Podcast transcript: How the BEPS Pillar Two rules could impact Oceania resources groups

Tony Merlo

Hello everyone and thank you for joining this edition of EY Oceania BEPS 2.0 podcast series where we discuss the latest developments and our subject-matter professionals from around the EY organization provide their practical insights.

My name is Tony Merlo and I'm the Tax Policy Leader for Oceania at Ernst & Young in Australia. In this installment of our BEPS 2.0 series, we focus on some of the key issues arising under the minimum tax rules for businesses in the resources and capital intensive industries.

Joining me today is Andrew Nelson, an International Tax Partner at EY Australia based in Perth, with a particular focus on the oil and gas and mining sectors, and Liz Cullinan, an International Tax Partner of EY Australia based in Melbourne. Both Andrew and Liz have been deeply involved in helping business in the capital intensive and resource industries to navigate their way through the Pillar Two rules.

So looking forward to hearing about some of the issues these businesses are facing.

So to kick us off, Andrew, capital intensive businesses are very much welcomed the adoption of modified deferred tax principles in the ETR calculation, but there are still issues to be navigated.

What are some of the issues that our listeners should be aware of?

Andrew Nelson

Thanks Tony, yes many of these issues cut across industries, but particularly relevant for miners, oil and gas companies and groups and infrastructure manufacturing space with capital intensive projects.

The issue is the same, but the materiality I think is a cut above. The main reason for this of course is that for many of these capital intensive projects it can be some time until the project recoups its costs and therefore cash taxes upfront will typically be nil or low initial years, due primarily of course to accelerated depreciation, exploration, write offs etc., and other capex incentives.

The current rules recognize this issue of low taxes potentially upfront in large capital intensive projects. We have a deferred tax regime to deal with this.

Now, that's welcome. It addresses the fundamental issue that if a group isn't paying any cash taxes, which results of course in their rate being less than 15%, then they shouldn't be penalized.

So I think while the idea of having a deferred tax system is welcome, there are many challenges, both from a technical and systems point of view.

One of the first observations I can make in that regard is that there is a window of time in which the deferred tax liability needs to reverse in order to be taken into account and therefore enable deferred taxes to be included in the effective tax rate.

This is a particularly relevant issue for long-lead projects where deferred taxes may well not unwind in the short term. The window is 5 years.

There are a number of exceptions to this window and all affected taxpayers with deferred tax liabilities that they expect to be sitting on the balance sheet for some time will need to consider whether they fall into these exceptions, and notably there are exceptions for cost recovery on tangible assets, some dispensation for natural resource projects, remediation and rehabilitation etc.

But, I think it over overall level, the key point there is that most of the exceptions relate to tangible assets. Where there are intangible deferred tax liabilities, they may well not falling this exception and therefore if they continue for a period of longer than five years then that may have the effect of actually reducing the effective tax rate of a group.

There are many other nuances and vagaries with these rules. We've done a lot of modeling on the deferred tax and worked with clients to identify where potential problems could arise with this. And there are many ambiguities in the law, and nuances with the law, that ultimately will require groups festival to re-cut their balance sheets, or develop a deferred tax balance sheet if they haven't done it.

A couple of observations there just to give a bit of a flavor for those of you who haven't looked into this. Losses need to be recognized irrespective of whether revaluation adjustments or the accounting treatment in general is not to recognize them.

There is a distinction between current and deferred taxes that needs to be made. Deferred taxes need to be restated at 15%, so even if you have a very tight deferred tax balance sheet, you're going to need to recut it, just to recognise that the movement in deferred taxes needs to be picked up 15%. 

This deferred tax capping can result on top up tax being payable in a jurisdiction when not expected. For example, where a company has existing tax losses, even the existence of a very small permanent difference reducing taxable income, for example, arising from research & development credits or a non-taxable incentive, can result in top up tax, which is quite a perverse result. And there are other examples too. These all fall into the territory where the rules throw up anomalous outcomes.

And there are some nuances with this that may mean that the classification of current and deferred can actually significantly impact the outcome and potentially result in the effective tax rate being much lower than it should be, particularly in relation to the recognition of losses and further in particular, whether those losses are taken to current or deferred.

And then I think the system challenge can't be underestimated. For many groups, the navigation through the BEPS 2 is actually becoming a deferred tax accounting exercise in principle.

And the implications for resourcing, upskilling internally within clients, as well as an issue for the regulatory bodies such as the Australian Tax Office or New Zealand IRD, to actually be able to audit these calculations - it's quite an immense challenge across all stakeholders in this space.

And I think probably clients who know that they're not going to be impacted because they've done sufficient modeling, nonetheless can be intimidated and probably should be a little bit intimidated by the systems challenge to actually prove that each year. And I think that's for many clients where they're spending primarily there resources now is actually that proving up an assumption that they may not be impacted by these. Others will need to be still validating the assumption that they're not going to be impacted.

And certainly EY can assist in both of those spaces, both from a modeling point of view, but also systems point of view. We have a separate podcast that's dedicated to the systems subject for your information, so hopefully you can listen to that.

The second issue is another issue that cuts across all industries, but is particularly relevant to the resources and capital intensive industries, and that is that local country incentives are at play and must be taken into account.

These could take the forms of cost-based incentives, investment tax credits, investment allowances, for example, production sharing royalty-type incentives, and profit-based incentives including tax stabilization, tax holidays etc., or even government grants.

Couple of matters to consider here:

One, the treatment of these can impact on the ETR calculation. At a very high level, these rules distinguish between refundable credits and non refundable credits.

Refundable credits are preferred because they are above the line and increase the denominator in the effective tax calculation.

Non refundable credits reduce the numerator (or the covered taxes) and therefore there's an issue of categorization of all these different types of incentives that needs to be undertaken by groups to understand their ETR impact. To the extent a credit or incentive system can be treated as a refundable system, an impact on the denominator, then that's going to be preferred and have may have a materially different outcome if it's alternatively captured in the numerator.

So clients need to understand in first instance the IFRS or accounting standard that's being applied, and the treatment of these different incentives.
And then also recognize that these GloBE rules have specific rules overlaying the accounting that also can modify the treatment notwithstanding the accounting.

In particular, there's a four-year refundable window in order to qualify as a refundable credit, so it'll be very important to evaluate the accounting treatment of these as part of the modeling exercise.

The other aspect on these is that these incentives are likely going to change substantially as these BEPS 2.0 rules unfold.

Tony, I might just throw you to make some comments around what's happening with incentives internationally, and potentially you could touch on domestic minimum taxes as well.

Merlo

Yeah, thanks Andrew.

Certainly what we're seeing is that many countries, including the UK, Switzerland and most recently Singapore, are considering implementing a domestic minimum tax to protect their domestic tax base.

And that will have significant impact on where tax is paid and how compliance systems will need to be adapted.

In addition, countries are also considering the form that future incentives will take with the move away from traditional tax incentives that impact the minimum tax calculation, towards other incentives that don't impact the calculation.

Andrew, any other comments from you before I hand over to Liz?

Nelson 

Yeah, thanks Tony.

I'll just quickly mention two other issues that come up in conversation with our clients a fair bit, particularly resource space.

One is just the accounting challenges associated with this, in particular with FX. I think the rules have some welcome changes that are in intending to remove any FX effects between, for example, the accounting functional currency and the tax functional currency, but also between either the tax or functional currency for accounting and third currencies, which is welcome. But I think the challenge here is the implementation of that and there really isn't enough information at this stage, I think, to understand exactly what it's going to look like.

I had one client raise the issue, that we're seeing a fair bit actually now the more we think about it, the impact at the consolidation level of elimination entries, particularly in relation to hedge accounting and matters impacting on FX treatment of derivatives and the like, whether they should be pushed down to local jurisdictions. So you can sort of see that there's a lot of issues here that potentially cover very material matters concerning FX and crossing over in the consolidation.

And finally, Tony something had been a little bit more positive than the flavor of the rest of this podcast in relation to deferred taxes. And that is that for resource intensive projects and companies, there is a substance-based exception or carve out rather in the rules that provides some relief for in country substance as measured by employees on the ground and tangible assets.

There is a percentage of those costs that are applied in the calculation of the income to which the tax top up is applied. So that is a positive for capital intensive projects.

There is also some specific inclusion there to recognize intangible assets, and resource projects themselves. So with that positive note, back to you, Tony.

Merlo 

Very interesting Andrew. So my key take away for our listeners is that there won't be any simple lift and shift of tax balances from your financial statements.

You're going to need to track tax balances on a line by line basis. So for many out there, there's going to be significant compliance challenges, subject to any safe harbors that may be announced in due course from the OECD.

Now, to you Liz. One of the one of the features of complex long term projects is that they often involve third party equity for various reasons such as to de-risk the investment or to access critical assets or skills.

These joint ventures and other structures give rise to interesting challenges under Pillar Two. What are some of these?

Liz Cullinan

Thanks Tony. Overall, different outcomes can arise under the GloBE rules where there is less than 100% ownership interest in a low tax entity by an ultimate parent entity, depending on the structure and level of the investment and the percentage ownership each party has in a particular low taxed entity.

Associates in which investments are recorded using the equity method are generally not included in the GloBE rules. However, a modification to this treatment is provided for joint ventures and their subsidiaries.

Specifically, for joint ventures, the GloBE rules are effectively applied as if the joint venture and its subsidiaries are a separate MNE group with the joint venture as your ultimate parent entity.

Parent entities holding a direct or indirect interest in the joint venture, then apply the income inclusion rule to their share of top up tax calculated by the JV Group.

Some issues corporates are currently grappling with in respect to joint ventures include: joint ventures, may not have the resources to perform top up tax calculations and may be on a different IT and accounting system to its owners.

This can make it harder to extract the relevant information, confirm its accuracy, and ensure it's compliant with the rules.

In addition, ownership interests in the joint venture entity may increase or decrease, potentially resulting in the application of different rules for an income year.

For example, if an ultimate parent entity increases its stake above 50%, will the ultimate parent entity need to undertake top up tax calculations for the entity and subsidiaries for the entire income year?

These are the types of things that current corporates are dealing with, with respect to joint ventures.

There are also split ownership rules were a partially-owned parent entity, which is an entity with more than 20% minority shareholders, is required to apply the income inclusion rule in priority over its controlling parent. There are three key points to note with respect to these rules.

If a minority shareholding is held directly in a low taxed entity, the normal rules apply and the ultimate parent entity applies the income inclusion rule to their proportionate interest in the low tax entity.

This will provide a different outcome to where there is instead a partially owned parent entity interposed as this partially owned parent must apply top-up tax to 100% of its interest in the low tax entity.

As you can see, there can be differences in the top-tax burden depending on the level of investment by minority shareholders.

In addition, minority shareholdings in a partially owned parent that are below 20% are not subject to these split ownership rules.

Again, the ultimate parent entity would apply the income inclusion rule on its proportionate interest in a low tax entity.

Lastly, an ultimate parent entity must also calculate its effective tax rate for a particular jurisdiction, taking into account the subsidiaries in that jurisdiction held by the partially owned parent.

This could potentially, for example, push the ETR for that jurisdiction below the minimum 15% rate, or skew the amount of top-up tax to the ultimate parent entity, or alternatively to the partially owned parent.

Lastly, special rules apply for the allocation of income or loss to flow through entities.

Special rules are also provided for multi parented MNE Groups such as dual-listed and stapled groups that, among other things, allows for filing of a single globe return upon election.

As you can see, the GloBE rules are quite complex when you have less than 100% ownership in a low tax entity.

As a result, we recommend corporates start thinking about the impact of these rules on these types of investments.

Back to you, Tony.

Merlo

Thanks Liz, so my key take away from your piece is that business should be very careful of the partially owned parent entity rules, which complicate both compliance but also where tax is paid.

But on the planning side, business could consider structuring joint ventures at the asset level to potentially obviate the complexity in those rules.

So as we've heard during the other podcasts in this series, the new minimum tax rules will require business to consider how these rules will impact their particular facts and circumstances, but also how compliance processes and systems will need to be adapted to comply.

These considerations will be impacted by further OECD announcements, but also how individual countries will respond will continue to explore these and other developments with our subject matter professionals in future sessions.

In the meantime, thank you to Andrew and Liz for your thoughtful insights. Thank you all for joining us. Until next time, take care.