How will the tax landscape be after the implementation of Pillar 2? Tax accountability starts with tax accounting!
Dear Tax Professional,
On December 20th, 2021, the OECD released the Pillar Two Model Rules. Pillar Two introduces new global minimum tax rules for multinational enterprises (MNEs) with an agreed rate of 15%. The minimum tax is calculated based on financial accounting standards and relies on two main components: profits and taxes paid.
Generally, the rules apply to MNE groups with an annual revenue of €750 million or more. Regarding the use of financial statements as basis for Pillar Two (Top-Up Tax) calculations the OECD made the following groundbreaking statement: “Given that most businesses already use deferred tax accounting to reconcile differences between financial accounting and tax results, the Pillar Two Model Rules leverage these existing accounting principles to simplify compliance.”
First, let me state that I fully agree with the OECD‘s decision to leverage the existing accounting principles. Why? It‘s because I am convinced that the fundaments of a strong (income) tax control framework start with a strong tax accounting framework. If your tax accounting process is in a good shape, it is easier to analyze, monitor, and predict the tax position of a multinational. Everything that impacts the MNEs tax position at the group level, country level, and the reporting unit level should be found in the financial statements. The tax items that are presented in the balance sheet and P&L reflect the outcome of the best guess (actual or pro forma) tax return for each affiliate, branch and/or reporting unit, including the tax payments and receipts.
However, the danger lies in the first sentence: “â€¦ that most businesses already use deferred tax accounting to reconcile differences between financial accounting and tax resultsâ€¦”
For most of you as tax professional, the use of deferred tax accounting is not “already” used (or understood), but something new and complex. Only few multinationals have a strong centralized tax accounting team and process in place and are in control of the concept of deferred tax accounting. For most multinationals, deferred tax accounting is primarily something known to (a few) accounting professionals. In short, it is dangerous to assume that the word “use” implies that multinationals are “in control” of their deferred tax accounting position. In my view, this is often not the case.
I will also refer to a quote from an article issued by Baker McKenzie on December 23rd, 2021: “The admission of deferred taxes is an evolution in the OECD‘s approach to dealing with timing differences. The Pillar Two Blueprint proposed bespoke mechanisms to smooth out cash tax liabilities over a time-limited window. This received criticism from many large businesses who viewed it as unnecessarily complicating an issue that deferred tax had already been designed to deal with. Whilst the OECD has now agreed to adopt a deferred tax approach, their reservations continue.”
The “pain point” of Pillar Two is therefore that you as tax professional will be required not only to understand the complex Pillar Two Model Rules, but also to gain a proper understanding of a complex deferred tax accounting concept, which is the basis for calculating the minimum tax under the Income Inclusion Rule (“IIR”) or the Undertaxed Payments Rule (“UTPR”).
You are probably not used to considering financials statements in order to understand the tax position of a company, let alone someone bringing up the concept of deferred tax accounting. The fact that tax items are disclosed under the Generally Accepted Accounting Principles (“GAAP”) makes it difficult to understand those items.
Thus, let me try to explain in layman‘s terms the logic of tax following the accounting principles:
- Companies sell products and/or services and they incur costs by doing so. The result of these two (revenue and costs) is a profit or a loss.
- The revenue, costs, profits (or losses) are recorded in the books and financial statements of a company. This is all part of the accounting process.
- It is only after all this that tax comes into the picture. The tax legislation of all countries reclassifies selected items of the accounting income and costs to determine the taxable basis to be reported in the tax return, i.e., the taxable profit or loss.
- The differences between 2. and 3. above are referred to as the book (= accounting)-tax differences.
- Book-tax differences come in 2 types: permanent and temporary:
- Permanent differences are easiest as these relate to income or cost items that never reverse in time, and in principle only affect the tax position once, i.e., in the year when they arise.
- Temporary differences are more complex, as these relate to timing. This means that these items affect the taxable base both in the year when they arise, but also in future years when they reverse. The GAAP states that financial statements must recognize such future tax expenses or future tax income. This accounting concept is referred to as deferred tax accounting.
The above hopefully clarifies the logic of starting from the financial statements and underlines the OECD‘s decision to do the same. Aside from Pillar 2, a good understanding of tax from an accounting perspective would save a massive amount of time in understanding the tax position of a company and the impact of tax advice. It would also make you a much better partner to finance professionals, as the GAAP would be the common denominator for both sides.
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After building our tax accounting solution, TaxProof, we now consider adding a Pillar 2 Module to calculate the amount and allocation of Top-Up Tax under the IIR and UTPR Rules.
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