Addressing the tax challenges arising from the digitalization of the economy has been a top priority of the OECD since 2015. In January 2019, the OECD agreed to examine proposals in two pillars. Pillar One is focused on nexus and profit allocation whereas Pillar Two is focused on global minimum tax. In July 2020 the OECD was mandated to produce reports on the Blueprints of Pillar One and Pillar Two by October 2020.
According to the OECD, in an increasingly digital age, businesses are able to generate profits through participation in the economic life of a jurisdiction with or without the benefit of a local physical presence, and this should be reflected in the design of nexus rules. The Pillar One Blueprint proposes to allocate a portion of residual profit of in-scope businesses to market or user jurisdictions (“Amount A”) generally without regard to physical presence.
Comment: Disregard of physical presence is, of course, a substantial departure from traditional rules of taxation, which typically rely on notions of physical presence to the exclusion of other possible bases for taxation.
The proposal would build in thresholds so that it minimizes compliance costs for taxpayers and keeps the administration of the new rules manageable for tax administrations. Amount A would be computed using consolidated financial statements as the starting point and will ensure that losses are appropriately taken into account.
Comment: The reliance on consolidated financial statements in computing Amount A is a novel concept. Many taxing authorities are likely to view reliance on consolidated financial statements as a departure from the arm’s length standard, which typically looks to profits earned by individual legal entities as the basis for taxation.
In determining the tax base, segmentation would be required to appropriately target the new taxing right in certain cases, with safe harbor or exemption rules to reduce complexity.
Comment: The use of segmentation to determine the tax base for Amount A is again a novel concept. While segmentation is sometimes a component of GAAP financial statements, segmentation has not heretofore been the basis for taxation and, again, is likely to be perceived by some as a departure from the arm’s length standard.
Amount B will encompass a fixed rate of return on baseline marketing and distribution activities intended to approximate results determined under the arm’s length principle. The Pillar One solution would contain a new multilateral tax certainty process with respect to Amount A, recognizing the importance of using simplified administrative procedures with respect to the administration of Amount A.
With Pillar One, the OECD has attempted to bridge the gap between members seeking to focus Pillar One on a narrow group of “digital” business models and those insisting that a solution should cover a wider scope of activities. As a result, two categories of activities to be included in the scope of the new taxing right created by Pillar One were identified: Automated Digital Services (ADS) and Consumer Facing Businesses (CFB). Some members have advocated for a phased implementation with ADS coming first and CFB following later.
Comment: Whether or not they concurred, no doubt many OECD member states understood the goal of Pillar One to be establishing a new nexus standard for Automated Digital Services, which might be viewed as relatively new forms of commerce. To the extent that this was a common understanding, member states may find the focus on Consumer Facing Businesses to be an attempt to modify tax rules for certain transactions the taxation of which had long been thought to be settled.
The amount of profit to be reallocated under the new taxing right (the “Quantum”) depends on the determination of different threshold amounts and percentages for the purpose of scope, nexus and profit allocation (the formula). Some OECD members are of the view that, beyond residual profit, a portion of routine profit should also be allocated to market jurisdictions in the case of remote marketing and distribution activities facilitated by digitalization. Under the OECD’s current proposal, Amount A would be an overlay to the existing nexus and profit allocation rules. It would apply broadly and would not be limited to a small number of multinational enterprises (MNEs) in a particular industry.
Some OECD members are mindful of the need to keep the number of MNEs affected at an administrable level and have agreed to consider thresholds and other features that help keep the approach targeted. Key design features of the new taxing right would include the following: (1) a revenue threshold based on annual consolidated group revenue coupled with a de minimis foreign in-scope revenue carve out; (2) scoping rules covering ADS and more broadly CFB, including businesses that are able to have significant and sustained interactions with customers and users in a market jurisdiction; (3) the use of a new nexus rule to identify market jurisdictions eligible to receive Amount A; (4) sourcing rules that are reflective of the particularities of digital services and consumer-facing businesses; (5) an administrable approach for reallocating residual profit such that eligible market jurisdictions will receive a portion of residual profit exceeding an agreed level of profit using a formula; and (6) a loss carry-forward regime to ensure that there is no Amount A allocation where the relevant business is not profitable over time.
The purpose of Amount B is two-fold. First, it is intended to simplify the administration of transfer pricing rules for tax administrations and lower compliance costs for taxpayers. Second, Amount B is intended to enhance tax certainty and reduce controversy between tax administrations and taxpayers. Amount B will standardize the remuneration of related party distributors that perform “baseline marketing and distribution activities” in the market jurisdiction.
Comment: To the extent that some taxpayers and taxing authorities regard application of the Comparable Profits Method and the Transaction Net Margin Method as departures from the arm’s length standard, the same criticism is likely to apply with respect to Amount B.