Substance-Based Carve-Outs under the OECD’s Pillar Two Rules

BEPS, Pillar Two, and Global Minimum Tax

Introduction

With the introduction of the OECD’s Global Minimum Tax (Pillar Two), multinational enterprises (MNEs) face significant changes in how jurisdictions tax their income. One of the most important features designed to soften the impact of the minimum tax is the Substance-Based Income Exclusion, commonly referred to as the Substance-Based Carve-Out.

This mechanism ensures that profits genuinely supported by real economic activity employees and tangible assets are partially shielded from top-up taxes.
For groups operating across the Middle East, Africa, and Europe, understanding these carve-outs is essential for planning, compliance, and minimizing additional tax exposure.

1. What Are Substance-Based Carve-Outs?

Under Pillar Two, the global minimum tax is applied on a jurisdiction-by-jurisdiction basis.
However, before calculating any top-up tax, MNEs are allowed to exclude a portion of their income tied to real substance.

This exclusion is designed to prevent penalizing jurisdictions that legitimately host:

  • Employees performing core functions

  • Tangible assets used in operations

  • Real economic activities that generate value

In short: the more substance you have, the less likely you are to pay top-up tax.

2. How the Substance-Based Exclusion Works

The exclusion is calculated as follows:

Substance Exclusion = (Payroll × Payroll Factor) + (Tangible Assets × Asset Factor)

Where:

  • Payroll Factor initially = 10% (declines to 5% over 10 years)

  • Asset Factor initially = 8% (declines to 5% over 10 years)

These factors gradually decline as the rules transition to a stable long-term model.

3. What Counts as “Payroll” and “Tangible Assets”?

Payroll Includes:

  • Salaries

  • Wages

  • Bonuses

  • Social insurance contributions

  • Employer pension contributions

Independent contractors may be excluded depending on local rules and economic substance tests.

Tangible Assets Include:

  • Machinery and equipment

  • Buildings

  • Production lines

  • Vehicles

  • Physical operational assets

Intangible assets (IP, trademarks, patents) do NOT count for the carve-out.

4. Why the Carve-Out Matters for MENA Multinationals

Many MENA jurisdictions especially the UAE, KSA special zones, Qatar Free Zones, Bahrain, and Egypt’s special economic areas offer competitive tax structures.
Under Pillar Two, these jurisdictions could easily fall below the 15% threshold unless they have substance.

The carve-out helps:

  • Protect legitimate operations

  • Reduce top-up tax exposure

  • Support business hubs and shared-service centers

  • Strengthen incentives for real investment in people and assets

MNEs with strong substance footprints benefit significantly from the exclusion.

5. Example: Computing a Substance-Based Exclusion

Assume a jurisdiction has:

  • Payroll: USD 10 million

  • Tangible assets: USD 50 million

  • Payroll factor: 10%

  • Asset factor: 8%

Exclusion = (10M × 10%) + (50M × 8%)

Exclusion = 1M + 4M = 5M

This means USD 5 million of GloBE income is excluded before computing any top-up tax.

6. Key Considerations When Using the Carve-Out

6.1 Substance must be real and demonstrable

Authorities will examine:

  • Where employees actually work

  • Who performs decision-making

  • Physical assets vs. shell structures

6.2 Outsourcing may reduce the carve-out

Heavy reliance on outsourcing lowers the payroll base.

6.3 Asset-heavy industries benefit the most

Manufacturing, logistics, and energy often get higher carve-outs.

6.4 Service hubs may need restructuring

Groups should reassess substance models to maximize the exclusion.

6.5 Carve-Out declines over time

Groups must plan for the reduction in payroll and asset factors.

7. Practical Steps for Multinationals in the MENA Region

1. Perform a Substance Gap Analysis

Identify weak areas vs. Pillar Two requirements.

2. Document Substance Thoroughly

Contracts, staffing, governance, and physical presence.

3. Reassess Holding, IP, and Financing Structures

To ensure optimal allocation of substance.

4. Strengthen local operational presence

Especially in low-tax jurisdictions.

5. Upgrade systems to produce GloBE-ready substance data

ERP, HR, finance, and compliance systems must be aligned.

Conclusion

Substance-Based Carve-Outs are one of the most critical tools for mitigating additional tax exposure under Pillar Two.
For MNEs operating across the MENA region, strengthening operational substance employees, assets, governance is not just a compliance measure, but a strategic advantage.

Organizations that proactively optimize their substance footprint will reduce top-up tax risks and maintain flexibility within the new global tax framework.

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