Luxembourg proposes changes to Pillar Two Law

• The Luxembourg government has submitted a draft law (Draft Law) to Parliament that modifies the law of 22 December 2023 (Pillar Two Law) transposing Council Directive 2022/25231 of 14 December 2022 on minimum taxation (Minimum Tax Directive).

• The Draft Law aims to incorporate, with effect for financial years starting from 31 December 2023, the clarifications and additional provisions that were agreed at the Organisation for Economic Co-operation and Development (OECD) /G20 Inclusive Framework through Agreed Administrative Guidance on the Global Anti-Base Erosion (GloBE) Model Rules (Pillar Two) in February 2023,2 July 20233 and December 20234 (OECD Guidance).

Executive summary

On 12 June 2024, the Luxembourg government transmitted to Parliament a Draft Law that amends the Pillar Two Law. The Draft Law aims to incorporate the clarifications and additional provisions of the OECD Guidance without going beyond the guidance.

Among other things, the Draft Law, in line with the OECD Guidance, extends the scope of Excluded Entities, adapts certain provisions relating to the Qualified Domestic Top-up Tax (QDMTT) and clarifies the application of the Transitional Country-by-Country Reporting (CbCR) safe harbor.

The Draft Law will enter into effect for financial years starting from 31 December 2023.

Detailed discussion

Extended scope for Excluded Entities

In line with the GloBE Model Rules, the Pillar Two Law excludes certain entities (Excluded Entities), which include investment funds and real estate investment vehicles that are the Ultimate Parent Entity (UPE) of a multinational enterprise (MNE) group as well as certain entities held by Excluded Entities (subject to an ownership and an activity test).

In line with the OECD Commentary to the GloBE Rules,5 the Draft Law proposes to assimilate to an Excluded Entity, for purposes of determining whether an entity it holds meets the ownership and activity test to itself qualify as an Excluded Entity, an investment fund or a real estate investment vehicle that is not a UPE solely because it is not required under acceptable financial accounting standards or authorized financial accounting standards, as applicable, to prepare consolidated accounts. As a result, a holding company that is held by an investment fund or a real estate investment vehicle would, going forward, still be able to meet the requirements for the exclusion even though the investment fund or the real estate investment vehicle is not required to consolidate and is, therefore, not the UPE of that group. The entity would, however, still need to be considered for purposes of determining whether a MNE group's annual revenues exceed the €750m threshold.

The Draft Law also clarifies, in line with the OECD Guidance, that a sovereign wealth fund that meets the definition of a Governmental Entity, and consequently is an Excluded Entity, is not considered a UPE or a member of an MNE group. The sovereign wealth fund is therefore disregarded for purposes of determining whether entities held by such a fund constitute an in-scope group.

QDMTT

Currency for QDMTT computations

In line with the July Guidance, the Draft Law introduces rules that specify the functional currency to be used for computing the QDMTT, as follows:

• Where the Luxembourg Constituent Entities determine GloBE income on the basis of a financial accounting standard that is authorized in Luxembourg (i.e., International Financial Reporting Standards (IFRS) or Luxembourg generally accepted accounting principles (GAAP)) the functional currency will be determined as follows:
  • If all these entities use euro as functional currency for their accounts, the QDMTT computation is to be made in euros.
    
    
  • If the functional currency of one or more Luxembourg Constituent Entities is a currency other than the euro, an election must be made to use either (i) the euro or (ii) the presentation currency of the Consolidated Financial Statements of the UPE for the computation of the QDMTT. This election will apply for a five-year period that is automatically renewed absent a new election.

• Where the Constituent Entities determine GloBE income on the basis of the net income or loss determined in preparing consolidated financial statements of the UPE (i.e., on the basis of the UPE financial accounting standard), QDMTT must be computed using the presentation currency of the Consolidated Financial Statements of the UPE.

Constituent Entities that prepare their financial statements on the basis of a functional currency that differs from the functional currency to be used for computing the QDMTT, must apply the conversion rules provided under the relevant financial accounting standard used for the QDMTT computation.

Excluding MNE Groups from QDMTT in initial phase of international activity

The Pillar Two Law provides for an exclusion from the Undertaxed Payment Rule (UTPR) and domestic Income Inclusion Rule (IIR) for up to five years for MNE groups during their initial phase of international activity. According to this provision, MNE groups will be exempt from UTPR and/or domestic IIR during this period, if (i) they have Constituent Entities in no more than six jurisdictions and (ii) the net book value of the tangible assets of all the MNE group's Constituent Entities located in all jurisdictions, other than the reference jurisdiction, does not exceed €50m.

The Draft Law takes the option given by the July Guidance to reduce the QDMTT of a Luxembourg Constituent Entity to zero during the first five years of the international activity of the MNE group of which the Constituent Entity is a member. The reduction may also apply to large-scale domestic groups during the first five years beginning with the first day of the fiscal year in which a domestic group of which the Constituent Entity is a member becomes a large-scale domestic group covered by the Pillar Two Law.

The five-year period begins on 31 December 2023 for MNE groups that were already in-scope on that date or from the beginning of the fiscal year during which the Pillar Two Law applies for the first time to the MNE group.

Treatment of foreign taxes for the QDMTT

The text of the Draft Law aligns the QDMTT rules to the July Guidance by specifying which foreign taxes (that would be allocated to a Luxembourg Constituent Entity under the IIR or the UTPR) should not be allocated for purposes of the QDMTT, with the effect that taxes incurred by foreign tax transparent entities are no longer excluded from the QDMTT computations.

QDMTT safe harbor

The Draft Law clarifies that the QDMTT safe harbor is based exclusively on the provisions of the July Guidance and aligns the wording of the Pillar Two Law with the said Guidance.

Transitional CbCR safe harbor

The Pillar Two Law provides for a transitional CbCR safe harbor that relies on CbCR data as the basis for calculating an MNE's revenue and income on a jurisdictional basis. The safe harbor rules apply for fiscal years beginning on or before 31 December 2026 and ending before 1 July 2028 (i.e., the years 2024 to 2026 if the fiscal year corresponds to the calendar year).

The Draft Law aligns the existing provision with the December Guidance to clarify the conditions for the safe harbor to apply. These alignments include:

• The requirement for consistent use of data: All of a Constituent Entity's data used to perform the safe harbor computations must come from the same Qualified Financial Statements. All the data used at the level of all Constituent Entities of an in-scope group must also come from the same type of Qualified Financial Statements.

• The prohibition to adjust Qualified Financial Statements: Adjustments to the data from Qualified Financial Statements or from a CbC Report are prohibited, unless an adjustment is explicitly required by the Pillar Two Law. An intra-group payment treated as income in the Qualified Financial Statements of the recipient and expense in the Qualified Financial Statements of the payer shall be included in Total Revenues and Result Before Tax of the recipient, irrespective of the treatment of that transaction for tax purposes in the jurisdiction of the recipient or the payer and the treatment of that transaction in the CbC Report.

• The determination of Qualified Financial Statements for permanent establishments: If Qualified Financial Statements are not available for a permanent establishment, the Group may determine the portion of the Main Entity's Total Revenue and Profit Before Tax that is attributable to the permanent establishment using separate financial statements prepared by the Main Entity for the permanent establishment. Tax on the Revenue of a permanent establishment in its jurisdiction of establishment is attributable only to that jurisdiction.

Groups that are in scope of the Pillar Two Law but are not required to file CbC Reports are still eligible for the transitional CbCR safe harbor if they use the data from Qualified Financial Statements that would have been reported if the Group were required to file a CbC Report.

Finally, the Draft Law incorporates the provisions of the December Guidance on the treatment of hybrid arbitrage arrangements under the transitional CbCR safe harbor rules. The provisions shall apply to hybrid arbitrage arrangements entered into or modified after 18 December 2023.

Moreover, in view of the transitional CbCR Safe harbor, the Draft Law incorporates OECD Guidance on: purchase price accounting adjustments in Qualified Financial Statements; the procedure in absence of separate financial statements for permanent establishments; the computation of the Simplified Effective Tax Rate (ETR) in cases where the Transitional CbCR safe harbor does not apply in a jurisdiction in which a permanent establishment, Controlled Foreign Entity (CFC) or Hybrid Entity is located, as well as the location of Joint Ventures (JVs) or members of a JV Group if the MNE Group has both Constituent Entities and a JV or members of a JV Group in the same jurisdiction.

Utilization of transition year tax attributes

In line with the Model Rules, the Pillar Two Law provides for a transition rule that is designed to allow preexisting deferred tax accounting attributes to be used in calculating the ETR to prevent distortions upon entry into the GloBE regime. It allows the MNE Group to take into account the deferred tax attributes of the MNE Group existing at the beginning of the Transition Year, at the lower of the minimum tax rate or the applicable domestic tax rate. If a deferred tax asset (DTA) has been recorded at a rate lower than the minimum tax rate, that DTA may be taken into account at the minimum tax rate if the taxpayer can demonstrate the DTA is attributable to a GloBE Loss.

The Draft Law clarifies a number of items in relation to the use of historic tax attributes, in line with the February Guidance. This includes clarification that DTAs resulting from tax credit carryforwards are available for the determination of the ETR, regardless of the type of tax credit as well as the simplified approach suggested by the OECD for recasting DTAs in relation to credits, particularly foreign tax credits.

Clarification on filing deadline

The Draft Law also clarifies that none of the Pillar Two-related deadlines (filing of the GloBE information return, top-up tax return and the registration or notification) can occur before 30 June 2026.

Other clarifications and adaptations to OECD Guidance

The Draft Law further aligns the Pillar Two Law wording to the OECD Guidance in respect of:

• The exact wording of the Equity Investment Inclusion Election — the election will also be available for transactions in the transition period

• The treatment of asset transfers after 30 November 2021 and before the beginning of the transition year as foreseen in the February Guidance

• The alignment of the definition of revenue to the December Guidance

• Excluded entities — details on accessory activity of nonprofit organizations are provided in line with the February Guidance

• The financial data to be used in case of mismatch between the fiscal years of the UPE and another Constituent Entity in line with the December Guidance

• The nondeductibility of insurance technical provisions that economically relate to excluded dividends or equity gains/losses and that originate in investments made for policyholders in line with the February Guidance

• The alignment of treatment of the restricted tier-one capital for insurance companies to the treatment of additional tier-one capital for banks in line with the February Guidance

• The incorporation of guidance on leasing in the substance-based income exclusion rule

• Profit/loss on transfer of assets between Constituent Entities to be determined based on arm's-length terms

• Clarification on cases in which the transparency election for investment entities held by a regulated mutual insurance company can be made

• Clarification in view of determination of allocable taxes related to blended CFC regimes

Next steps and implications

The Draft Law will now go through the legislative process, which involves the analysis of the text by a dedicated parliamentary commission, the collection of opinions from different advisory bodies (most importantly, the Council of State), discussion of and vote on the text in a parliamentary session and finally its publication in the Official Gazette (Memorial). The entire process may take a couple of months.

Taxpayers potentially affected by the Draft Law should remain aware of its progress through Parliament and consult with their tax advisors to fully understand how it could affect them.