What is the CbCR Safe Harbor?
The Transitional Country-by-Country report (CbCR) Safe Harbor (CbCR Safe Harbor) is the first published of two transitional safe harbors under Pillar Two. It is temporary in nature and operates to reduce the top-up tax of a multinational enterprise (MNE) for a particular jurisdiction to zero where one of three criteria is met. This transitional safe harbor applies for fiscal years beginning on or before December 31, 2026, but not including a fiscal year that ends after June 30, 2028 (effectively for the first three years that Pillar Two is in effect).
Why is the CbCR Safe Harbor important?
By qualifying for, and availing of, the transitional CbCR Safe Harbor, taxpayers may be able to significantly reduce their compliance obligations and data required in relation to Pillar Two calculations.
The benefits of the CbCR Safe Harbor are only available, however, where the MNE Group prepares and files its CbCR using certain data (i.e., a Qualified CbCR) following certain processes and related regulations (e.g., the OECD’s Action 13 paper, US federal CbCR regulations, etc.). Specifically, the CbCR must be prepared and filed using Qualified Financial Statements. Qualified Financial Statements means:
- the accounts used to prepare the Consolidated Financial Statements of the ultimate parent entity (UPE);
- separate financial statements of each Constituent Entity, provided they are prepared in accordance with an Acceptable Financial Accounting Standard or an Authorized Financial Accounting Standard if the information contained in such statements is maintained based on that accounting standard and it is reliable; or
- in the case of a Constituent Entity that is not included in an MNE Group’s Consolidated Financial Statements on a line-by-line basis solely due to size or materiality grounds, the financial accounts of that Constituent Entity that are used for preparation of the MNE Group’s CbCR.
What steps are needed to apply the CbCR Safe Harbor?
One of three tests must be satisfied for the CbCR Safe Harbor to be applied. We note that this is an ‘or’ test, rather than an ‘and’ test.
1. De minimis test
The jurisdiction has total CbCR revenue of less than €10 million, and the CbCR profit (loss) before income tax is less than €1 million (including a loss).
2. Simplified ETR test
The jurisdiction has a “Simplified ETR” that is equal to or greater than the “transition rate” in the jurisdiction for the fiscal year.
- The Simplified ETR is calculated by dividing the simplified covered taxes (income tax expense reported in the MNE’s financial statements, minus any taxes that are not covered taxes or taxes relating to uncertain tax positions) by the profit or loss before tax reported in the MNE Group’s CbCR.
- The ‘transition rate’ is:
- 15% for fiscal years beginning in 2023 and 2024;
- 16% for fiscal years beginning in 2025; and
- 17% for fiscal years beginning in 2026.
3. Routine profits test
The tested jurisdiction’s profit or loss before income tax for the jurisdiction is equal to or less than the substance-based income exclusion (SBIE) for constituent entities resident in that jurisdiction under the CbCR, as calculated under the Pillar Two Model Rules. The SBIE under the Pillar Two Model Rules provides that MNEs will receive a carve-out on income for 5% of the carrying value of their tangible assets and payroll, with a transition period of ten years that offers an exclusion of 7.8% of tangible assets and 9.8% of payroll in 2024, gradually declining to 5% in 2033. There was uncertainty as to whether the transitional rates could be used for this purpose or whether the standard 5% was required; however, the latest package of administrative guidance released by the OECD on December 18, 2023 (December Administrative Guidance) provides that the higher transitional rates should be used for the respective year.
Recent guidance adds complexity to compliance
The December Administrative Guidance provides significant updates to the CbCR Safe Harbor and clarifies the application of the CbCR Safe Harbor in several respects that are of immediate concern to MNEs:
- The guidance addresses the consistent use of data and what constitutes a ‘qualifying’ CbCR (including where there are purchase price accounting adjustments). The guidance clarifies the tested jurisdictions and the taxes that can be included as part of an entity’s simplified covered taxes.
- Generally, MNEs may not use data from different types of Qualified Financial Statements within a jurisdiction. Nevertheless, in most cases, an MNE Group may use different types of Qualified Financial Statements as the source of data for different tested jurisdictions in a Qualified CbCR.
- In what may have been an effort to prevent potential abuse of the CbCR Safe Harbor, the guidance provides for treatment of ‘Hybrid Arbitrage Arrangements’ that arise from differences in the source of financial information or differences between tax and financial accounting treatment (but need not involve an actual hybrid instrument or arrangement).
- The guidance defines a ‘Hybrid Arbitrage Arrangement’ as an arrangement that is (1) a deduction / non-inclusion arrangement (D/NI), (2) a duplicate loss arrangement (DD), or (3) a duplicate tax recognition arrangement.
- Accordingly, the CbCR Safe Harbor will not be available to the extent that inconsistent treatment of a Hybrid Arbitrage Arrangement otherwise would result in a jurisdiction qualifying for the CbCR Safe Harbor.
- The D/NI and DD rules are expected to have broad applicability and impact to MNEs, including common business transactions that may not have been intended to be impacted by this rule.
- The December Administrative Guidance provides that post year-end adjustments (e.g., transfer pricing adjustments) to the financial statement data on which the CbCR is based are not permitted under the CbCR Safe Harbor.
This last piece of the updated guidance may require the most attention from a transfer pricing perspective. In many cases, CbCRs are prepared using ‘actual’ numbers, which typically reflect such post year-end adjustments. Accordingly, many MNEs will need to modify their approach to preparing their CbCR or risk disqualifying themselves from using the CbCR Safe Harbor.
What should MNEs be doing now?
The CbCR Safe Harbor can help companies significantly reduce their compliance obligations and data requirements in relation to Pillar Two calculations.
An important point to note, however, is that the data source required to be used for preparing and filing the CbCR for purposes of the CbCR Safe Harbor (i.e., Qualified Financial Statements) is a category of data sources than is more stringent than what is permitted for purposes of filing IRS Form 8975 (U.S. Country-by-Country Report). Consequently, MNE Groups will need to consider whether the data source that is being used to prepare and file the CbCR is acceptable for applying the CbCR Safe Harbor.
Moreover, given that CbCRs may provide the basis for a simplified exemption from the top-up tax for a particular jurisdiction, CbCRs likely will receive more scrutiny from tax authorities going forward. In the past, because CbCRs were informational returns that did not directly impact any tax liability, they may not have been prepared with the rigor and scrutiny that underlies the preparation of tax returns that impact tax liability.
Consequently, MNEs should be cognizant of this in preparing their CbCR to ensure that not only the right data source is being used in preparing and filing the CbCR (i.e., Qualified Financial Statements), but also that the underlying data is accurate and reliable and in line with all guidance to date (including the December Administrative Guidance). There is also an expectation that any increased focus on CbCRs by tax authorities may result in more tax disputes.
Finally, the urgency to act is even more profound beginning in 2024. Financial auditors will begin the process of reviewing regulatory compliance, which will include a need to review CbCRs to verify that they are qualified for purposes of the CbCR Safe Harbor.
Alignment of CbCR data with transfer pricing policies
Note that while much of the information for the CbCR Safe Harbor will come from the CbCR, MNEs will have to complete a full substance-based income exclusion calculation for the routine profits test. Further, for the calculation of the simplified ETR, MNEs will need to calculate Simplified Covered Taxes using ‘Income Tax accrued - current year,’ but users would have to add deferred tax expense accrued in the financial statements (and remove any uncertain tax positions) to accurately reflect Simplified Covered Taxes.
From an operational transfer pricing (TP) perspective, getting TP policies in place and determining whether they are priced and adjusted accurately in each statutory reporting cycle is more important than ever. The Pillar Two and CbCR Safe Harbor calculations are based on the constituent entity’s financial results for that year, without regard for post year-end true-up adjustments.
Robust price setting and profit monitoring processes will be important, as well as documenting the existence and rationale for these policies.
Part of an overall ETR/Pillar Two exercise
Companies should reach across their tax and finance functions to understand how their CbCR data will be used to determine the applicability of the transitional CbCR Safe Harbor, required adjustments to CbCRs, reliance on CbCRs as ‘qualifying,’ and CbC financial statement audit reliance and traceability.
Qualifying for a safe harbor (whether temporary or permanent) does not exempt an MNE Group from complying with the group-wide Global Anti-Base Erosion (GloBE) requirements, such as the requirements to prepare and file a GloBE Information Return (GIR), albeit information required for the GIR or other filing may be reduced if the transitional CbCR Safe Harbor is met for a jurisdiction.
Action items
MNEs should:
- Assess the quality of CbCRs, including the existing source data and compliance process to support eligibility for the CbCR Safe Harbor rules;
- Assess the quality of the document process used to prepare CbCRs, including data sources, any enabling technology, and controls to facilitate understanding and discussions with external auditors;
- Assess TP pricing policies and gaps for Pillar Two calculation purposes;
- Assess operational TP readiness to review existing price setting and profit monitoring process and technology;
- Model which jurisdictions could be eligible for the CbCR Safe Harbor based on current CbCRs available; and
- Stay close to their audit teams to determine whether the Qualified CbCR meets all of the regulatory requirements necessary for financial audit filings.
