What Is Tax Pillar 2 and How Does It Work?

An evolution in international tax policy, a component of the Base Erosion and Profit Shifting (BEPS) project, is underway to address tax challenges arising from an increasingly globalized and digital economy. The core of this reform is a system to ensure large, international businesses pay a minimum tax on income earned in every country of operation. This framework aims to curb strategies that shift profits to low-tax jurisdictions, creating a more level playing field for international taxation. It adapts long-standing tax principles for modern commerce, where companies can have an economic presence without a substantial physical one.

Scope of Application

The global minimum tax rules are designed to apply to large multinational enterprise (MNE) groups with annual consolidated revenues of €750 million or more. This threshold, consistent with other international tax standards, must be met in at least two of the four fiscal years preceding the tested year. An MNE group includes the ultimate parent entity and all its worldwide subsidiaries and branches that are linked through ownership and required to prepare consolidated financial statements.

The framework excludes specific types of entities, even if their group meets the revenue threshold, because they serve a public function or pose a low risk of profit shifting. Excluded entities include government bodies, international organizations, and non-profit organizations. Pension funds and certain investment funds that are the ultimate parent entity of an MNE group are also excluded to keep the rules focused on commercial profits.

The Global Minimum Tax Mechanism

Enforcement is achieved through the Global Anti-Base Erosion (GloBE) rules, which provide a framework for MNEs to pay at least a 15% effective tax rate in each jurisdiction. If the tax paid in a country is below this minimum, the GloBE rules trigger a “top-up tax” to cover the shortfall. This system is designed to work with existing tax treaties and domestic laws.

The primary enforcement tool is the Income Inclusion Rule (IIR), which places liability for the top-up tax on the ultimate parent entity of the MNE group. For example, if a subsidiary pays a 10% effective tax rate, the IIR requires the parent company to pay an additional 5% tax to its own government on that income. The IIR is applied on a jurisdictional basis, neutralizing the benefit of shifting profits to a low-tax country by imposing the minimum tax at the parent level.

Functioning as a backstop to the IIR is the Undertaxed Payments Rule (UTPR). This rule applies in situations where the IIR is not effective, such as when the parent entity’s country has not adopted the rule. The UTPR allows other countries where the MNE group operates to collect the top-up tax. This is achieved by denying corporate income tax deductions for payments to other group members or by requiring an equivalent adjustment, ensuring the tax is collected within the group.

Calculating the Effective Tax Rate

Determining if a top-up tax is owed requires calculating the effective tax rate (ETR) for each jurisdiction. The ETR is the amount of adjusted covered taxes divided by the amount of GloBE income. If the ETR for a jurisdiction is below the 15% minimum rate, a top-up tax is triggered, and the calculation uses standardized definitions for consistency.

The denominator, GloBE Income, starts with the net income from the MNE’s consolidated financial statements and is adjusted to create a uniform tax base. The numerator, Adjusted Covered Taxes, begins with the current tax expense and is adjusted to include specific corporate income and profit taxes. These standardized definitions ensure the ETR calculation is not distorted by different accounting treatments across jurisdictions.

The Substance-Based Income Exclusion (SBIE) is a component of the ETR calculation that reduces the amount of profit subject to the GloBE rules. This carve-out is based on the costs of genuine economic activities, focusing the top-up tax on “excess” profits rather than routine returns. Initially, the exclusion is 8% of the value of tangible assets and 10% of eligible payroll costs, with these rates gradually decreasing over a 10-year transition period to a permanent rate of 5% for both.

Administrative and Compliance Obligations

A standardized reporting requirement, the GloBE Information Return (GIR), is a feature of the Pillar Two framework. This annual return requires in-scope MNEs to provide tax authorities with the information needed to assess their top-up tax liability. The GIR mandates a detailed breakdown of the ETR calculation for each jurisdiction, including financial data, covered taxes, and SBIE components. The standardized format provides tax administrations a consistent view of an MNE’s tax position.

The framework includes safe harbor provisions to ease the administrative burden of these calculations. Safe harbors offer a simplified path to compliance for MNEs in certain low-risk jurisdictions. If a company’s operations in a country meet specific tests, it may be relieved from performing the full GloBE calculations for that jurisdiction for a period.

The Transitional CbCR Safe Harbour applies for fiscal years beginning on or before December 31, 2026. It allows a company to avoid the full ETR calculation in a jurisdiction if it meets one of three tests using data from its Country-by-Country Report. The first is a de minimis test for jurisdictions with revenues below €10 million and profits below €1 million. The second is a simplified ETR test, met if the rate is at least 16% for 2025 and 17% for 2026. The third is a routine profits test, met if the profit is equal to or less than the SBIE amount.

This transitional safe harbor has a “once out, always out” condition. If an MNE group does not use or qualify for the safe harbor in a jurisdiction for one year, it cannot use it there in any subsequent year. The rules also envision a permanent safe harbor framework for ongoing simplification for qualifying entities.