Pillar Two draft law—Phase four: Administrative compliance obligations

At a glance

On 4 August 2023, the Luxembourg government submitted to the Luxembourg parliament the draft law (“the draft”) for the implementation of Council Directive (EU) 2022/2523 of 14 December 2022 on ensuring a global minimum level of taxation (15%) for multinational enterprise (MNE) groups and large-scale domestic groups (DGs) within the EU (“Pillar Two directive”). The draft still needs to complete the legislative process but must be implemented by 31 December 2023 to comply with the EU deadline.

According to the draft, when an MNE group or DG is within the scope of the Pillar Two rules (as discussed in our phase one article), an additional amount of tax (top-up tax) would have to be paid in relation to each jurisdiction in which the effective tax rate (ETR) is below the agreed 15% minimum level of taxation.

The amount of top-up tax determined would be levied through the application of what the draft presents as three new taxes. These new taxes relate to the income inclusion rule (IIR), the undertaxed profits rule (UTPR), and the qualified domestic top-up tax (referred to as the QDMTT based on the acronym used by the OECD).

Special rules have been included in the draft to potentially delay the application of the Pillar Two rules to some in-scope MNE groups and DGs. These rules would provide certain exclusions from the application of the Pillar Two rules, based either on the group being in its first phase of international expansion, or on a specific parameter (e.g., revenue or profit).
 

A closer look

Our first article, issued on 7 September 2023, “Pillar Two draft law—Phase one: To be or not to be in scope of Pillar Two,” summarizes the main principles driving the determination of the scope of application of the Pillar Two rules and provides a practical approach that may be followed to assess the Pillar Two Luxembourg perimeter.

Our second article, issued on 19 September 2023, “Pillar Two draft law—Phase two: Demystification of the top-up tax,” addresses the complex set of rules to be applied to compute the potential amount of top-up tax due and to determine how, to which jurisdictions, and to which entity the tax should be allocated.

Our third article, issued on 28 September 2023 “Pillar Two draft law—Phase three: Diving into the effective tax rate computation,” explains the primary factors (numerator and denominator) behind the computation of the ETR, given its pivotal role in assessing whether an amount of top-up tax has to be allocated at the level of the respective constituent entities.

This article covers the final phase of the Pillar Two analysis, with a primary emphasis on the administrative compliance obligations that must be fulfilled by an MNE group or DG within the scope of Pillar Two. It also provides further clarification on the computation of the top-up tax and on transitional rules.
 

Administrative compliance obligations

To successfully navigate the compliance requirements outlined in the draft, the three steps outlined below would have to be followed:

Step 1: Registration, notification of change, and deregistration

According to the draft, all Luxembourg constituent entities, together with Luxembourg joint ventures and their Luxembourg affiliates that are part of an MNE group or DG falling within the scope of the Pillar Two rules, would have to register with the Luxembourg tax authorities.

This registration would be relevant only for Pillar Two purposes and would be a separate registration process to be completed alongside the mandatory tax registration process that all Luxembourg taxpayers are required to undergo.

When registering, the constituent entity or joint venture would be required to provide the following information:

1. Information on the constituent entity/joint venture: Name and Luxembourg fiscal number;
2.  Information on the MNE group or DG: Name, identification of the ultimate parent entity (UPE), and jurisdiction in which it is located;
3.  Fiscal year information: The first fiscal year in which the MNE group or DG falls within the scope of the Pillar Two rules, together with the end of that fiscal year; and
4. Information on the designated constituent entities (if applicable): Identity of the designated constituent entity for the purpose of filing the IR or for the allocation and payment of the top-up tax for UTPR and/or QDMTT purposes.

The registration would have to be completed within 15 months after the end of the first reporting year, although a grace period would apply for the transition year (further discussed below).

Any change in the information provided during the registration process would also have to be reported to the tax authorities within 15 months following the end of the fiscal year during which the change occurred.

Similarly, the Luxembourg constituent entity would have to deregister within 15 months following the last day of the fiscal year (i) in which the MNE group or DG no longer falls within the scope of the draft rules, or (ii) during which the constituent entity ceases to be part of the MNE group or DG.

Failure to (i) register, (ii) notify the tax authorities of any changes to the information provided upon registration, or (iii) deregister within the required timeframe could result in a penalty of EUR 5,000 per constituent entity. The same penalty could apply when providing incomplete or incorrect information. Fines would be determined by the tax office in charge of withholding tax on interest.

The draft stipulates that additional details on the registration form and procedures will be outlined in a forthcoming Grand Ducal decree.

Step 2: Information return (IR) and related notification

According to the draft, every Luxembourg constituent entity would be required to file an IR with the Luxembourg tax authorities, unless one of the two following exemptions applies:

• The IR is submitted by a Luxembourg constituent entity of the MNE group or DG that has been appointed by the other Luxembourg constituent entities (“designated Luxembourg entity”); or
• The IR is submitted by the UPE or by a foreign constituent entity of the MNE group that has been appointed by the MNE group (“designated foreign entity”) provided that it is situated in a jurisdiction with which Luxembourg has an agreement for the automatic exchange of IR information and that is included in the list to be published in a Grand Ducal decree.

In case the second exemption applies, the Luxembourg constituent entity, or designated Luxembourg entity acting in the name of the Luxembourg constituent entity, would have to notify the Luxembourg tax authorities about the entity filing the IR and the jurisdiction in which it is located.

The IR would have to be completed following a standard template that would include the following information:

• Identification of the constituent entities, i.e., their fiscal number (if applicable), the jurisdiction in which they are located, and their classification in the context of the Pillar Two rules;
• Information on the overall corporate structure of the MNE group, including, in particular, the ownership interests in the constituent entities held by other constituent entities;
• Information necessary for i) the computation of the jurisdictional effective tax rate (ETR) and the top-up tax for each constituent entity, ii) the top-up tax applicable to joint ventures, and iii) the allocation of the top-up tax to each country under the IIR and UTPR; and
• A record of the elections made in accordance with the relevant rules of the draft. 

The computation of the ETR, the computation of the top-up tax, and its allocation under the IIR and UTPR, together with the list of options available for the computation of qualifying income or loss were addressed in more detail, respectively, in our phase two and phase three articles.

In derogation to the filing of the above IR, where a constituent entity is located in an EU member state while the UPE is situated in a non-EU jurisdiction that applies rules considered equivalent to a qualified IIR, the Luxembourg constituent entity or the designated Luxembourg constituent entity would have to file a separate IR that includes all the information needed for the application of:

• The IIR at the level of the partially-owned parent entity (POPE);
• The UTPR in respect of the UPE when the UPE is situated either (i) in a non-EU jurisdiction that is considered low-taxed and that does not apply a qualified IIR, or (ii) in an EU jurisdiction opting to delay implementation of the Pillar Two rules; or
• The Luxembourg domestic top-up tax or the QDMTT applied by any other member state that opted to introduce such method of taxation.
  

Both the IRs and related notifications, as applicable, would have to be filed within 15 months after the end of the reporting fiscal year.

Failure to make a complete and exact filing in a timely manner could result in a penalty of:

• EUR 5,000 per Luxembourg constituent entity for notifications; and
• Up to EUR 250,000 for IRs.

The fines would be determined by the tax office in charge of withholding tax on interest.

The statutory period of limitation would be 10 years as from the end of the relevant fiscal year.

The draft stipulates that additional details on the IR form and procedures will be outlined in a forthcoming Grand Ducal decree.

When the filed IR contains information in relation to a jurisdiction i) with which Luxembourg has concluded an eligible agreement for the exchange of IR information, and ii) that is listed in the forthcoming Grand Ducal decree, the Luxembourg tax authorities would communicate the relevant IR via the automatic exchange of information.

Step 3: Top-up tax return

To correctly identify the entities required to file a top-up tax return, the initial step would involve identifying the entity(ies) responsible for remitting the top-up tax (i.e., the paying entity).

Identification of the paying entity

The top-up tax amount of low-tax constituent entities (LTCEs) would be allocated according to the three new taxes created under the draft, i.e., the QDMTT, the tax related to IIR, and the tax related to UTPR. Once this allocation is performed, a further allocation could be necessary to identify the entity or entities liable to pay the amount due under the QDMTT and UTPR.

When an amount of QDMTT is due in Luxembourg, it would be payable either (i) by a Luxembourg designated entity, or (ii) by each Luxembourg constituent entity based on the ratio of each entity’s qualifying income to the total amount of positive qualifying income of all such entities reported in the fiscal year.

No specific rule is provided in relation to the payment of the IIR since only the parent entity to which it is allocated would be liable to pay it.

When the UTPR top-up tax has been allocated to Luxembourg, the amount would be paid either (i) by a Luxembourg designated entity, or (ii) proportionally by the Luxembourg constituent entities using a substance-based formula, i.e., the ratio of each entity’s number of employees and net book value of tangible assets to the total number of employees and net book value of tangible assets of all such entities.

The draft clarifies that each Luxembourg constituent entity in the group would be jointly and severally liable for the IIR, UTPR, and QDMTT.

Top-up tax return obligations

While the rules on the IR and the notifications are in line with the rules of the Pillar Two directive, the draft provides for an additional filing requirement.

A designated return would have to be filed, when needed, in relation to the declaration of the top-up tax (top-up tax return). The entities to which the tax related to the IIR, UTPR, and QDMTT is allocated would have to file a return indicating the amount due in respect of such taxes.

The return would have to be filed annually with the Luxembourg tax authorities (at the Diekirch tax office ) within 15 months after the last day of the relevant fiscal year. The payment of the top-up tax would be due within one month after the filing of the return. A Grand Ducal decree will be issued explaining the practical modalities of this return.

In case of failure to file or the filing of an incorrect top-up tax return, a tax assessment could be issued by the Luxembourg tax authorities. This assessment could encompass the top-up tax arising in relation to an LTCE in Luxembourg or abroad. The payment of the additional top-up tax arising from the tax authorities’ assessment would be due within one month as from the issuance of the tax assessment.

Interest would be imposed for the late payment of top-up tax based on the same rules included in the Income Tax Law. However, if the Luxembourg QDMTT top-up tax for an MNE group (DGs being excluded from this provision) remains unpaid for a period exceeding four fiscal years as from the year in which it was due, the outstanding amount would not be collected by Luxembourg. Symmetrically, the rules would add to jurisdictional top-up tax the amount of foreign QDMTT which is not levied within the same required timeframe. Also in this case, the additional amount would be subject to IIR or UTPR and potentially attributable to Luxembourg according to the rules.

To claim a refund for any top-up tax paid in excess of the actual liability, a request would have to be filed with the Diekirch tax office by the end of the calendar year following the year in which the top-up tax was paid.

More generally, the draft states that, in absence of a contrary provision, the General Tax Law dated 22 May 1931, the Adaptation Law dated 16 October 1934, and any other general law for the recovery of taxes would remain applicable.

Other clarifications

Additional top-up tax

The additional top-up tax plays a role in the computation of the jurisdictional top-up tax:

According to the draft, an additional top-up tax could be triggered in certain scenarios.

In a first scenario, an additional top-up tax could arise in relation to a previous year recalculation. Generally, any additional top-up tax triggered by the recalculation of the ETR and top-up tax of a previous year would be added to the top-up tax of the year during which the recalculation is made.

In a second scenario, an additional top-up tax could arise in relation to “excessive” tax losses. This would happen when a tax loss determined under the Luxembourg tax rules is higher than the tax loss computed under the Pillar Two rules (i.e., by multiplying the qualifying loss by the 15% minimum tax rate). This situation could arise, for example, when permanent differences exist between the qualifying income or loss computation and the specific features of a jurisdiction’s tax rules (e.g., enhanced tax deduction for certain expenses). As a result, unless a qualifying loss election applies, the rule effectively would impose a current additional top-up tax equal to the portion of the loss carryforward deferred tax asset (DTA) attributable to the permanent difference. According to a jurisdictional qualifying loss election, for each fiscal year in which there is a net qualifying loss, a qualifying loss DTA would be determined by multiplying the net qualifying loss by the 15% minimum tax rate.

The draft does not specifically include the optional mechanism called “carry forward of excess negative tax expense” foreseen in the OCED administrative guidelines issued in February 2023. Such an election would allow a constituent entity that would otherwise be liable for an additional top-up tax under the second scenario above to exclude the negative tax expense associated with the permanent difference from its aggregate adjusted covered taxes computed for the fiscal year and establish a carryforward mechanism for such amount. The carryforward amount then would have to be used in the subsequent computations of the jurisdictional ETR.

It remains uncertain at this stage if such mechanism would apply in Luxembourg.

Transitional rules

The draft includes a number of provisions that would specifically apply during the transition year, i.e., the first year of application of the Pillar Two rules. In case of application of a transitional safe harbor (TSH), the transitional rules would be applicable as from the first fiscal year after the TSH no longer applies to a jurisdiction.

The transitional rules notably would allow taxpayers to take into account DTAs and deferred tax liabilities (DTLs) existing on the first day of the transition year as booked or referred to in the financial statements. DTAs would have to be taken into account regardless of any valuation allowance or non-recognition. DTAs and DTLs would have to be recast at the lower of the minimum tax rate of 15% or the national tax rate. Therefore, for Luxembourg, DTAs and DTLs generally would be recast at 15%.

The transitional rules also include the following provisions:

• DTAs that arise from excluded items for the qualifying income or loss calculation would be excluded when they are generated from a transaction that occurred after 30 November 2021;
• Transfers of assets, other than stock, between constituent entities after 30 November 2021 and before the start of the transition year would have to be performed at book value based on the accounts of the disposing entity so that the tax bases of these assets equal their book bases, and the related DTAs and DTLs would have to be computed on these bases. If the final legislation takes into consideration the administrative guidance released by the OECD in February 2023, this would potentially include the exception to this provision according to which the value at the level of the acquiring entity could be higher if the assets have been taxed at the level of the disposing entity;
• The 5% to be applied in the calculation of the substance-based income exclusion would be replaced by higher percentages, starting at 10% for payroll carve-out and 8% for tangible asset carve-out for fiscal years beginning on or after 31 December 2023, and decreasing in the subsequent 10 years until they reach the general 5% rate again; and
• All filings that are due within 15 months after the last day of the relevant fiscal year would be due 18 months after the last day of the transition year.

Conclusion

Although the draft is only expected to be final by the end of 2023 and clarification of the wording provided in the Pillar Two directive and the OECD guidance may still be provided in response to feedback from diverse public and private stakeholders, it is imperative that any group falling within the scope of Pillar Two has a good understanding of the administrative compliance obligations to mitigate the risk of incurring penalties.

Should you have any questions or need assistance in this respect, you may contact our tax professionals.