Pillar Two and nonprofit organizations

Editor: Rochelle Hodes, J.D., LL.M.

Though the United States has yet to implement Pillar Two of the Organisation for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting (OECD/G20 IF), a number of countries have enacted laws to implement Pillar Two in 2024.  While much of the discussion around Pillar Two has focused on for-profit companies, nonprofit organizations (NPOs) are also subject to these rules.  This item provides a brief overview of Pillar Two and discusses some of the ways that these rules are applied to NPOs.

Background

In October 2021, more than 130 countries agreed to collaborate on implementation of the OECD/G20 IF to reform the international tax rules (see OECD, “Base Erosion and Profit Shifting (BEPS)”).  These reforms respond to international business tax-avoidance strategies made easier by increased digitalization and globalization of economies. As part of the OECD/G20 IF, participating countries agree to implement a minimum 15% corporate tax rate for certain multinational enterprises (MNEs) with global revenue over €750 million (approximately $812 million on July 8, 2024).  This is more commonly known as Pillar Two.

Pillar Two operates by assessing a top-up tax on entities whose effective tax rate (ETR) falls below 15% in a jurisdiction.  In December 2021, the OECD issued the Global Anti-Base Erosion (GloBE) Model Rules to implement Pillar Two (OECD, Tax Challenges Arising From the Digitalisation of the Economy — Global Anti-Base Erosion Model Rules (Pillar Two): Inclusive Framework on BEPS (December 2021)). The OECD has issued additional administrative guidance on Pillar Two rules and has indicated that it will continue to provide additional guidance.

As the Model Rules and administrative guidance (collectively, the GloBE rules) have no binding legislative authority, each OECD/G20 IF country must enact statutory provisions to implement them.  While the GloBE rules have been adopted by some countries for 2024, many participating jurisdictions have yet to implement Pillar Two in their domestic tax law.  Most prominently, the United States has not yet taken steps to implement any of the provisions.  However, by June 30, 2026, U. S. MNEs meeting global revenue thresholds will generally be required to report GloBE income and pay top-up taxes in countries that have adopted the GloBE rules from 2024.

Top-up taxes

Pillar Two has three primary mechanisms to charge top-up tax when an entity’s ETR is below 15% in a jurisdiction. The first is the qualified domestic minimum top-up tax (QDMTT).  A QDMTT applies to an entity or activity when its tax rate in the jurisdiction of operation falls below 15%. Under a QDMTT, the local authorities simply top up the tax to the 15% minimum rate.

The second top-up tax is the income inclusion rule (IIR), which applies if a parent entity in one jurisdiction that has implemented an IIR owns a subsidiary with an ETR below 15% in another jurisdiction that does not have a QDMTT. In that case, the parent’s jurisdiction would assess a tax on the parent equal to the amount needed to raise the subsidiary’s ETR to at least 15%.

The third top-up tax is the undertaxed profits rule (UTPR), which is a backstop to the QDMTT and the IIR. Under this rule, a third jurisdiction can tax an MNE if its ETR in another jurisdiction falls below 15%.

Pillar 2 includes a de minimis exclusion and a number of safe-harbor rules that help minimize the impact of these rules.  For example, the GloBE rules provide temporary relief for MNEs, allowing them to reduce top-up tax for a particular jurisdiction to zero in tax years 2024 to 2026 if specific qualifications are met (i.e., transitional safe harbor).

Excluded entities

Article 1.5 of the Model Rules excludes certain entities from the GloBE rules, including NPOs.  Under Article 1.5.1, the following types of entities are excluded: governmental entities, international organizations, NPOs, pension funds, and certain investment and real estate funds.

Also, Article 1.5.2 treats an entity owned by an excluded entity as an excluded entity to the extent that an ownership test and activities test are met (collectively, excluded-entity tests).  The ownership test is met if at least 95% of the value of the entity’s equity is owned by an excluded entity.  The activities test is met if either (1) the entity operates exclusively or almost exclusively to hold assets or invest funds (e.g., a mere holding company), or (2) the entity only carries out activities that are ancillary to the activities carried out by an excluded entity (e.g., back-office functions for a charitable organization parent).

The attributes and computations of Pillar Two do not apply to excluded entities other than to determine whether an MNE meets the €750 million revenue threshold.  Excluded entities are not required to file a GloBE information return.

NPOs

Article 10 of the Model Rules defines an NPO as “an entity … established and operated in its jurisdiction of residence: scientific, artistic, cultural, athletic, educational, or other similar purposes” such as public health, the advancement and protection of human rights or animal rights, or environmental protection.  It also includes “a professional organization, business league, chamber of commerce, labour organisation, agricultural or horticultural organisation, civic league or an organisation operated exclusively for the promotion of social welfare. “Additional requirements to be an NPO include:

• Substantially all of the income of the entity is tax-exempt in its jurisdiction of residence;
• No shareholder or member has a beneficial interest in the entity’s income or assets;
• Income or assets are not distributed for the benefit of a private person or a noncharitable entity other than in pursuit of the entity’s exempt purpose, with certain exceptions for payments for services or the acquisition of assets;
• Upon termination, liquidation, or dissolution, all of the entity’s assets must be distributed or revert to an NPO or to the government (including any governmental entity) of the entity’s jurisdiction of residence or any political subdivision thereof; and
• A trade or business carried on by the entity is directly related to the purpose for which the entity is established.

NPOs may set up subsidiaries to carry out limited commercial activities to raise funds for their charitable activities. To mitigate unintended top-up tax consequences for NPOs, the administrative guidance issued in February 2023 provides a bright-line test to provide relief and treat 100%-owned subsidiaries of NPOs as excluded entities (OECD, Tax Challenges Arising From the Digitalisation of the Economy. Administrative Guidance on the Global Anti-Base Erosion Model Rules (Pillar Two), Section 1.6.1 (February 2023)).  Under the bright-line test, the activities of an NPO’s wholly owned subsidiary are ancillary if the aggregate revenue of all group entities (excluding revenue derived by the NPO or by an excluded entity) is less than .750 million or 25% of the revenue of the MNE group to which the NPO belongs, if lower.

NPOs and their affiliates are not subject to the GloBE rules if all affiliates are considered excluded entities.  However, if an NPO has a subsidiary or group member engaged in a taxable trade or business in a jurisdiction other than the jurisdiction where the NPO is resident, that entity must be tested to determine if it qualifies as an excluded entity under the excluded-entity tests or the brightline test.

An NPO must engage in the following analysis to determine if it is subject to the GloBE rules and, if so, how those rules apply.

• The NPO must confirm whether the revenue of the NPO group to which it belongs is at least .750 million on a consolidated basis to identify whether it is in scope for MNE group status;
• If the NPO group is determined to be in scope, it needs to confirm the eligibility of subsidiaries and group members to be treated as excluded entities; and
• If a subsidiary or group member is not an excluded entity, it is treated as a constituent entity (CE) and, therefore, subject to the GloBE rules.  An NPO parent will need to determine the jurisdictional ETR of each CE under the GloBE rules.  If the ETR is below 15%, and the NPO group operates or has subsidiaries in a jurisdiction that has implemented the GloBE rules, it needs to determine whether it is subject to a top-up tax on the CE’s activities.

Open questions for NPOs

As noted, each OECD/G20 IF jurisdiction is required to implement the rules into its local tax laws, which may leave an incredible amount of room for interpreting how that jurisdictionfs laws apply.  As an example, the eligibility for the transitional safe harbors is based on information in country-by-country reports.  However, many NPOs may not be required to file such reports.  For example, in the United States, IRS Form 8975, Country-by-Country Report, is required to be filed by U.S. entities with revenue of $850 million or more, which in July 2024 is over the OECD/G20 IF .750 million revenue threshold.  Under Regs.  Sec.  1.6038-4(d)(3)(ii), revenue for an MNE that is an NPO includes only unrelated business taxable income (UBTI).  Few U.S. NPOs will meet the revenue threshold based on their UBTI, and therefore most will not be required to file Form 8975.

The OECD/G20 IF administrative guidance provides relief to NPOs with annual UBTI revenue below .750 million, allowing them to use different procedures to determine eligibility for the transitional safe harbor for tax years 2024 to 2026 (OECD, Tax Challenges Arising From the Digitalisation of the Economy. Administrative Guidance on the Global Anti-Base Erosion Model Rules (Pillar Two) (December 2023)).  Under the relief, MNE groups can use information from qualified financial statements to partially complete a GloBE information return for the safe harbor.  Depending on their structure, NPOs might use GloBE information returns separately filed by a CE because an NPO ultimate parent would generally be exempt from the filing as an excluded entity.

Other questions have arisen about how the GloBE rules apply to NPOs. For example, “substantially all of the income” needs to be tax-exempt for local tax purposes for an entity to qualify as an NPO.  However, the rules create significant uncertainty because the level of taxable income permitted before losing NPO status could vary by jurisdiction. A related question for NPOs with an ultimate parent entity based in the United States is whether they can rely on the definition of UBTI under the Internal Revenue Code to measure the trade or business activities conducted by their non-U.S. subsidiaries for purposes of the GloBE rules.

Clarification is also needed regarding how to determine whether a trade or business carried out by an entity is directly related to the purposes for which it was established.  Commentary issued in March 2022 provides examples on this point, one of which indicates that commercial activities to raise funds for an NPO would not disqualify the entity from being treated as an excluded entity and another indicating that an entity exclusively engaging in commercial activities would not qualify, even when it gives up its profits to a good cause (OECD, Tax Challenges Arising From the Digitalisation of the Economy — Commentary to the Global Anti-Base Erosion Model Rules (Pillar Two) (March 2022)).  Despite these examples, it remains unclear how this rule is to be applied.

In addition, it is unclear whether the tax-exempt status of an entity under the laws of one jurisdiction will be respected by another jurisdiction if the other jurisdiction does not have a double tax treaty in place addressing NPO activities for purposes of the GloBE rules.  In these cases, an entity will be required to review the local tax rules to confirm whether an NPO will be treated as an excluded entity.  Where local tax rules are unclear, it might be necessary to take measures to mitigate the potential risk that a subsidiary or group member will be treated as a CE subject to the GloBE rules in the nontreaty jurisdiction.

Key takeaways

NPOs that have annual revenue of €750 million or more on a consolidated basis will need to determine how Pillar Two will affect them.  It is important to determine whether any of their subsidiaries carry out commercial activities that would disqualify them from being an excluded entity in jurisdictions that have implemented the GloBE rules or that are likely to implement the rules in the near future.  NPOs with subsidiaries not qualifying as excluded entities should consider the applicability of safe harbors and employ strategies to manage potential top-up tax consequences and associated compliance obligations.

Editor notes

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.