The treatment of investment portfolios under the GloBE rules is likely to prove particularly complex. This will be the case whether the portfolio in question is held as part of a broader asset management business, or as an ancillary part of a trading group. Both will require careful thought under the new Pillar Two rules.

Precisely what the issues are will depend on the nature and composition of the portfolio in question. For a full calculation, knowledge of a range of facts for each individual investment will be necessary including the size of stake of each investment, length of time held, the type of asset or entity, withholding tax position, and the accounting treatment of the asset itself and any returns. This will be no mean feat and may require disaggregation of the detail of a portfolio on a scale some investors may not be used to.

No distinction between income and capital

Portfolio managers will traditionally have been alive to whether their returns comprise income or gains for tax purposes, not least because many tax systems distinguish between the two. Some jurisdictions, for instance, do not tax capital gains at all (but do tax income). Others may tax income and capital returns at different rates, or have specific reliefs that apply to one but not the other.

Pillar Two, however, is not couched in the concepts of income and capital. The fundamental mechanic defines a group’s jurisdictional “GloBE income” by reference to the amounts recognised in its income statement, into which both income and capital items may have fed. That same mechanic then asks whether that profit has been subject to the minimum ETR of 15%. If the answer is “no”, the GloBE rules are indifferent to whether this is because of distinctions deliberately drawn in a domestic system between the types of return.

No exclusion for investment incentives

Portfolio returns may be exempt from tax, or subject to reduced rates, for reasons other than their classification as capital rather than income. Jurisdictions may offer specific tax incentives to funds or portfolios that meet certain conditions. The effect of the GloBE rules on these incentives will be the same as any other tax incentives that reduce the applicable tax rate payable – to the extent the result is to reduce the jurisdictional ETR to below 15%, then top-up tax is likely to become due.

Exclusion for returns on some equity investments

The GloBE rules contain a reasonably broad-based exception for returns on equity investments, the scope of which turns, to an extent, on the size of the stake in question, and the availability of which may affect a group’s investment strategy.

The key threshold that will affect the treatment of both distributions and capital returns is whether the investing entity holds 10% or more of the investee – this is explained further below.

Size of stake: dividends and other distributions

The GloBE rules distinguish between what investors might view as “good” and “bad” distributions (which include but are not limited to dividends).

“Good” distributions are those paid from investments held for over 12 months, or in virtue of a stake of 10% or more. Those distributions will not be taken into account in the computation of a group’s GloBE income (and therefore the rules will not “expect” tax to have been paid on them, and will not move to counteract cases where it hasn’t been).

“Bad” distributions are the rest, i.e. those that are not “excluded” – the rules refer to these as “short-term portfolio holdings”. Such distributions will form part of an entity’s GloBE income; to the extent those distributions have not been taxed at 15% they are likely to drag down a group’s ETR making it more likely that its profits will attract a top-up tax.

The broad result of this is that GloBE rules operate to counteract low or no tax paid on distributions from short-term, minority stake investments.

Size of stake: capital disposals

Similar principles apply to capital returns, with the important distinction that it is only the size of the stake (whether or not it more than or equal to 10%) that determines whether or not the return is included - longevity of holding is irrelevant.

Breadth of application

The exclusions, which we have discussed above, apply to distributions and capital returns from entities in which the recipient has an “ownership interest”. An ownership interest is defined as an equity interest that carries rights to the profits, capital or reserves of an entity (or its permanent establishment).

There is little guidance as to what an “equity interest” means in this context. While the commentary tells us that equity interests are those which are “accounted for as equity under the financial accounting standard” used to prepare the consolidated financial statements, the application of this test in practice raises a range of questions which are not obviously dealt with in the commentary.

It is clear that such interests are intended to extend beyond stocks and shares (for example, the commentary confirms they can include interests in partnerships and trusts). However, it is also clear that the definition has limits, and that distributions and returns on interests which are not equity interests will not benefit from the exclusions at all – whatever their size and however long they have been held.

Source taxation

Tax may have been paid and withheld at source on returns from an investment and it will be important to think about how this affects a group’s ETR. Withholding taxes are included as covered taxes in the numerator of the GloBE ETR fraction. To the extent a group’s ETR is below 15%, therefore, additional tax at source will simply increase the group’s ETR and reduce its top-up tax exposure. Where there is no substance-based income exclusion, it may be possible that GloBE top-up tax is precluded on a pound for pound basis. This may affect portfolios’ investment strategy: to the extent withholding tax suffered is currently viewed as “leakage” – i.e. an absolute cost – this may no longer be true in all circumstances under GloBE if such leakage goes to reduce or eliminate the corresponding top-up tax that would be imposed in its absence.

Whose tax is it anyway?

As tax withheld at source is economically suffered by the ultimate recipient of the distribution it is generally shown as a tax expense in that recipient’s accounts. While the GloBE rules mirror this position (the entity in whose accounts tax is included as an expense treats that tax as “covered tax”, thereby raising the ETR in the jurisdiction of that entity), there is an important exception where the tax has been withheld on a payment by a subsidiary that is part of the same group as the recipient. In that case, it is that subsidiary (and not the recipient) to whom the tax is allocated as a “covered tax”. It will be important to bear this in mind when considering the effect that source taxation will have on a group’s ETR, particularly where the payer and recipient are in different jurisdictions.

Directly held assets and jurisdictional ETRs

A related consideration is where an entity suffers tax in respect of foreign real estate.

A group company in Luxembourg may, for instance, suffer non-resident capital gains tax in respect of the disposal of its property held in the UK, payable in the UK. Notwithstanding the fact that it is the UK tax system that created the liability and collects the tax, because that tax appears as an expense suffered by a Luxembourg entity it will feature as a covered tax that goes towards raising that group’s Luxembourg – rather than UK – ETR. This may affect the choice of holding entity where a group holds real estate located and subject to tax in a given jurisdiction.

Movements in fair value

The accounting treatment of a given return affects its treatment under the GloBE rules. For example, an asset may be expected primarily to deliver capital growth without providing any cash returns prior to realisation. How the GloBE rules treat this growth will depend in first instance on how it is reflected in financial statements.

The GloBE rules look primarily at the income or loss recognised in the consolidated financial statements. Where a domestic tax regime “follows the accounts” (and taxes movements in the fair value of assets that are reflected in the net income or loss shown in the consolidated financial statements) there is unlikely to be a significant mismatch with its treatment under GloBE - i.e. both the domestic tax system and GloBE rules will view increases as taxable and decreases as deductible (albeit at what rate is another question).

However, a mismatch between domestic and GloBE treatment may arise where GloBE recognises accounting movements in fair value but a domestic tax regime only expects tax to be paid on realisation. For example, a domestic system might ignore movements in the fair value of investment property that are recognised in the owning company’s income statement for accounting purposes, instead taxing the company on its overall gain or loss only when the property is disposed of. However, because the year-to-year movements in fair value have hit the income statement, the GloBE rules will expect tax to have been paid on any increases, with the result that top-up tax becomes due on the same.

Groups would be justified in feeling this is unfair where the net result of those movements is going to be subject to capital gains tax on a future disposal and find the timing difference created here unattractive. The rules acknowledge this, and groups may elect for assets subject to fair value (or impairment) accounting to be dealt with under the realisation method instead. The result is that the calculation of GloBE income will ignore gains/losses attributable to fair value movements, which are instead treated as arising only when the asset is disposed of.

Conclusion

This is far from a comprehensive tour of all the issues that entities holding investment portfolios will need to consider when establishing the exposure those portfolios may create under the GloBE rules. It is indicative, however, of the range and complexity of the features of both the rules and the portfolios themselves that groups will need to identify in order to ensure their GloBE calculation is correct.