The impact of the OECD Pillar Two model rules on natural resource companies

As part of its two-pillar proposal to counteract base erosion and profit shifting (BEPS), the OCED is consulting on ways to exclude extractive industries from its Pillar 1 proposals of market jurisdiction taxation of digital transactions. However, all natural resources companies will be affected by the Pillar 2 proposals and this article considers some areas of immediate concern.

Pillar Two global minimum tax local implementation

On 20 December 2021, the OECD released model rules to assist the 137 jurisdictions that agreed to the OECD/G20 Inclusive Framework with the implementation of Pillar Two into domestic legislation. The OECD commentary and the detailed rules will be released by mid-2022.

Pillar Two seeks to establish a 15% global minimum tax rate through the introduction of two interlocking rules, i.e., the income inclusion rule (IIR) and the under-taxed payments rule (UTPR), collectively referred to as the GloBE rules. Under the IIR, the ultimate parent entity is primarily liable for all top-up tax. The top-up tax is applied to profits if the effective tax rate in any jurisdiction is below the minimum 15% rate. As a backstop, the UTPR can apply by way of a denial of tax deduction to low-taxed income not brought into charge under the IIR. Pillar Two broadly applies where a company has consolidated revenue in excess of EUR 750 million.

The model rules also include a subject to tax rule (STTR) designed to allow source jurisdictions to impose a top-up withholding tax on certain types of outbound payments (e.g., royalties) when such payments are made between related parties and are not subject to a minimum tax rate.

The jurisdictions which have agreed to apply this framework are currently working through how they will implement it into their domestic legislation. In addition, they are also seeking to ensure that they do not lose out on tax revenues through the application of the IIR at the parent level, for example, with the introduction of domestic minimum taxation. Significantly, certain jurisdictions are looking to implement those changes as early as in 2023 or 2024. As such, natural resource companies should carefully monitor worldwide developments in this area. For an overview of the rules, please click here.

Pillar Two model rules are very complex, and we are working with businesses to help them understand their potential implications. The new provisions may prove particularly challenging for natural resource companies, which have largely outside the scope of most of the digital service taxes/equalisation levies to date.

Re-design of tax incentives in the NR industry?

To attract foreign investment (“FDI”) in the natural resources sectors, developing countries have habitually offered tax incentives to companies considering activities in their jurisdictions.

These countries may now find themselves in the position where they have granted an investor a local tax holiday but, as a result of the IIR, a top-up tax is collected in another jurisdiction – reducing or negating the incentive. This may encourage such countries to consider the introduction of a minimum tax to protect their own tax base.

However, such tax incentives are often contained in individual investment contracts, which frequently incorporate stabilisation provisions preventing governments from unilaterally changing terms and conditions of such contracts. This could cause potential issues for the relevant governments and lead to arbitration risks. It remains to be seen how governments will choose to respond to protect their commitments to investors without losing tax revenues to other jurisdictions.

Going forward to ensure optimal outcomes, international tax and investment policy will have to go hand in hand and be coherent. While this could result in a significant detriment to developing countries which had granted tax incentives to attract FDI, there is a general expectation that such countries will start looking at other types of incentives in order not to lose revenues. For example, countries may opt to reduce regulation or compliance burdens in other areas, providing new incentives in areas outside the scope of Pillar 2 (such as employment incentives), or increase direct grants being offered.

These expected changes in local approaches to tax incentives means that there will be consequences of Pillar Two for all natural resource companies - even for those companies which are not directly impacted by the tax rules.

Impact of long-term timing differences

The model rules provide that the effective jurisdictional tax rate is calculated by reference to the accounting net income and current tax expense accrued. While deferred taxes are taken into account, certain adjustments are required, one of which limits allowable timing differences to those which will reverse in five years.

In the case of natural resource companies, there are typically large investments in capital expenditure that take a long time to be recovered, and domestic rules often allow some form of accelerated tax depreciation. This creates substantial timing differences, often in excess of five years, at the country level.

The approach of the Pillar 2 rules in this area is not yet clear, however, the risk is that deferred tax is not sufficiently taken into account for natural resource groups and, as a result, they fail the 15% effective tax rate test. In turn, this will trigger the GloBE income inclusion rule and means the group is subject to a top-up tax at the parent level - negating the benefit of accelerated tax depreciation to the investor and meaning that the local country unnecessarily loses on tax revenues.

Losses

Long, early loss-making periods are relatively common for natural resource companies, e.g., during exploration and initial production phases etc. Consideration of pre-GLoBE losses and transitional rules will be key to ensure that top-up tax is not imposed on such timing differences.

Significant compliance burden

The Pillar Two model rules will only apply to constituent entities that are members of an MNE group with annual revenue of EUR 750 million or more in at least two of the four fiscal years immediately preceding the tested fiscal year. However, there is a concern that even those larger groups will be required to undertake a significant and costly compliance exercise to find the source data, apply the required adjustments and perform calculations to establish how and when tax is going to be collected.

Significantly, the threshold of EUR 750 million has nothing to do with the margin. Therefore, defining the required compliance processes and balancing the group and local compliance responsibilities will be key to ensuring that the right data is captured and that the deferred tax balances are tracked as and when they arise. Undertaking a modelling exercise to understand the range of potential implications will enable MNEs to consider the variety of elections available under the Pillar Two model rules to optimise compliance and cash tax.

These few examples illustrate the significant complexity in these rules. Groups with income over EUR 750 million will, therefore, need to perform complicated calculations and there will remain a significant degree of uncertainty in the interpretation of the rules. Even where there is no jurisdiction with an effective tax rate below 15%, the compliance cost will be substantial. Domestic minimum taxes which may be implemented by various jurisdictions to protect their tax bases may increase the compliance cost even further as well as increase the risks of double taxation.

While not directly relevant to the Pillar Two considerations, it is also worth noting that the OECD has recently released a public consultation document on Pillar One – Amount A: Extractives Exclusion. This exclusion applies where a group derives revenue from the exploitation of extractive products and the group has carried out the relevant exploration, development or extraction.

Action to take now

We recommend that natural resource groups should be:

• Working through the Pillar Two model rules and tracking policy responses in those countries where they have taxable presence
• Undertaking modelling exercises to understand the range of potential implications as well as estimating the cost of compliance, and 
• Keeping their C-suite informed of the potential tax and compliance costs as well as risks associated with global implementation of Pillar Two. 

For help and advice on assessing the impact on your business please contact Julia McCullagh, Agata Kozolup or Ross Robertson.