Pillar Two: Luxembourg implements additional OECD guidance

Background

The initial Pillar Two law of 22 December 2023 did not explicitly incorporate certain elements of the agreed OECD administrative guidance adopted respectively in February and July 2023, and it did not at all incorporate guidance released by the OECD in December 2023 and in June 2024. Therefore, the government had already announced plans to revisit the initial law to implement additional pieces of that OECD guidance which could not be seen as merely clarifying existing rules but required a legislative change.

Key elements

Clarification for SPVs held by investments funds or real estate investment vehicles

In principle, a special purpose vehicle (SPV) owned for at least 95% (or 85% in case of equity investments) by an “Excluded Entity” is, subject to certain conditions, also qualifying as “Excluded Entity”. Amongst others, investment funds and real estate investment vehicles (REIT-type of entities) qualify as “Excluded Entities” if they are the ultimate parent entity (UPE) of the group.

As most investments funds do not have consolidation obligations (neither under Luxembourg law, nor under IFRS 10), they do not qualify strictly speaking as UPE of a group. However, OECD guidance allowed SPVs of investment funds or real estate investment vehicles could still qualify as “Excluded Entities” (if they met all other criteria) even if the investment fund or real estate investment vehicle was not required to prepare consolidated financial statements (and also not caught by the deemed consolidation rule). This guidance has been explicitly implemented in the law.

Clarification for situations of voluntary consolidation

Parliamentary documents clarify that an optional consolidation for internal or contractual purposes does not mean the parent entity is automatically considered to “control” a subsidiary for (deemed) accounting consolidation purposes.

Clarifications on the country-by-country reporting (‘CbCR’) safe harbour

Multiple elements of December 2023 OECD guidance are introduced in the law, notably:

• The prohibition to make adjustments to the financial accounting data unless explicitly required under the safe harbour rules (and with specific rules in case of adjustments attributable to purchase price accounting);
• The requirement for all data of a constituent entity to come from the same qualified financial statements (except for deferred tax assets booked solely in the consolidated financial statements);
• The requirement to adopt a consistent approach for all constituent entities (except for permanent establishments and non-material constituent entities) in a given jurisdiction, i.e., consolidated financial statements or individual financial statements of each constituent entity;
• Payments between constituent entities booked as income in the financial statements of the beneficiary must be taken into account in the profits before taxes, regardless of CbCR rules or local tax rules applicable to such payment;
• For groups that are not required to file a qualified CbC report, CbC data to take into account is the data that would have been included in a CbC report if the requirement to file had applied;
• The share of turnover and profits before taxes of a permanent establishment is determined based on the data prepared by the head office;
• Taxes paid under controlled foreign companies (CFC) rules or on foreign permanent establishments or hybrid entities are allocated to the payor of such taxes if the foreign subsidiary, permanent establishment or hybrid entity is situated in a jurisdiction in which the CbCR safe harbour does not apply.
• The CbCR safe harbour computations are made separately for joint ventures (and joint venture groups) as if they were located in a separate jurisdiction.
• The anti-hybrid arbitrage rule is also implemented. It requires ignoring expenses, losses or tax amounts arising as a result of a hybrid arrangement entered into on or after 18 December 2023 with the purpose of benefiting from the CbCR safe harbour. A hybrid arrangement arises in case of deduction non-inclusion outcome, double deduction outcome or double counting of a tax liability. For purposes of assessing whether there is a deduction non-inclusion outcome, there is no inclusion if (i) the amount included in taxable income is offset by a tax attribute with respect to which a valuation adjustment or accounting recognition adjustment has been made or (ii) the payment that gives rise to the expense or loss also gives rises to a taxable deduction or loss of a constituent entity that is located in the same jurisdiction as the constituent entity counterparty without being included as an expense or loss in determining the profit before tax.
  
  

Changes and clarifications related to QDMTT

Application of the exemption for MNE groups in the start-up phase of their international activities and large-scale domestic groups.
This 5-year exclusion aims at applying for qualified domestic minimum top-up tax (“QDMTT”) purposes the exclusion that already applies for income inclusion rule (IIR) and undertaxed profits rule (UTPR) purposes. An MNE group is in the start-up phase of its international activities if it has constituent entities in maximum 6 jurisdictions and the net accounting value of its tangible assets outside of the UPE jurisdiction does not exceed EUR 50M.

Allocation of taxes of tax transparent entities to its constituent entity owner(s).
For QDMTT purposes, various rules governing the reallocation of covered taxes from one constituent entity to another constituent entity do not apply. However, this rule on the allocation of taxes paid by tax transparent entities will be upheld for QDMTT purposes.

Currency to be used for QDMTT computations.
If all Luxembourg constituent entities have EUR-denominated financial statements, EUR will be the currency for QDMTT computation purposes. If some use another currency, the MNE group will have to make a 5-year election to use either EUR or the currency used for the consolidated financial statements. The currency conversion follows the rules of the applicable accounting standard used for QDMTT purposes.

Challenges to the compliance of QDMTT with superior legal norms.
If a constituent entity challenges its QDMTT liability under judicial or administrative procedures by invoking constitutional norms or other legal norms of superior rank (i.e., by challenging the legality of the QDMTT per se rather than challenging factual elements or the interpretation of the rules in the specific case at hand), or if the QDMTT is ruled not to be payable or recoverable, then such QDMTT is not taken into account and IIR or UTPR may still apply. If the QDMTT becomes payable after all or is no longer challenged, it will be taken into account in the year to which it relates. A QDMTT that is not paid/recovered pursuant to the above can also not qualify for the QDMTT safe harbour.

Deferred tax assets (DTAs)
Two main changes are implemented (in line with OECD guidance released during 2023):

• DTAs in respect of pre-Pillar Two tax credits. The bill of law introduces the formula to determine such DTAs arising from tax credits generated before the transition year (i.e., the first year in which the group is in scope of the Pillar Two rules).
• Prevention of double taxation. The requirement to account for intra-group transfers of assets that occurred after 30 November 2021 at book value could cause double taxation if for local tax purposes the transferor was taxed on the transfer (considered to have occurred at fair market value). The bill of law implements the OECD’s solution: recognising a DTA in the hands of the transferee (without reducing the adjusted covered taxes in that year). The rules detail the computation of the DTA. The concept of “transfer of assets” entails any transaction considered as transfer of assets under accounting norms and imply the recognition of an asset (or an increase in the accounting value of an asset) at transferee level or the recognition of a DTA (based on the difference between the tax and accounting value of the asset) at transferee level. The same applies to transfers between a head office and a permanent establishment of the same entity.

Exclusion of sovereign wealth funds from the definition of Ultimate Parent Entity

Entities that meet the four criteria of the definition of sovereign wealth funds will not be treated as Ultimate Parent Entity, even if they consolidate investments / subsidiaries. Whether direct or indirectly owned subsidiaries in turn form an MNE group in scope of Pillar Two depends on whether, disregarding the sovereign wealth fund ownership, they meet the conditions – notably the EUR 750 million consolidated turnover threshold.

Application of the rules to securitisation vehicles

June 2024 OECD guidance is implemented. The new rules and related guidance apply only to the extent the securitisation vehicle would, in the first place, be consolidated and qualify as a constituent entity of an MNE group in scope of the rules. In view of the tax neutrality of securitisation vehicles, unless there is no other constituent entity of the in-scope group in Luxembourg, such group can allocate to other constituent entities the top-up tax liability that would be otherwise payable by the securitisation vehicle. 

Clarifications to the notion of turnover and to the computations in case of divergent tax years

The bill of law implements the clarification to the concept of turnover with a view to the uniform application of threshold of EUR 750M of group consolidated turnover. It confirms that turnover should also include realised or unrealised gains on investments, as well as extraordinary/non-recurrent gains or income.

The bill of law also provides that if a constituent entity has a book year diverging from that of the UPE, the method used in the consolidated financial statements to treat this divergence should be applied also for Pillar Two purposes. For joint ventures (and joint venture groups), Pillar Two computations for a given year take into account the accounting data of such joint venture (or joint venture group) of its accounting year that ends during the tax year of the UPE.

Clarification in respect of Equity Investment Inclusion Election rule

This rule allows taking into account for Pillar Two purposes gains or losses on investments that would otherwise be exempt under the Pillar Two rules and that are taxable or deductible under domestic law. The bill of law clarifies that this option is open both in case the entity applies fair value accounting (such as under IFRS) or in respect of impairments booked in a cost-based accounting system (such as Lux GAAP).
In addition, parliamentary documents clarify that if the EIIE is made in the transition year (i.e., the first year in which a group is in scope of the regular rules and not the CbC safe harbour provisions), then deferred taxes related to gains or losses realised after 30 November 2021 on participations that would have otherwise been exempt can nevertheless be taken into account for Pillar Two purposes  

Other clarifications

Other topics addressed by the bill of law include:

• Certain modifications to the transitional regime applicable to mixed CFC regime (such as GILTI), including the interaction with the QDMTT safe harbour provision and the transitional CbCR safe harbour.
• A clarification of the approach to qualify a tax transparent entity as a flow-through entity and/or a reverse hybrid entity. Importantly, if a tax transparent entity has several owners, it may be a flow-through entity in respect of some owners and a reverse hybrid entity in respect of those that treat the entity as tax opaque in their own jurisdiction. There are corresponding clarifications on the computation of the GloBE income of that entity.
• The non-deductibility of technical provisions of an insurance company if those are economically related to exempt dividends or exempt gains/losses and if they arise from investments for the account of insurance holders.
• A clarification of the treatment of operational leases for purposes of the substance-based income exclusion.
• As regards the rules on transfers of assets between constituent entities, a clarification that when the transfer is recognized as a taxable transaction, the transfer price to be taken into account must comply with the arm’s length principle.
  Some pieces of OECD guidance will also be implemented by means of grand-ducal regulation, e.g., foreign tax credits. 

Compliance with the principle of non-retroactivity

Parliament considers that there is no violation of the principle of non-retroactivity, as (i) any top-up tax liability for 2024 would arise only at the end of 2024. Moreover, it is in the general interest to ensure Luxembourg implements the Pillar Two rules in line with the OECD model rules and guidance, so as to have a “qualified” status necessary for mutual recognition by the other countries.

Next steps

We will keep you informed about further developments. Should you have any question, please do not hesitate to contact an author of this newsletter or your trusted Loyens & Loeff adviser.