Original Content by BDO Global

Pillar Two calculations are based on financial data. Depending on the type of calculation to be made, this can be the consolidated financials of a multinational enterprise (MNE) or local statutory accounts. Based on these financial data, an effective tax rate is calculated and compared with the minimum tax rate under Pillar Two.

Because of the time constraints imposed on the preparation of consolidated financials, some top-side adjustments made by a parent company on the accounting sheets of its subsidiaries during the preparation of consolidated financial statements -- are not pushed through to the local financials. Transfer pricing (TP) adjustments or true-ups are another example of instances where timing differences may arise between consolidated accounts and local financials. TP adjustments can find their way into the local statutory accounts of the transaction year, but may appear in the consolidated accounts only in the subsequent year.

Some Pillar Two implications of these practices are discussed below.

Accounting and Legislative Framework

Pillar Two calculations are generally undertaken at a jurisdictional level (subject to exceptions for certain entity types), and may be based either on data drawn from the financial statements used in the preparation of the consolidated financial statements (excluding consolidation eliminations) or on data drawn from local statutory financial statements prepared under local GAAP, depending on the applicable legislative framework. The first step in the Pillar Two calculation is to identify the relevant data source, and the applicable legislative framework(s), noting that entities in different jurisdictions may be subject to different legislative frameworks, and therefore the treatment of transactions between the two entities may differ.

Potential Scenarios

When TP adjustments are posted in the financial data that form the basis of the GloBE calculations, i.e. the consolidated or local financial statements, there should not be any negative Pillar Two effects. In practice, that is not always the case. The following scenarios in connection to TP adjustments are possible:

• Scenario 1: A TP adjustment is posted top-side in the consolidated financial statements (including any corresponding tax effect), but those top-side adjustments are not “pushed down” to the entity level until the subsequent financial period.
• Scenario 2: TP true-ups are posted in the consolidated financial statements in the subsequent period and allocated to the relevant entities in that subsequent period.

• Scenario 3: A TP adjustment is not posted in the financial statements, and imputation of income or expense is made solely through the corporate income tax returns in the relevant jurisdictions.

Relevant GloBE Principles

One of the core principles of the GloBE rules is the arm’s length principle. Article 3.2.3 of the GloBE rules requires that an adjustment be made to financial accounting net income or loss (FANIL) if a cross-border transaction is not in line with the arm’s length principle. To the extent an item of income is excluded as a result of this, the corresponding tax is excluded from the amount of covered taxes (Article 4.1.3(a).

The GloBE rules also contain detailed rules regarding dealing with prior period errors (Article 3.2.1(h)) and adjustments arising after the GloBE Information Return (GIR) has been filed (Article 4.6.1). TP adjustments would not generally be expected to be prior period errors as the term is defined; however, this should be considered based on the accounting treatment based on the facts. Moreover, TP adjustments relating to a particular year in the scenarios described above are generally made prior to the filing of the GIR for that year, so the post-filing adjustment rules would not have an impact. Post-filing adjustments may be relevant in cases of tax audits that give rise to TP adjustments.

Scenario 1 – Top-side Adjustments

Consolidated financials are the foundation for Pillar Two GloBE calculations under the OECD model rules. Effective tax rate (ETR) calculations must be made for all entities in the MNE group. The calculation begins with each entity’s FANIL, as reported in the accounts used to prepare the consolidated financial statements. If top-side adjustments are not pushed down into those accounts in the period in which they are posted, the question arises whether there is an impact on the Pillar Two ETR calculations.

Allocation of Top-side Adjustments

Guidance on this question from the OECD or tax administrations is limited. The OECD Commentary to the GloBE rules does mention that non-purchase price accounting items of income and expense that are reflected in the consolidated accounts but not in the entity’s local financials may be taken into account in the entity’s FANIL computation, but only to the extent that they can be “reliably and consistently” traced to that entity [1]. Stock-based compensation is mentioned as an example.

BDO Insight

We interpret this to mean that as long as there is a consistent policy applied in relation to these consolidation adjustments and that they can be traced to the relevant entity, they can be taken into account for the Pillar Two calculations for that entity. The tracing requirement does imply that the adjustments should properly document what entity they relate to and that netting should be avoided, as that may make tracing less clear.

The commentary to the OECD model rules “permitting” allocation relates to Article 3.1.2, which addresses GloBE income or loss. It is therefore less clear whether corresponding tax in respect of the top-side adjustments should (or may) also be allocated to constituent entities to which it relates when it can be reliably traced or when there is an arm’s length override.

BDO Insight

The new simplified ETR safe harbour introduces two rules for dealing with transfer pricing adjustments, allocating these adjustments to either the accrual year or (by election) the transaction year. In both rules the adjustment and associated tax are processed in the same year. Because the simplified ETR safe harbour design had to avoid system integrity concerns, it may be argued that it would be logical for the full GloBE calculations to allow tax associated with TP adjustments to be allocated together. Unfortunately, due to the lack of specific guidance, the matter remains unclear.

No Allocation of Top-Side Adjustments

If no allocation is made in respect of the top-side adjustments, Article 3.2.3 requires an adjustment to bring cross-border transactions in line with the arm’s length principle when computing FANIL.

There is a general expectation within the GloBE rules that adjustments to income should also result in adjustments to the corresponding tax amounts to achieve consistency. However, the OECD model rules only deal explicitly with adjustments (i.e., removal) for the amount of current tax expense with respect to income excluded from the computation of GloBE income or loss under Chapter 3. This could be read to include an adjustment for covered taxes in respect of income that is partially excluded in the GloBE calculation, for example, a downward TP adjustment. Such an adjustment could have no effect, or a reducing effect on the ETR, in the territory where the downward adjustment is posted, depending on the specific facts.

Differences in GloBE Implementation

For jurisdictions that have enacted a comprehensive arm’s length principle override, the better view would be that top-side adjustments should be allocated to individual entities in a manner that accords with the arm’s length principle.

If one side of the TP adjustment is in a jurisdiction with such a comprehensive arm’s length override, and the other side is in a territory that does not require adjustment, it may nonetheless be advisable to apply the guidance to allocate the topside adjustment to the latter territory’s financial results to mitigate the risk of ETR distortion across periods. However, this decision will require review on a case-by-case basis.

Application Under Transitional Country-by-Country Report (CbCR) Safe Harbour

The adjustment of CbCR data -- regardless of whether such adjustments are intended to make CbCR data more consistent with the GloBE rules -- will disqualify such computations. The OECD commentary does not provide further insights. UK Revenue guidance [2] seems to indicate attribution of CbCR data, i.e. amounts in the consolidated amounts, between entities and jurisdictions seem to be acceptable if this is done in the course of preparing a CbC report. As this attribution seems to relate only to CbC report preparation, it does not provide any indication that the tax element in the ETR calculation allocation is also allowed, or that merely the actual tax is taken from the entity accounts as stipulated by the transitional CbCR safe harbour rules.

BDO Insight

Based on the above, it is advisable that any TP adjustment be actually pushed down in the period in which it is posted, both for full GloBE computation as well as transitional CbCR safe harbour purposes. This would avoid possible ETR volatility.

Scenario 2: Transfer Pricing Adjustments

As indicated above, this scenario concerns situations whereby a TP adjustment is included in the local statutory accounts in the transaction year, but the consolidated accounts only record the adjustment a year later.

In such a situation, Article 3.2.3 generally requires an amendment to transaction-year FANIL if a cross-border transaction within the MNE group is not accounted for in accordance with the arm’s length principle. It is worth noting that this requirement has not been legislated in such a broad manner by all jurisdictions that have implemented Pillar Two. If a transaction is not in line with the arm’s length principle, there may be an upward or downward adjustment of income required for Pillar Two purposes in the period of the underlying transaction (that is, the period prior to the true-up being posted). In this scenario, it would be expected that the adjustment in the underlying transaction period (when required by the applicable legislative framework) would align to the TP true-up posted in the subsequent period, and that the subsequent period would also be adjusted to exclude the TP true-up that relates to an underlying transaction not relevant to the subsequent period for consistency.

As discussed above, an adjustment of the covered taxes resulting from any such adjustment is not automatic. The Pillar Two rules only provide for an adjustment of taxes to the extent they refer to income that is excluded as a result of the TP adjustment, i.e. a downward TP adjustment. There is no such rule for upward adjustments. As a result, an upward TP adjustment can negatively impact the entity’s ETR, given the increase in income with no ability to reflect the corresponding increase in covered taxes. The tax effect included a year later in the financials does not impact the transaction year if the GIR is filed after the date of the adjustment.

BDO Insight

This practice can result in ETR volatility. An MNE can avoid such volatility if the TP process is conducted in real-time, minimising the need for TP adjustments and true-ups.

Application Under Transitional CbCR Safe Harbour

The approach under the transitional CbCR safe harbour is different. As noted, the adjustment of CbCR data -- regardless of the reason for the adjustment -- will preclude the use of the safe harbour. 

For instance, when the CbC report is based on consolidated accounts, these will typically not reflect the TP adjustments that are required under the GloBE rules.  However, these TP adjustments are not allowed for purposes of the safe harbour test. If the CbC report is based on local financial accounts in which the TP adjustments have been made, these should also be used for the safe harbour test.

Simplified ETR Safe Harbour

The recently introduced simplified ETR safe harbour rules include a provision aimed at preventing such ETR volatility. This provision allows taking into account, in the transaction year, TP adjustments (and associated covered taxes) made within 12 months after that year.

Scenario 3: Adjustments in Tax Returns Only

As in Scenario 2, adjustments to bring the cross-border transactions in line with the arm’s length principle would be required, based on Article 3.2.3. Any tax associated with these must be removed from the covered taxes calculation, to the extent that there are downward adjustments.

TP Adjustments in Later Years

TP adjustments can also arise as a result of disputes with tax authorities that are ultimately settled in a bilateral or unilateral setting. These adjustments will often arise after the GIR for the disputed year has been filed. These cases would then fall under the post-filing adjustment rules of Article 4.6.1. Generally, these rules require a recalculation of the transaction year in the event of a reduction of tax as a result of the TP adjustment. Increases are dealt with in the settlement year. An election can be made to account for reductions in tax up to EUR 1 million in the settlement year rather than the transaction year.

Closing Remarks

The 2025 OECD Consolidated Commentary indicates that further guidance on transfer pricing matters may be forthcoming. So far, such further clarification has not yet emerged.

Contact

For more information on the implications of transfer pricing adjustments on the Pillar Two calculations, please contact us.