The landscape of international taxation is facing a significant transformation with the ongoing implementation of Pillar One and Pillar Two, collectively known as the Global Anti-Base Erosion (GloBE) rules. 

Implemented by the Organization for Economic Cooperation and Development (OECD), Pillar One seeks to expand a country's authority to tax profits from companies that conduct sales within their borders but lack a physical presence, and Pillar Two addresses the broader tax challenges stemming from the digitalization of the global economy.

Often perceived as relevant primarily to multinational enterprises (MNEs), Pillar Two may have far-reaching implications for institutional investors as well, particularly those in the asset management industry.

Understanding Pillar Two and GloBE Rules

Established in December 2021 and effective as of January 2024, Pillar Two seeks to ensure that MNE groups pay a minimum effective tax rate of 15% in each jurisdiction where they operate. The rules apply to MNE groups with annual revenue of €750 million or more and are designed to prevent profit shifting and tax avoidance strategies.

The GloBE rules create a leveled playing field by imposing a top-up tax when the effective tax rate falls below the specified threshold. Despite initial assumptions that institutional investors, including investment funds, pension funds, and sovereign wealth funds, are automatically excluded from the scope of Pillar Two, that may not always be the case.

Impact on Investment Funds

Investment funds are typically not required to consolidate their portfolio investments under international financial reporting standards. This is one of the main factors that shield them from the scope of Pillar Two, given that their revenues usually fall below the €750 million threshold. Nonetheless, the application of Pillar Two to investment funds entails nuanced considerations.

For instance, private equity vehicles structured as unincorporated funds may avoid consolidated accounts filing obligations due to their transparent legal structure for tax purposes. However, this exemption hinges on the diversity of investors in the fund. 

In contrast, captive funds may fall under the ambit of GloBE Rules. These funds are specialized private pooled investment funds managed for a specific investor group or in association with a single organization, tailored for the benefit of specific organization members or employees. They are termed "captive" due to restricted investor pools and limited transferability. For entities of this nature, it is imperative to incorporate elements of diversified ownership if they wish to protect themselves from Pillar Two implications.

Moreover, while exemptions exist under Art 1.5 for investment funds acting as the Ultimate Parent Entity (UPE) of an MNE Group, they may not apply if the investment funds are not positioned at the summit of such a structure. Especially when the aforementioned fund consolidates with an entity not classified as an Excluded Entity, the investment fund is likely to be deemed a Constituent Entity, thereby subjecting it to the new taxing rules introduced by Pillar Two. Nevertheless, these Investment Funds would retain their status as Investment Entities, subject to specific rules governing the calculation of the Effective Tax Rate (ETR) under Article 7.4.

Pillar 2 and Pension Funds

Pension funds are subject to specific criteria under Pillar Two. Like Investment Funds, Pension Funds are also generally excluded from the scope of Pillar Two under Art. 1.5. However, this exception is not granted if the Pension fund is owned by another Pension Services Entity as defined under Art 10.1. 

This means that the pension fund would be subject to the rules and requirements of Pillar Two and required to comply with the GloBE Rules, including the calculation of the ETR and the application of the Top-up Tax provisions. Furthermore, the pension fund would need to submit a GloBE Information Return and provide all the necessary information as required by the rules. This additional layer of scrutiny prevents the misuse of structures to inappropriately claim Excluded Entity status under Pillar Two.

The emphasis is on ensuring that the exclusion is only granted to genuine entities directly involved in the functions of providing retirement benefits and ancillary or incidental benefits to individuals and not to entities established solely to circumvent the rules.

Scrutiny on Insurance Companies

Insurance companies, unlike pension and investment funds, are not specifically exempted under the Pillar Two GloBE Rules. Insurance Investment Entities receive special treatment under the GloBE Rules of Pillar Two. According to Article 10.1 of the Model Rules, an insurance investment entity is defined as an entity that meets the criteria for being an investment fund or real estate investment vehicle, except for being fully owned by an insurance company and established concerning liabilities under one or more insurance or annuity contracts. A single entity or multiple entities may wholly own such entities within the same MNE Group, but their owner(s) must be regulated as insurance companies in their respective jurisdictions.

Key Considerations for Sovereign Wealth Funds

Sovereign Wealth Funds that fit the criteria of a Governmental Entity (specified in Article 10.1 of the Pillar Two Model Rules) will not be classified as a UPE or part of an MNE Group for the Pillar Two rules. This clarification is intended to guarantee that, for most SWFs, the application of Pillar Two rules would only be relevant at the level of the portfolio company, assuming that the SWF can prove it meets the requirements as a Governmental Entity.

SWFs cannot be classified as Ultimate Parent Entities according to the Pillar Two rules. However, there is still a potential issue with designating a holding company of a SWF as a UPE within the scope of Pillar Two. This raises concerns because the Pillar Two rules establish the parameters of an MNE Group based on entities owned by a UPE.

If these rules are applied at the level of a holding entity rather than at the level of individual operating companies overseen by such an entity, there is an increased risk that the overall group may exceed the EUR 750 million consolidated revenue threshold. In cases where a SWF chooses to have its portfolio managed and overseen in such a manner, especially by a holding company that is not resident in the same jurisdiction, this holding company could be considered a UPE under the Pillar Two rules. As a result, it would be required to prepare Consolidated Financial Statements to assess whether the consolidated revenue exceeds the threshold.

Reporting Challenges and Uncertainties

Institutional investors face challenges in determining whether they fall within the scope of Pillar Two. Reporting obligations vary across jurisdictions, adding complexity to compliance. Questions arise about whether Excluded Entities must report their status, and uncertainties persist due to revenue proximity to the €750 million limit and discretion allowed at the national level.

Pillar Two's impact extends beyond MNEs, significantly influencing institutional investors in the asset management industry. A thorough understanding of the rules and potential restructuring is necessary to navigate the evolving landscape of international taxation for these investors. As global tax regulations continue to evolve, institutional investors must remain vigilant to ensure compliance and mitigate potential risks associated with Pillar Two.