Pillar 2 - Grouping issues for private equity and sovereign wealth funds

The OECD’s Pillar 2 model rules, once adopted by a critical mass of participating jurisdictions, will require multinational groups with an annual consolidated revenue in excess of at least €750 million to pay a top-up tax in any jurisdiction in which their profits are subject to an effective corporate tax rate of less than 15%. Groups that are in scope face a significant compliance burden even if ultimately no tax is payable under the rules. It is expected that these rules will come into effect, at least within the EU and the UK, from 2024.

Early in the process, it had seemed clear that unrelated businesses which are owned by a private equity or other investment funds would not be treated as part of the same group for the purposes of the rules. A quick glance at the draft rules (either the UK draft legislation or the OECD model rules) seems to confirm this – investment funds and certain holding companies are “Excluded Entities”.

However, the quick glance is misleading. “Excluded Entities” are only excluded from themselves having tax and compliance obligations under the rules. This is not a complete exclusion. In particular, a group for the purposes of applying the revenue threshold can still be traced through “Excluded Entities”.

Instead, private equity funds and their holding companies need to rely on applicable accounting standards. The starting point for the constitution of a group under the rules is the actual consolidated financial statements.

Often, but not always, private equity funds and their holding companies will not be required to consolidate their investments and will therefore be outside the scope of the rules. In a limited number of cases where the funds are not excluded from the consolidation requirement by this exemption in IFRS and US GAAP for investment entities, such funds may rely on another accounting exemption where the companies they have invested in are held available for sale to mean that they do not need to be consolidated.

However, unlike the country-by-country reporting rules, which are aimed at multinational groups of a similar size, the OECD Pillar 2 rules disregard this held-for-sale exemption. While rare, there may be circumstances in which consolidation is either applicable or deemed to be applicable for the purposes of determining whether unrelated businesses are grouped.

In order to be completely confident of the position, private equity managers will therefore need to review their accounting treatment carefully in order to determine whether they might inadvertently bring portfolio companies into scope as grouped for the purposes of the Pillar 2 rules, which are otherwise below the threshold on a standalone basis. 

The recently published OECD administrative guidance on the Pillar 2 model rules recognises a similar issue for sovereign wealth funds, noting that such funds may not qualify for the exemption from consolidation for investment entities because, unlike most private equity funds, sovereign wealth funds may not have an exit strategy for their investments. In addition, such funds are considered more likely to be in jurisdictions where local accounting rules do not recognise exemption from consolidation for investment entities.

On the basis that bringing unrelated businesses owned by sovereign wealth funds into scope is not intended, the administrative guidance proposes an update to the commentary on the OECD model Pillar 2 rules to clarify that this outcome does not follow where sovereign wealth funds are required to consolidate their investments. While this is a necessary and helpful clarification for sovereign wealth funds, it is a shame that an equivalent simple exclusion is not offered to private equity funds too. 

It is also a shame that the OECD felt unable to update their model rules to bring about this change. It will only be in the OECD commentary, rather than the rules themselves, that you find out that the implications of being an “Excluded Entity” for sovereign wealth funds under the rules are very different than they are for private equity funds.

In order to implement the rules in a uniform manner, jurisdictions are encouraged to keep their rules as close to the OECD model rules as possible. However, in jurisdictions such as the UK, where courts have consistently found that the clear wording of legislation cannot be changed through guidance, this is an awkward position.

With thanks to Stephanie Kleefstra, Visiting European Lawyer, for her input in this article.