Pillar 2 and flow-through entities: partnership or partner-split?

Pillar 2 and flow-through entities: partnership or partner-split?

The issue of how GloBE rules treat transparent entities plays a critical role in income allocation. While the Model Rules provide guidance, there is some prevailing uncertainty in the industry. In this piece, Vincent Remy, EY Luxembourg Partner and Private Debt Leader, and Alex Pouchard, EY Partner and Luxembourg Tax Desk Leader based in the US, seek to provide some answers. 

The tax treatment of flow-through entities is best explained by way of illustrative example. In this case, we consider an investment structure in which investors invest through a partnership, taking into account the inherent risks of being subject to the 15% global minimum tax* on the partnership’s income. The extract will revolve around the definition and rules attached to “flow-through ultimate parent entities (“UPE”)”.

Here are the hypothetical facts: a Luxembourg Limited Partnership (“Lux LP”) in the form of an SCS is held 60% and 40% by a Luxembourg and a United Arab Emirates (“UAE”) resident individual, respectively. The Lux LP owns 100% of a Luxembourg Holding Company (“Lux Holdco”), see illustration below. Lux Holdco and Lux LP own a multinational group whose annual revenue on a consolidated basis exceeds EUR 750M during at least two out of the four immediately preceding financial years, bringing it in scope of the minimum tax rules. Lux Holdco is financed with debt, which produces 100 of interest in any given year out of which at the level of Lux LP 60 and 40 are allocated to the Luxembourg and UAE individuals respectively. Lux LP therefore has 100 of interest income that is not subject to tax at Lux LP level. The interest that is attributable to the Luxembourg individual is taxed at a rate of at least 15% while the interest attributable to the UAE individual is taxed at zero percent. No dividend income is earned by Lux LP.

To determine whether Lux LP is at risk of suffering top-up tax on the 100 of income from the loan, one needs to understand and apply the following questions:

Which entity of the group is the UPE?

Is Lux LP a flow-through entity?

How can Lux LP demonstrate that its income is subject to a minimum taxation of 15%?

1. A UPE is essentially the entity that is (or would be) required to prepare consolidated financial statements under the applicable financial standards of such entity’s jurisdiction. The Lux LP would be the UPE in the present case.
2. A flow-through entity is an entity that is fiscally transparent in the jurisdiction in which it was created. For an entity to be fiscally transparent under the regulations of a jurisdiction (in the present case, Luxembourg), it must treat that income, expenditure, profit or loss as if they were incurred by the direct owner(s) in proportion to their interest in that jurisdiction.
   The Lux LP is a flow-through entity from a Luxembourg tax standpoint here because the income of the Lux LP is not considered taxable at the LP level but at the level of the UAE and Luxembourg resident partners.
3. Because the UPE is a flow-through entity, specific rules apply. To the extent the Luxembourg and UAE resident individuals are each essentially subject to tax on their share of Lux LP income at a nominal rate of at least 15%, then the income of Lux LP that is subject to the minimum tax rules is reduced by the respective share in Lux LP income.

For the Luxembourg individual partner, the income is subject to Luxembourg income tax at a rate of at least 15%, however this would not be the case for the UAE partner. As a result, 40 of the income remains at the level of the Lux LP as GloBE income for Pillar 2 purposes without any associated tax. This would result in a 15% top-up tax on the income of 40 to be levied on the Lux LP. 

Absent of any specific language in the Lux LP agreement to that effect, it may well be that the newly enacted top-up tax of 6 (40 x 15%) needs to be split in proportion to the LP ownership. As a result of no tax being paid in the UAE on the interest income, the Luxembourg partner will now have to suffer an additional tax liability on the UAE partner’s behalf of up to 60% of such amount. 

What would you do if you were this Luxembourg resident partner? The sensitivities around this brings with it a whole new set of questions. Would you agreeably pay a potentially sizable tax that is caused due to the tax regime applicable to your partner, or would it cause controversy? Are there any possible ways to remediate this situation? These are the situations that numerous high-net-worth individuals may have to face in the future, and may be better handled with eyes wide open.

*This tax is also known as a “top-up tax” that is being introduced by the BEPS Pillar 2 project.

This article was written by Vincent Remy and Alex Pouchard, with guest contributions from Adrian Grew, EY New York Tax Manager on the Irish Desk.