The EU Pillar 2 Directive: A Breakdown of the Rules

The EU Pillar 2 Directive is the European Union’s implementation of the Global Anti-Base Erosion (GloBE) rules developed by the OECD. The directive’s goal is to ensure large multinational enterprises (MNEs) pay a minimum effective tax rate of 15% on profits in every jurisdiction where they operate. The rules were formally adopted by all EU member states, with a deadline for transposition into national law by the end of 2023. However, the actual implementation has varied, as the directive permits member states to defer the application of the rules in certain circumstances.

Scope of the Directive

The Pillar 2 rules target large corporate groups, both international and domestic, with a presence in an EU Member State. The threshold for inclusion is annual consolidated revenues of €750 million or more in at least two of the four preceding fiscal years. This revenue threshold aligns with standards for Country-by-Country Reporting (CbCR).

A “group” includes a parent entity and all its “constituent entities,” whose financial results are consolidated. A constituent entity can be a company or a permanent establishment, which is treated as a separate entity under these rules. The rules also apply to large-scale domestic groups to ensure equal treatment between groups with cross-border activities and those operating in a single EU country.

Certain “excluded entities” are outside the directive’s scope due to their public function or status. These include government bodies, international organizations, non-profit organizations, pension funds, and certain investment or real estate funds that are the ultimate parent entity of a group.

Calculating the Effective Tax Rate

The central calculation for the Pillar 2 directive is the jurisdictional Effective Tax Rate (ETR). The formula divides a group’s Adjusted Covered Taxes in a jurisdiction by its GloBE Income in that same jurisdiction. This calculation is performed for each country where the group operates, a concept known as jurisdictional blending. If the ETR for a jurisdiction is below the 15% minimum, a top-up tax is triggered.

Adjusted Covered Taxes

The numerator, “Adjusted Covered Taxes,” starts with the current and deferred income taxes from a company’s financial statements. This figure is then modified with several adjustments to align it with the GloBE framework. Deferred tax liabilities, which are future tax obligations, are included to prevent temporary differences from distorting the ETR.

Adjustments are also made to exclude tax expenses related to income that is not part of the GloBE income base. The impact of uncertain tax positions, which are tax benefits that may not be sustained upon audit, must also be removed.

GloBE Income

The denominator, “GloBE Income,” begins with the financial accounting net income or loss for each constituent entity in a jurisdiction. This figure is modified through standardized adjustments to create a uniform tax base. The net tax expense is added back to the after-tax accounting income, as taxes are addressed in the numerator.

Other adjustments align accounting profit with a standard measure of taxable income. These include excluding certain dividends and equity capital gains to avoid double taxation. The sum of the adjusted incomes and losses of all constituent entities in a jurisdiction results in the net GloBE income for that location.

The GloBE Enforcement Rules

When a jurisdiction’s ETR falls below the 15% minimum, the Pillar 2 framework activates a sequence of enforcement rules to collect the “top-up tax.” These rules function as an interlocking system with a clear order of application that prioritizes collecting the tax at the income’s source.

Qualified Domestic Minimum Top-up Tax (QDMTT)

The primary enforcement mechanism is the Qualified Domestic Minimum Top-up Tax (QDMTT). This rule allows a jurisdiction to impose and collect the top-up tax on the profits of MNE operations within its own borders. By implementing a QDMTT, the country where the low-taxed income is generated retains the first right to collect the additional tax revenue.

This “source country” taxation prevents the tax revenue from being transferred to another country where a parent company might be located. If a jurisdiction implements a QDMTT, the amount paid is credited against any top-up tax liability calculated under the other GloBE rules.

Income Inclusion Rule (IIR)

If the source jurisdiction does not have a QDMTT, the secondary mechanism, the Income Inclusion Rule (IIR), applies. The IIR uses a “top-down” approach, where the responsibility for the top-up tax moves up the MNE group’s ownership chain. The ultimate parent entity (UPE) must pay the top-up tax on its share of the income of its foreign subsidiaries that are taxed below the minimum rate.

The liability is allocated to the parent entity in proportion to its ownership interest in the low-taxed entity. The IIR became effective for fiscal years starting on or after December 31, 2023.

Undertaxed Profits Rule (UTPR)

The Undertaxed Profits Rule (UTPR) is a backstop to the IIR. It applies when the top-up tax has not been fully collected under the IIR, such as when the UPE is in a jurisdiction that has not implemented the Pillar 2 rules. The UTPR allocates the remaining top-up tax among other jurisdictions where the MNE group operates.

The allocation is based on a formula considering the group’s relative share of employees and tangible assets in each qualifying jurisdiction. Those jurisdictions then collect the tax, often by denying tax deductions for payments to other group entities. The UTPR is scheduled to take effect for fiscal years starting on or after December 31, 2024.

Available Safe Harbours and Simplifications

To ease the compliance burden of the full GloBE calculations, the Pillar 2 framework includes safe harbour provisions. These allow MNEs to avoid complex ETR calculations for operations in lower-risk jurisdictions. The most prominent is the Transitional CbCR Safe Harbour, which uses data from Country-by-Country Reporting (CbCR). This transitional period covers fiscal years beginning on or before December 31, 2026, but not ending after June 30, 2028.

If a group’s operations in a jurisdiction meet one of three tests under this safe harbour, the top-up tax for that jurisdiction is deemed to be zero for the period.

• The de minimis test: This is met if the jurisdiction has total revenues below €10 million and a profit before tax of less than €1 million on the CbCR.
• The simplified ETR test: This applies if a simplified ETR is at or above a specified transition rate (15% for 2024, 16% for 2025, and 17% for 2026). The simplified ETR is the income tax expense from financial statements divided by the profit before tax from the CbCR.
• The routine profits test: This is met if the jurisdiction’s profit before tax is equal to or less than the “substance-based income exclusion” amount, which is a carve-out for routine returns on tangible assets and payroll.

A “once out, always out” feature applies: if a group does not use the safe harbour in a jurisdiction in one year, it cannot use it for that jurisdiction in a subsequent year. Beyond the transitional period, a permanent safe harbour is planned for jurisdictions that adopt a QDMTT.

Compliance and Reporting Information

Compliance with the Pillar 2 directive requires filing a standardized return known as the GloBE Information Return (GIR), developed by the OECD. The GIR provides tax authorities with the information needed to assess an MNE’s top-up tax liability. It is a data-intensive document that expands based on the number of jurisdictions and entities in the group.

The GIR is structured into several sections. One section requires general information about the MNE group, its corporate structure, and the filing entity. Another section is for reporting the application of any safe harbours or exclusions being claimed.

The most detailed part of the GIR covers the GloBE computations. For each jurisdiction not qualifying for a safe harbour, the return requires the financial data used in the ETR and top-up tax calculations. This includes the starting financial data and all adjustments made to determine GloBE Income and Adjusted Covered Taxes. The OECD provides an XML schema to standardize the electronic filing and exchange of this information between tax administrations.