P2 contains several mechanisms to levy top-up tax (‘TT’) on the profits of a low-taxed constituent entity (‘LTCE’). Besides the Income Inclusion Rule (‘IIR’) and the Undertaxed Profits Rule (‘UTPR’), countries have the option to introduce a Qualified Domestic Minimum Top-up Tax (‘QDMTT’). The QDMTT is a domestic TT that is aligned with P2 principles. It enables countries to tax the low-taxed profits arising in their country before another country can tax such profits under the IIR or UTPR.
We illustrate below how the ordering rules work through a simplified example.
A US parent company (‘USCo’) holds a subsidiary (‘HoldCo’) in country X which holds subsidiaries in countries Y (‘Sub Y’) and Z (‘Sub Z’). USCo has an effective tax rate (‘ETR’) for P2 purposes of 10% because it benefits from FDII and tax credits in the US. Countries X, Y and Z have adopted P2 and the ETR in each country is 25%, 5%, and 20%, respectively.
No TT should be due with respect to group companies located in a country where the domestic taxes result in an ETR of at least 15%. Therefore, no TT should be due with respect to HoldCo and Sub Z.
If the ETR in a country is below 15% and if such a country has adopted a QDMTT, that country will have the first right to tax the undertaxed profits of the LTCE(s) in that country. As the US did not adopt P2, no QDMTT can be imposed at the level of USCo. However, country Y would be entitled to tax the low-taxed profits of Sub Y if it implements a QDMTT.
If not, then as a second step, CFC taxes will be allocated to Sub Y as LTCE. It has been clarified in OECD guidance that GILTI qualifies as a CFC regime for P2 purposes. Therefore, GILTI due at the level of USCo may be allocated to Sub Y pursuant to a formula (to be discussed in the next Snippet). This increases the ETR of Sub Y and reduces the amount of TT levied in another country in respect of its low-taxed profits.
As a third step, the Ultimate Parent Entity (‘UPE’) can impose a TT under the IIR if the ETR of the LCTE is still below 15% after applying the previous steps. As the US did not adopt P2, USCo will not impose TT. Instead, country X will levy TT on the low-taxed profits of Sub Y, as it is the first subsidiary of the UPE located in a country that has adopted the IIR.
The final step is the application of the UTPR, which becomes effective if no TT is imposed under the QDMTT and/or IIR. The UTPR is allocated to countries that adopted P2 pursuant to an allocation key based on employees and tangible assets in those countries. In this case, USCo has an ETR of less than 15%. Therefore, countries X and Z can subject a pro-rata share of USCo’s profits to TT under the UTPR.
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