For P2, asset transfers must generally occur against market value (‘MV’). I.e., the transferring entity (‘TE’) generally recognizes gain or loss on the transfer and the acquiring entity (‘AE’) reflects it at MV. However, P2 contains a transitional rule that denies a step-up in basis (‘P2 Step-Up’) in case the transfer takes place between entities forming part of the same P2 group after Nov. 30, 2021, but before the ‘transition year’ starts (a ‘TR Transfer’). The latter is the first year in which a jurisdiction is subject to the P2 rules. The goal of that transitional rule is to limit tax-free transactions to create a P2 Step-Up in a pre-P2 period.
Denial of the P2 Step-Up could give rise to adverse P2 consequences as the TR Transfer generally results in a step-up for tax purposes. Assume that an asset with a book value of 20 and a MV of 100 is depreciated in 4 years to 0 and is transferred in 2022 between P2 entities. The AE has other income of 120 and its tax rate is 15%. The AE obtains a step-up for tax purposes (100), but not for accounting/ P2 (20). That means that the depreciation is 25 (tax) and 5 (P2), respectively. The AE’s P2 income is 115 (120-5) and its P2 tax liability is 14.25 ((120-25) x 15%). This results in an ETR of 12.39% (14.25/115) and a top-up tax (‘TT’) due.
In February, the OECD released guidance providing for relief in case the TR Transfer is subject to tax in the country of the TE. The AE can then either (a) form a deferred tax asset (‘DTA’) or (b) claim a P2 Step-Up. Option (b) requires that the asset is reflected at MV in the AE’s financial accounts and is subject to tax at a rate of at least 15%. This means that a US AE cannot benefit from option (b) if the TR Transfer is not reflected at MV under US GAAP.
In our example, the AE would form a DTA for P2 purposes of 12 ((100-20) x 15%). In each of the 4 depreciation years, an amount of 3 will be reversed and added to the P2 tax liability. As a result, no TT will be due since the ETR equals 15% ((14.25 + 3)/115).
A TR Transfer can benefit from the abovementioned relief in case the taxable gain upon the TR Transfer is offset against NOLs of the TE. In that case, it is required that such NOLs will not expire before the beginning of the transition year.
A point of attention is that the application of the CbCR safe harbor (‘SH’) rules can be unfavorable with respect to TR Transfers as the SH rules delay the start of the transition year until the end of the SH period. This means that it also extends the period in which TR Transfers can be denied a P2 Step-Up pursuant to the transitional rule described above.
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