On 12 October 2020, the OECD released for public consultation updated reports on its two-pillar proposal to address the tax challenges of the digitalisation of the economy.
The Pillar One proposal focuses on new nexus and profit allocation rules for certain business models, whereas the Pillar Two proposal pursues more broadly a global minimum effective taxation. The reports identify key issues, both political and technical, where divergences remain to be solved. The goal is to reach consensus amongst the 137 participating jurisdictions by mid-2021. Stakeholders are invited to provide their written comments no later than 14 December 2020.
What is the purpose of Pillar One?
The Pillar One proposal is designed to re-allocate to market jurisdictions (MJs) the taxing right on a particular share of an MNE’s `residual profit´ (Amount A). MJs are countries from which foreign companies derive profits without having (under current rules) any taxable presence in such countries. Further, Pillar One is aimed at simplifying the application of transfer pricing rules to determine the profit attributable to standard marketing and distribution functions (Amount B) and enhancing tax certainty through extensive multilateral tax co-operation. The report serves as the basis for a final round of negotiations to reach a consensus-based solution by mid-2021, which should also include the abolition of uncoordinated unilateral measures that individual countries have taken in the meantime.
Which taxpayers are targeted?
The proposal covers highly digitalized businesses providing “Automated Digital Services” (ADS), such as online advertising services, social media platforms and online intermediation platforms, and also consumer-facing businesses (CFB), i.e., businesses that sell goods and services primarily targeted at consumers . The detailed scope of each of the two groups is one of the key pending political issues. For ADS, a general definition applies coupled with a positive and a negative list of activities that are in any event `in´, respectively `out´ of scope.
To be effectively covered, an MNE group’s global consolidated revenue must meet a threshold amount (initially set at EUR 750 million) as established under international financial accounting standards, while at the same time a significant part of that global revenue needs to be derived from foreign sources (no threshold set yet).
How would it work?
Amount A
MNE groups that are covered by the proposal may be taxed by MJs on a particular share of their `residual profit´ (Amount A), regardless of any physical presence (such as a permanent establishment) in such jurisdictions. This taxing right of MJs reduces the effective taxing rights that other states may have under the current rules – as residence country or source country – to tax cross-border profits of MNEs.
To establish the profits taxable by MJs as Amount A profits, a three-step formula applies. First, an amount representing the `deemed routine profit´ (computed on the basis of a fixed percentage) would be deducted from the MNE group’s global profit. Next, a fraction (still to be agreed upon) of the remaining ‘deemed residual profit’ is allocated to the MJs (and distributed among them on the basis of a certain formula). If an amount of residual profit of an MNE has already been allocated to a MJ under the existing arm’s length profit allocation rules (e.g. because of the presence of a permanent establishment), a certain mechanism is provided to grant relief of the double taxation that otherwise would occur.
According to the report, rules relating to the MJs’ taxing right would need to be implemented in domestic laws on the basis of a multilateral convention. Further, the report proposes the introduction of a multilateral “tax certainty process” to provide MNEs with certainty regarding the computation of Amount A and the relief to be provided where the new taxing rights coincide with the application of the existing rules.
Amount B
Amount B refers to a fixed return (based on third party comparables using the Transactional Net Margin Method) for standard (`baseline´) marketing and distribution activities taking place physically in a MJ. These standard activities involve group entities that act as routine distributors, e.g., through purchasing products from associated companies and reselling them to unrelated parties. To increase simplicity, it is proposed to define the covered baseline activities by reference to a “positive list” of typical functions performed, assets owned and risks incurred by routine distributors, along with a “negative list” that would include non-routine marketing and distribution activities.
Improved tax certainty processes
Pillar One also aims to improve tax certainty through innovative and effective dispute prevention and resolution mechanisms. In employing these mechanisms, the report makes a distinction between issues involving Amount A and other issues.
- For issues involving Amount A, a binding dispute prevention procedure is proposed. The MNE would submit a request to apply this procedure to the `lead´ tax administration (e.g., the jurisdiction where the parent company is located) which would conduct an initial review to assess whether a review panel is needed. If the tax administration concludes that a panel review is needed, a panel comprising representatives of 6 to 8 affected tax administrations is set up. The conclusion reached by the panel can be accepted or rejected by the MNE. If the review panel is unable to reach a conclusion, the relevant questions will be submitted to a ‘determination panel’, which is obliged to reach a decision. The outcome of this process will be binding for the MNE and the tax administrations involved. If the MNE does not accept the panel’s decision, it may withdraw its request and use domestic administrative and judicial review procedures in the respective jurisdictions. Also, if an MNE prefers to not submit a request to apply for this binding procedure, any dispute that arises should be dealt with through appropriate mandatory binding dispute resolution mechanisms. It is anticipated by the OECD, however, that most MNEs will make use of the early certainty procedure.
- Other issues: the report proposes to improve existing dispute prevention mechanisms (such as joint audits, bilateral and multilateral APAs, etc.) as well as the existing mutual agreement procedure. In addition, it is proposed to develop mandatory binding dispute resolution mechanisms.
What are the main open items?
Over the last few months, significant progress has been made on the technical design of Pillar One. At the same time, it is recognized that various important issues, both technical and political, are still pending. The technical work cannot be completed until political decisions have been made on key issues, including:
- Scope: the definition of ADS and CFB activities and the thresholds to be applied. Various options have been reviewed, such as a phased implementation that starts with higher thresholds, and the application of the rules to ADS first, with CFB following later. Such a phased approach may help to make the new rules manageable and will offer an opportunity to gain practical experience. Another – less likely – option would be to implement Amount A on a “safe harbour” basis, whereby MNEs could elect to apply Pillar One.
- Determination of Amount A: the fraction to be applied to the deemed residual profits in order to establish Amount A will be difficult to be agreed upon. In addition, several members of the Inclusive Framework (IF) have proposed to expand the scope of Amount A by also allocating a portion of routine profit for remote performance of marketing and distribution activities to MJs
- Application of Amount B: some IF members wish to broaden the scope of Amount B (e.g., by way of standardising the remuneration for the various business models functions) and other members wish to refine the design of Amount B or to implement it only for an initial trial period.
- Tax certainty measures: the IF still did not bridge the gap between members in favour of introducing a binding dispute resolution mechanism and those that are of the view that disputes should be resolved only through the existing MAP mechanism and other non-binding administrative tools.
Which actions can businesses take?
In the short term, MNEs that may be affected by the future rules should take the opportunity of the public consultation to communicate the concerns they may have in terms of complexity of the proposed rules and the administrative burdens they bring along. Comments can be submitted to the OECD until 14 December 2020 with a public consultation meeting scheduled for mid-January 2021. Loyens & Loeff gladly assists in providing input to the consultation.
In the coming months, MNEs that are subject to country-by-country reporting obligations (or may reach the EUR 750 million turnover threshold in the next 2 years) are strongly advised to assess whether or to what extent they may be affected by the reallocation of taxing rights to market jurisdictions, and in which countries this may occur. Although some (practical) aspects of the Pillar One proposal are still unknown, the mechanics thereof seems to be rather clear. Clients could choose to model the implications of the introduction based on various scenario’s so that they can determine what the potential impact for them is in order to (i) explain this to various stakeholders, (ii) to prepare themselves while participating in the public consultations and (iii) to assess whether it is possible to perform a re-structuring in order to mitigate any potential adverse consequences. Loyens & Loeff gladly assists MNEs that may be affected with this assessment, where we can make a scenario and sensitivity analysis to model the expected impact of Pillar One.
The new target deadline for an overall political agreement on Pillar One and Pillar Two is mid-2021. For a summary of the report on Pillar Two, please see our Tax Flash on Pillar Two. We will keep you informed about further developments. Should you have any question, please contact a member of our Digital Economy Taxation team or your trusted Loyens & Loeff adviser.
