What Are the Pillar 2 Model Rules & How Do They Work?

The Pillar 2 Model Rules, developed by the OECD/G20 Inclusive Framework, represent a major shift in international taxation. The initiative aims to address tax challenges from the economy’s digitalization and globalization. It ensures large multinational enterprises (MNEs) pay a minimum level of tax on income generated in every jurisdiction where they operate.

This is achieved by establishing a global minimum corporate tax rate of 15%. The framework is a coordinated system that limits opportunities for MNEs to shift profits to low or no-tax jurisdictions. The rules provide a template for countries to incorporate into their domestic laws, fostering a consistent approach to taxing large, global businesses.

Scope of Application

The Pillar 2 rules target large multinational groups based on a revenue threshold. An MNE group falls within the scope if its annual consolidated revenues are €750 million or more in at least two of the four fiscal years preceding the test year. This is assessed using the ultimate parent entity’s consolidated financial statements.

An “MNE Group” is any group with at least one entity or permanent establishment not located in the ultimate parent entity’s jurisdiction. A “Constituent Entity” is any entity included in the group’s consolidated financial statements or a permanent establishment of another group entity. This broad definition captures the MNE’s full operational footprint.

Despite the revenue test, certain entities are carved out from the rules. The rationale for these exclusions is tied to their public purpose or the specific regulatory regimes they are already subject to. These “Excluded Entities” include:

• Governmental bodies
• International organizations
• Non-profit organizations
• Pension funds

Investment funds and real estate funds that are ultimate parent entities of an MNE group may also be excluded.

The GloBE Rules Framework

The core of Pillar 2 is the Global Anti-Base Erosion (GloBE) rules, which enforce the 15% global minimum corporate tax rate. If an MNE’s income in a jurisdiction is taxed below this minimum, the GloBE rules trigger a “top-up tax” to collect the difference. This system is not a direct tax on the low-tax entity but a mechanism allowing other jurisdictions where the MNE operates to collect the shortfall. The framework operates through two interlocking rules.

Income Inclusion Rule

The primary enforcement mechanism is the Income Inclusion Rule (IIR). This rule operates from the top down, placing the liability for the top-up tax on a parent entity within the MNE group. When a constituent entity, such as a foreign subsidiary, has an effective tax rate below the 15% minimum, the IIR requires its parent company to pay a top-up tax to cover the deficit. The tax is calculated to bring the total tax on that subsidiary’s income up to the 15% minimum.

For example, if a subsidiary in a low-tax jurisdiction earns $100 million and pays $5 million in local taxes (a 5% rate), its income is undertaxed by 10%. The IIR would require the ultimate parent entity, located in a jurisdiction that has adopted the rule, to include its share of that undertaxed income in its tax base. This results in an additional $10 million in tax, ensuring the profit is taxed at the 15% global minimum rate.

Undertaxed Payments Rule

The Undertaxed Payments Rule (UTPR) is a secondary or backstop mechanism to the IIR. It applies when the IIR cannot effectively impose the top-up tax. This might occur if the ultimate parent entity is in a jurisdiction that has not implemented an IIR or if the ownership structure prevents the IIR from applying to all low-taxed income.

The UTPR allows other jurisdictions where the MNE group operates to collect the top-up tax. This is achieved by denying tax deductions for payments made to the low-taxed group member or by requiring an equivalent adjustment. This denial of deductions increases the taxable income of the paying entity, resulting in a higher tax liability that collects the top-up tax missed under the IIR.

Calculating the Effective Tax Rate

The central calculation for the GloBE rules is the jurisdictional Effective Tax Rate (ETR). This rate determines if any top-up tax is due for an MNE’s operations in a country. The ETR is calculated by dividing the “Adjusted Covered Taxes” by the “GloBE Income” for all constituent entities in that jurisdiction. If this ETR is below the 15% minimum, a top-up tax is triggered.

GloBE Income or Loss

The starting point for calculating GloBE Income is the financial accounting net income or loss of each constituent entity from the ultimate parent’s consolidated financial statements. This accounting income must undergo a series of adjustments to create a standardized tax base. These adjustments create a more uniform measure of profit across different accounting standards and jurisdictions.

Specific adjustments are required to align the income base with policy goals. For instance, certain income is excluded, such as dividends and capital gains from the disposal of shares held for a significant period. The rules also require adding back certain expenses, such as bribes and fines or penalties exceeding €50,000. Other adjustments address prior period errors and accrued pension expenses.

Adjusted Covered Taxes

The numerator of the ETR fraction, Adjusted Covered Taxes, consists of the taxes recorded in the financial accounts of the constituent entities. This primarily includes taxes on corporate income and profits. Covered taxes do not include taxes that are not based on income, such as value-added taxes (VAT), customs duties, or property taxes.

The tax expense reported in financial statements is subject to several adjustments. A key adjustment relates to deferred taxes, which may need to be recast at the 15% minimum rate if the local tax rate is higher. Adjustments are also made for taxes related to uncertain tax positions and for taxes paid under other regimes, like a controlled foreign corporation (CFC) regime, to prevent double counting.

Key Exclusions and Safe Harbours

The Pillar 2 framework includes provisions to reduce the income subject to top-up tax and to simplify compliance for MNEs. These mechanisms acknowledge that not all low-taxed income results from aggressive tax planning and provide relief in specific circumstances. They help target the rules more precisely toward their intended purpose without penalizing substantive economic operations.

Substance-Based Income Exclusion

The Substance-Based Income Exclusion (SBIE) is a carve-out that protects a portion of an MNE’s income derived from genuine economic activities in a jurisdiction. The exclusion reduces the GloBE income base, lowering the potential top-up tax liability. It is designed to differentiate between profits from substantive operations and those that may have been artificially shifted to a low-tax jurisdiction.

The SBIE is calculated as a fixed percentage of the carrying value of eligible tangible assets, like property and equipment, and a percentage of eligible payroll costs. During a transition period, the exclusion is 8% for tangible assets and 10% for payroll. These rates will gradually decrease over ten years to a permanent rate of 5% for both, focusing the top-up tax on profits that exceed a normal return on substantive activities.

Transitional Safe Harbours

To ease administrative challenges, a transitional safe harbour period is available. These safe harbours reduce the need for MNEs to perform full GloBE calculations in the initial years for certain lower-risk jurisdictions. If a jurisdiction qualifies for a safe harbour, the MNE is deemed to have no top-up tax liability there for that year.

The primary mechanism is the Transitional Country-by-Country Reporting (CbCR) Safe Harbour, which uses data already prepared for CbCR requirements. This safe harbour has three tests: a de minimis test, a routine profits test, and a simplified ETR test. If an MNE’s operations in a jurisdiction meet any one of these tests, it can avoid the detailed Pillar 2 calculations for that jurisdiction during the transitional period. The simplified ETR test requires a rate of at least 16% for fiscal years beginning in 2025, increasing to 17% for fiscal years beginning in 2026.

Compliance and Administration

The administrative foundation of Pillar 2 is the requirement for MNEs to file a standardized tax return known as the GloBE Information Return (GIR). The GIR is designed to provide tax authorities with the necessary information to assess an MNE’s potential top-up tax liability. This ensures a consistent and transparent flow of information between taxpayers and tax administrations.

The GIR is a detailed document requiring MNEs to report extensive information. This includes general information about the MNE group, the computation of the ETR for each jurisdiction, and the calculation of any resulting top-up tax. The return must also detail the allocation of the top-up tax to the specific entities liable to pay it under the IIR or UTPR.

A single constituent entity within the MNE group is designated to file the GIR on behalf of the entire group with its local tax authority. That tax administration will then automatically exchange the GIR with tax authorities in other jurisdictions where the MNE operates and that have implemented the Pillar 2 rules. This centralized filing and exchange system streamlines reporting and ensures all relevant authorities have the data to enforce the global minimum tax.