Edition

Introduction to Pillars One and Two for Insurers

By Matthew Lodes, Julie Goosman, Surjya Mitra, and Peter Sproul

TAXING TIMES, October 2022

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The OECD/G20 Inclusive Framework (IF) on Base Erosion and Profit Shifting (BEPS) sets forth a two-pillar approach to taxation that broadly impacts large multinational enterprises (MNEs), including many insurance companies that operate in multiple jurisdictions. The proposed two-pillar approach of the Global Anti-Base Erosion (GloBE) rules, which could be adopted by some IF member countries as early as 2024, would be an incremental tax regime with which insurers would need to comply.

One major feature of the two-pillar regime is that MNEs would base the calculation of taxes due on book-based financial statements. A summary of how these rules operate follows, along with suggested actions insurers can take today to prepare for timely compliance.

High-level Impact

The two-pillar tax regime addresses different issues.

Pillar One addresses the allocation of taxing rights between jurisdictions. It is intended to address the digitization of the economy and to prevent countries from unilaterally enacting digital services taxes to take a disproportionate  share of corporate taxes based on customers in their country. Pillar One’s new taxing right, as currently proposed, does not apply to regulated financial services, including insurance and reinsurance MNEs and asset management businesses, and therefore would not be a significant concern for insurers. Accordingly, the rest of this article focuses on Pillar Two.

Pillar Two addresses the issue of global tax competition (the so-called “race to the bottom”) and the use of low-tax jurisdictions by MNEs. It is intended to ensure that MNEs pay a minimum level of tax on profits earned in every country. These rules, which continue to develop, could be implemented by some IF member countries as early as 2024.

Pillar Two could have a significant impact on insurance MNEs. These businesses operate through subsidiaries and branches in various foreign jurisdictions, each of which already may have domestic tax rules that follow the general OECD framework, but with certain permitted differences. Therefore, the IF two-pillar regime often could operate as an incremental tax regime.

The base for the Pillar Two calculation stems from the consolidated financial statements of the ultimate parent entity (UPE). However, adjustments would need to be made to determine the Pillar Two taxable income base. Intercompany transactions, such as reinsurance, M&A activity, intra-group financing and capital support, and the provision of services that are routine for the MNEs, would complicate the application of Pillar Two.

Summary of Pillar Two Provisions

Under Pillar Two, the IF members (including the United States) agreed to enact a jurisdictional-level minimum tax system with a minimum effective tax rate (GloBE ETR) of 15 percent. Companies with global revenues above EUR 750m are within the scope of Pillar Two. In addition, IF members retain the option to apply these rules to smaller, domestic MNEs.

Pillar Two primarily operates through two rules: (1) the Income Inclusion Rule (IIR) and (2) the Undertaxed Payments Rule (UTPR). The IIR imposes a “top-up” tax on a parent entity with respect to the low-taxed income of a constituent entity (i.e., income that has not been subject to an effective minimum tax of at least 15 percent). The UTPR would apply when the IIR has not resulted in a top-up tax, such as when the owner of a low-taxed entity is a resident of a jurisdiction that has not adopted Pillar Two. The IRR and the UTPR are intended, in combination, to ensure that the income of low-taxed entities of an MNE are subject to a minimum ETR of at least 15 percent. This result also would apply to the entities in the jurisdiction of the UPE. The rules generally would apply on a separate-company basis for included entities (i.e., constituent entities). The rules would have the status of a common approach, not of a minimum standard.

For example, if there is 100X of book-based profits earned in a corporation that is domiciled in a country with zero tax, and that corporation is owned by a parent in a country that implements the IIR, 15X of tax would need to be paid to that parent-company jurisdiction under Pillar Two.

The IIR and UTPR are to be bolstered by a Subject to Tax Rule (STTR). The STTR would apply to royalties, interest, and other defined payments made to a constituent member of an IF member state that applies a nominal corporate tax rate lower than a minimum STTR rate of between 7.5 percent and 9 percent. The additional tax payable would be limited to the difference between the STTR minimum rate and the tax rate that otherwise would apply to the payment. The STTR is intended to help developing countries by allowing them to turn off tax treaty relief and collect additional withholding taxes on payments to low-taxed affiliates.

The Pillar Two rules also provide for the possibility that a country adopts a qualified domestic minimum top-up tax (QDMTT). To the extent a country adopts a domestic minimum tax that is considered a QDMTT, it would take precedence and reduce any top-up tax under the Pillar Two rules. Stated differently, this would allow a country to collect any minimum taxes first and prevent other countries from charging top-up taxes on any low-taxed profits of that country.

Pillar Two Calculation Considerations

Compliance with Pillar Two potentially would require a determination of consolidated financial statement income and ETR by country under a new set of common global tax rules. Although intended to leverage existing information used in preparing consolidated financial statements, Pillar Two may require significant development of systems and investment of resources so that companies can gather data and make appropriate adjustments at a separate-entity level (e.g., to reflect certain affiliated transactions on a standalone basis and to allocate consolidated financial statement income and related taxes between entities and their branches).

Steps in Calculation

The starting point for the Pillar Two ETR calculation is the MNE’s consolidated financial statements, typically prepared under US GAAP or IFRS. The MNE then must determine the net income included in those financial statements for each constituent entity on a per-country, stand-alone basis. The rules do not simply use the US GAAP or IFRS ETR for each country. Instead, the net income and taxes from the financial statements are adjusted to calculate a GloBE ETR for each country in which the MNE earns income.

If the GloBE ETR for any country is below the 15 percent minimum tax rate, the MNE will be charged a top-up tax on profits in excess of a routine return based on certain tangible assets (e.g., property, plant, and equipment) and payroll. There also can be a top-up tax when there is an adjusted loss for the year with a tax benefit in excess of the 15 percent minimum rate.

The GloBE ETR calculation consists of “covered taxes” (including taxes resulting from the STTR) divided by adjusted profits and losses derived from the consolidated financial statements. The measure of accounting profit is subject to certain adjustments intended to address, for example, common permanent and temporary differences between taxable and accounting profits. Likewise, covered taxes are subject to several adjustments, including deferred taxes (capped at a 15 percent rate) and amounts excluded from accounting profits. GloBE elections also would be available, such as an election to consolidate the adjusted profits and losses of entities that file a consolidated tax return and an election to use realized gains and losses instead of fair value gains and losses.

Observations on Calculation

Although the U.S. federal tax rate for corporations at 21 percent is higher than the 15 percent minimum rate, a combination of favorable permanent book-tax differences (e.g., tax-exempt income) and the cap on the amount of deferred taxes for timing differences could result in a GloBE ETR lower than 15 percent and a top-up tax for U.S. companies. There also is uncertainty regarding how some non-refundable tax credits (e.g., low-income housing tax credits) should be treated in this context.

To the extent a country has tax rules that are “compliant” with the two-pillar tax regime, they supplant the need to apply the Pillar Two provisions to companies subject to the Pillar Two GloBE framework and the in-country compliant tax regime. This creates another area of potential difficulty in applying these rules because an MNC operating in 10 jurisdictions might have 10 different interpretations and applications of the Pillar Two rules that would need to be followed.

For U.S. MNEs, the picture is unclear because current U.S. tax law presumably would not be deemed compliant with the Pillar Two model rules. Certain changes intended to align U.S. international tax rules with the OECD common approach were proposed as part of the “Build Back Better” reconciliation bill considered by the House. However, on Aug. 16, 2022, the “Inflation Reduction Act” reconciliation bill (the Act) became law. This new legislation is a scaled-back version of the House-passed Build Back Better reconciliation bill and does not contain any of the provisions that were proposed to align with the OECD rules. Although the Act includes a 15 percent book income alternative minimum tax on corporations with adjusted financial statement income over $1 billion (effective for tax years beginning after Dec, 31, 2022), that tax is not expected to be a QDMTT.

Meanwhile, the EU has yet to adopt the Pillar Two rules, while the U.K. recently became the first country to release draft legislation (with a request for public consultation responses by Sept. 14, 2022). If enacted, the U.K. legislation would adopt the IIR rule for accounting periods beginning on or after Dec. 31, 2023, which would impact U.S. insurance companies that are members of U.K.-parented groups (including groups with U.S. subsidiaries of U.K. intermediate holding companies).

Differences in Taxable Base Amounts

As discussed above, calculating the GloBE ETR for each country requires making certain adjustments to financial statement income to arrive at the adjusted accounting profits or losses (GloBE income) and adjusted covered taxes. The following are some of the differences in taxable base amounts that may be applicable to insurers:

  • Income tax expenses from the financial statements generally are excluded from GloBE income, with prescribed rules as to what tax expenses are considered covered taxes, and to which country they are allocated for Pillar Two purposes. For insurers, certain tax expenses may need special consideration as to whether they are includible as a covered tax (e.g., taxes paid in lieu of income taxes that may be covered taxes, like certain state premium taxes, and federal excise taxes on reinsurance premiums).
  • Dividend income generally is excluded from GloBE income, and any related tax expense is excluded from adjusted covered taxes. Dividend income earned through separate accounts would require special consideration for insurers. Observation: This provision generally should be helpful to insurers in preventing the dividends-received deduction from causing or increasing a top-up tax.
  • Gains and losses on equity investments generally are excluded from GloBE income, and any related tax expense is excluded from covered taxes. The Pillar Two rules do not seek to impose a top-up tax on an MNE’s share of income, gains, and losses from equity-method investments, although special rules do apply for joint-ventures. This could be significant for insurers, especially those that invest in limited partnerships accounted for under US GAAP or IFRS using the equity method. This rule also would be important to insurers as it relates to certain low-income housing, renewable energy, and other tax-credit investments, the credits from which could otherwise be treated as a reduction in covered taxes and GloBE ETR. This issue has received a fair amount of attention, and Treasury officials have made public comments indicating that Treasury may exclude tax-equity investments from the top-up tax under this proposed rule. However, some uncertainty remains, and this may be an area where additional clarification and guidance is needed.
  • To address the impact of timing differences between financial statement income and local taxable income, the Pillar Two rules allow for deferred tax expense to be included in covered taxes. However, when deferred tax expense is recorded at a local tax rate higher than the 15 percent minimum rate, the rules would require the deferred tax expense to be “recast” at the 15 percent minimum rate. Observation: Although helpful, this is a key rule that, in combination with other permanent tax differences, could result in a GloBE ETR below 15 percent, even though the US GAAP or IFRS ETR is above 15 percent. For insurers, especially those with cyclical or volatile earnings, there is a particular concern regarding loss years. If the total adjusted tax benefit on the loss is more than 15 percent, a top-up tax would result in the loss year, with the potential for additional top-up taxes as net operating losses (NOLs) are used in later years.
  • Tax credits that are non-refundable generally are treated as a reduction to covered taxes in the year they are used on a tax return (except for equity-method investments, as described above), with no deferred tax adjustment for tax-credit carryovers. Observation: This would be particularly important for U.S. insurers with cyclical or volatile earnings that build up significant tax-credit carryforwards. U.S. tax rules generally allow a 20-year carryforward for general business credits. In the year the credits are used, any reduction in covered taxes could cause the GloBE ETR to go below 15 percent and effectively result in a top-up tax to repay some or all of the tax credits used.
  • Generally, only deferred tax expense for timing differences that reverse over a five-year horizon are included in adjusted covered taxes. Certain insurance company exemptions exist in the Pillar Two model rules and commentary for deferred tax liabilities (DTLs) related to insurance reserves, deferred acquisitions costs (DAC), and the value of businesses acquired (as a subset of DAC). Observation: Other DTLs may exist that could reverse after five years and result in adjustments to decrease covered taxes and the GloBE ETR.
  • Fair value adjustments flowing through the income statement and purchase accounting adjustments are subject to complex rules with respect to the treatment of Pillar Two taxable income.
  • Intercompany transactions generally are eliminated in the consolidated financial statement. Observation: Some jurisdictions have financial statement regimes that either do not provide for consolidation of legal entities or do not provide for consolidation of all legal entities.
  • The impacts of IFRS 17 (Insurance Contracts) and Long-Duration Targeted Improvements (LDTI) on financial statement income and taxes would need to be considered, with the potential for any additional volatility in earnings impacting the calculation of top-up taxes under the Pillar Two rules. (IFRS 17 and LDTI are both newer accounting standards that require the use of current estimates of insurance liabilities on the balance sheet.)

What Should Companies Consider Doing to Prepare and Comply?

The timeline for implementation is unclear, although U.S. companies and branches of U.K.-parented groups, or those with intermediate U.K. holding companies, should consider their readiness in light of the proposed Jan. 1, 2024 implementation date for the U.K. IIR.

The basic calculation of the GloBE ETR conceptually is fairly straightforward. However, the granular data needed to calculate adjusted consolidated financial statement income and taxes on a per-entity, stand-alone basis would be a major exercise, with significant impacts on the end-to-end operations of the tax function. To comply, insurance companies will need to manage uncertainty regarding exactly how and when the rules will be implemented in the local countries in which they earn income. Companies also will need to accumulate the requisite data to forecast and model in the interim under different scenarios, as well as the entity-level data to meet reporting and compliance requirements upon implementation.

Pillar Two rules could have wide-reaching impacts for insurance companies. Many organizations may face a gap in the resources needed to prepare for, and address, dependencies and requirements across multiple operational areas (e.g., people, process, technology, and data), while maintaining connectivity and alignment with their strategic priorities (e.g., policy and legislation, impact analysis, and planning). This could include consideration of new global minimum tax rules in valuations, pricing models, and projections of future cash flows and distributable earnings. Tax functions will need to work closely with actuarial, financial planning and analysis, government affairs, and other departments within the organization, as adoptions of global minimum tax rules develop over the coming months and years.

To prepare for the Pillar Two rules, insurance companies may want to start by gathering the requisite data and modeling the potential impacts to identify critical gaps in data and systems. As more information becomes available and draft legislation is proposed, this may become an iterative process.

Creating a high-level roadmap also may be a worthwhile exercise. This may require working backward from potential implementation dates and assessing what resources and efforts may be needed to model and ultimately implement the rules. In particular, insurance companies may want to analyze what adjustments and issues matter most to them as countries go through their legislative and consultative processes to implement the rules.

Conclusion

The Pillar Two rules could result in a major change in the taxation of global insurance groups under a new common set of global rules, together with new tax compliance and reporting requirements. Companies that currently pay taxes at a level above the 15 percent minimum rate may be surprised once they model out the rules and take into account the adjustments highlighted above. With that said, significant uncertainty remains as to whether and when the rules may be enacted into local tax legislation. Lastly, it should be noted that the Pillar Two model rules and draft U.K. legislation both contemplate the possibility of adopting simplifying safe harbors. Safe harbors could exempt high-tax countries that adopt the Pillar Two rules into their domestic tax law and reduce the overall compliance burden for MNEs.

The views expressed herein are solely those of the authors and do not necessarily reflect those of PwC, the Society of Actuaries or the editors. All errors and views are those of the authors and should not be ascribed to PwC or any other person.

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

Matthew Lodes is PwC’s US Insurance Tax Leader. He may be reached at matthew.j.lodes@pwc.com.

Julie Goosman is PwC’s Global Insurance Tax Leader. She may be reached at julie.v.goosman@pwc.com.

Peter Sproul is an insurance tax partner with PwC. He may be reached at
peter.j.sproul@pwc.com.

Surjya Mitra is an insurance managing director with PwC. He may be reached at surjya.mitra@pwc.com.