BDO Corporate Tax News

International - Understanding the Subject to Tax Rule

On 3 October 2023, the OECD published the Multilateral Convention to Facilitate the Implementation of the Pillar Two Subject to Tax Rule (STTR MLC), and opened it for signature. The STTR MLI can swiftly implement the STTR in existing bilateral tax treaties without the need for bilateral negotiations.

Alongside the Income Inclusion Rule (IIR) and Undertaxed Profits Rule (UTPR), together known as the GloBE rules, the STTR is the third component of the OECD/G20 Inclusive Framework’s Two‐Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy.
What is the STTR?
The STTR is a fundamental part of Pillar Two. It is intended to work in harmony with the GloBE Rules but takes priority over them. Therefore, the STTR does not take account of an IIR, UTPR or any Qualified Domestic Minimum Top-up Tax (QDMTT). Any tax paid under the STTR will be creditable for the purposes of both the IIR and the UTPR.

However, unlike the IIR and the UTPR, the STTR is a treaty-based provision that will be automatically added to the double tax treaties of jurisdictions that choose to sign the STTR MLC.

The primary objective of the STTR is to safeguard the tax base of developing country members of the Inclusive Framework. For the purposes of the STTR, a country is considered to be developing country if its Gross National Income (GNI) per capita (calculated using the World Bank Atlas method) falls below a specified threshold for a relevant year. A list of countries meeting the definition will be created and maintained.

The STTR has been designed to enable these countries to reclaim certain taxing rights over cross-border payments from their countries in circumstances where their tax treaties would otherwise have ceded such rights. The STTR was crucial in maintaining the cohesion of the OECD/G20 Inclusive Framework.
How does the STTR work?
The STTR allows source jurisdictions to ‘tax back’ specific categories of payments of ‘covered income’; it will operate as a derogation from the restrictions on the taxing rights of the source state under the allocation rules set out in a relevant treaty.

The STTR will apply where:
  • Subject to a further reduction for any preferential arrangements, the income paid is subject to a nominal (importantly, not an effective) income tax rate of below 9% in the destination (residence) jurisdiction, and
  • Domestic (source state) taxing rights have been ceded under a double tax treaty.
The source jurisdiction is entitled to tax back covered income at a rate of up to 9%. The 9% figure will be reduced by the nominal tax rate in the recipient jurisdiction and any existing taxing rights retained under the applicable tax treaty. Special rules apply in situations involving permanent establishments.

The STTR does not operate as a new form of withholding tax on each payment of covered income. Instead, it is levied as an annual charge after the end of a fiscal year and must be self-assessed by the tax-paying entity.
Scope of the STTR
The STTR encompasses several types of payments of income, commonly identified as representing a risk of eroding a source state’s tax base, made between connected persons. Covered income includes:
  • Interest;
  • Royalties;
  • Payments for the use (or right to use) distribution rights in respect of a product or service;
  • Insurance and reinsurance premiums;
  • Fees to provide a financial guarantee or other financing fees;
  • Rental payments for the use (or right to use) industrial, commercial or scientific equipment; and
  • Payments for the provision of services.
Two entities are treated as connected where, as a matter of fact and circumstance, there is a control relationship (directly or indirectly) between them. To prevent particular types of abuse arrangements designed to break a connection, the STTR includes a targeted anti-avoidance rule.
Limitations and exclusions
The STTR does not apply to income paid by or to:
  • Individuals;
  • Pension funds;
  • Investment funds (and other tax neutral vehicles);
  • Non-profit organisations;
  • Contracting states, political subdivisions, local authorities (and other agencies created by a contracting state);
  • Sovereign wealth funds; and
  • International organisations.
The STTR does not create a tax obligation in itself. Instead, the intention is to enable jurisdictions to impose the tax in circumstances where they would otherwise have been unable to do so under their treaty obligations. In addition, the STTR does not apply where the source state can already impose a higher rate of tax under different treaty provisions.

In addition, a materiality threshold ensures the STTR does not apply unless the aggregate sum of covered income paid in any fiscal year exceeds EUR 1 million. That threshold is reduced to EUR 250,000 for smaller jurisdictions, where the country’s gross domestic product (GDP) for that year is less than EUR 40 billion.

Importantly, the STTR operates to amend double tax treaties in a way that is intended to preserve the position that would have applied without the application of the STTR. That is, in cases where the STTR applies, the recipient jurisdiction is not required to either:
  • Exempt payments of covered income taxed under the STTR; or
  • Provide a tax credit for the tax paid under the STTR.
Implementation and commitments
As mentioned above, the STTR MLC will implement the STTR by automatically amending any double tax treaty identified by any developing country signing up to it. At least 70 developing countries are expected to sign the STTR MLC. In addition, individual countries can choose to amend a treaty through bilateral negotiation.

Importantly, as part of the negotiations to finalise the STTR MLC, members of the Inclusive Framework with a corporate income tax rates of less than 9% (in respect of any type of applicable covered income) have committed to incorporate the STTR into their bilateral treaties whenever requested to do so by a developing country (under the MLC).
BDO insight

The STTR is an important part of the wider Pillar Two package. It plays a crucial role in protecting the tax base of developing countries and has helped maintain the consensus within the Inclusive Framework. It remains to be seen how many jurisdictions will sign the STTR MLC, and how many tax treaties will then be amended by it. However, it is essential for multinational entities with operations in developing countries to track the implementation of the STTR in their respective jurisdictions and to stay informed about international tax developments more generally.

Robert O’Hare
BDO Global