Tax Insight - Australia’s Second Income Tax

The recent Budget contained only a few surprises but one important announcement was the confirmation of what many had already suspected: Australia will soon have a second income tax. In fact, it will start in just over 6 months.

Australia will enact a so-called “qualified domestic minimum top-up tax” (“QDMTT”) as part of the suite of measures to enact the OECD’s Pillar Two proposals into Australian law, along with the proposed Income Inclusion Rule (“IIR”), Undertaxed Profits Rule (“UTPR”) and possibly a Subject to Tax Rule. Those rules will be enacted to set out Australia’s claim to any low-taxed profits earned by foreign companies in case other countries forget to enact their own QDMTT. But they are almost certainly going to become irrelevant verbiage and very quickly: the main game has already shifted to countries enacting their own QDMTT, allowing them to get in first and switch off other countries’ tax claims. The impetus to do this has only increased with the threat from the Republican members of the US Congress Ways and Means Committee to retaliate against the companies of any country which tries to collect tax on the profits of US companies under the UTPR.

Consequently, speculation has now shifted to just what Australia’s second income tax will look like. The optimists are hoping Treasury will closely follow the design of the IIR and UTPR: the QDMTT will be designed in such a way that it leaves no room for other countries’ IIRs and UTPRs to operate, but nothing more. The pessimists suspect Treasury won’t want to stop there: Treasury will take the opportunity of imposing a brand new tax to design one unpolluted by any of Treasury’s bêtes noires. The optimists reply: a tax that departs from the design of the IIR and UTPR won’t meet the test of a QDMTT so Treasury will be constrained from being too ambitious. The pessimists respond: the new tax will still switch off foreign governments’ claims as long as it is a tax on profits (“a covered tax”); it doesn’t also need to meet the definition of a QDMTT to be effective in blocking foreign governments.

This issue is currently playing out in the debate around the US’ second alternate corporate minimum tax which began operation on 1 January: people are asking whether it is a QDMTT or not. But the answer to that question is not especially important if it is instead either a second covered tax or if it increases the amount of an existing covered tax.

The same question arises for Australia: will Treasury aim for (i) a tax that is a very close approximation of the IIR and UTPR rules, or (ii) a tax that takes the IIR and UTPR as the model but has some important departures, or (iii) a tax that abandons any attempt to be a QDMTT and aims instead to be a second covered tax?

Option (i) would be the least ambitious approach – to have the QDMTT simply mirror the IIR and UTPR design.

But there are reasons to suspect the tax Australia will end up with is option (ii) – a tax which meets the QDMTT definition, but ends up departing from the model and is more ambitious.

First, the OECD is already encouraging countries to be more aggressive when it comes to their QDMTT. For example,

• the IIR and UTPR are only triggered for very large taxpayers: MNE groups with revenue exceeding €750m. But when it comes to a QDMTT the OECD invites countries to waive this requirement, “… the application of a QDMTT could be extended to groups … that are not within the scope of the [IIR and UTPR] Rules because their revenues are below the EUR 750 million threshold”;
• in the same vein, the IIR and UTPR are only triggered for groups with cross-border operations: either a subsidiary or PE located in a jurisdiction different from the ultimate parent. The OECD invites countries to waive this requirement as well: “… a QDMTT could also apply to purely domestic groups, i.e. groups with no foreign subsidiaries or branches”. Some countries will take up this invitation. For example, the EU has decided it will apply the Pillar Two measures to groups that only operate domestically and have no foreign subsidiaries or branches;
• the IIR does not apply if the low-taxed entity in the group is the ultimate parent. The OECD says a QDMTT should apply to the ultimate parent: “… a QDMTT should impose a Top-up Tax on … all domestic Constituent Entities, including the domestic Parent Entity”;
• the IIR and UTPR have an active income exemption (the “substance-based income exception”) which renders some income immune from top-up tax. The QDMTT does not need to have such an exemption: “a QDMTT is not required to have a substance carve-out”;
• the IIR and UTPR have a de minimis exemption but a QDMTT is not required to have a de minimis exclusion: “a QDMTT is not required to have a De minimis exclusion … in order to be considered functionally equivalent to the GloBE rules”;
• the base for the IIR and UTPR is set by the accounting standards used for preparing the consolidated accounts of the ultimate parent entity. The tax base of a QDMTT can be based on local financial accounting standards: “… a jurisdiction may require income or loss for the jurisdiction to be computed using an Authorised Financial Accounting Standard that differs from the one used in the Consolidated Financial Statements”;
• the base of the IIR and UTPR reverses deductions for fines and penalties above €50,000 if they are deducted in the financial accounts. A QDMTT can reverse a deduction for even smaller fines or penalties: “… a jurisdiction that does not permit deduction of fines and penalties in any amount under its corporate income tax (CIT) can apply the same standard under its QDMTT”;
• the amount of top-up tax which will have to be paid under the IIR and UTPR requires a decision about which foreign taxes will count toward the minimum. But the OECD is quite happy if a QDMTT does not treat as a covered tax a tax which would be counted toward reducing the IIR or UTPR: “the determination of Adjusted Covered Taxes needs to be the same or more restrictive”;
• the IIR and UTPR are subject to transitional and permanent safe harbours. The OECD says safe harbours should also exist in a QDMTT but they do not need to be exactly the same: “the Inclusive Framework will undertake further work on the development of a QDMTT Safe Harbour …”
• the IIR and UTP rules contain many elections which groups may choose in order to mitigate some requirement or other. When it comes to a QDMTT, the OECD says the QDMTT should generally provide a corresponding election, except, “a QDMTT that does not provide for certain elections, for example GloBE Loss Election, may be functionally equivalent.”

We could go on, but these examples are sufficient to show the OECD is trying to sit on 2 horses at the same time. On the one hand, it tells countries, “a minimum tax must follow the architecture of the [IIR and UTPR] rules using mechanisms that are substantially the same as those used to calculate the effective tax rate and top-up tax payable ...”

On the other hand, it tells countries that being more ambitious won’t disqualify their tax as a QDMTT: “Some degree of customisation of a QDMTT in each jurisdiction is to be expected [and] variations in outcomes between the minimum tax and [IIR and UTPR] Rules will not prevent that tax from being treated as a QDMTT if those variations systemically produce a greater incremental tax liability …” The message is clear: a QDMTT must not collect less tax than the IIR or UTPR; collecting more is no problem.

A second reason to expect divergence is, there are aspects of IIR and UTPR design which serve no purpose in a QDMTT. For example,

• the IIR and UTPR rules devote a large amount of legislative effort to rules that determine which country will get the top-up tax if the IIR is enlivened [which entity is the “ultimate parent entity”, an “intermediate parent entity,” or “partly-owned parent entity”], or if the UTPR is enlivened [the allocation key rules]. None of that detail needs to exist in a QDMTT since all of the tax to be paid under the QDMTT is meant to be paid to the Australian government and no-one else;
• the IIR and UTPR rules devote a large amount of legislative effort to determining who is an MNE group and whose income and losses can be aggregated [netting is prohibited with entities that are investment entities, joint ventures and minority-owned constituent entities]. Treasury won’t be able to use the tax consolidated group definition from the Australian consolidation regime since it is under-inclusive compared to the IIR and UTPR so there will need to be both more entities included and more entities excluded. The simplest solution may simply be to treat all affected entities as stand-alone entities and not allow netting across any entities in the QDMTT.

It is inevitable the QDMTT will not simply mirror the IIR and UTPR design: Australia can be more ambitious in designing a QDMTT to tax Australian companies than it can be when applying the IIR or UTPR to claim tax from foreign companies.

Option (iii) would be the most ambitious approach: Treasury might abandon any effort at meeting the definition of a QDMTT (or simply not care whether its variations have strayed too far from the definition) and rely instead on the new tax meeting the definition of “covered tax”: a tax “recorded in the financial accounts of a Constituent Entity with respect to its income or profits …” The Commentary to the Model Rules already contemplates, and explains how to handle, “a domestic minimum tax that is not a Qualified Domestic Minimum Top-up Tax but that meets the definition of a Covered Tax …” The opportunity to write the corporate tax Treasury always dreamt of might prove irresistible. There is no down-side in enacting radical departures from the IIR and UTPR provided the tax is still a tax on profits.

It seems inevitable that Australia’s second income tax will end up departing from the parameters set in the IIR and UTPR regimes, but we won’t know just how far until the legislation is released, hopefully later this year.