According to the OECD, the new international taxation framework set forth in its Pillar One blueprint recognizes that in an increasingly digital age, taxing rights can no longer be exclusively determined by reference to physical presence. The blueprint therefore contains new nexus rules for in-scope revenue under Amount A. (For an overview of Pillar One and a discussion of the scope of Amount A, please see our prior blog posts.) The scope tests seek to capture those large MNEs that are able to participate in an active and sustained manner in the economic life of market jurisdictions through engagement extending beyond the mere conclusion of sales, in order to generate profits, without necessarily having a commensurate level of taxable presence in that market (based on existing nexus rules).
The nexus rules are designed to protect the interests of smaller jurisdictions, and in particular developing economies, and their desire to benefit from the new taxing right. The new nexus rules determine entitlement of a market jurisdiction to an allocation of Amount A only. They do not alter the nexus rules for other tax purposes. The new nexus rules could apply differently for ADS (Automated Digital Services) and CFB (Consumer Facing Businesses). For ADS, exceeding a market revenue threshold could be the only test to establish nexus. According to the OECD, the very nature of the ADS allows them to be provided remotely and such businesses generally have a significant and sustained engagement with the market even if there is not a physical presence. For CFB, the OECD believes that the ability to participate remotely in a market jurisdiction is less pronounced. This, together with the additional complexity and compliance costs associated with sourcing revenue derived by CFB and the broad acknowledgment that profit margins are typically lower for CFB compared to ADS, could justify a higher nexus standard for CFB. One approach for satisfying this higher nexus standard is through a higher threshold and the presence of additional indicators (“plus” factors) which would evidence an active and sustained engagement in that jurisdiction beyond mere sales.
The Blueprint therefore sets out an approach based on these elements: for ADS, nexus is achieved based solely on a revenue threshold; for CFB, nexus is based on a revenue threshold and a “plus factor” to indicate a significant and sustained engagement with the market. One plus factor could be a subsidiary or a “fixed place of business” (e.g. a permanent establishment based on the commonalities of the UN and OECD Model definitions) with the requirement that the entity or PE is carrying out activities that are connected to in-scope sales.
The market revenue thresholds will apply to the in-scope revenue of a group (or segment of a group where relevant) generated in a market jurisdiction. The market revenue will be identified and measured in accordance with revenue sourcing rules and could apply separately to ADS and CFB. The nexus rules will follow any wider segmentation approach, i.e., the nexus will be assessed at the level of a segment where a group segments its operations in computing its Amount A tax base.
Comment: Of course, determining nexus based solely on revenue would be a departure from traditional notions of nexus.
Further work will need to be undertaken to decide whether to apply a temporal requirement. Such a requirement would avoid covering isolated or one-off transactions that might not demonstrate a sustained engagement with a market. A duration test could be designed by requiring that the market revenue threshold be exceeded over a period spanning more than one year before establishing nexus. The nexus rules could use a simple monetary amount of revenue in the market – one for ADS and a higher one for CFB. However, consideration is also being given to using higher thresholds for large markets and lower thresholds for small, developing economies.
For CFB, a level of sales just over the market revenue threshold may not denote the active and sustained engagement with the market beyond the mere conclusion of sales that is envisaged as the justification of the new taxing right. To demonstrate this level of engagement, the presence of additional indicators (“plus factors”) may be necessary. One option being considered is that, where sales in a market have passed a certain level, the MNE can be presumed to have an active engagement. In that case, plus factors would be deemed to exist.
Several possible plus factors have been examined. They include having an existing physical presence in the form of a permanent establishment or the residence of a group entity; a physical presence that falls short of a permanent establishment; and the undertaking of material, targeted and sustained advertising and promotion activities that support in-scope sales into the market jurisdiction.
In the interest of simplicity, the likely indicator used would be just physical presence. The OECD believes that a physical presence in the form of a subsidiary or permanent establishment seems the simplest way to establish a nexus (beyond mere selling) particularly as the PE or resident entity will likely already have filing and reporting requirements in that jurisdiction. To establish an “active and sustained physical presence”, there could be a requirement in this test that the activities carried out are connected to in-scope revenues. This requirement could include not only distribution activities but also activities directly supporting sales into the market.
One possibility is to take the PE definition in any tax treaty that exists between the state of residence of a group entity and the market jurisdiction that has triggered the existence of a PE. But this option could lead to issues of fairness and risk of distortions. To remove these concerns, the preferred approach may be to use a single, self-standing group PE definition instead of relying on a PE definition in a tax treaty or domestic law. One possibility is to develop a group-PE test taking the basic PE principle shared between the UN and the OECD models: a fixed place of business through which an in-scope CFB of the MNE group is wholly or partly carried on.
Another approach may be to assume that once a group’s CFB sales in a market reach a certain threshold it will no longer be necessary to establish the existence of plus factors (i.e. the group could be treated as having a nexus). Depending on where revenue thresholds are set, consideration may also need to be given to using a lower nexus standard for small, developing economies. A few OECD members have favored the addition of a test based on a sustained presence or personnel in a market jurisdiction. A test of advertising and promotion expenditure is another test that has been explored.
Comment: Of course, a nexus test based solely on advertising and promotion expenditures would be a departure from traditional notions of nexus.