Subject to Tax Rule - An Analysis

1. Introduction & The Pillar Two Architecture

Large Multinational Enterprises (‘MNEs’) take advantage of various aggressive tax planning strategies in a way that developing countries lose out on their fair share of taxes. To address the concern of developing countries and to ensure that MNEs pay a minimum level of tax on the income arising in each jurisdiction in which they operate, the OECD proposed the introduction of Global Anti–Base Erosion Rules (‘GloBE Rules’).

The Pillar Two framework comprises two interlocking domestic rules and a treaty-based rule:

• Income Inclusion Rule (‘IIR’): Under IIR, the country of the ultimate parent entity collects top-up tax if overseas group entities are not adequately taxed (below 15%).
• Under-Taxed Profits Rule / Under Tax Payment Rule (‘UTPR’): IIR further works with UTPR, wherein deductions for related-party payments are denied if the country of the ultimate parent entity does not collect top-up tax under IIR.
• Subject to Tax Rule (‘STTR’): A treaty-based rule where the payer jurisdiction collects top-up withholding tax if the recipient country does not tax the income adequately.

Thereby, the rules are interlocking and interrelated. The Pillar 2 mechanism is designed to ensure that an MNE pays a minimum level of tax on the income arising in each of the jurisdictions in which they operate. This article focuses on STTR, which specifically targets risk exposure to source jurisdictions posed by BEPS structures that take advantage of low nominal rates of taxation in the other contracting jurisdiction (that is, the jurisdiction of the payee).

2. Subject to Tax Rules – An Understanding

STTR is one of the key components of the GloBE Rules. It is a model treaty provision that allows jurisdictions to impose additional tax on certain defined cross-border payments between connected persons, where the recipient is subject to a nominal corporate income tax rate below 9% in its jurisdiction.

STTR covers specific intra-group service payments whereby the payor jurisdiction can impose additional tax on the gross amount of Covered Income up to 9% of the income. Hence, STTR would not apply if the source country can already sufficiently tax this payment (over and above 9%) under the normal allocation rules of the Tax Treaty or domestic law.

3. Coverage: Connected Persons & Covered Income

Connected Persons

STTR covers payments between Connected Persons. Two persons are considered connected if one is directly or indirectly controlled by another, or both are under the control of the same person through legal or beneficial ownership of more than 50%, or based on facts and circumstances. Further, an additional measure—the Targeted Anti-Avoidance Rule (TAAR)—has also been introduced to prevent abuse on account of routing covered payments through the interposition of an unconnected intermediary.

Covered Income

STTR is applicable only on specified items of covered income. Seven categories of income that constitute “covered income” are mentioned in the rules:

1. Interest;
2. Royalties;
3. Payments for distribution rights for a product or service;
4. Insurance or reinsurance premiums;
5. Payments of guarantee or financing fees;
6. Rental payments for industrial, commercial, or scientific equipment; and
7. Payments for services.

Having said that, STTR only applies when the taxing right of the source state is limited under Article 7 (Business Profits), Article 11 (Interest), Article 12 (Royalties), and Article 21 (Other Income). Article 8 (International shipping and air transport income) is not within the scope of the STTR.

Provisions of Article 7, instead of STTR, would apply where the covered income is effectively connected with or attributable to a Permanent Establishment (PE) in the source state via which the payee carries on business in that state.

4. Statutory Exclusions & Materiality Thresholds

Pertinent to note that there are several exclusions based on recipient, amount, and materiality thresholds:

• Recipient Exclusions: STTR will not apply where the recipient is an individual, a non-profit organization, a State, or part of a State, an international organization, an investment fund that meets certain conditions (including pension funds), or an entity wholly, or almost wholly, owned by an excluded recipient.
• Mark-Up Threshold: STTR only applies to Covered Income (other than interest and royalties) where the amount of Covered Income exceeds the costs incurred in earning that income plus a mark-up of 8.5%. The mark-up threshold does not apply where the targeted anti-avoidance rule under the STTR applies to the covered income.
• Materiality Threshold: STTR only applies if the aggregate sum of Covered Income paid in a fiscal year exceeds EUR 1 million (or EUR 250,000 for jurisdictions with GDP below EUR 40 billion).

The MLI adopted by the IF on BEPS in September 2023 will facilitate the implementation of Pillar-2 STTR in existing bilateral tax treaties. As a result, the STTR MLI will introduce the STTR into all “Covered payments” without the need for bilateral amendments.

5. How to Compute STTR Tax Liability?

STTR is designed in a way to expand the taxing rights of the source state where the residence state exercises its taxing rights at a rate below 9%, and will apply with or without Treaty application. As such, the STTR is calculated as the gross amount of covered income multiplied by the ‘specified rate’.

Applicable tax rate in the residence state is either the statutory corporate tax rate or the reduced statutory rate (if the covered income or the recipient is subject to a special reduced rate) subject to any preferential adjustment. In cases where the Treaty Withholding rate is higher than the domestic Withholding rate, STTR does not call for a comparison between the two rates and accordingly, the specified rate shall be reduced by the WHT rate provided in the relevant Treaty, even though higher than the domestic withholding rate.

Computation Examples

Example 1: If the tax rate on income of EUR 1,000,000 was 5% in the residence state, the source state could levy tax up to 4% (9% − 5%) of EUR 1m, i.e., EUR 40,000. Note that the source state isn’t required to tax this full amount, but it cannot exceed it.

Example 2: Taking it further, if the payor jurisdiction can impose a 5% withholding tax on a payment of Covered income and the recipient is subject to a 2% nominal tax rate, the payor jurisdiction retains a 5% withholding right but can impose an additional tax under STTR equal to 2% of the Covered income amount (9% − 5% − 2%).

6. Key Takeaways on STTR Provisions

7. Way Forward

STTR is an important part of the BEPS Pillar Two Project providing taxing rights to source countries, mostly developing countries. However, such benefits to developing countries come with the cost of complexity of tax treaties for taxpayers and tax authorities. Now, there is a need for MNEs to analyze all direct and indirect intra-group cross-border payments, as some that were earlier subject to exclusive residence taxation (e.g., services) will now be covered under both residence and source taxation.

Also, Pillar Two is going ahead with ambitious timelines. Companies should immediately start evaluating their international operating structures, especially in low-tax jurisdictions wherein the tax rate on income received is expected to be less than 9%.