Understanding ‘Adjusted Covered Taxes' in Pillar Two framework

Kuwait Times

3 days ago

Kuwait's recent stride into the era of global minimum taxation, marked by Law 157/2024 and its executive regulations, brings with it a precise methodology for assessing the tax contributions of large multinational enterprises (MNEs). We have previously explored 'GloBE Income or Loss' – the specially defined profit measure for these rules. Now, we turn our attention to the other vital component, that is 'Adjusted Covered Taxes'. Together, GloBE Income and Adjusted Covered Taxes form the numerator and denominator of the Effective Tax Rate (ETR) calculation. Just as GloBE Income is not simply accounting profit, Adjusted Covered Taxes is not merely the 'tax paid' figure on a company's financial statement. It is a meticulously crafted measure designed to ensure that only the relevant taxes on GloBE Income are counted towards the 15 percent global minimum. This precision is critical for the fairness and effectiveness of Pillar Two, and particularly for Kuwait's ability to collect its Qualified Domestic Minimum Top-up Tax (QDMTT).
The starting point: Current and deferred tax expense
The calculation of Adjusted Covered Taxes begins with the current and deferred tax expense, or benefit, recognized in the financial statements of each constituent entity within an MNE group. This is the amount of income tax a company records in its books, reflecting not just the tax due for the current year, i.e. the current tax, but also the tax implications of future events resulting from today's transactions, that is the deferred tax.
Why both current and deferred tax?
Because taxes are complex. Companies often have differences between their accounting profit and their taxable profit due to timing. For instance, an expense might be recognized in accounting records now but deductible for tax purposes only in a future year. This creates a 'deferred tax asset (DTA)' or 'deferred tax liability (DTL)' on the balance sheet. Pillar Two aims for a comprehensive picture of the tax burden over time, hence the inclusion of both.
The necessity of adjustments: Filtering what truly 'covers' GloBE Income
Just as with GloBE Income, various adjustments are made to the financial accounting tax expense. These adjustments ensure that only taxes directly attributable to the GloBE Income are considered, and that certain non-qualifying or distorting items are excluded. The goal is to arrive at a clean measure of the actual tax burden that relates to the income subject to the 15 percent minimum tax. Here are some of the key types of adjustments:
1.Exclusion of non-income taxes: The GloBE Rules are specifically about income taxes. Therefore, taxes that are not imposed on income or profits, e.g., property taxes, customs duties, value-added tax, or even general business levies that are not profit-based, are excluded from Adjusted Covered Taxes, even if they are labeled as 'taxes' in the financial statements. They are treated as ordinary business expenses.
2.Taxes on excluded income: If certain types of income or gains are excluded from GloBE Income, as we discussed in the previous article, such as most dividends or specific equity gains, then any income tax paid on that specific excluded income must also be removed from Adjusted Covered Taxes. This 'matching principle' is vital: if income is not counted towards GloBE Income, its related tax should not count towards Covered Taxes.
3.Uncertain tax positions (UTPs): Companies often record provisions for uncertain tax positions – amounts they might have to pay if a tax authority challenges their tax treatment. These provisions are initially excluded from Adjusted Covered Taxes. Why? Because they represent a potential future liability, not a tax currently paid or firmly committed. They are only included when the underlying tax is actually paid. This ensures that the ETR calculation reflects taxes that are genuinely borne by the MNE.
4.Qualified refundable tax credits (QRTCs): As previously noted, QRTCs, ie tax credits that are essentially direct government subsidies because they are refundable in cash, even if there is no tax liability, are treated as income for GloBE purposes.
Consequently, any reduction in current tax expense due to a QRTC is added back to Adjusted Covered Taxes. This prevents them from artificially lowering the ETR, as they are not true tax payments. Non-qualified refundable tax credits, however, reduce the Covered Taxes.
5.Deferred tax adjustments: A complex area: This is arguably the most intricate part of the 'Adjusted Covered Taxes' calculation. While deferred tax expense is a starting point, it undergoes several important adjustments:
• Recapture rule: A key safeguard is the 'recapture rule' for deferred tax liabilities (DTLs). If a DTL, which increased Adjusted Covered Taxes in an earlier year, thus improving the ETR, does not reverse into taxable income within a specified period, generally five years, it is 'recaptured.' This means the original DTL amount is reversed from Adjusted Covered Taxes, and the ETR for the earlier year is recalculated, potentially leading to a top-up tax being due. This prevents MNEs from using long-term timing differences to permanently lower their ETR.
• Deferred tax assets (DTAs) from tax credits and losses: Generally, DTAs arising from tax credits are not included in Adjusted Covered Taxes unless explicitly provided for, e.g., transitional rules for pre-Pillar Two losses. Similarly, DTAs from tax losses may be limited in their use to prevent distortions. The rules focus on ensuring that only those deferred taxes that truly represent a future cash tax payment related to GloBE income are counted.
• Valuation allowances: Adjustments are made for valuation allowances related to deferred tax assets. A valuation allowance is an accounting reserve against a deferred tax asset, reflecting uncertainty about whether the company will generate enough future taxable income to utilize the DTA. For GloBE purposes, these allowances are typically reversed to avoid volatility and ensure a consistent approach to the recognition of deferred taxes.
• Rate cap on deferred taxes: Deferred taxes are generally taken into account at the 15 percent minimum rate, even if the domestic tax rate is higher. This caps the benefit of deferred taxes in the ETR calculation.
6.Allocation of taxes: In certain complex scenarios, taxes may need to be allocated between different Constituent Entities or jurisdictions to ensure they are matched with the corresponding GloBE Income. For example, taxes imposed on a parent company for the income of its Controlled Foreign Corporation (CFC) are allocated to the CFC's jurisdiction to ensure the tax is paired with the underlying income. Similarly, taxes paid by an owner on the income of a 'flow-through' such as partnership entity are allocated to that entity.
The role of adjusted covered taxes in Kuwait's QDMTT for the Ministry of Finance in Kuwait, correctly identifying and calculating 'Adjusted Covered Taxes' for each in-scope MNE's Constituent Entities in Kuwait is paramount for the operation of its Qualified Domestic Minimum Top-up Tax (QDMTT). The QDMTT, as implemented by Law 157/2024, works by comparing the aggregate GloBE Income of all Kuwaiti constituent entities against their aggregate Adjusted Covered Taxes. If the resulting jurisdictional ETR for Kuwait falls below 15 percent, the QDMTT applies. The accuracy of the Adjusted Covered Taxes figure directly impacts this calculation. If taxes are incorrectly included or excluded, it could lead to an inaccurate ETR, potentially resulting in either an under-collection or over-collection of the QDMTT.
The Challenge for MNEs in Kuwait
The detailed requirements for calculating Adjusted Covered Taxes present a significant operational challenge for MNEs with a presence in Kuwait.
Companies must: Reconcile book-to-tax differences: Meticulously track and adjust for all temporary and permanent differences between their financial accounting tax expense and the GloBE definition of Covered Taxes.
Manage deferred taxes: Implement robust systems to track deferred tax balances, monitor the reversal of DTLs for the recapture rule, and correctly account for DTAs under the GloBE framework.
Data systems: Ensure their financial and tax reporting systems can capture the necessary data at the required level of granularity for each Constituent Entity in Kuwait. Precision for Fair Taxation Adjusted Covered Taxes might seem like a technical detail, but it is a critical pillar supporting the entire Pillar Two framework. It ensures that the ETR calculation is based on a consistent, globally comparable measure of the actual tax burden borne by MNEs on their GloBE Income. By meticulously defining what constitutes 'Adjusted Covered Taxes,' the GloBE Rules aim for accuracy and fairness, preventing companies from artificially lowering their effective tax rates. For Kuwait, this precision allows our nation to accurately calculate and collect its domestic minimum top-up tax, ensuring that large multinational corporations operating on our soil contribute their fair share, ultimately supporting Kuwait's ongoing development and prosperity. This deep dive into the numbers underscores the robust nature of Kuwait's commitment to modern, equitable international taxation.
NOTE: Hassan M Abdulrahim is a Senior Instructor (Business) at Canadian College Kuwait and CEO & Co-founder of Visionary Consulting Company