Global Minimum Tax – Part 18 - Treatment of Flow-through Entities

[Amit Jalan]

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In the previous edition we explained the concepts and types of FlowThrough Entities for GloBE Purposes and the special rules contained therein. Given the special status for such entities which could lead to tax deferrals or double taxation or double non-taxation in certain situations and jurisdictions, the OECD realising this has formulated special rules within the GloBE Rules relating to allocation of GloBE Income or Loss and Covered Tax for such entities, which we have covered in detail in this edition.

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The GloBE Rules has special rules to deal with treatment of tax transparent entities, such as partnerships and trusts, to ensure there is a suitable mechanism to allocate income between the entity and the owners.

In summary, the general mechanics of Article 3.5 of the GloBE Rules are as follows:

i) First, the Financial Accounting Net Income or Loss of the Flow-through Entity is reduced by the amount attributable to the owners that are not members of the MNE Group. Therefore, only the income of owners that are members of the MNE group are taken, any amounts attributable to owners outside of the group are excluded. This ensures that the jurisdictional ETR of the members of the MNE Group is properly computed given that taxes paid by members outside of the Group are not taken into account for purposes of the ETR computation.

ii) Second, if the Financial Accounting Net Income or Loss of a PE is included in the Financial Accounting Net Income or Loss of a Flow-through Entity because the business of the latter is carried out through the PE, then such amount is excluded to ensure it is not double counted (as PEs are treated as separate Constituent Entities for GloBE calculation).

iii) Third, the remaining amount of the Financial Accounting Net Income or Loss of the Flow-through Entity is allocated as follows:

a) If the Flow-through Entity is a Tax Transparent Entity (other than the UPE), then it is allocated to its Constituent Entity owners;

b) If the Flow-through Entity is a Reverse Hybrid, then it is allocated to the Entity and not to its owners, because according to the owner’s tax legislation, the Entity is not Fiscally Transparent, and its income or loss is not directly taxed in the hands of its owners. In such cases, the rules around stateless income are brought into effect i.e. it is treated on a standalone basis;

c) If the Flow-through Entity is a Tax Transparent Entity and also the UPE of the MNE Group, then the amount is allocated to the UPE instead of the owners because the owners are not Constituent Entities of the MNE Group required to apply the GloBE Rules. Article 7.1 provides additional rules that apply when a Flow-through Entity is the UPE of the MNE Group.

The above can be explained through the following example.

Hold-Co is an Entity located in Country-A and is also the UPE of an MNE Group. It holds 60% of the Ownership Interests of B-LP, a Tax Transparent Entity created in Country-B.

The remaining 40% of the Ownership Interests of B-LP are held by non-Group Entities (the “minorities”), which are also located in Country-A.

B-LP has a store in Country-B.

Country B considers that this store constitutes a PE for Hold-Co and the minorities. The Financial Accounting Net Income of B-LP is $200. Only $100 of the Financial Accounting Net Income of B-LP is attributable to the PE and taxed in Country-B.

In this case, as per the aforementioned provisions under Article 3.5 of the GloBE Rules, the Financial Accounting Net Income of B-LP is allocated as below:

i) First, it is reduced by $80 because that is the amount that is attributable to the minorities ($200 x 40%).

ii) Second, out of the remaining $120 of income, $60 is allocated to the PE because, after backing out the minorities’ share, this is the amount that relates to the PE income which is attributable to the Ownership Interests held by the Group Entities (i.e. 50% as per given information).

iii) The remaining amount of $60 is allocated to the Hold-Co because B-LP is a Tax Transparent Entity whose income is allocated to its Constituent Entity-owners.

As such, provided the Tax Transparent Entity is not the UPE, the GloBE Income simply passes up to the ownership chain in the group in line with most domestic tax treatment.

Similarly, Article 4.3.2 (a) and (b) of the GloBE Rules also provides that the covered taxes included in the financial accounts are also allocated to the PE or the owners (respectively, as the case may be) to match the income with the associated tax.

This treatment flows up the chain. Therefore, if a tax transparent entity was held by another tax transparent entity, the allocation of GloBE income and covered tax would flow up the chain. If all entities were tax transparent, the end result would be that GloBE income would be allocated to the UPE.

Allocation of income or Loss and Tax in case the UPE is a Flow-through entity T

There are special rules to UPEs that are tax transparent, as the UPE owners are not constituent entities of the MNE Group and would not be required to apply the GloBE Rules.  In such a case, the default treatment under Article 3.5.1(c) is that the UPE’s GloBE Income is allocated to the UPE, i.e. in the jurisdiction in which the UPE was created.

However, the ETR of the Tax Transparent UPE may be very low or even nil given that tax on the income would be incurred by the owners of the UPE and not the UPE itself. Therefore, without further provisions this would lead to a substantial top-up tax obligation for tax transparent UPEs even though the income may be subject to significant tax in the hands of the owners. The difficulty here is identifying the tax that the owners incur. Simply allocating taxes to the UPE on the UPE income that accrues to its owners that are outside the MNE Group would be extremely difficult to apply.

As per the standard allocation rules for tax transparent entities, the amount allocated to such entities should be reduced by any amount attributable to a PE or to non-group owners based on their ownership interests.

As such, Article 7.1 of the GloBE Rules provides special rules for the reduction of the GloBE Income of UPE. The broad intention is that if the owners of the UPE pay tax at or above the 15% minimum rate, the UPEs GloBE income should also be reduced.

Under Article 7.1, the GloBE Income of the UPE is reduced in the following three situations, by the amounts attributable to:

i) The holder who is subject to tax at a nominal rate above the Minimum rate (i.e. 15%), on its share of the UPE’s GloBE Income for a taxable period that ends within 12 months of the end of the MNE Group’s Fiscal Year or if the UPE can demonstrate that it is reasonable to expect that its income will be subject to tax at a rate of at least 15%;

ii) The holders, being a natural persons, who are a tax resident in the UPE jurisdiction and who holds in aggregate, 5% or less Ownership Interest in the UPE (i.e., rights of 5% or lower, in aggregate, to the profits and assets of the UPE). The GloBE rules recognise that determining the tax position of minority owners may be burdensome and also those individuals would not ordinarily be subject to preferential tax rates below the 15% rate for income from a Tax Transparent Entity. This means that a UPE would be required to identify the tax position of no more than 19 individuals.

iii) The holder is a Governmental Entity, an International Organisation, a Non-profit Organisation, or a Pension Fund that is a resident in the UPE jurisdiction where they are created and managed, and that each Entity holds Ownership Interests that in aggregate carry rights to 5% or less of the profits and assets of the UPE. Such types of Entities are generally prohibited from carrying on a trade or business and hence generally exempt from tax. Therefore, the ownership limitation to 5% ensures that Article 7.1 cannot be used to circumvent this prohibition by carrying on a trade or business through a Tax Transparent Entity.

These three are a kind of safe harbour provisions under the GloBE Rules to a tax transparent UPE.

The remainder of the income of the UPE, if any, will be included in the computation of the UPE’s GloBE Income or Loss and included in the computation of the Net GloBE Income for the jurisdiction under Article 5.1.2.

Article 7.1.3 of the GloBE Rules also requires the UPE to reduce its covered taxes (under domestic tax laws, if there are any) proportionately to the GloBE Income reduction calculated above (e.g., a 50% reduction in GloBE Income would result in a 50% reduction in covered taxes).

Article 7.1 can be explained by way of an example, as below: UK LLP (Profit = £ 100 million) 75 UK Resident Partners (Tax Resident in UK) 25 French Resident Partners (Tax Resident in France) All Partners have equal profit share / ownership interest in UK LLP. Therefore, UK LLP s GloBE Income is reduced by: 1. £ 75 million attributable to UK resident Partners that have ownership interest of <5% 2. £ 25 million attributable to French resident Partners that are subject to French Personal Taxation at a rate above the Minimum Rate of 15%

In this example, based on the foregoing discussion, the UK LLP’s GloBE Income is reduced to nil. The assumption is:

• Firstly, the 25 French resident partners are subject to income tax at a rate above 15% and therefore it can be concluded that the GloBE income is being taxed at an appropriate level (i.e., clause (i) above satisfied);
• Secondly, the 75 UK resident partners have ownership interests of less than 5% in aggregate, and those individuals are tax residents and subject to tax in the UPE’s jurisdiction, i.e. the UK (i.e., clause (ii) above satisfied).

Share of Income and gains from Tax Transparent Entities that are not Constituent Entities within the MNE Group

Under the GloBE Rules, receipts from corporate entities that are not constituent entities are taxable unless they are excluded dividends or excluded equity gains. The Commentary to the GloBE Rules for Article 3.2.1 (para 34) provides that, a constituent entity’s income should include “distributions received or accrued in respect of an Ownership Interest held in a flow-through entity” and states that such distributions may be treated as excluded dividends when the conditions as to ownership percentage and holding period are met. By implication, the equity gain exclusion is also capable of applying to gains or losses on disposal of an interest in a partnership. This would therefore mean that if an MNE Group received a profit share from a 10% (or more) interest in an investment partnership that is not a constituent entity of the group then that profit share will be an excluded dividend and excluded from the group’s GloBE income.