction to the current tax expense."

C: Simply stated, covered taxes, which are significant for invoking the top-up tax rules, include the current tax expense accrued for financial accounting net income and qualified refundable tax credits. If the ETR based on the covered taxes and additions thereto falls below the minimum tax rate of 15%, top-up tax percentage will be determined as the difference between 15% and the ETR. At this stage, the only method available for preventing the levy of top-up tax in the manner noted in articles 2.1 to 2.6 of the model rules is the qualified domestic minimum top-up tax as defined in article 10.1, the qualified domestic minimum top-up tax regime albeit required to be legislated in national laws before a jurisdiction moves forward to invoking the said provisions in the model rules.

D: In India context, no doubt, the current corporate tax rate depending on some factors and situations varies variously at 30%, 22% and 15% (average reported ETR being 23.26 % for FY 21-22 and 22.20 % for FY 20-21) and would not be a low-tax jurisdiction within the meaning of the model rules, however, model rules intending to trigger the top-up tax mechanism in respect of any tax jurisdiction with regard to ETR of a specific entity, when it is lower than the minimum rate, in-scope MNEs whether operating through constituent entities and/or having the ultimate parent entities incorporated in India are liable for getting considered under the model rules for pillar two. That said, corporates in India are statutorily entitled to various deductions and exemptions: u/s 10AA for profits of units located in SEZ, u/s 32 for accelerated depreciation, u/s 35 for scientific research expenditure, u/s 35AD in respect of specified business, u/s 80IA in respect of profits of undertakings engaged in development of infrastructural facilities, or generation, transmission and distribution of power, u/s 80IAB in respect of profits of undertakings engaged in development of SEZs, u/s 80IB/ 80IE in respect of undertakings located in J&K or in NE states and Sikkim, u/s 80JJAA in respect of employment of new workmen in businesses or u/s 80LA in respect of certain income of OBU and IFSC and many more of such provisions, making the specific ETR for those entities go lower than the minimum tax rate as per pillar two rules. These deductions and exemptions allowed under the domestic tax legislation though are not recognised for making adjustment to the financial accounting net income of the constituent entity for the fiscal year in terms of article 3.2 to 3.5 of the model rules and hence would have zero impact on determination of ETR as per the model rules.

E: Model rules while not proscribing the deductions and exemptions allowed under domestic legislations offered as avenues to promote serious national objects such as research or employment generation, backward area development, upgradation of infrastructure, such tax provisions not considered as harmful tax practices as per BEPS action 5, ultimately do not change the determination of ETR in the manner laid down in the model rules, as the adjusted covered taxes for the purposes of ETR in essence take into account the current tax expense accrued in the entity's financial accounting net income and the qualified refundable tax credit that is recorded as a reduction to the entity's current tax expense.

F: Qualified refundable tax credit defined in article 10.1.1 of the model rules reads as follows: "means a refundable tax credit designed in a way such that it must be paid as cash or available as cash equivalents within four years from when a constituent entity satisfies the conditions for receiving the credit under the laws of the jurisdiction granting the credit. A tax credit that is refundable in part is a qualified refundable credit to the extent it must be paid as cash or available as cash equivalents within four years from when a constituent entity satisfies the conditions for receiving the credit under the laws of the jurisdiction granting the credit. A qualified refundable tax credit does not include any amount of tax creditable or refundable pursuant to a qualified imputation tax or a disqualified refundable imputation tax."

By way of working illustration, qualified refundable tax credit is added to the denominator in the equation of tax expense / GloBE income for deriving the ETR without any changes to the numerator, whereas a tax credit not regarded as a qualified refundable tax credit is reduced from the numerator without changes to the denominator.

G: In the OECD commentary on the pillar 2 rules, article 3.2.4 of the rules have been explained as below:

110. Article 3.2.4 prescribes the treatment of certain refundable tax credits. The refundable tax credits referred to in article 3.2.4 are government incentives delivered via the tax system. They are not ordinary refunds of tax paid in a prior period due to an error in the computation of tax liability or pursuant to an imputation system. Instead, they are incentives to engage in certain activities, such as research and development, whereby the government allows the company to offset its taxes dollar-for-dollar for engaging in specified activities or incurring specified expenditures or the government will refund the amount of the unused credit if the company doesn't have any tax liability. In this way, the government effectively pays for the activity or expenditure in a similar manner to a grant. The basic idea is that the incentive or grant is delivered by a tax reduction to the extent possible because it is more efficient than having checks from the government and taxpayer crossing in the mail.

111. The full amount of a qualified refundable tax credit will be treated as GloBE income of the recipient constituent entity in the year such entitlement accrues. This reflects that these types of refundable tax credits share features of, and should be treated in the same way as, government grants that form part of income, given that they are in effect government support for a certain type of activity that can ultimately be received in cash or cash equivalent.

112. In cases where an amount of a qualified refundable tax credit has been recorded as a reduction in current income tax expense (or other covered taxes) in the financial accounts of the constituent entity, that amount must be treated as an addition to covered taxes under article 4.1.2(d) to fully reverse the accounting entry that treated it as a tax reduction instead of income. This ensures that the qualified refundable tax credit is treated as an item of income rather than a reduction of accrued taxes. No adjustment is required if a tax credit that meets the definition of qualified refundable tax credit was already treated as income in the financial accounts.

113. Likewise, a tax credit that does not meet the conditions for being a qualified refundable tax credit, i.e. a non-qualified refundable tax credit, but that was treated as income in the financial accounts, must be deducted in full from the measure of net income in the financial statements, and there must be a corresponding reduction of adjusted covered taxes under article 4.1.3(b).

114. Where the tax credit regime under the laws of a jurisdiction provides for partial refundability, such that only a fixed percentage or portion of the credit is refundable, these rules apply separately to the refundable part and the non-refundable part of the tax credit."

H: In the rules and the commentary, two aspects of the qualified refundable tax credit have been made mandatory: one, the refundability of the credit meaning if the taxpayer has lesser than required tax liability, it is entitled to refund from out of the tax credit that it was entitled to; and two, the payment of cash or cash equivalent cannot be any later than 4 years from when a constituent entity becomes entitled to credit under the laws of that jurisdiction. While India has enacted few tax credit regimes, for example u/s 115JAA for MAT credit where MAT credit set off is allowed only if tax payable under normal provisions is greater than the tax payable as per MAT and also to the extent of the difference between the two, or the system of tax rebate u/s 87A mitigating the applicable tax liability by a specified amount of tax rebate, none of such provisions entail refundability of tax credit in the manner that the pillar two rules have set up and defined or in the manner that few other tax jurisdictions such as USA have legislated through its system of Earned Income Tax Credit or Additional Child Tax Credit etc.

I: If the idea of protecting the regime of deductions and exemptions already in place in few sectors and geographies under India's current tax dispensation from the impact of pillar two application is to be achieved through converting all such deductions and exemptions to qualified refundable tax credit, apart from innovating a structure and a design of the tax credit in line with the pillar two rules, few associated issues need be addressed as well: one, the potential revenue impact that the conversion will entail for the government; two, the administrative burden for addressing the new provisions; and three, addressing the issue of equity among classes of eligible taxpayers entitled to and otherwise enjoying these deductions and exemptions who are impacted by pillar two and those who are not impacted.