Draft Law implementing Pillar Two in Luxembourg

Background and summary

The Directive derives its foundation from the OECD/G20 Model Rules on Pillar Two dated 20 December 2021 (“Pillar Two”), which seek to enforce a minimum corporate tax of at least 15%. The global minimum level of taxation would apply to both MNEs and large-scale domestic groups with a combined annual turnover above EUR 750 million in at least two of the last four fiscal years, irrespective of their corporate headquarters or global operational presence.

The application of Pillar Two’s global minimum corporate tax rate of 15% is achieved through the implementation of a supplementary tax mechanism, based on the effective tax rate (“ETR”) calculation on a jurisdictional basis. The framework includes a standardized definition for the scope of taxable elements and utilizes a tax base derived from financial accounting income. Moreover, it accommodates the agreed-upon adjustments aligned with the tax policy objectives of Pillar Two and addresses temporal disparities.

The requirement of the group’s annual turnover above EUR 750 million refers to the consolidated financial statements of the group’s parent entity. The Draft Law defines a “group” as a set of entities related to each other by the ownership or control structure (…) and included in the consolidated financial statements of the ultimate parent entity (“UPE”). This definition also includes entities that have been excluded from the consolidated financial statements of the UPE because of their small size, materiality, or because they are intended for sale.

Additionally, a group can also be defined as an entity that has one or more permanent establishments, provided it is not part of another group, as defined previously.

The Draft Law proposes the introduction of three new taxes in Luxembourg:

1. Income Inclusion Rule Tax (“IIR”);
2. Undertaxed Profits Rule Tax (“UTPR“);
3. Qualified Domestic Minimum Top-up Tax (“QDMTT“).

The effective dates for these taxes are as follows:

1. The IIR and the QDMTT should come into effect for fiscal years beginning on or after 31 December 2023.
2. The UTPR is scheduled to become effective for fiscal years commencing on or after 31 December 2024.

1. The IIR and the UTPR

On 20 December 2021, the OECD unveiled its model regulations for the IIR and the UTPR, collectively referred to as the Global Anti-Base Erosion (GloBE) Rules. The Draft Law envisions the implementation of these taxes, as provided by the EU Pillar Two Directive.

The IIR

The IIR is one of the key components of the Draft Law. It requires the UPE (as a rule) to include in its taxable income a certain portion of the income of a foreign constituent entity of the group, if that income is subject to tax at a rate below 15%. In other words, the IIR aims at preventing profit shifting to low-tax jurisdictions by including the low-taxed income in the tax base of the UPE’s country of residence.

The IIR is designed as a mechanism for application by a  Luxembourg UPE, an intermediate parent entity, or a partially owned parent entity. Following a top-down approach, it allows these entities to collect additional taxes for any constituent entities, whether located in Luxembourg or abroad, that have been subject to low taxation and are directly or indirectly owned by the Luxembourg parent entity.

The UTPR

The UTPR acts as a backstop to the IIR. In situations where a UPE is situated in a low-tax third-country jurisdiction or in a third-country jurisdiction that does not administer a qualified IIR, the Draft Law envisages that a Luxembourg constituent entity of the same group will be subject to an additional tax that equals the UTPR amount. The UTPR amount imposed will correspond to the top-up tax attributed to the group’s low-taxed entities on which the IIR was not collected. A pro-rata allocation formula based on the number of employees and tangible assets would be applied.  

2. The QDMTT

Luxembourg is also planning to introduce the QDMTT, under which a domestic top-up tax will take precedence over the application of both foreign IIR and UTPR for all constituent entities located in Luxembourg that have been subject to low taxation.

Under this rule, any top-up tax obligation owed by a foreign UPE would be offset by the amount of Luxembourg QDMTT payable by the constituent entities of the MNE group in Luxembourg.

The QDMTT would be calculated and administered in accordance with the Pillar Two regulations outlined in the Draft Law. This includes the determination of the ETR and the calculation of the top-up tax amount, as specified in the rules.

Safe harbor rule in case of foreign QDMTT application

The Draft Law provides for a safe harbor rule according to which the top-up tax (either IIR or UTPR) relating to a specific jurisdiction is reduced to zero, provided that the jurisdiction in question applies a qualifying QDMTT which has been calculated in accordance with the financial accounting standard of the UPE or the International Financial Reporting Standards.

3. Penalties

The Draft Law incorporates provisions for imposing penalties on constituent entities that fail to fulfill their registration and filing responsibilities. Specifically, it allows for fines of up to EUR 250,000 in cases of delayed filing or submission of incomplete or inaccurate information.

4. Exchange of information

The information filed with the Luxembourg tax authorities will be subject to automatic exchange with jurisdictions that have entered into an agreement with Luxembourg (with the list of such jurisdictions to be provided through a Grand Ducal regulation).

5. Our observations

The Draft Law, which should be further voted by the Luxemborug Parliament, seeks to integrate the global minimum tax into Luxembourg's tax framework. It aligns with the complex provisions articulated in the EU Pillar Two Directive. It also introduces the supplementary components, notably the QDMTT and the transitional safe harbour rules. However a few aspects could be improved, such as foreseeing, in the context of the ETR computations, an opt-out possibility from the Luxembourg participation exemption regime rules (as these rules are not entirely aligned with the Pillar 2 rules).

Possible amendments to the text of the draft law are not excluded and to be followed closely. Nevertheless, considering the planned entry into force of the IIR and the QDMTT shortly (for fiscal years beginning on or after 31 December 2023), we would recommend to the concerned taxpayers to carefully consider potential implications on their businesses through an impact analysis.

Should you have any questions on that matter, please do not hesitate to reach out to the Tax team at Grant Thornton Luxembourg.