On 3 October 2023, the OECD published the multilateral convention (“MLC”) to facilitate the implementation of the Pillar Two Subject to Tax Rule (“STTR”) together with an explanatory statement.
The STTR is part of Pillar Two together with the GloBE Rules (i.e., Income Inclusion Rule and Undertaxed Profits Rule) and designed as a treaty-based rule providing for a partial and conditional reallocation of taxing rights to the source country on certain intra-group payments. The STTR would apply before the GloBE Rules and tax levied under the STTR is creditable when computing the effective tax rate under these rules.
The STTR was developed to take into consideration priorities of developing countries part of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (“IF”). IF members applying a nominal corporate tax rate below 9% to certain payments committed to implement this rule when requested to do so by a developing IF member (otherwise countries are free to request implementation of the STTR).
Per the IF agreement, a jurisdiction is considered as developing when its gross national income per capita, calculated using the World Bank Atlas method, is of USD 12,535 or less in any of 2019, 2020, 2021 or 2022. In October 2023, the OECD stated that more than 70 IF members should be considered as developing countries.
The STTR is relevant regarding intra-group payments of targeted income (e.g., interest, royalties) which are subject in the hands of the recipient to a tax rate below 9% taking into account any applicable preferential regime.
Multilateral Convention
The MLC is intended to simplify the process of STTR integration within double tax treaties (“DTT”) currently in force although amendments through bilateral negotiations remains possible. IF members choosing to sign the MLC will need to notify which DTTs are to be considered as covered tax agreements (“CTAs”). The MLC will act as a protocol to the DTT by adding the relevant annex to the treaty without amending the text of the DTT. In addition, the instrument does not provide for the possibility of contracting States to have reservations.
Annexes to the MLC are composed of mandatory Annex I which includes the STTR mechanism, Annex II is applicable in case a contracting State computes taxes on covered income other than on a net income basis, and, Annex III is applicable in case a contracting State levies tax on covered income only upon distribution. Contracting States can opt to include Annex IV to apply a specific definition of recognized pension fund for the purpose of the STTR and Annex V providing a “circuit breaker provision” allowing automatic suspension or application of the STTR based on the classification of contracting States as high-income economy (as defined in the MLC).
Conditions for the STTR application
Payments within the scope of the STTR (“Covered Income”) include (i) interest, (ii) royalties, (iii) payments for the use or right to use distribution rights in respect of a product or service, (iv) insurance and reinsurance premiums, (v) fees to provide a financial guarantee, or other financing fees, (vi) rent or any other payment for the use of, or the right to use, industrial, commercial or scientific equipment, (vii) any income received in consideration for the provision of services. Specific exclusions are applicable to shipping activities.
To ensure the STTR application remains targeted, it is enclosed within two limitations:
- Mark-up on Covered Income: At the level of the recipient, Covered Income, other than interest and royalties, must exceed the costs incurred in relation with that income plus an 8.5% mark-up on those costs. Specific rules are provided for the determination of the mark-up.
- Materiality threshold: Covered Income paid from the source country to a connected person resident of the other contracting State shall exceed EUR 1 million (lowered to EUR 250,000 per year where one of the contracting jurisdictions has a GDP of less than EUR 40 billion).
The STTR applies to payments between related parties (“Connected Persons”). Entities are considered as Connected Persons where, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same person. Two persons will be considered as Connected Persons where one person holds in another (or a third person holds in two persons) more than 50% of the beneficial interest or aggregate vote and value of the company’s shares or beneficial equity interest in the company.
Certain persons are excluded: The STTR does not apply when the payer of the Covered Income is an individual or the recipient is an individual, a pension fund, a non-profit organization, the other contracting State and governmental entities, international organizations, certain investment vehicles and persons held by an excluded person (under conditions).
Finally, the STTR contains a targeted anti-abuse rule (“TAAR”). Per the OECD, the TAAR mainly targets two situations, the interposition of unconnected persons between two Connected Persons and the routing of Covered Income through a high-taxed connected person. The TAAR would apply where (i) covered income is paid to an intermediary resident of either contracting jurisdiction, (ii) the intermediary makes, within a 365-day period, a tax deductible payment (in case the income was included in its tax base) of an amount equal to the initial payment to a person connected to the original payer, (iii) the ultimate payee is subject on such payment to a tax rate below 9% in its jurisdiction and a statutory rate below 9% in the jurisdiction of the intermediary, and (iv) it is reasonable to conclude that the intermediary would not have made the related payments in the absence of the original payment. The TAAR neutralizes the effects of such interposition whether the intermediary is resident in the source jurisdiction or in the other contracting jurisdiction.
STTR taxation
The source country is allowed to levy additional tax on the gross amount of Covered Income at an adjusted tax rate. The adjusted tax rate is equal to the difference between 9% and the nominal rate applicable in the recipient’s jurisdiction further reduced by the source taxation rate already granted under the DTT.
The nominal rate applicable in the recipient’s jurisdiction is adjusted where a preferential adjustment is applicable. A preferential adjustment is defined as a permanent reduction in the amount of the covered income subject to tax, or the tax payable on that income which takes the form of either an exemption, a deduction from the tax base computed based on income received or a tax credit computed on the basis on the amount of income or related tax (excluding credit for foreign taxes) to the extent that it is directly linked to the item of Covered Income or that arises under a regime that provides a tax preference for income from geographically mobile activities.
In practice, the additional taxation is assessed and payable after the end of the fiscal year in which the taxpayer derives the payments of covered income. The MLC provides that DTT provisions on the elimination of the double taxation shall not affect the effectiveness of the STTR by granting an additional tax credit or exemption.
Entry into force
The MLC is open for signature since 2 October 2023 and will enter into force for a CTA three calendar months after the second instrument of ratification is deposited. The STTR, will come into effect the first day of a fiscal year beginning on or after the expiration of a period of six calendar months from the date the MLC entered into force for the CTA.
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