Pillar Two elections explained: realisation method instead of fair value method

Pillar 2 elections explained

In this blog series we explain the Pillar Two elections as prescribed in Global Anti-Base Erosion Model Rules.

Realisation method instead of fair value method

Article 3.2.5 provides an election to use the realisation method for assets and liabilities that, in the Constituent Entity’s financial accounts, are accounted for using the fair value method or the impairment accounting method.

Rationale election

The policy justification for this treatment is to reduce volatility by allowing the taxpayer to crystallize the gain for GloBE purposes as of the actual disposition date rather than from one period to the next, in line with the accounting treatment.

What is realisation method of accounting?

The realisation method focuses on the historical cost of assets and liabilities instead of fair value accounting, which refers to measuring and reporting financial assets and liabilities at their current market values or the prices at which they could be exchanged between willing parties in an orderly transaction. Fair value accounting aims to provide a more accurate and timely representation of an entity’s financial position by reflecting current market conditions. Here are some examples of the differences between the realisation method and fair value accounting:

Property, Plant, and Equipment (PPE): Under the realization method, PPE is recorded at the original cost (purchase price plus additional costs, such as installation and transportation) and then depreciated over its useful life. In contrast, fair value accounting may require periodic revaluations of PPE to reflect current market values.
Inventory: With the realisation method, companies typically value inventory using the cost basis, such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or weighted average cost methods. In comparison, fair value accounting would require the inventory to be valued at the current market value, which may fluctuate more frequently.
Investments: Long-term investments in stocks, bonds, or other securities are recorded at their historical cost under the realisation method. This contrasts with fair value accounting, where investments are marked to market and adjusted to reflect their current market value.
Intangible Assets: Under the realisation method, intangible assets like patents, copyrights, and trademarks are recorded at their historical cost and amortised over their useful life. Fair value accounting may require periodic assessments of the intangible assets’ current value, which can be challenging due to the need for an active market for many intangible assets.
Long-term Liabilities: The realisation method records long-term liabilities, such as bonds or loans, at their historical cost (the amount borrowed) and adjusts for any amortization of discounts or premiums. On the other hand, fair value accounting would require the revaluation of these liabilities based on current market interest rates, which can result in fluctuations in the reported liability value.

What is impairment accounting?

Impairment accounting, is a specific process that involves the evaluation and recognition of a decline in the carrying value of an asset. Impairment occurs when the carrying value of an asset (the amount at which it is recorded on the balance sheet) exceeds its recoverable amount, which is the higher of its fair value minus costs to sell and its value in use (the present value of future cash flows expected to be generated from the asset). Impairment accounting aims to ensure that assets are not overstated on the balance sheet, which could mislead financial statement users.

When an impairment is identified, the carrying value of the asset must be reduced to its recoverable amount, and an impairment loss is recognised in the income statement. Impairment accounting is typically applied to long-lived assets, such as property, plant, and equipment (PPE), intangible assets, and goodwill.

What are the differences between fair value and impairment accounting?

Fair value method accounting is a broader concept that deals with the measurement and reporting of assets and liabilities at their current market values, whereas impairment accounting specifically focuses on the identification and recognition of declines in the carrying value of assets. Although both concepts involve the use of fair value, impairment accounting is a subset of the overall fair value accounting framework.

Another difference is that Impairment accounting primarily deals with the identification and recognition of declines in the carrying value of assets. However, under specific circumstances, some accounting standards allow for reversing impairment losses, which can result in an upward adjustment of the carrying value. The treatment for reversal of impairment losses depends on the type of asset and the accounting standards being followed.

Under IFRS (International Financial Reporting Standards):

Non-financial assets: For assets such as property, plant, and equipment (PPE) and intangible assets other than goodwill, IFRS allows the reversal of impairment losses when there is a clear indication that the circumstances that led to the impairment have changed, and the asset’s recoverable amount has increased. The carrying value of the asset can be adjusted upward, but it should not exceed the carrying amount that would have been determined if the impairment had not been recognised.

Goodwill: IFRS does not allow the reversal of impairment losses related to goodwill. Once an impairment loss has been recognised for goodwill, it cannot be reversed, even if the circumstances that led to the impairment change.

Under US GAAP (Generally Accepted Accounting Principles):

Non-financial assets: For assets such as property, plant, and equipment (PPE) and intangible assets with finite useful lives, US GAAP does not generally allow the reversal of impairment losses. Once an impairment loss has been recognised, it cannot be reversed in future periods.

Goodwill: Similar to IFRS, US GAAP does not permit the reversal of impairment losses related to goodwill.

It is essential to note that the ability to reverse impairment losses and adjust the carrying value of an asset upward is subject to specific conditions and limitations, depending on the applicable accounting standards.

Specifics election

Aspect – Description
Scope – Assets and liabilities of all Constituent Entities in a jurisdiction
Timing – Election may be made after the year in which the asset was acquired
Applicability Option 1 – Limited to tangible assets of the Constituent Entities
Applicability Option 2 – Limited to assets and liabilities of Constituent Entities that are Investment Entities

What are Tangible assets of Constituent Entities under Pillar Two?

Land – Undeveloped or developed land used for various purposes such as agriculture, commercial, or residential
Buildings – Structures used for residential, commercial, or industrial purposes
Machinery and Equipment – Machines, tools, and equipment used in manufacturing or production processes
Vehicles – Cars, trucks, and other transportation equipment used for business purposes
Furniture and Fixtures – Desks, chairs, and other office furniture, as well as lighting and other fixtures
Inventory – Raw materials, work-in-progress, and finished goods held for sale
Leasehold Improvements – Alterations or improvements made to a leased property by the tenant
Infrastructure – Roads, bridges, tunnels, and other large-scale public works
Natural resources – Oil, gas, minerals, timber, and other resources that are extracted or harvested
Art and collectibles – Paintings, sculptures, rare coins, stamps, and other items with cultural or historical value
Livestock and agricultural assets – Animals, crops, and farming equipment
Computer hardware – Servers, computers, laptops, and other electronic devices

Important note: It is essential to note that tangible assets can be industry-specific and may vary across businesses and sectors. The list provided should be considered as a starting point rather than an exhaustive representation of all possible tangible assets.

What are Investment Entities under Pillar Two?

Category – Investment Entity

(a) Investment Fund or Real Estate Investment Vehicle
(b) Entity at least 95% owned directly by an Entity described in (a) or through a chain of such Entities, operating exclusively or almost exclusively to hold assets or invest funds for the benefit of such Investment Entities
(c) Entity where at least 85% of the value is owned by an Entity referred to in (a), and substantially all of the Entity’s income is Excluded Dividends or Excluded Equity Gain or Loss that is excluded from the computation of GloBE Income or Loss in accordance with Articles 3.2.1 (b) or (c)

What is Investment Fund under Pillar Two?

Criterion – Investment Fund

(a) Collects money from different investors (not all related) to combine into one large pool
(b) Follows a specific strategy or plan when investing the pooled money
(c) Helps investors save on transaction costs, research, and analysis, and allows them to share risks
(d) Main goal is to earn money from investments or provide protection against specific or general events or outcomes
(e) Investors have the right to get back their share of the fund’s assets or earnings, based on how much they invested
(f) The fund or its managers must follow rules and regulations in the country where it operates, including anti-money laundering and investor protection
(g) Managed by professional investment fund managers who make decisions on behalf of the investors

What is Real Estate Investment Vehicle under Pillar Two?

Real Estate Investment Vehicle is a type of organisation that mainly focuses on owning property. This organisation is designed to have only one level of taxation, either at the organisation level or at the level of its investors (with a possible delay of up to one year). Additionally, this organisation is widely owned by many different investors.

One level of taxation refers to a situation where income generated by an entity is taxed only once, either at the entity level or at the investor/owner level, but not at both levels. This concept is meant to avoid double taxation, which occurs when the same income is taxed twice: first at the entity level (such as a corporation) and then again at the individual level when the income is distributed to investors or shareholders.

In the context of a Real Estate Investment Vehicle, having one level of taxation means that the income generated by the vehicle is taxed either within the entity itself or in the hands of its investors. This structure helps to simplify the tax treatment and reduce the overall tax burden for the investors.