What Pillar Two Means for Income Tax Accounting

Understanding Calculations, Income Tax Accounting Issues, and the Role of Data Management and Technology

The Organization for Economic Co-operation and Development (OECD) estimates that the implementation of a global minimum tax as part of Pillar Two will impact thousands of multinational enterprises (MNEs). According to BDO’s 2024 Tax Strategist Survey, 87% of U.S. tax leaders say Pillar Two represents a challenge to their business in the next 12 months, as tax teams will need to dedicate significant resources to calculate their global anti-base erosion (GloBE) income and determine whether they need to pay a top-up tax. 

In addition to the complex calculations and tax compliance challenges, Pillar Two introduces new considerations for tax accounting and financial statement disclosures. Issues include questions regarding deferred tax accounting, treatment of stock-based compensation, and disclosure requirements. Tax leaders will need to monitor new Pillar Two guidance and make the right investments in technology and data management to address the impact of Pillar Two. 

Calculating Taxes Owed Under Pillar Two

Pillar Two requires in-scope MNEs – those with global revenues above EUR 750 million -- to complete several calculations to not only determine how much tax (if any) is owed and where it must be paid, but also to accurately record these payments on company income statements and balance sheets for income tax accounting purposes. The process can be summarized in six steps: 

• Step 1: Determine whether an MNE group is in scope for Pillar Two.
• Step 2: Identify if any jurisdictions meet the requirements for the transitional country-by-country reporting (CbCR) or other safe harbors.
• Step 3: Calculate GloBE income or loss for each constituent entity (CE).
• Step 4: Compute adjusted covered taxes for each CE.
• Step 5: Determine the effective tax rate and top-up tax for the jurisdiction.
• Step 6: Apply the relevant charging provision (income inclusion rule or undertaxed payments rule). 

For more information on how to perform these calculations, listen to our recent webcast: Pillar Two Fundamentals – A Practical Overview.

Pillar Two Increases Income Tax Accounting Complexity

In addition to these complicated calculations, Pillar Two increases the complexity of income tax financial reporting by introducing more variables and data points for MNEs to factor in to achieve accurate income tax accounting calculations. 

Deferred tax accounting in particular is rendered more complicated by Pillar Two. MNEs must now consider the potential impact of a top-up tax when calculating deferred tax assets and liabilities. If a deferred tax asset or liability is recognized in a jurisdiction where the effective tax rate is above 15%, the company may need to reassess the value of that asset or liability, which requires additional calculations, time, and resources.

Deferred Taxes Under Pillar Two

The GloBE minimum tax is considered an income tax and is accounted for under ASC 740. It is also considered an alternative minimum tax. On that basis, the Financial Accounting Standards Board (FASB) determined that deferred tax assets (DTAs) and deferred tax liabilities (DTLs) would not be recognized or adjusted for the estimated future effects of the minimum tax. There is no deferred tax accounting for the impact of Pillar Two and such taxes are recorded as period costs. 

However, due to the intricacies of the GloBE computations, some DTAs are disallowed or not fully realized for Pillar Two purposes. There are two views on how to account for such DTAs under Pillar Two:

• View A: Record the DTA under Pillar Two based on the regular tax system. For U.S.-based multinationals, that would mean recording the DTA determined under U.S. GAAP. 
• View B: Assess the realizability of DTAs, with consideration for the Pillar Two rules, which may give rise to a valuation allowance. 
  
  

To determine which approach to follow, companies should perform a “with and without” calculation to model both views and determine which treatment of DTAs results in a preferred outcome. Once a company adopts a specific view, it must apply it consistently going forward, as the view taken is an accounting policy. 

Deferred Tax Expense Under Pillar Two

The introduction of Pillar Two creates a new set of temporary differences between the tax basis of an asset or liability and the carrying amount in financial statements, plus temporary differences under U.S. GAAP. 

To account for these temporary differences, CEs should begin with the deferred tax expense in the U.S. entity’s financial statements computed under U.S. GAAP for the specific jurisdiction. The deferred tax expense is then recast to the lower of the statutory rate in the jurisdiction, or 15%. However, there are many adjustments and exclusions from deferred tax expense, notably: 

• Items excluded from GloBE income: If an item is excluded from GLoBE income (pre-tax income under Pillar Two), then any deferred or current tax associated with that item is also excluded from adjusted covered taxes. One example may be income or loss recorded under the equity method. 
• Uncertain tax position (UTP): As UTPs are accrued, they are removed from adjusted covered taxes and then added to adjusted covered taxes when paid. 
• Valuation allowance (VA): VAs are removed from the deferred tax computation of Pillar Two because they create volatility in the effective tax rate. 
• Credits: Generally, a DTA under Pillar Two cannot be recorded for credits. The only exception is the end of the year preceding the transition year when companies can set up a DTA for credits. Rather, the impact on the effective tax rate is recorded when the credit is utilized on the tax return. If the credit is nonrefundable, it will drive down the effective rate and might increase the top-up tax. 
• Tax rate changes: Many tax rate changes that impact deferred tax expense under ASC 740 will be eliminated from the Pillar Two computation because the inclusion of such changes distorts the effective tax rate. 
• Five-year recapture rule: The five-year recapture rule can be a trap for the unwary. DTLs that are not expected to fully reverse within a five-year period are disallowed, and the deferred tax expense is recalculated for the year in which it was recognized as a covered tax. There are simplification options available, given the complicated nature of this rule. 
  
  
  

Pillar Two Rules That Create Challenges for Income Tax Accounting

While Pillar Two deferred tax rules are broadly complex, taxpayers frequently encounter issues in the following areas, among others: 

• Treatment of stock-based compensation (SBC): Windfalls for stock-based compensation are permanent differences under U.S. GAAP that may drive down the effective tax rate and therefore give rise to a top-up tax. Because of this anomaly, an SBC election is available, allowing the use of tax-deductible amounts for GloBE income computations. The election is done on a jurisdictional basis and applies for a five-year period. 
• Acquisition accounting for non-taxable deals: This rule applies to nontaxable transactions when there is no change in the underlying tax basis of the assets. The book step-up amortization is excluded from the GloBE calculation, but deferred taxes related to book step-ups are also excluded. In many situations, these exclusions will not give rise to or increase a top-up tax, but it’s worth noting that this rule applies to acquisitions that occurred prior to the years when Pillar Two became effective. MNEs must still capture the data from prior period acquisitions and make the necessary adjustments for the current year. 
• Qualified refundable tax credits and non-refundable tax credits: Refundable credits are recorded as pre-tax income for U.S. GAAP. Non-refundable credits, such as the U.S. R&D credit, are recorded as part of the tax provision. These rules are similar under the GloBE regime, where the qualified refundable credits are included in GloBE income. Since the credits are not taxable, refundable credits reduce the effective rate. Nonrefundable credits, such as the U.S. R&D credit, have a dollar-for-dollar reduction to covered taxes and can significantly lower the effective tax rate and give rise to or increase a top-up tax. 

Disclosures

There are no specific disclosure requirements under U.S. GAAP for the impact of Pillar Two. However, in some situations, an entity should consider disclosures related to Pillar Two in the management discussion and analysis (MD&A) section; for example, if future top-up tax amounts are significant and reasonably likely to cause reported financial information to not be indicative of future operating results. Additionally, ASC 740 requires disclosures concerning significant matters that may impact the comparability of the results for the periods presented. 

Updating Resources to Support Calculations

To prepare for Pillar Two and its impact on the tax provision process, as well as the additional compliance burden it presents, tax teams must have the right solutions in place to consistently and efficiently gather the required data. 

Before an organization considers updating its existing technology and processes to address the impact of Pillar Two, it should conduct a technical analysis from a U.S. tax point of view. A key component of that analysis is determining what data points the tax team needs to perform Pillar Two calculations and finding where that data sits. Businesses may be required to pull data from the trial balance, the tax provision, qualified CbCR, and other new data points for the GloBE calculation. While tax teams are likely already accustomed to pulling data from the enterprise resource planning (ERP), the consolidation system, and the tax provision and compliance systems, some Pillar Two data might live in other systems to which tax professionals have traditionally not had access. Therefore, businesses must develop a repeatable and scalable way of pulling data required for Pillar Two analysis and a similarly replicable way of incorporating that data into updated calculations and processes. 

To enhance automation opportunities, begin by organizing non-transactional metadata, often referred to as master data, to enhance automation opportunities. Examples of metadata include:

• Legal entity structure
• Types of legal entities and flowthroughs
• Jurisdictions
• Pillar Two elections
• Categorization of accounts and adjustments

Consider working with a service provider to improve your master data management strategy and capabilities. If you are not already using extract, transform, and load (ETL) tools, these applications can allow you to quickly grab required data on demand. An advisor can help your organization adopt ETL and integrate it into your existing processes. 

Once your organization has implemented proper data management and automation, your tax provision and compliance processes should move more efficiently. Be careful not to underestimate the time it takes for your team to gather the necessary data and perform the calculations. Teams still need to identify which GloBE adjustments apply to an entity and in which jurisdictions, as well as the determination of covered taxes. Evaluate how these additional steps will impact your quarterly and annual close process and look to mitigate the additional time with a mix of technology, additional resources, and outsourcing. 

Some technology solutions that can help drive Pillar Two calculations include financial planning and analysis (FP&A) systems and enterprise performance management (EPM) systems, which sit on top of the organization’s ERP systems.  These systems consolidate data and help with financial statement preparation, planning, budgeting, and forecasting. Much of the data needed for Pillar Two exists in FP&A and EPM systems so Pillar Two calculations can be performed in them directly.  

Depending on your organization’s footprint and complexity, you may be able to perform Pillar Two calculations on either a short- or long-term basis using a spreadsheet model. Working with a service provider can help your organization determine the best solution.

Your organization should also consider whether it has the internal resources to perform Pillar Two tax compliance, such as the preparation of the global information return (GIR). If you decide to prepare the GIR internally, you should evaluate if the compliance software you use in each country will meet your Pillar Two needs, or if you require an international tax platform for Pillar Two research and compliance. 

Finally, assess how you may need to update your existing U.S. international tax calculation and model for global intangible low-tax income (GILTI), foreign-derived intangible income (FDII), and the foreign tax credit (FTC) and what may need to change in a post-Pillar Two world. 

Get Ahead of Pillar Two

Due to the complexity of the necessary Pillar Two calculations, the various data points required to complete these calculations and the implications on income tax accounting, tax teams should consider working with an advisor. A Pillar Two specialist can help your organization achieve accurate forecasts and calculations, understand and resolve income tax accounting issues arising from Pillar Two, implement appropriate Pillar Two technology solutions, and stay up to date as more countries adopt Pillar Two into their domestic legislations. 

Without proper planning, your organization could be at risk of expensive foreign tax footprints, errors in your tax provision and financial reporting, and potential control deficiencies. Taking steps now to address how Pillar Two will affect your income tax accounting processes will put your organization in the best position to adapt to the impacts. 

Want to learn more about what Pillar Two means for your income tax accounting? Contact us.