OECD Pillar 1 and 2 Summary: The Rules Explained

The international tax system, built on principles established in the early 20th century, has faced challenges with the rise of globalization and the digital economy. Multinational enterprises (MNEs) can operate extensively in a country with little to no physical presence, earning substantial profits from consumers while paying minimal corporate taxes in that jurisdiction. This has led to a disconnect between where value is created and where taxes are paid, a phenomenon known as base erosion and profit shifting (BEPS). The Organization for Economic Co-operation and aDevelopment (OECD), along with the G20, has spearheaded an effort to modernize the international tax framework to address these issues.

The result of this effort is the OECD/G20 Inclusive Framework on BEPS, a project involving over 140 countries and jurisdictions that developed a plan to reform international taxation rules. The framework is designed to ensure that MNEs contribute their fair share of taxes in the locations where they conduct business and generate profits.

At the heart of this reform is a two-pillar solution. This approach was developed to address the tax challenges arising from the digitalization of the economy. The first pillar focuses on changing how taxing rights are allocated among countries, while the second pillar aims to establish a global minimum level of taxation for MNEs.

Understanding Pillar One Profit Reallocation

Pillar One represents a shift in international tax rules, aiming to reallocate a portion of the profits of the largest and most profitable multinational enterprises (MNEs) to the jurisdictions where their customers and users are located. This reallocation is a departure from the long-standing arm’s-length principle, which governs how associated enterprises price transactions among themselves.

The scope of Pillar One is intentionally narrow, targeting a specific subset of MNEs. To be subject to these rules, a company must meet two criteria: a global turnover exceeding €20 billion and a profitability margin of more than 10%. This high threshold ensures that only the world’s largest corporations are included. The €20 billion revenue threshold is designed to be reviewed and potentially lowered to €10 billion after the rules have been in effect for seven years. Certain industries, such as extractives and regulated financial services, are excluded.

A central component of Pillar One is Amount A, which establishes a new taxing right for market jurisdictions. This mechanism allows for the reallocation of 25% of an MNE’s residual profit, defined as profit exceeding 10% of its revenue. To implement Amount A, detailed revenue sourcing rules have been developed to trace sales of goods and services to the end-market jurisdiction. For example, revenue from finished goods is sourced to the location of final delivery, while services are sourced based on where they are used or consumed.

Pillar One also includes Amount B, which is designed to simplify the application of the arm’s-length principle for specific routine activities. Amount B focuses on baseline marketing and distribution activities by providing a fixed return for these functions, reducing disputes over transfer pricing. This standardized remuneration is expected to be beneficial for developing countries that may lack resources for complex transfer pricing analyses, and the final report is intended to be incorporated into the OECD Transfer Pricing Guidelines.

Understanding Pillar Two Global Minimum Tax

Pillar Two introduces a global minimum tax regime designed to ensure that large multinational enterprises (MNEs) pay a minimum level of tax on their income in every jurisdiction where they operate. The primary goal is to curtail the “race to the bottom,” a phenomenon where countries compete to attract investment by offering progressively lower corporate tax rates. The agreed-upon minimum effective tax rate is 15%.

The scope of Pillar Two is broader than that of Pillar One, applying to MNEs with annual consolidated group revenue of more than €750 million. This threshold aligns with the country-by-country reporting requirements. Certain entities are generally excluded from its scope, including:

• Government entities
• International organizations
• Non-profit organizations
• Pension funds

The core of Pillar Two is a set of interlocking rules known as the Global Anti-Base Erosion (GloBE) rules. These rules provide a standardized framework for calculating a company’s effective tax rate in each jurisdiction and for imposing a top-up tax on profits that are taxed below the 15% minimum. The GloBE rules are designed to be implemented as a common approach, meaning jurisdictions are not required to adopt them but must accept their application by other jurisdictions.

A key element of the GloBE rules is the calculation of the effective tax rate (ETR) on a jurisdictional basis. The ETR is determined by dividing the covered taxes paid by an MNE’s entities in a jurisdiction by their GloBE income in that same jurisdiction. The calculation of the GloBE income base starts with financial accounting income and is subject to a series of adjustments to align it more closely with tax principles.

The primary mechanism within the GloBE rules is the Income Inclusion Rule (IIR). The IIR imposes a top-up tax on a parent entity of an MNE group with respect to the low-taxed income of its foreign subsidiaries. If a subsidiary operates in a jurisdiction where its effective tax rate is below 15%, the IIR requires the parent company’s home jurisdiction to collect the difference. A secondary rule, the Undertaxed Payments Rule (UTPR), comes into effect if the IIR does not apply. The UTPR works by denying tax deductions or requiring an equivalent adjustment for payments made to a low-taxed entity within the MNE group.

Separate from the GloBE rules, Pillar Two also includes the Subject to Tax Rule (STTR). The STTR is a treaty-based rule that allows source jurisdictions to impose a withholding tax on certain intra-group payments, such as interest and royalties, when those payments are subject to a nominal corporate income tax rate below 9% in the recipient’s jurisdiction. The STTR is applied before the GloBE rules and is creditable as a covered tax in the GloBE ETR calculation.

Implementation Status and Timeline

The implementation of Pillar One is a complex undertaking that requires broad international consensus, as it involves the creation of new taxing rights that override existing bilateral tax treaties. To achieve this, a Multilateral Convention (MLC) has been developed. The MLC is a legal instrument that will allow participating jurisdictions to uniformly adopt the new profit reallocation rules.

Negotiations on the text of the MLC have faced significant delays. The process of resolving technical details and securing political agreement from all participating members has proven complex, and a signing ceremony planned for the end of 2023 did not occur. The new goal is to finalize the text of the convention by mid-2025. As a result, the timeline for the MLC’s entry into force remains uncertain.

In contrast to Pillar One, the implementation of Pillar Two is being carried out through domestic legislation enacted by individual countries. The OECD has provided a comprehensive framework, including model rules, commentary, and administrative guidance, to assist governments in translating the GloBE rules into their national laws. The interlocking nature of the rules, particularly the UTPR, creates a strong incentive for jurisdictions to adopt them to protect their tax bases.

The adoption of Pillar Two has been rapid and widespread. A significant number of jurisdictions around the world have already enacted or are in the process of enacting legislation to implement the GloBE rules. The European Union, for example, has adopted a directive requiring all member states to apply the rules. For many of these early-adopting countries, the rules became effective at the beginning of 2024, particularly the Income Inclusion Rule. The Undertaxed Payments Rule is generally scheduled to come into effect one year later, in 2025.