REITs and real estate investment funds that meet the EUR 750 million revenue threshold are in principle carved-out of the scope of Pillar 2. In this publication our experts Roel de Vries and Nick Crama explore the various carve-outs that are relevant for the real estate investment industry and share their views on items that are unclear.
Pillar 2 is becoming a reality
The Netherlands and the United Kingdom have published draft legislation to implement the OECD’s Pillar 2 Model Rules and are targeting an effective date of 1 January 2024 with the undertaxed profits rule to become effective as of 2025.
France, Germany, Italy and Spain are expectedto publish their draft legislation shortly and commit to the same timeline.
With these developments, Pillar 2 is becoming a reality in Europe.
REITs and real estate funds with entities and investments in these European countries are recommended to assess the impact of the OECD’s Pillar 2 Model Rules, starting with whether they are in scope.
It goes without saying that Pillar 2 is only relevant for some of the largest REITs and real estate funds in the world given the EUR 750 million revenue threshold.
Mechanics of Pillar 2
The OECD’s Pillar 2 Model Rules - also referred to as the Anti Global Base Erosion Rules (GloBE Rules) - are in essence a system of top-up taxes to ensure that certain cross-border groups - referred to as multinational enterprises (MNEs) - pay at least 15% tax in the jurisdictions where their effective tax rate (ETR) is lower.
The GloBE Rules consist of eight steps to determine the top-up tax liability of an MNE:
- Scope - The first step is to assess whether an MNE is in scope and to what extent. Examples of relevant items are the identification of the ultimate parent entity (UPE), the EUR 750 million annual revenue threshold and carve-outs.
- Calculate GloBE income - The second step is to calculate the so-called GloBE income (or loss) of each entity by making certain adjustments to the entity’s financial accounting income. Examples of such adjustments are disallowed expenses, excluded dividends and capital gains (or losses), fair value accounting adjustments and transfer pricing corrections.
- Identify and calculate GloBE taxes - The third step is to identify and calculate the GloBE taxes of each entity. The starting point is the current tax expense accrued in the entity’s financial accounts. Examples of subsequent adjustments are deferred tax adjustments to consider book to tax differences and prior year losses.
- Effective tax rate - The fourth step is to calculate the ETR per jurisdiction by dividing the GloBE taxes on a jurisdictional basis by the Globe income on a jurisdictional basis.
- Top-up tax rate - The fifth step is to calculate the top-up tax rate per jurisdiction. This rate is equal to the GloBE minimum tax rate of 15% less the jurisdictional ETR.
- Top-up tax - The sixth step is to calculate the top-up tax by multiplying the top-up tax rate with the GloBE income on a jurisdictional basis. The GloBE income can first be reduced with an amount based on a formula that considers the level of jurisdictional substance. If a jurisdiction decides to implement its own domestic top-up tax, then such top-up tax can in principle be deducted from the GloBE top-up tax.
- Income inclusion rule - The seventh step is that the top-up tax is imposed on the UPE of the entities in the low-taxed jurisdiction. This is known as the income inclusion rule (IIR). If the jurisdiction of the UPE does not apply the IRR, the top-up tax is in principle imposed on the next parent entity in the ownership chain, and so on.
- Undertaxed profits rule - If the top-up tax remains unallocated after the IIR has been applied (e.g., because the parent entity jurisdictions have not implemented the GloBE Rules), then there is a backstop mechanism known as the undertaxed profits rule (UTPR). The UTPR allocation mechanism results in a top-up tax liability in the other jurisdictions of the MNE that have implemented the UTPR. The top-up tax is allocated to each such jurisdiction based on a formula that considers substance and is collected through a denial of a deduction (or an equivalent adjustment under domestic law) to create a cash tax expense equal to the top-up tax. The UTPR can also apply in respect of top-up tax that arises in relation to the low-tax outcomes in the (ultimate) parent entity jurisdiction(s).
Carve-outs for REITs and real estate funds
UPE – The UPE is the starting point. The EUR 750 million annual revenue threshold to be in scope of the GloBE Rules is tested at the level of an MNE’s UPE based on its consolidated financial statements. A UPE is broadly defined as the top-entity that prepares consolidated financial statements under IFRS or local GAAP.
If a top-entity is not subject to IFRS or local GAAP, then the outcome of a deemed application of the IFRS or local GAAP consolidation rules will be decisive. This is especially relevant for real estate fund vehicles and entities that are resident in jurisdictions where they are excluded from IFRS or local GAAP.
Under IFRS, an “investment entity” is in principle exempt from the requirement to consolidate subsidiaries. This exemption typically applies to private equity funds, whereby portfolio investments are instead reported at fair value. This is relevant as a private equity fund that does not prepare consolidated financial statements including entities located in different jurisdictions should not be in scope of the GloBE Rules.
It is good to be aware that REITs and real estate investment funds generally do consolidate their “controlled” subsidiaries as they cannot (always) make use of this exemption from preparing consolidated financial statements.
Real estate investment vehicles – An exclusion from the scope of the GloBE Rules exists for UPEs that qualify as a real estate investment vehicle (REIV). A REIV is defined as an entity the taxation of which achieves a single level of taxation either in its hands or the hands of its interest holders (with at most one year of deferral), provided that that person holds predominantly immovable property and is itself widely held.
This exclusion targets REITs as tax neutral collective investment vehicles. It was included in the GloBE Rules following feedback provided by various industry associations, including EPRA, BPFand NAREIT.
The most striking requirement in the REIV definition is that the taxation of such entity should achieve a single layer of taxation.
For REITs, a single level of taxation is typically achieved by virtue of either (a) the REIT itself being tax exempt in combination with a distribution requirement or (b) the REIT being subject to tax in combination with a distribution deduction regime. In both scenarios, distributions are typically subject to withholding tax.
These REIT mechanics are aimed at achieving a single layer of taxation to facilitate collective investing via corporate entities we that would otherwise be subject to corporate income tax (which would create an additional layer of taxation). In our view, the actual taxation at the level of the investors is in principle irrelevant as the REIV definition primarily focuses on the taxation of the REIT.The OECD has confirmed this view.
Another striking requirement is that the single layer of taxation should be achieved with at most one year of deferral.
This seemingly relates to the fact that most REIT regimes require taxable income to be distributed within a certain period of time to create a taxable event for the investors and avoid that taxation is postponed indefinitely.
It also raises the question whether it is relevant to what extent a REIT’s taxable income needs to be distributed.
US REITs are subject to a distribution deduction mechanism for corporate income tax purposes and are in principle required to distribute at least 90% of their taxable income. In Europe, REITs are typically exempt from corporate income tax and subject to varying distribution requirements. Somewhat simplified examples are the Dutch FBI-regime that requires 100% of the taxable income to be distributed with a possibility to exclude capital gains, the UK REIT regime that requires 90% of the taxable income to be distributed but excludes capital gains, the Italian SIIQ that requires 85% of the taxable income to be distributed including capital gains and the Spanish SOCIMI that requires 80% of the taxable income to be distributed but only 50% of capital gains.
Without further guidance, there seems to be an incentive for REITs that are at risk of being in scope of the GloBE Rules to distribute 100% of their taxable income including capital gains. This can prove to be challenging from a practical perspective.The OECD has explicitly confirmed that REITs that are subject to corporate income tax over undistributed taxable income meet the single layer of taxation requirement. This provides comfort for the US REIT regime which makes use of such mechanism.
Investment funds – An exclusion from the GloBE Rules also exists for UPEs that qualify as an investment fund (IF). An IF is defined as an entity that meets all of the following criteria:
- It is designed to pool assets (which may be financial and non-financial) from a number of investors (some of which are not connected);
- It invests in accordance with a defined investment policy;
- It allows investors to reduce transaction, research, and analytical costs, or to spread risk collectively;
- It is primarily designed to generate investment income or gains, or protection against a particular or general event or outcome;
- Investors have a right to return from the assets of the fund or income earned on those assets, based on the contributions made by those investors;
- The entity or its management is subject to a regulatory regime in the jurisdiction in which it is established or managed (including appropriate anti-money laundering and investor protection regulation); and
- It is managed by investment fund management professionals on behalf of the investors.
Regulated real estate funds in Europe (e.g., the Luxembourg SICAV-SIF or SICAV-RAIF), should generally meet these conditions.
Given the lack of guidance from the OECD, the term ‘regulatory regime’ included in the sixth requirement will require careful consideration for IFs established outside the EU, especially given the different regulatory standards that jurisdictions have. This could lead to a fragmented interpretation.
Asset-holding and investment subsidiaries – Subsidiaries of REIVs and IFs can also be excluded from the scope of the GloBE Rules when such entity operates exclusively or almost exclusively to hold assets or invest funds for the benefit of the REIV or IF. The REIV or IF has to own at least 95% of the value of the entity directly or indirectly through a chain of excluded entities.
The background of this exclusion is that commercial or regulatory requirements may prevent a REIV or IF from investing directly in an asset and may require the investment to be made through a separate vehicle.
The words “exclusively or almost exclusively” have been included to rule out entities that actively carry out activities other than holding assets or investing funds.
Ancillary activity subsidiaries – Another category of subsidiaries that can be excluded from the scope of the GloBE Rules are entities that only carry out activities that are ancillary to those carried out by the REIV or IF. The REIV or IF has to, again, own at least 95% of the value of the entity directly or indirectly through a chain of excluded entities.
This exclusion aims to ensure that activities that would otherwise be performed by the REIV or IF can be outsourced to a separate legal entity. An example given by the OECD applies the exclusion to entities that only provide services to the REIV or IF or their excluded subsidiaries. In our view this allows for a broad scope (e.g., financing and asset and property management of a REIT’s or real estate fund’s own portfolio).
The OECD guidance does not address whether a subsidiary can also provide ancillary services to third parties. Based on the wording of the provision this should be allowed. However, this raises another challenge which is the interpretation of the term ancillary.
For REITs and real estate funds, given the strong link between the GloBE Rules and IFRS, it should be reasonable to rely on the ancillary services guidance under IFRS when assessing the “investment property” definition. This would also allow for a framework that can be used globally without each jurisdiction designing and applying its own framework.
Under the IFRS guidance, if an entity provides ancillary services to the occupants of a property held by the entity, the appropriateness of classification as investment property is determined by the significance of the services provided. If those services are a relatively insignificant component of the arrangement as a whole (for instance, the supply of security and maintenance services to the lessees), then the entity may treat the property as investment property. Where the services provided are more significant (such as in the case of an owner-managed hotel), the property should be classified as owner-occupied instead of investment property.
Holding company subsidiaries – Subsidiaries of REIVs and IFs can also be excluded from the scope of the GloBE Rules when such entity reports income that is substantially all excluded from the computation of the GloBE income by virtue of qualifying as an excluded dividend or excluded equity gain or loss. The REIV or IF has to own at least 85% of the value of the entity directly or indirectly through a chain of excluded entities.
Dividends are broadly excluded, unless (a) an interest of less than 10% is held for less than one year on the date of distribution, or (b) the distributing entity is a REIT that meets certain conditions.
Excluded equity gains or losses are broadly (a) fair value changes of interests held in other entities of 10% or more, (b) profits or losses on an interest held in an entity under the equity method of accounting, and (c) gains or losses resulting from the disposal of an entity owned for at least 10%.
The reason for excluding holding entities is that they are not expected to be subject to a top-up tax as all their income is excluded from the GloBE income.
The ownership percentage of 85% (instead of 95%) is to provide greater flexibility for holding entities held by IFs where third parties may hold a greater stake or where the interests are issued to management.
According to the OECD, the phrase “substantially all of its income” means all or almost all of its income. This phrase was included to avoid a situation where an entity fails to qualify as excluded solely because it receives a small amount of other income.
An example is given of interest income received on a bank account provided that such interest income represents an insignificant amount of the entity’s overall income.
GloBE safe-harbours – The OECD may develop certain safe-harbours to limit the compliance and administration burden for an MNE’s operations that are likely to be subject to an ETR of at least 15% on a jurisdictional basis. The design of such safe-harbours is still pending.
How can A&M help?
A&M can help with assessing to what extent REITs and real estate funds are in scope of the GloBe Rules. For more information, please feel free to get in touch with your usual A&M adviser, Roel de Vries or Nick Crama.
