Multinational Top-up Tax and Domestic Top-up Tax

MTT25310 - Calculating the effective tax rate: Covered tax balance: Post-filing adjustment of covered taxes - Effect of rate changes to deferred tax expense

Any deferred tax expense resulting from a change in tax rate is excluded when determining the total deferred tax adjustment amount in the current year (see MTT27140).

The impact of a change in tax rate on the deferred tax expense is instead addressed as a post-filing adjustment to covered taxes under section 217 (see MTT25300), to the extent that the movement in the tax rate occurs below 15% (a ‘relevant change’ in the rate).

In some cases, where there is a change in the rate of tax for a member, there will be an increase or decrease to the value of deferred tax expense that was reflected in the covered tax balance of the member in a previous accounting period.

This is set out in section 218 of Finance (No. 2) Act 2023.

Relevant change of rate

If there is a change of rate but, both before and after the change, the rate remains at the minimum rate of 15% or above, none of the change of rate will be relevant.

When the rate is below 15% and increases, the relevant rate of change will be the change from the original rate to 15%. The change in rate beyond 15% will not be relevant.

When the rate is above 15% and decreases, the change from 15% to the new rate will be relevant. The change from the original rate to 15% is not relevant.

If the rate is below 15% and decreases, the entire decrease will be relevant.

Example 1

In Territory A, the tax rate is 10% and changes to 12.5%. The entire change in rate is relevant as it does not increase beyond 15%.

In Territory B, the tax rate is 14% and changes to 16%. The relevant change in rate is 1% as the increase beyond 15% is not relevant.

In Territory C, the tax rate is 25% and changes to 19%. None of the change is relevant as the rate is above 15% before and after the change.

In Territory D, the tax rate is 17% and changes to 10%. The decrease from 17% to 15% is not relevant. The relevant change in rate is 5%, which is the decrease from 15% to the new rate of 10%.

Change in domestic tax rate reduces the member’s covered tax balance 

Section 217 will apply to reduce a member’s covered tax balance for a prior period by the relevant amount of the rate change where:

• the tax rate of a member changes in an accounting period,
• that change is to some extent relevant, and
• if the deferred tax expense for a previous period were recalculated to account for the rate change, the member’s covered tax balance would be reduced.

Change in domestic tax rate increases the member’s covered tax balance 

Section 217 will apply to increase a member’s covered tax balance where:

• the tax rate of a member changed in a previous accounting period,
• that change is to some extent relevant,
• the member’s deferred tax expense for the current accounting period reflects the reversal of deferred tax assets or liabilities,
• those deferred tax assets or liabilities were recognised at a different rate in an accounting period prior to the rate change, and
• if the deferred tax expense for a previous period were recalculated to account for the rate change, the member’s covered tax balance would be increased.

Example 2

In Year 1, a member claims 15 of covered tax resulting from a deferred tax liability on 100 adjusted profits at 15%.

In Year 2, the domestic tax rate in the territory changes from 15% to 10%. The entire change of rate is relevant as the entire decrease is below 15%.

If, as a result of the change in the domestic tax rate, the member recalculated the deferred tax expense using the new rate of 10% for Year 1, the covered tax balance would be reduced from 15 to 10.

As the entire rate of change is relevant, the whole amount of the reduction of 5 in the prior year covered tax balance is subject to section 217 and recalculations will be required if the conditions of that section are met.

Example 3

A member has adjusted profits of 100 in each of the Years 1, 2 and 3. The 100 income is attributable to interest income which is taxed when received in cash.

In Year 1, the member has adjusted profits of 100 and the domestic tax rate is 10%. The member has a deferred tax liability of 10 (as the tax will only be paid when the cash is received in Year 3) which results in a deferred tax expense of 10. There is no current tax expense and the effective tax rate for the member is 10% (covered tax of 10/ adjusted profits of 100).

In Year 2, the member accrues interest income of 100 and recognises a deferred tax liability at the Year 2 tax rate. In Year 3, the member accrues 100 interest income for the year. The member also receives the 300 of interest income in cash (relating to Years 1, 2 and 3), resulting in a current tax charge equal to 300 x Year 3 tax rate. There is no other income and expenses in any year.

If the tax rate remained the same, the accounting and covered tax balance entries would be as follows:

Scenario 1: the tax rate is 10% in Years 1, 2 and 3

-	10% rate	10% rate	10% rate
Accounts	Year 1	Year 2	Year 3
Pre-tax profit	100	100	100
Current tax	0	0	(30)
Deferred tax	(10)	(10)	20
Post-tax profit	90	90	90
Covered tax	10	10	10

Let us now assume the domestic rate in Year 2 increases to 15%.

The Year 2 deferred tax liability is 15 (100 x 15%). The accounts also record an additional deferred tax expense of 5 attributable to the difference in tax rate from 10% of 15% for the 100 income in Year 1 that has not yet been taxed. The total deferred tax expense in the accounts in Year 2 is therefore 20.

However, under section 182(2)(d) (see MTT27140), the additional deferred tax expense of 5 in respect of the change in tax rate is excluded from the covered tax balance in Year 2. The covered tax balance for Pillar 2 is therefore 15 in Year 2.

In Year 3, the member must pay tax at 15% on the 300 of interest income which is received in cash in Year 3 (representing the 100 of interest which accrued in Year 3 and the 200 which accrued in Years 1 and 2). This result in a current tax expense of 45 (300 x 15%). The deferred tax liability attributable to the Year 1 and Year 2 interest income also reverses.  

Ignoring section 218, the accounting and covered tax balance entries would be as follows:

Scenario 2: Tax rate increases from 10% to 15% (absent section 218)

-	10% rate	Increase to 15% rate	15% rate
Accounts	Year 1	Year 2	Year 3
Pre-tax profit	100	100	100
Current tax	0	0	(45)
Deferred tax	(10)	(20)	30
Post-tax profit	90	80	85
Covered tax	10	15	15

Accordingly, the aggregate covered tax balance for Years 1, 2 and 3 would only reflect a tax expense of 40 when in fact there had been actual tax paid of 45.

Section 218(2) seeks to address this point by requiring an adjustment under section 217 to record an additional expense of 5 in Year 3.

Taking into account section 218, the accounting and covered tax balance entries would be as follows:

Scenario 3: Tax rate increases from 10% to 15% (including impact of section 218)

-	10% rate	Increase to 15% rate	15% rate
Accounts	Year 1	Year 2	Year 3
Pre-tax profit	100	100	100
Current tax	0	0	(45)
Deferred tax	(10)	(20)	30
Post-tax profit	90	80	85
Covered tax	10	15	20

This results in the aggregate covered tax balance for Years 1, 2 and 3 being 45 which matches the actual tax paid.