BEPS Pillar II – What are the impacts on M&A transactions?

Since the beginning of this century, developments in international tax policy have accelerated significantly. The latest is the introduction of the OECD/G20 BEPS Pillar II. Our EY expert explains how the BEPS Pillar II initiative impacts M&A transactions, from the evaluation of a potential target to the tax due diligence and the transaction agreements.

In 2013, the Organization for Economic Co-operation and Development (“OECD”) launched an initiative to target base erosion and profit shifting (“BEPS”). As a continuation of the initial BEPS initiative, the project “Tax challenges arising from the digitalisation of the economy” (“BEPS 2.0”) has been expanded and contains now two “pillars”:

• “Pillar I” includes new nexus and profit allocation rules for multinational groups with an annual turnover of more than EUR 20 billion and a profit margin of more than 10% per year.
  
• “Pillar II” aims to implement global anti-base erosion model rules (“GloBE Rules”) ensuring a 15% minimum effective tax rate (“ETR”) across the jurisdictions a multinational group operates.
  

This article focuses on Pillar II due to its greater impact on M&A deal practice.

The basics

In a nutshell, Pillar II applies to multinational enterprises (“MNEs”) (as well as large domestic groups) with a relevant worldwide turnover equivalent to EUR 750 million or more (subject to certain exceptions, exemptions, and de-minimis exclusions).

To calculate the ETR for a jurisdiction in which the MNE operates, the GloBE Rules standardize (i) the tax base (the “GloBE Income or Loss”) and (ii) the relevant taxes (the “Covered Taxes”). In addition to subsidiaries, also permanent establishments are considered separate business units for the application of Pillar II (and, therefore, included in the definition of the “Constituent Entities”).

Where the ETR of an MNE in a particular jurisdiction is lower than the minimum rate of 15%, the GloBE Rules provide for a set of coordinated top-up taxes:

1. Priority: The respective jurisdiction may impose a domestic minimum/top-up tax in line with GloBE Rules (the Qualified Domestic Minimum Top-up Tax, “QDMTT”).
2. Main: The jurisdiction of the group’s ultimate parent entity (“UPE”) may impose a top-up tax based on the Income Inclusion Rule (“IIR”). This applies, mutatis mutandis, to the intermediate parent entity if the jurisdiction of the UPE does not apply an IIR.
3. Backstop: As a backstop for situations where the UPE is not subject to IIR (or the top-up tax is otherwise not collected), other jurisdictions in which the MNE operates may apply a top-up tax (or deny relief for an undertaxed deduction) based on the Undertaxed Payments Rule (“UTPR”).

As a result, an MNE in the scope of Pillar II has to comply with the minimum ETR even if only one jurisdiction where it operates implemented the GloBE Rules in its domestic legislation. In addition, the OECD has recently supplemented the “IIR” and the “UTPR” rules by releasing a model provision (as well as a commentary) for a treaty-based Subject to Tax Rule (“STTR”).

In the context of M&A transactions, the following concepts and rules are particularly important:

• Excluded entities: The GloBE Rules provide for certain types of Constituent Entities which are excluded for calculating the jurisdictional ETR, the top-up taxes as well as the compliance requirements (“Excluded Entities”). Such Excluded Entities are, among others, Investment Funds and Real Estate Investment Vehicles (both only as a UPE of an MNE) as well as Pension Funds. This exclusion also applies to certain entities which are held directly or indirectly by an Excluded Entity.
• Jurisdictional blending: As the relevant ETR is computed on a jurisdiction-by-jurisdiction basis, the GloBE Rules allow offsetting a “low” ETR of a group entity with a “high” ETR of another entity in the same jurisdiction.
• Transitional provisions: The majority of participating jurisdictions (including the EU member states and Switzerland)¹ are expected to implement Pillar II in their national legislation as of 1 January 2024. As part of the provisions covering the transition into Pillar II (“Transition Rules”), the GloBE Rules include certain limitations on intra-group asset transfers to prevent MNEs from manipulating outcomes in the period between 30 November 2021 (publication of the GloBE Rules) and the enactment of the national legislation (the “Transition Period”).
  
• Safe Harbor Rules: In order to facilitate the implementation of Pillar II for taxpayers as well as tax authorities, the GloBE Rules provide for a “transitional” safe harbor rule (for fiscal years beginning on or before 31 December 2026 and ending 30 June 2028 the latest) as well as the development of “permanent” safe harbor rule. The transitional safe harbor rule excludes a MNE’s operations in “lower-risk” jurisdictions from Pillar II compliance obligations if (i) a de-minimis test, (ii) a simplified ETR test, or (iii) a routine profits test are alternatively met (each test assessed on a per-jurisdiction basis).

Before the M&A transaction: Suitable targets and business combinations

From the buyer’s perspective, the ETR of the target group is material to the commercial considerations as well as the purchase price offered. In this respect, Pillar II has an immediate impact if the target is an MNE in scope.

• An acquisition may push the acquiring group’s turnover above the EUR 750 million threshold, bringing the group immediately within the scope of Pillar II. As a result, Pillar II would not only be relevant for the financial and tax modelling of the target but also impact the acquiring group’s ETR and reporting obligations.
• Conversely, a “high” ETR of a target group may be less detrimental to its valuation if the acquiring MNE can make use of jurisdictional blending (i.e., by “sheltering” some of its own “low” taxed Constituent Entities in the same jurisdiction).

Nonetheless, the importance of Pillar II goes beyond mere ETR considerations. Particularly in auction processes, Pillar II (and the additional complexity it introduces) can also tilt the playing field in favor of certain types of bidders. For example, private equity funds may gain an advantage over strategic buyers (such as industrial conglomerates) in certain cases as the portfolio investments of such funds are typically not subject to consolidation for purposes of the EUR 750 million revenue threshold.

Tax Due Diligence

The implementation of Pillar II also poses several challenges for tax due diligence:

• Access to information: GloBE Rules focus on the MNE as a whole, balancing “inadequate” ETR in low-tax jurisdictions through IIR and UTPR in other countries. Hence, the acquirer of an MNE subject to Pillar II needs to have visibility of the ETRs calculated per jurisdiction. This becomes even more delicate if the target group has been carved out of an MNE before the transaction. In this case, the buyer needs insights into potentially sensitive information about the selling MNE’s tax profile and attributes to assess the impact on the acquired target. In practice, this may require installing a “clean team” like the ones involved to avoid antitrust and competition law issues.
• Cross-border liability for top-up taxes: Traditionally, tax risks relating to secondary liabilities for unpaid taxes or to memberships in tax groups were limited to the respective target group entity’s jurisdiction. In contrast, IIR and UTPR provide the basis for cross-border liabilities for “foreign” taxes of target group entities situated in other jurisdictions. If such other group entities are not within the transaction perimeter, the Pillar II assessment requires more extensive access to information.
• Case-by-case analysis: Even if an MNE regularly operates (i) with an ETR of more than 15% (under GloBE Rules) and/or (ii) exclusively outside low-tax jurisdictions, a top-up tax (QDMTT, IIR, or UTPR) may nevertheless apply as a result of a specific (one-off) transaction. From a tax due diligence perspective, this requires a more detailed analysis of potentially harmful pre-closing transactions.
• Tax regimes and incentives: Under Pillar II, domestic tax regimes and incentives need to be scrutinized not only from the respective jurisdiction’s perspective, but due to IIR and UTPR also considering the interpretation of every other participating jurisdiction the MNE operates in. For example, the GloBE Rules provide for an exclusion of International Shipping Income and Qualified Ancillary International Shipping Income from the computation of the GloBE Income or Loss. Thus, whether a domestic tax regime (such as a tonnage tax) qualifies for such exclusion needs to be assessed for an internationally operating MNE under the GloBE Rules reading of several jurisdictions. Another point to consider is the different treatment of Qualified Refundable Tax Credits (increasing GloBE Income) and “non-refundable” tax credits (reduction in Covered Taxes), especially in connection with R&D and ESG tax incentives.
  
• Intra-group asset transfers during the Transition Period: Particular attention should be paid to intra-group transactions involving the target during the Transition Period. While the GloBE Rules just refer to a “transfer of assets” (excluding inventory), the OECD’s Administrative Guidance² defines the term broadly to also include any transaction having a similar effect (such as, e.g., fully paid-up leases/licenses, disposal of controlling interests, prepayments of royalties, total return swaps, migrations between jurisdictions resulting in a step-up in basis as well as a change to fair value accounting). Hence, a considerable number of Pillar II tax issues may (unconsciously) be triggered through intra-group transactions/reorganizations during the Transition Period – i.e., between 30 November 2021 and the first year an MNE is subject to Pillar II.
  
• Implementation of compliance and reporting processes required for Pillar II: The implementation of Pillar II leads to new compliance and reporting obligations. Hence, another key area to evaluate in a tax due diligence is the target’s implementation of such reporting processes, particularly regarding data-collecting procedures. A frequent problem in this respect is the quality of the data itself. Thus, apart from the target’s compliance history, also its capacity to comply with Pillar II reporting obligations going forward should be assessed.
  
• Different accounting standards: The GloBE Rules require the application of IFRS or the generally accepted accounting principles of a list of exhaustively enumerated jurisdictions (“Acceptable Financial Accounting Standard”). If the target group does not (yet) apply an Acceptable Financial Accounting Standard, it is difficult to assess the tax impact(s) of the acquisition of this group by a buyer either already subject to Pillar II or becoming so as a result of this transaction.  

Transaction Agreements

Pillar II also has implications for the negotiation of the transaction agreements, reaching from the drafting of tax indemnities as well as tax representations and warranties (“R&Ws”) to post-acquisition cooperation and information rights.

• Tax indemnities/R&Ws: Pillar II requires new standard clauses and wordings to allocate risks between the parties and to cover the various implications of the top-up taxes. From a buyer’s perspective, for example, the tax indemnity should cover any (secondary) liability for taxes imposed based on IIR and UTPR. Also, the R&Ws should be drafted in such a way as to fulfill their disclosure function with respect to the impact of the GloBE Rules (e.g., regarding being in scope for Pillar II or complying with reporting obligations). From a more general perspective, also the allocation of (additional) taxes resulting from subsequent changes in the laws will gain importance in the fast-paced BEPS 2.0 environment.
• Temporary differences: Pillar II introduces specific rules on the treatment of deferred tax assets (“DTAs”) and deferred tax liabilities (“DTLs”). Among others, certain DTLs are subject to a recapture mechanism (i.e., deduction from Covered Taxes) if they do not become an actual liability within five years. Although there is a set-back of the clock if the target is disposed by an MNE and acquired by another, this may result in a post-closing tax liability (if the ETR falls below 15%) for an item relating to a pre-closing period. Also, Pillar II affects the value attributed to DTAs and DTLs in cases such assets and liabilities are included in the purchase price calculation (see also How tax impacts the determination of the purchase price in M&A transactions | EY – Switzerland).
• W&I insurance: In light of the complexity and information required to assess the impact of Pillar II on a specific transaction, it remains to be seen whether such tax risks will be covered under standard W&I insurance policies or join the list of regular carve-outs (considering that secondary tax liabilities and risk from tax groups are usually exempt in the policies, see also How do W&I insurances impact SPA negotiations and tax due diligences? | EY – Switzerland)
• Post-acquisition cooperation and information rights: Even after the deal is closed, Pillar II may require the parties to closely cooperate. This reaches from support in discussions and disputes with tax authorities regarding the applicability of Pillar II to providing access to historical carrying values and DTA/DTL computations. Particularly in carve-out transactions, the buyer needs insights into the wider seller’s group (see also above "Tax Due Diligence – Access to information"). Hence, such post-closing information rights and cooperation duties need to be properly provided for in the transaction agreements.