How the OECD‘s Pillar II impacts Global Transfer Pricing policies
Kris (Kestutis) Rudzika |
January 21, 2025
The OECD’s Pillar II implementation introduces a global minimum tax rate of 15%, targeting multinational enterprises (MNEs) with consolidated revenues exceeding €750 million. While aimed at curbing tax avoidance and profit shifting, Pillar II has profound implications for Transfer Pricing strategies, compelling MNEs to reassess how they allocate income and expenses across jurisdictions.
What is Pillar Two?
In January 2019, the OECD introduced a policy note outlining a two-pillar framework to modernize international tax rules. Pillar One focuses on reallocating profits to ensure MNEs contribute a fair share of taxes in all jurisdictions where they operate, particularly addressing challenges posed by digital business models. Pillar Two tackles broader issues related to Base Erosion and Profit Shifting (BEPS) and establishes a framework for implementing a global minimum tax.
Pillar Two is part of the OECD’s broader BEPS initiative, which seeks to address inequities in global taxation. The key mechanisms of Pillar Two include:
- Income Inclusion Rule (IIR): Ensures the parent company pays a “top-up tax” if subsidiaries’ income is taxed below the 15% minimum.
- Undertaxed Payments Rule (UTPR): Allows other jurisdictions to impose taxes if income remains below the threshold.
- Subject to Tax Rule (STTR): Focuses on taxing certain cross-border payments (e.g., interest or royalties) in source jurisdictions.
The BEPS 2.0 initiative aims to allocate more value to the markets where business activities occur remotely, distributing a larger portion of profits based on the presence of customers in different regions.
Pillar Two’s Influence on Transfer Pricing
Pillar Two significantly alters how businesses manage their global tax liabilities, influencing Transfer Pricing policies in the following ways:
| Diminishing Low-Tax Jurisdiction Incentives | Historically, MNEs often used low-tax jurisdictions to house intellectual property (IP) or structure financing arrangements. However, under Pillar II, income taxed below 15% will trigger top-up taxes, reducing the financial benefits of profit shifting. This compels MNEs to align profits more closely with real economic activities, including where goods are produced, services are provided, and employees are based. |
| Substance and Profit Alignment | Transfer Pricing policies must now emphasize substance, ensuring that profits are aligned with operational functions, assets, and risks. For example, entities in low-tax jurisdictions with limited physical operations or employees may no longer be viable under Pillar Two. |
| Reassessment of Intercompany Arrangements | Intercompany transactions, such as royalties, management fees, and interest payments, are being scrutinized to ensure compliance with both Pillar Two and the arm’s length principle. MNEs must carefully document and justify these arrangements to withstand audits and avoid double taxation. |
| Cost Allocation Challenges | The allocation of costs among related entities is becoming more complex, as the global minimum tax interacts with local transfer pricing rules. Businesses must ensure that shared costs (e.g., for R&D) are allocated based on actual contributions and benefits derived. |
Strategic Adjustments by Multinational Enterprises
MNEs are adapting to the new tax environment by reshaping their Transfer Pricing strategies. A significant focus is being placed on emphasizing economic substance. Substance requirements have become very important under Pillar Two, compelling businesses to align profits with tangible economic activities. This involves situating profits in jurisdictions where they have substantial physical assets and operations, as well as ensuring that the workforce, infrastructure, and overall economic activity in a location justify the profit levels attributed there.
Intellectual property (IP) structures are also under scrutiny, given their frequent use in profit-shifting strategies. Companies are now reassessing their IP ownership arrangements, relocating IP to jurisdictions where R&D activities and innovation genuinely occur. For example, MNEs are increasingly transferring IP from tax havens to countries that offer R&D incentives in compliance with Pillar Two rules.
In addition, financing arrangements are being optimized to align with the new tax framework. Intercompany loans, which previously involved subsidiaries in low-tax jurisdictions, are being reevaluated. Businesses are moving financing functions to jurisdictions with tax rates closer to 15%, minimizing exposure to additional tax liabilities under the global minimum tax.
The OECD’s safe harbor provisions provide another avenue for adaptation, simplifying compliance for MNEs operating in jurisdictions with statutory tax rates exceeding 15%. By identifying such jurisdictions, companies can reduce administrative burdens and streamline their compliance processes.
Finally, MNEs are increasingly pursuing advanced pricing agreements (APAs) with tax authorities. These agreements help businesses establish clear frameworks for their Transfer Pricing arrangements, providing certainty and reducing the likelihood of disputes or double taxation.
Implications for Governments and Tax Authorities
Governments in low-tax jurisdictions are responding to Pillar Two by adopting Qualified Domestic Minimum Top-up Taxes, ensuring they retain revenue rather than ceding it to parent jurisdictions. Additionally, many are shifting from tax rate incentives to direct subsidies and grants to attract foreign investment.
Tax authorities in high-tax jurisdictions are enhancing scrutiny of MNEs’ compliance with both Pillar Two and local Transfer Pricing regulations. This increases the importance of robust documentation and transparent reporting.
The OECD’s Pillar Two framework is a transformative initiative reshaping global Transfer Pricing strategies. By introducing a minimum global tax rate, it reduces the appeal of profit shifting and emphasizes the alignment of profits with economic substance. While compliance brings challenges, it also presents opportunities for MNEs to optimize tax structures and foster transparency. Businesses that proactively adapt to this evolving landscape will not only ensure compliance but also strengthen their global tax strategies.
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