What is Pillar Two?
Pillar Two is a set of international tax rules designed to ensure that large multinational groups (with revenues exceeding Eur750m per annum) pay a minimum level of tax in the countries in which they operate.
Although the headline minimum effective rate for Pillar Two purposes is 15%, the position is not as simple as comparing that rate with a domestic corporation tax rate. Pillar Two has its own rules for calculating profits, which means that Pillar Two issues can arise even where an entity is already taxed at domestic tax rates above 15%, including in jurisdictions such as the UK and elsewhere in Europe.
Pillar Two is a complex regime from a compliance perspective and for many taxpayers the cost of compliance may exceed the actual tax cost.
And although Pillar Two is targeted at large groups, its impact may extend beyond them. As explained below, where a member of a large group is an investor in a fund, in some circumstances there may be a Pillar Two tax cost and therefore an impact upon overall net returns.
Perhaps counterintuitively, this is therefore not an issue which a small fund or fund manager can safely ignore.
How could investor status create a problem?
There are two principal traps for the unwary in this context.
The first is where an investor, which is within scope of Pillar Two, consolidates the fund and its investments. The second is where an investor, which is within scope of Pillar Two, holds at least a 50% interest in the fund and accounts for its interest using the equity method of accounting.
A number of detailed accounting rules determine whether consolidation / equity accounting will apply and these are beyond the scope of this article.
Next steps
This will depend on whether you are looking at a new or existing fund structure. For new funds, Pillar Two provisions should be included within the Subscription Agreement, in order to protect against these potential traps.
Representations should be sought, to confirm that an investor will not consolidate its investment, or be deemed to do so for Pillar Two purposes, and will not hold a 50% interest for which it will equity account.
Appropriate remedies should be included in the fund documentation, if these representations are breached and a tax cost arises in consequence of that breach. This could include indemnification, reorganisation requirements and possibly kick-out rights for the manager. Further, the investor should be obliged to make notification, in the event that it breaches a representation at any point subsequently, for example as a result of a change in its accounting policies at some point in the future.
For existing funds, things can potentially be more complicated. As a first step managers should be assessing whether any of the investors in a fund are potentially within the scope of Pillar Two and whether those investors could potentially either consolidate the fund investment for accounting purposes, or hold a stake of 50% or more and apply the equity method of accounting. There are likely to be requirements within the existing fund documentation that requires investors to provide necessary tax information to the manager, but they won’t be specific to Pillar Two.
Where a Pillar Two issue is identified, managers should be considering whether the fund documentation provides for a remedy. This may not be the case where Pillar Two was not identified, but it is possible that other tax indemnities within the fund documentation may be capable of being repurposed to protect other investors. Either way it is likely to be appropriate for the manager and the investor to work together to find a solution. In conclusion, this is not an issue which a small fund or fund manager can safely ignore.
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