Transitioning into a ‘brave new world’ of Pillar Two

Monday 8 April 2024

Report on a session at the 13th annual IBA Finance & Capital Markets Conference in London

Monday 15 and Tuesday 16 January 2024

Session Chair

Sam K Kaywood Jr, Alston & Bird, Georgia


Dèlcia M Capocasale, Cuatrecasas, Barcelona and New York

Sylvia Dikmans, Houthoff, Amsterdam

Michael Orchowski, Sullivan & Cromwell, London

Gerry Thornton, Matheson, Dublin

Amanda Pedvin Varma, Steptoe & Johnson, Washington DC


Nikol Nikolova, Kambourov and Partners, Sofia


The panel discussion was focused on the critical aspects and potential impact of the Organisation for Economic Co-operation and Development’s (OECD) Pillar Two Model Rules framework on various tax and corporate structures. The first segment of the discussion was dedicated to how Pillar Two affects investment funds, certain International Financial Reporting Standards (IFRS) definitions and considerations, the particulars concerning joint ventures and the ramifications of Pillar Two in the context of mergers and acquisitions (M&A). The first half of the discussion highlighted the critical factors that must be taken into account for the strategic structuring of investments in accordance with Pillar Two.

In the second half, attention shifted towards a comprehensive review of the recent developments in regard to United States foreign tax credits, a topic of significant relevance given its potential influence on cross-border investments and the international tax landscape.

Panel discussion

Investment funds

Gerry Thornton began the discussion by examining the definitions pertaining to investment funds and investment entities. Thornton clarified seven specific conditions that must be met to be recognised as an ‘investment fund.’ Concretely, those conditions are as follows:

  • it consolidates capital from multiple investors, including those who may not have prior connections;
  • it must operate according to a clear investment policy;
  • it should enable investors to minimise their costs or distribute their investment risk;
  • its primary objective is to generate investment income or gains;
  • the returns to investors correlate directly with their contribution;
  • the entity is regulated or the investment manager is regulated; and
  • the entity is managed by investment fund management professionals.

Furthermore, Thornton defined two specific conditions that differentiate ‘investment entities’ that are subsidiaries from ‘investment funds’ themselves. These are:

  • the necessity for an ‘investment entity’ to be at least 95 per cent owned by a singular ‘investment fund’ or by a chain of such entities; and
  • the operational mandate of the ‘investment entity’ must be exclusively, or almost exclusively, to hold assets or to manage investments for their benefit.

Finally, Thronton concluded the definition part with a clarification as to the criteria for classification as an ‘excluded entity’ within the framework of Pillar Two. Specifically, for a fund entity to be an ‘excluded entity’, it must fall under the following conditions:

  • the entity can be an ‘investment fund’ that also serves as the ‘ultimate parent entity’. This denotes that the fund is at the top of an investment fund hierarchy; or
  • the entity, alternatively, can be at least 95 per cent owned, whether directly or through a succession of other ‘excluded entities’, by one or more entities that meet the abovementioned condition. Additionally, its operational activities must be focused solely or predominantly on holding assets or investing capital solely for the benefit of these entities.

Practice points

In concluding his contribution to the panel session, Thornton addressed several practice points that bear significant relevance to professionals navigating the investment fund landscape under Pillar Two. One of the key issues that Thornton explored was the acceptability of the ‘look-through’ approach for identifying unconnected investors who invest through a number of feeder funds, controlled by the same general partner, into a master fund.

Another practice point addressed by Thornton was the Pillar Two in-scope/carve-out treatment of managers’ co-investments, in light of the five per cent (or, in some cases, 15 per cent) threshold. The issue here revolves around the degree to which a manager’s stake, if invested in a lower-tier entity, can influence the fund’s qualification as an ‘investment fund’ if the manager’s stake breaches the applicable five per cent (or 15 per cent) ownership threshold. Thornton emphasised the importance of understanding how these investments are viewed under Pillar Two, given that they can have implications for the fund’s overall tax strategy.

Accounting test vs model rule test

Dèlcia M Capocasale continued the discussion by providing an overview of the interplay between tax and accounting regulations. Her exploration of the subject highlighted the distinct parameters that differentiate the scope of the  model rules and accounting, emphasising the need for a comprehensive understanding of these differences when dealing with Pillar Two regulations.

Capocasale then delved into the implications of the IFRS, specifically concerning investment entities as outlined in IFRS 10. She elaborated on the exclusion rule within the IFRS, explaining the importance of determining whether an entity is within the scope of the obligations for accounting purposes. She underlined that since 2012, the IFRS has included its own exclusion rule for investment entities that parallels the exclusion rule in Pillar Two, yet with practical differences that could lead to different outcomes.

To illustrate her point, Capocasale presented an example where, despite individual holding entities not qualifying as investment entities for IFRS purposes, they could, as a collective group, exhibit the hallmark characteristics of an investment entity, thereby circumventing the consolidation rules. She explained that in regard to such structures, the ultimate parent entity (UPE) might potentially be in the scope of Pillar Two but excluded from an accounting perspective, as the latter classifies as an investment entity. This exemption could similarly apply to a subsidiary investment company that, while within the scope of the Pillar Two framework, might also be excluded if it is deemed an investment entity according to accounting evaluations. This is a crucial aspect because it affects the application of jurisdictional blending at the level of target entities, contingent upon whether these entities meet the defined thresholds of Pillar Two.

Pillar Two and joint ventures 

As for the treatment of joint ventures (JVs) under Pillar Two, Capocasale emphasised that the focal point is whether the interest in the JV is consolidated on a line-by-line basis or by the equity method.

The key accounting criterion is the extent of significant influence, as defined by the IFRS, which is generally indicated by ownership of 20 per cent to 50 per cent of the voting rights, classifying such entities as associated entities.

Pillar Two introduces a specialised rule that widens the scope beyond the traditional accounting definition to include certain unconsolidated JVs. Under the Pillar Two paradigm, a JV may be brought back into scope if:

  • its results are reported using the equity method;
  • the UPE’s direct or indirect ownership interest in the JV is at least 50 per cent; and
  • the JV itself is not the UPE of a multinational enterprise (MNE) that falls within Pillar Two’s scope.

Should all the aforementioned criteria be satisfied, the effective tax rate is calculated as if the JV were the UPE of a separate MNE, on the condition that the JV shareholders are themselves within the scope of Pillar Two.

In the concluding segment of her presentation, Capocasale enhanced the discussion on JVs and their status when it comes to Pillar Two by presenting two illustrative examples that delved into the intricate test of determining control or the lack thereof. These examples provided a practical assessment of the criteria and considerations that dictate whether a JV falls within the ambit of Pillar Two, where the determination of control has direct implications on tax obligations and compliance requirements.

M&A and Pillar Two

Michael Orchowski led the discussion on M&A and the influence Pillar Two is having on this area of law. He directed the panel’s discourse with an analytical dive into the traditional approaches to tax diligence and sale and purchase agreements (SPAs). Orchowski addressed the foundational step in any M&A transaction - financial due diligence - with a particular emphasis on the purchase price mechanism. He highlighted the necessity of this stage, as it primarily focuses on the financial health and valuation of the target group, setting the stage for subsequent negotiations.

His analysis further pinpointed the conventional scope of due diligence, which is typically concentrated on the target group, often to the exclusion of broader considerations, such as deferred tax assets (DTAs) and deferred tax liabilities (DTLs). These elements, though sometimes overlooked in traditional models, carry significant implications for the financial projections and tax positions of the entities involved.

Orchowski highlighted a prevailing preference within the industry for businesses that exhibit lower effective tax rates, as these entities are generally regarded as more desirable from an M&A perspective.

Building on the foundation laid by the previous speaker, Sylvia Dikmans advanced the panel’s discussion by addressing the evolving landscape of M&A in the wake of Pillar Two’s implementation. She acknowledged that this new regulatory framework has ushered in a series of novel inquiries that are reshaping the traditional tax due diligence process. Dikmans emphasised that the primary questions now extend beyond basic tax and financial assessments and venture into the domain of Pillar Two’s applicability.

Dikmans highlighted that these new considerations have significantly broadened the remit of tax investigations in regard to M&A activities. The necessary due diligence now requires more in-depth analysis to ensure compliance with the nuanced demands of Pillar Two, necessitating a comprehensive understanding of the rule’s international tax implications and the interplay between various tax jurisdictions.

Dikmans emphasised the critical nature of comprehensive questioning during tax due diligence, as demonstrated through a scenario involving the acquisition of a Dutch entity with a subsidiary that falls outside the ambit of Pillar Two. She stressed the importance of carrying out a meticulous review, beginning with the verification of whether the entity meets the €750m revenue threshold stipulated by Pillar Two. It is imperative to confirm the accuracy of the taxable income calculations and to ensure that the participation exemption has been correctly utilised. Furthermore, she advised tax professionals to consider the implications of permanent establishments and hybrid entities, and how these factors influence tax obligations.

Orchowski then elaborated on the extensive ramifications of misapplying Pillar Two rules within the corporate structure, as follows:

  • parent companies bear the primary responsibility for the tax stipulated by the income inclusion rule (IIR) under Pillar Two;
  • all entities within a group could potentially shoulder a share of the Pillar Two tax liability as dictated by the undertaxed profits rule (UTPR);
  • each group company is individually accountable for the qualified domestic minimum top-up tax (QDMTT); and
  • Pillar Two does not inherently impose joint or several liability among group companies, distinguishing the autonomous tax obligations of individual entities within the group.

Dikmans brought to the discussion an intriguing contrast in regard to the application of Pillar Two tax liabilities. She highlighted that, unlike many other countries, the Netherlands imposes joint and several liability for Pillar Two taxes on all group companies. This approach means that any entity within a group could be held accountable for the Pillar Two taxes levied by the Dutch authorities, thereby creating a collective fiscal responsibility within the group.

She pointed out that this unique liability structure presents a significant challenge when it comes to assessing and forecasting potential risks, as the financial implications of such liabilities are complex and difficult to model.

In the Netherlands, Dutch companies must notify the authorities if they are subject to Pillar Two, unless already done so by their parent company. Non-compliance may lead to fines of up to €1,030,000 in 2024. Moreover, companies must report within two weeks any misapplication of Pillar Two that they identify, facing penalties up to 100 per cent of the missed Pillar Two tax, which highlights the importance of prompt and precise compliance.

Orchowski then continued with a noteworthy takeaway that any restructuring conducted between 30 November 2021 and the inaugural year of Pillar Two’s coming into force must be scrutinised for compliance and strategic impact. From a valuation standpoint, the allure of low local effective tax rates (ETRs) may be reconsidered; they may still hold appeal, yet their desirability is not as clear cut under the Pillar Two regime. Additionally, the buyer’s status in relation to the €750m revenue threshold has significant valuation implications, potentially affecting the attractiveness and financial dynamics of a deal.

The subject of DTAs was then discussed. Orchowski emphasised that the DTAs resulting from transactions within a group conducted between 30 November 2021 and the start of the first fiscal year of the Pillar Two Model Rules (also referred to as the Global Anti-Base Erosion or ‘GloBE’ rules) may be overturned for GloBE calculations. This could potentially lower an entity’s ETR, necessitating a supplementary top-up tax.

For temporary differences, such as those due to accelerated depreciation, the usual accounting outcome is a reduction in the current tax and the creation of a DTL. Under the GloBE rules, however, the value of a DTL is capped at the lower of the relevant tax rate or 15 per cent. This cap could, in certain circumstances where credits are applicable, push an entity’s ETR below the 15 per cent threshold.

Dikmans concluded this part of the discussion with suggestions and best practices in the context of M&A. Buyers should pay attention to precise tax warranties within share purchase agreements (SPAs) to address Pillar Two concerns. These warranties aim to ensure that either the target companies have not been under the purview of Pillar Two rules up to the effective or completion date, or that they have been in full compliance with these rules, including fulfilling any notification obligations.

Pillar Two foreign tax credit issues in the US

Amanda Pedvin Varma dedicated her part of the discussion to Pillar Two-related foreign tax credit issues in the US. There have been some legislative proposals on certain aspects of Pillar Two in the US, but such implementation is not envisaged in the near future. The US Tax Code does not currently contain a qualified IIR, a QDMTT, or a UTPR, which are pivotal components of the Pillar Two framework.

Varma further expanded on the guidance issued by the Internal Revenue Service (IRS) and the Treasury Department in December 2023, which provides clarity on the US position concerning foreign tax credits in the era of Pillar Two. The Treasury Department’s recent guidance, encapsulated in Notice 2023-80, offers some guidance, although not complete, as to how the intricacies of US tax law intersect with Pillar Two. This guidance is a step forward in addressing the complex interplay between national and international tax regulations.

A pivotal takeaway from this guidance is the US decision to generally disallow foreign tax credits in instances where an IIR is applied by other jurisdictions. The reasoning for this disallowance has to do with potential circularities in the calculations, as discussed below. An exception to this rule exists, particularly concerning minority shareholders in international groups. For example, in a situation where a US entity owns a 70 per cent interest in a global business group, with the remaining 30 per cent held by US minority shareholders, the IIR tax paid by these minority shareholders can be recognised.

Another salient feature of the recent IRS and Treasury guidance, as Varma highlighted, concerns the potential creditability of the QDMTT under US tax law. This aspect of the guidelines has sparked considerable interest among tax professionals and US multinationals, given its potential impact. The guidance would not prevent the creditability of QDMTTs, and an example assumes a QDMTT is creditable, though the guidance stops short of providing a definitive statement on the creditability of the QDMTT. This is reflective of the US government’s broader approach of not issuing blanket rulings on the creditability of specific non-US taxes.

To elucidate the complex tax calculations under Pillar Two for US multinational groups, Varma provided a simplified example. The computation sequence commences with local country tax calculations, where the taxable income is ascertained, and the local taxes are computed. If enacted, the QDMTT is applied to ensure the local tax rate meets the global minimum standard. Following this, the US parent company calculates its tax liability concerning the income of its controlled foreign corporations (CFCs), with a 21 per cent tax levied on Subpart F income and a 10.5 per cent tax on global intangible low-taxed income (GILTI). The next phase involves the attribution of taxes on CFC income to the jurisdictions of the CFCs. Finally, the IIR/UTPR calculation is performed for each jurisdiction and the IIR/UTPR applied accordingly. This GloBE ETR takes into account the CFC taxes allocated in the previous step. Through this simple example, a circularity issue can been seen if the US were to provide a credit for an IIR, thus the US tax on CFC income would be recomputed and such tax would be pushed down to CFC jurisdictions for the purposes of calculating the IIR. This would also then raise an additional question about whether the US would provide a credit for the recalculated amount and then the cycle of circularity would continue.

Conclusion and final remarks

In conclusion, the extensive discussions in this panel session provided a holistic view of investment strategies, regulatory compliance and the multifaceted landscape of Pillar Two in the context of M&A. The speakers shed light on critical considerations such as manager alignment, profitability and structuring investments to optimise financial outcomes, while ensuring regulatory adherence. The exploration of Pillar Two intricacies contributes to a nuanced understanding of international tax frameworks, emphasising the importance of thorough analysis in navigating complex structures.

The unique US approach to Pillar Two introduces additional challenges, reflecting uncertainties and the ongoing need for further study to align domestic tax laws with international standards.