What Is the Global Minimum Tax and How Does It Work?

The global minimum tax is a shift in international tax cooperation, developed by the Organisation for Economic Co-operation and Development (OECD) as part of its Two-Pillar Solution. Its objective is to address the tax challenges arising from the digitalization and globalization of the economy. The framework seeks to ensure large multinational corporations pay a fair share of tax in the jurisdictions where they operate, mitigating the incentives for companies to shift profits to low-tax or no-tax jurisdictions.

This initiative aims to curtail the “race to the bottom,” a phenomenon where countries competitively lower their corporate income tax rates to attract foreign investment. By establishing a global floor for corporate taxation, the measure intends to stabilize the international tax system. It represents a coordinated effort by over 145 countries and jurisdictions to address base erosion and profit shifting (BEPS), which occurs when companies exploit gaps and mismatches in tax rules to avoid paying tax. The implementation of this framework is expected to generate new tax revenues.

Scope and Applicability

The global minimum tax rules specifically target large multinational enterprises (MNEs). The threshold for an entity to fall within the scope of these regulations is having annual consolidated group revenues of €750 million or more. This threshold must be met in at least two of the four fiscal years immediately preceding the tested year.

An MNE is defined as a group of companies with business establishments in more than one country. The rules apply to the ultimate parent entity of such a group and its constituent entities. Even companies that are part of a larger consolidated group, such as those held by a family office or foundation, may be subject to these rules if the overall group meets the revenue threshold.

Certain types of entities are explicitly carved out from the scope of the global minimum tax. These excluded entities include:

• Government entities
• International organizations
• Non-profit organizations
• Pension funds and investment funds that are the ultimate parent entity of an MNE group

The GloBE Rules Framework

The foundation of the global minimum tax is the Global Anti-Base Erosion (GloBE) rules, which are designed to ensure that MNEs pay a minimum level of tax on the income arising in each jurisdiction where they operate. The framework operates through two primary interlocking rules: the Income Inclusion Rule (IIR) and the Undertaxed Payments Rule (UTPR).

The Income Inclusion Rule (IIR) serves as the primary mechanism for applying the top-up tax. Under the IIR, the ultimate parent entity of an MNE group is responsible for paying the top-up tax in its home jurisdiction. This tax is calculated based on the parent entity’s proportionate share of the income of any foreign subsidiary that is taxed at an effective rate below the 15% minimum.

The Undertaxed Payments Rule (UTPR) acts as a secondary or backstop mechanism. It is designed to apply in situations where the IIR is not fully effective, such as if the jurisdiction of the ultimate parent entity has not implemented the IIR. In such cases, the UTPR allows other countries in which the MNE group operates to collect any remaining portion of the top-up tax.

The UTPR works by allocating the right to charge the top-up tax among the jurisdictions that have adopted the rule. This is achieved by denying tax deductions for payments made to other group companies, which effectively increases the taxable income in that jurisdiction. The priority is given to the IIR, with the UTPR only applying to the extent that the low-taxed income has not already been subject to a top-up tax under an IIR, which prevents double taxation.

Calculating the Effective Tax Rate

A component of the GloBE rules is the calculation of the effective tax rate (ETR) for the MNE’s operations in each jurisdiction. This ETR is a specific calculation for the purposes of the global minimum tax and is not the same as a company’s statutory tax rate. The jurisdictional ETR is determined by a formula: the amount of covered taxes paid is divided by the GloBE income for that jurisdiction. If this calculated ETR is below the 15% minimum, the top-up tax mechanism is triggered.

GloBE income begins with the financial accounting net income or loss of the entities within a specific jurisdiction, as determined by the accounting standards used by the ultimate parent entity. This figure is then subject to a series of specific adjustments to create a standardized tax base. For example, adjustments may be made for items like excluded dividends, certain capital gains and losses, and asymmetrical foreign currency gains or losses.

Covered taxes are the taxes included in the numerator of the ETR calculation. This primarily includes taxes recorded in the financial accounts of the constituent entities with respect to their income or profits. Corporate income taxes and withholding taxes are common examples of covered taxes, and the rules provide guidance on the treatment of deferred tax items.

A feature of the ETR calculation is the substance-based income exclusion. This provision allows MNEs to exclude a certain amount of income from the GloBE tax base, which reduces the potential for a top-up tax. The exclusion is based on a percentage of the carrying value of tangible assets and payroll costs to differentiate between profits from genuine economic activity and those shifted for tax avoidance.

While the long-term exclusion is set at 5% for both, the framework includes a transitional period. During this transition, the exclusion starts at 8% for tangible assets and 10% for payroll costs, with these rates gradually decreasing to the permanent 5% level over ten years. This carve-out recognizes the contribution of substantive economic activities, like employing workers and making physical investments.

Application of the Top-Up Tax

Once the jurisdictional effective tax rate is determined to be below the 15% minimum, the next step is to calculate and apply the top-up tax. The process begins with a calculation to find the top-up tax percentage. This is derived by subtracting the calculated ETR in a jurisdiction from the 15% minimum rate.

This percentage is then applied to the MNE’s GloBE income base for that specific jurisdiction to determine the total top-up tax amount. The substance-based income exclusion is applied before this step, reducing the income base subject to the top-up tax. This ensures that the tax is levied only on the portion of profits that exceeds the routine return on substantive activities like payroll and tangible assets.

The final step is determining which country has the right to collect this calculated top-up tax. The allocation of this tax liability is directly linked to the GloBE rules framework. Under the primary Income Inclusion Rule (IIR), the jurisdiction of the ultimate parent entity of the MNE group has the first right to collect the tax.

If the parent entity’s jurisdiction has not implemented the IIR, the Undertaxed Payments Rule (UTPR) comes into effect. In this scenario, the total top-up tax is allocated among the various jurisdictions where the MNE has constituent entities and which have implemented the UTPR. The allocation is based on a formula that considers the relative share of employees and tangible assets in each of those UTPR jurisdictions. This ensures that the top-up tax is collected even if the parent company’s home country does not participate in the system.