GLOBAL MINIMUM TAX SERIES – PART 17 - Flow Through and Tax Transparent Entities

[Amit Jalan]

Friends

The Global Minimum Tax framework under Pillar Two is already a reality, with over 50 jurisdictions across the globe taking steps towards implementation. Earlierthis week on 11th July 2023, members of the OECD/G20 Inclusive Framework on BEPS delivered a package to further implement the Two‐Pillar Solution to address the tax challenges arising from the Digitalisation of the Economy, which was approved by 138 members of the Inclusive Framework.

In the last edition we explained the rules around a key aspect of the GloBE Rules, viz. Permanent Establishments.

In the next couple of editions starting with this one, we will discuss another important aspect, i.e., Flow-through Entities and all the rules around it as contained within the GloBE Rules.

We hope this bulletin adds Value in your professional Sphere.

Tax transparency is a feature of many domestic tax regimes as a means of applying a single layer of taxation.

Tax transparent entities are also used by MNEs for a variety of tax (and non-tax) reasons, not least the ability to maximize double tax relief. A tax transparent entity is treated for Pillar Two purposes in the same way as it is for domestic tax purposes, subject to some specific GloBE adjustments (e.g., to reflect income of non-group members or permanent establishments). However, where the tax transparent entity is itself the Ultimate Parent Entity (UPE) of the group, this poses some problems in the application of the GloBE Rules.

In this case, income cannot be allocated to the owners, as they would not be within the scope of the Pillar Two GloBE rules. In addition, tax paid by the UPE may be minimal given tax is payable on the income by its owners. This could lead to very low effective tax rates for a tax transparent UPE and substantial top-up tax obligations. Therefore, the Model Rules include a number of special rules to deal with these situations. Under Article 10.2.1 of the GloBE Rules, a flow-through entity is an entity that is fiscally transparent in the jurisdiction where it was created, unless it is tax resident and subject to a covered tax on its income or profit in another jurisdiction. Article 10.2.2 of the GloBE Rules describes a fiscally transparent entity as an entity that is not subject to tax as a separate entity in a jurisdiction, i.e., jurisdiction does not impose a Covered Tax on the Entity and treats the income, expenditure, profit, or loss of that Entity as if they were derived or incurred by the direct owner of the entity in proportion to their ownership interest. In other words, the tax consequences of the entity's activities are passed through to its owners, and the owners are taxed on their respective shares of the entity's income or loss.

Therefore, such entities are generally not subject to double taxation, as the income is taxed only at the owner's level and not at the entity level. This rule does not require the jurisdiction to treat the owners as incurring their respective shares of the Entity’s net losses. Accordingly, an Entity may also be considered fiscally transparent where the laws of the jurisdiction where it is established allow for the passthrough of income but requires net losses to be carried forward by the Entity itself and taken into account in the computation of the Entity’s income in a subsequent period. An example of this kind of Entity can be a trust which allocates income of a specific category to certain beneficiaries but it is allowed to carry forward any net loss from one taxable year to the next one in order to be offset against future income in that year. Flow-through entities can be further divided into two categories, viz. Tax Transparent Entity or a Reverse Hybrid Entity.

1. Tax Transparent Entity: It is a flow-through entity that is treated as fiscally transparent under the tax laws of the jurisdiction where it is incorporated as well as under the tax laws of the jurisdiction where its owners are tax residents, i.e., the domestic tax law of the owners also treats it as fiscally transparent and requires the owner to recognize the income, expenditure, profit, or loss of the entity as if it was income earned or expenditure borne by the owners themselves. In other words, the entity itself is not subject to tax and the owners are taxed on their respective shares of the entity's income or loss. For example, a Jersey LP with Partners in the UK, would be treated as a tax transparent entity because the UK, where the Partners/Owners are located, views the limited partnership as transparent and requires the owners to recognise the income/expenditure of the flow-through entity as if it had arisen to the owners. The entity, i.e Jersey LP itself does not pay income tax as it is fiscally transparent in the US.

2. Reverse Hybrid Entity: It is a flow-through entity that is treated as fiscally transparent under the tax laws of the jurisdiction where it is incorporated but treated as a separate taxable entity under the tax laws of the jurisdiction where its owners are tax residents, i.e. the domestic tax law of the owners does not treat it as fiscally transparent and therefore, the owners does not recognize the income, expenditure, profit, or loss when earned or incurred by the entity, but only when the entity distributes profits or makes an equivalent payment to its owners. This means that the entity is treated as opaque or not fiscally transparent by the owners, even though it is considered fiscally transparent in the jurisdiction where it is created. For example, a foreign corporation owned by U.S. shareholders is treated as a corporation in its home country but as a flow-through entity for U.S. tax purposes; the U.S. shareholders, would therefore not recognize the income, expenses, profits, or losses of the foreign corporation until it distributes profits to them. This can lead to tax deferral or potential double taxation or double nontaxation, depending on the tax laws of the jurisdictions involved. Therefore, in both the above categories, the entity is considered fiscally transparent under the domestic tax law of the jurisdiction where it was created/incorporated, however in the domestic tax law of the owners jurisdiction, the Tax Transparent entity is also considered fiscally transparent but the Reverse Hybrid entity is not. For GloBE purposes, if an entity is not treated as fiscally transparent in another jurisdiction and is treated as tax resident and therefore taxed on its income, it would not be a flowthrough entity (and therefore not a tax transparent entity). For example, a US LLC has its place of effective management in the UK. This may be treated as tax transparent for US tax purposes (the jurisdiction where it was created) but would be treated as opaque for UK tax purposes. The tax residency test in UK is the place of effective management and therefore UK taxes the Entity as a tax resident. Therefore, under the GloBE Rules, such entities would simply be another constituent entity and would be subject to the jurisdictional effective tax rate (ETR) and top-up tax calculation just as for other constituent entities within the MNE Group. Therefore, once it is determined that an entity is a flow through entity, in order for it to be a tax transparent entity, it would need to be treated as tax transparent in the jurisdiction of its owners. It is worth noting that the same Flow-through Entity can be treated as a Tax Transparent Entity by some of its owners and a Reverse Hybrid Entity by its other owners. In such cases, the rules are applied separately from the perspective of each Constituent Entityowner. For example, a fiscally transparent entity is held equally by two constituent entities wherein one of the owner jurisdictions considers the investee entity a separate entity, and the other treats it as fiscally transparent. In such a case, the income and taxes of the investee entity would partially get assigned to the owner’s jurisdiction and partially to the tax transparent (i.e., stateless) jurisdiction. Additionally, under Article 10.2.4 of the GloBE Rules, an Entity could be treated as a Flowthrough Entity and Tax Transparent Entity, and at the same time, treated as an Entity that is not a Flow-through Entity. In the latter case, the Entity is not treated as a Reverse Hybrid Entity because it is not a Flow-through Entity (i.e., the jurisdiction of creation does not treat the income, expenditure, profit or loss as derived or incurred by its owners). For example, C Co is a Constituent Entity created in Country C, a jurisdiction with no CIT. C Co has no place of business in the jurisdiction where it was created and its income is not attributable to a PE. The Ownership Interests of C Co are equally distributed among A Co and B Co, which are Constituent Entities of the same MNE Group. A Co is a resident of Country A, which treats C Co as fiscally transparent. B Co is a resident of Country B, which does not treat C Co as fiscally transparent. In this case, only 50% of the income of C Co is treated as being derived by a Tax Transparent Entity (which is subject to Article 3.5). The remaining 50% of the income of C Co is treated as being derived by an Entity that is not a Flow-through Entity (i.e. not subject to Article 3.5 of the GloBE Rules). In this case, the Entity C Co. treated as a Flow-through Entity and Tax Transparent Entity (w.r.t. A Co.), however, C Co. is not treated as a Reverse Hybrid Entity (w.r.t. B Co.) because it is not a Flow-through Entity (i.e., the jurisdiction of creation does not treat the income, expenditure, profit or loss as derived or incurred by its owners).