Pillar Two: An Evolution of Tax Neutrality

In a jurisdiction where any change in tax policy has the potential to concern investors, what are the consequences of introducing a 15% effective tax rate for those entities which form part of the largest multinational groups? Is Pillar Two the beginning of major change for international finance centres (IFCs) such as Jersey or is this simply the next development in an ever evolving and increasingly complex international tax landscape?

Before we dive into the multiple reasons that Jersey has for optimism surrounding the introduction of Pillar Two, here is a quick recap on what the Pillar Two Framework is and why it has been introduced.

Unveiled by the Organisation for Economic Cooperation and Development (OECD) in 2021, Pillar Two is the boldest part of the OECD’s broader initiatives to tackle base erosion and profit shifting (BEPS), a term adopted by the OECD to describe tax planning strategies used by multinational groups to minimise their taxes by artificially shifting profits to low or no-tax jurisdictions.

The Pillar Two framework contains a comprehensive set of measures to combat BEPS by the largest multinational groups through the introduction of a minimum effective tax rate of 15%. This 15% rate will apply to the profits of all multinational groups with global revenues exceeding €750 million per annum, thus undermining some of the BEPS strategies employed and thereby seeking to alter the distribution of tax revenues across jurisdictions.

When considering the particular challenges and opportunities arising from the introduction of Pillar Two in Jersey, there are two specific facets of the construction of the framework that are fundamental to understand.

First, all taxes under Pillar Two are determined on a jurisdictional (i.e. all the entities in a jurisdiction are treated as one) rather than an entity-by-entity basis. Second, once a multinational group falls within the scope of Pillar Two, the 15% tax will be paid somewhere even if not in the jurisdiction in which the profits are reported. Therefore, if a particular jurisdiction were to decide not to implement any Pillar Two changes, any taxes that would have been payable there under the Pillar Two framework will be payable somewhere else.

This facet of the Pillar Two framework is designed to neutralise tax as a value proposition. While this may have been intended to undermine the relative desirability of Jersey along with other low or no-tax jurisdictions, recent analysis published by the OECD has raised questions as to which jurisdictions might ultimately be most impacted by this feature of the framework.

The OECD’s own analysis from November 2023 highlights that, despite the fact that most academic discourse surrounding international tax policy focusses on the undesirable impact low or no-tax jurisdictions have on tax competition, traditionally high tax jurisdictions actually account for the majority of global ‘undertaxed profits’ (i.e. profits taxed at less than 15%), at an estimated 53.2%.

Against this backdrop, Jersey’s proposal to introduce both a Multinational Corporate Income Tax, which closely aligns to the Pillar Two principles, alongside an income inclusion rule for multinational groups headquartered in the Island, represents a reiteration of Jersey’s long held commitment to the introduction of internationally agreed tax standards. It should also help to address the outdated notion that IFCs are inherently harmful.

Some commentators are suggesting that IFCs are fundamentally opposed to the introduction of Pillar Two changes, however we do not agree. The important point for IFCs is that Pillar Two is truly global. Hence when charging in-scope multinational groups 15%, IFCs will not find themselves being undercut by other centres which do not introduce Pillar Two measures or by high tax jurisdictions which offer large tax exemptions and deductions, and also will be reducing the administrative burden that would otherwise fall on in-scope multinational groups operating in that IFC by enabling them to avoid the application of either an income inclusion rule or under taxed profits rule elsewhere.

We would therefore contend that Pillar Two does not constitute the elemental shift from an IFC perspective that is often suggested, whilst it will be interesting to see whether the introduction of Pillar Two will put pressure on onshore tax rates to reduce towards 15%.

It is undeniable that one of the cornerstones of tax policies in any IFC, such as Jersey, is the provision of tax-neutral platforms for international business and investment. For multinational groups in-scope of Pillar Two this tax-neutrality will no longer be available, so the broader offering of IFCs – their expertise, robust legal frameworks and ability to innovate − will become increasingly important in the future.

All of this is not to suggest by any means that there are not significant challenges ahead or that Jersey will be somewhat insulated from the paradigm shift that Pillar Two marks in the global tax landscape. Pillar Two by its very nature requires a fundamental reset in how tax professionals approach the calculation of tax liabilities, due in no small part to the introduction of both jurisdictional blending and the lesser-known accounting concept of deferred tax into annual income tax calculations.

There are, however, other systemic issues arising on the implementation of Pillar Two that all implementing jurisdictions will need to engage with, many driven by the potential for mismatches between the approaches taken by different jurisdictions in implementing the rules, with others arising from disparities in how different jurisdictions classify entities (such as a Jersey LLP which is considered transparent in Jersey but opaque in the UK).

Whilst every jurisdiction is getting to grips with these systemic issues there are a number of specific issues which will be of particular importance to Jersey.

In particular, given the significance of the trust industry, both locally and through the export of Jersey law trusts, queries have arisen as to how a trust should be classified under the Pillar Two provisions. An entity, as defined by Pillar Two, is either a) any legal person or b) an arrangement that prepares separate financial accounts, such as a partnership or trust. Questions have therefore been raised as to whether a trust should be deemed to be an entity for these purposes absent any specific requirement to prepare ‘financial accounts’ – itself an ambiguous term.

Indeed, further queries have also been raised as to where a trust should be deemed to be located for these purposes as the wording of Pillar Two is somewhat ambiguous, referring to the ‘place of creation’. It is therefore conceivable a trust created under Jersey law with no Jersey trustees, could be deemed to fall within the scope of Jersey’s domestic taxing provisions, notwithstanding the fact that the trust has no requirement to register in Jersey. While we are hopeful that the residence of trustees will remain the deciding factor, there remains some uncertainty in this regard, which is arguably more unsettling for jurisdictions such as Jersey than a positive tax rate.

The Pillar Two framework represents a significant evolution in tax neutrality, with IFCs like Jersey at the forefront of this transformation, balancing tax neutrality with transparency and responsible tax practices.

Jersey’s commitment to introducing a domestic minimum tax for those entities in-scope of Pillar Two and an income inclusion rule, exemplifies the positive response that is underway. While there are many points where further work is required to provide taxpayers and tax authorities alike with the required levels of certainty, it is clear that by its introduction Pillar Two is starting to challenge many of the pre-existing narratives surrounding IFCs.

PUBLICATION: TIMES GROUP – First for Finance 16th Edition