As discussed in prior blog posts, Amount A will apply as an overlay to the existing profit allocation rules. As the profit of an MNE group is already allocated under the existing profit allocation rules, a mechanism to reconcile the new taxing right (calculated at the level of a group or segment) and the existing profit allocation rules (calculated at an entity basis) is necessary to prevent double taxation. This is the purpose of the mechanism to eliminate double taxation from Amount A. To reconcile the two profit allocation systems, it identifies which entity or entities within an MNE group bears the Amount A tax liability, which effectively determines which jurisdiction or jurisdictions need to relieve the double taxation arising from Amount A. This mechanism is based on two components: (i) the identification of the paying entity or entities within an MNE group or segment; and (ii) the methods to eliminate double taxation.
As discussed in prior blog posts, Amount A will be calculated at a group or segment level using a simple formula, incorporating a profit threshold and a reallocation percentage. The process to identify the paying entities will include a profitability test. However, there are two reasons why the profitability test applied at an entity level cannot be the same test as applied to the group. First, using the same formula to calculate residual profit at a group and entity level could be distortive, because entity-level accounts include intragroup transactions that are eliminated on consolidation and because the inclusion in entity-level accounts of intragroup transactions means that an entity’s revenue and hence profit margin can be easily distorted or manipulated. Second, the use of consolidated accounts at the group or segment level means that for most MNE groups the financial information necessary to compute the Amount A tax base and apply the Amount A formula will be readily available and prepared under a comparable accounting standard, while at an entity level financial information will be less readily available or may be prepared under local standards, and therefore the financial statements for different entities may not be comparable.
Conceptually, different approaches could be considered. For example, consistent with the formulaic nature of Amount A, one option would be to identify the paying entities using a quantitative approach similar to that used to calculate Amount A. Another option would start from the basis that that conceptually, the different features of Amount A suggest that paying entities should not only be profitable, but should also be those that make material and sustained contributions to an MNE group’s residual profits, rather than those that perform only activities that generate routine profits.
The process to identify the paying entities could have up to four steps: step one: identify the entities within an MNE Group that perform activities that make a material and sustained contribution to the group’s ability to generate residual profits; step two: apply a profitability test to ensure the entities identified have the capacity to bear the Amount A tax liability; step three: allocate, in order of priority, the Amount A tax liability to the entities that have a connection to the markets where Amount A is allocated; and step four: allocate, on a pro rata basis, where no sufficiently strong connection is found or where those with a market connection lack the necessary amount of profit.
An activities test would require that taxpayers undertake a qualitative assessment to identify the entities within the MNE group that make material and sustained contributions to a group’s residual profits. This reflects the fact that conceptually, it is these entities within the MNE group collectively that should earn the residual profits corresponding to Amount A profit. Indicia would include the functions, assets and risk profile of an entity, an entity’s characterization for transfer pricing purposes and the transfer pricing method used to determine the remuneration of an entity.
The profitability test would ensure that the potential paying entities have the capacity to bear the Amount A tax liability. The profitability test would ensure that an entity making routine, low profits or losses is not identified as a paying entity, and is consistent with the decision of the OECD to limit the application of Amount A to in-scope MNE groups that earn residual profits rather than all in-scope MNE groups irrespective of profitability. The profitability test, like the Amount A formula, will be applied to financial, rather than tax accounts.
The application of the activities and profitability test will identify a pool of potential paying entities on an MNE group or segment basis. However, there will be instances where these potential paying entities derive profits from only a limited number of market jurisdictions allocated taxing rights over Amount A. A market connection priority test could be introduced to require that, in the first instance, the Amount A liability for a market jurisdiction is allocated to a paying entity that is connected to a market jurisdiction through the performance of activities identified under the activities test.
Where the entity or entities identified under the market connection priority test do not have sufficient profits to bear the full Amount A tax liability for a given market jurisdiction, other paying entities within the group or segment will be required to bear the remaining portion of Amount A tax liability. This portion of the Amount A tax liability would be apportioned between these entities on a formulaic pro-rata basis.
The second component of the mechanism to eliminate double taxation deals with the methods to eliminate double taxation. The application of these methods will ensure that a paying entity is not subject to tax twice on the same profits in different jurisdictions, once under the existing rules and once under the new Amount A system. Jurisdictions apply two main methods to eliminate international double taxation, the exemption method and the credit method, and either method could be applied here.
Component 1: identifying the paying entities. As discussed in prior blog posts, Amount A is calculated at a group level using a simple formula, incorporating a profitability threshold and reallocation percentage. The calculation of residual profit at a group or segment level, which is allocated to market jurisdictions under Amount A, must be broken down to an entity level. This is necessary as the mechanism to relieve double taxation arising from Amount A operates at an entity level rather than a group or segment level. The Blueprint uses an approach that combines tax and accounting concepts, as well as simplifying conventions, to identify the entities within the MNE group that earn the residual profit under existing rules corresponding to Amount A and that are therefore designated as paying entities for the purpose of Amount A. As discussed above, it could be argued that the same or similar formulaic approach used to determine Amount A should be adopted to identify entities that will bear the Amount A liability – the paying entities – for example as those entities with a PBT to revenue ratio in excess of the agreed profitability threshold. As discussed above, however, there are drawbacks to this approach. Therefore, the test of profitability used at an entity level in designating paying entities must be structured somewhat differently from that applied at a group level in the determination of Amount A. As discussed above, one option would be to identify the paying entities using a quantitative approach similar to that used to calculate Amount A. Another option would start from the basis that conceptually, the different features of Amount A suggest that paying entities should not only be profitable, but should be those that make material and sustained contributions to an MNE group’s residual profits, rather than those that perform only activities that generate routine profits.
Identifying the paying entities. As discussed above there will be a process with potentially up to four steps to identify the paying entities.
Step 1: Activities test. As discussed above, an activities test would require that taxpayers undertake a qualitative assessment to identify entities within the group that make material and sustained contributions to an MNE group’s ability to generate residual profits. This reflects the fact that conceptually these are the entities that should bear the Amount A tax liability. The OECD believes it is important that the activities test is developed in a way that is clear and simple to apply in practice, and draws on the existing transfer pricing analysis and documentation prepared by MNE groups. By doing so it will limit the additional compliance costs of MNE groups. The transfer pricing master file and relevant local files prepared by MNE groups provide a first point of reference for the application of the activities test, taking into account that this documentation should describe an arm’s length allocation of assets and risks based on the functional analysis of the MNE group. Where activities that make material and sustained contributions to an MNE group’s ability to generate residual profits are performed in market jurisdictions, the application of the marketing and distribution profits safe harbor may mean that these groups do not need to apply the mechanism to eliminate double taxation, or only need to do so for a limited number of jurisdictions. The conceptual development of the activities test requires the identification of the set of activities that are likely to make a material and sustained contribution to an MNE group’s ability to generate residual profits, and potentially to specifically identify the activities that relate to their engagement in market jurisdictions. The activities that relate to an MNE group’s engagement in a market jurisdiction would extend beyond the ownership of relevant marketing intangibles and would, for example, include the ownership of product or technology intangibles that help to support sales as well as the oversight/control of economically significant risks and decisions relating to the business. The OECD transfer pricing guidelines identify a series of factors that may entitle an entity to participate in the residual profits generated by an MNE group for transfer pricing purposes that will also be relevant for identifying the paying entities. According to the OECD, it may be considered that the provision of intragroup financing is not an activity that makes material and sustained contributions to Automated Digital Services (ADS) or Consumer Facing Business (CFB) business’s ability to generate residual profits, specifically as it relates to their engagement in market jurisdictions, although some OECD members disagree.
To facilitate ease of compliance and reduce complexity, a general principle derived from the activities identified above will govern the identification of paying entities and will assist with clarifying the expected profile of a paying entity. The proposed general principle is to identify paying entities as “the member or members of an MNE group (or segment) that perform functions, use or own assets and/or assume risks that are economically significant, for which they are allocated residual profits relevant to Amount A.” An entity that is entitled to the entrepreneurial profit from exploiting key intangibles, from assuming economically significant risks, which is characterized as an entrepreneurial principal entity and which should receive the residual profit according to the transfer pricing method from a group’s value chain would, under this approach, be identified as a potential paying entity.
Step 2: Profitability test. As discussed above, the profitability test would ensure that the potential paying entities have the capacity to bear the Amount A tax liability. The test would ensure that an entity making low profits (or losses) is not identified as a paying entity, and is consistent with the decision of the OECD to limit the application of Amount A to MNE groups that earn residual profits. In combination with the activities test, the objective of the profitability test is to identify the entities that earn residual profits relevant to Amount A. The activities test, by incorporating concepts imported from transfer pricing, will identify entities within a group that derive residual profits from the performance of non-routine activities that relate to the engagement of the group in market jurisdictions. The profitability test will apply based on entity-level financial accounts used by a group to prepare its consolidated accounts. Where a potential paying entity derives profits from more than one segment, it will be necessary to subdivide the entity-level accounts between these two or more segments in order to apply the profitability test.
Step 3: Market connection priority test. The application of the activities and profitability test would identify a pool of potential paying entities on an MNE group or segment basis. There will be instances where these potential paying entities derive profits from only a limited number of market jurisdictions allocated taxing rights over Amount A. Therefore, a market connection priority test could be introduced, whereby, in the first instance an Amount A tax liability for a given market jurisdiction would be relieved against the profits of a paying entity that performs, in relation to a given market, the activities identified as part of the activities test. As amount A will apply on a group or segment basis, without taking into account the profitability of different regions or sub-segments, this approach could result in situations arising where it is not possible to identify a paying entity that meets the profitability test. In that scenario, other paying entities within a group or segment will be required to bear the remaining portion of the Amount A tax liability. For each market jurisdiction allocated Amount A, a taxpayer will be required to determine which (if any) potential paying entities identified have sufficient connection to be identified as a paying entity for that market jurisdiction. For many groups it will be relatively straightforward to identify the paying entities connected to different markets. This is because most MNE groups will have legal entity structures and legal agreements that clearly document which entities in the group have the rights to exploit specific intangible assets in and receive residual profits from specific markets. In many instances, this information will be available to tax administrations through a group’s master file or other transfer pricing documentation. A paying entity should derive profits that are ultimately connected to sales to third parties in a particular market jurisdiction. It would not be necessary, however, for a paying entity to have a direct transactional connection with a market jurisdiction. The OECD will look at situations where a market jurisdiction may be sufficiently connected with multiple paying entities and explore whether there should be a hierarchy so that the Amount A tax liability would first be allocated to the paying entity with the strongest connection and then allocated to an entity with a less strong connection until the tax liability has been fully allocated.
Step 4: Pro-rata allocation. As paying entities will only be entities that earn above a routine return, it can be argued that after applying the mechanism to eliminate double taxation a residence jurisdiction should, at a minimum, retain taxing rights over the routine profit. There is a risk that in some circumstances the paying entities that are sufficiently connected to a market jurisdiction will have insufficient profits to bear the full Amount A liability. In order to ensure that the Amount A does not lead to double taxation, if the paying entities connected to a market do not have sufficient profits to bear the full Amount A tax liability, then as a back stop any outstanding liability will be apportioned between all other potential paying entities within a segment. The apportionment will be on a formulaic pro-rata basis. This formula will be based on an entity’s PBT in excess of routine profit or profitability of the entity. A paying entity will be deemed to have no profits to bear a further Amount A tax liability once the taxing rights of the residence jurisdiction have been reduced to a routine return. Transfer pricing audits may lead to a reassessment of an entity’s risk profile, its characterization for transfer pricing purposes and the transfer pricing method used to determine the arm’s length profits, which may have an impact on whether the entity has been correctly identified as a paying entity. In addition, the rules to compute the Amount A tax base will incorporate loss carry forward rules that will be separate from existing domestic loss carry forward rules. This group level loss carryforward regime should ensure that most taxpayers continue to benefit from domestic loss carry forward regimes at an entity level.
Component Two: Methods to eliminate double taxation. The second component of the mechanism to eliminate double taxation concerns the methods to eliminate double taxation. The application of this method will ensure that a paying entity is not subject to tax twice on the same profits in different jurisdictions, once under the existing profit allocation rules and once under Amount A. As discussed above, the identification of paying entities under Component 1 is structured such that the entities that earn residual profits under existing rules are designated as paying entities. These paying entities are potentially subject to tax on the amount reflected in Amount A by both their jurisdiction of residence under existing tax rules and by the market jurisdiction that is given a new taxing right with respect to Amount A. This suggests that the use of either the exemption or credit method would be appropriate. Under the credit method, the residence jurisdiction retains secondary taxing rights over the profits of a paying entity where these profits are taxed in the market jurisdictions at a rate that is lower than the rate in the residence country. Whereas, under the exemption method, the residence jurisdiction would not retain secondary taxing rights over the profits of a paying entity because those profits are exempted or removed. In situations where a group has a local subsidiary in a market jurisdiction, an alternative reallocation method could be contemplated. Under this approach, the Amount A profit allocated to a market jurisdiction would be deemed to arise in the local subsidiary and an upward adjustment to its profits would be made for tax purposes, resulting in the local subsidiary being liable to pay Amount A. Double taxation would be relieved by providing a deduction or downward adjustment to the profits of the relieving entity. Under the exemption method, a paying entity would simply exempt from taxation the portion of its profits that had been allocated to market jurisdictions under Amount A. Under this method, a residence jurisdiction would not be required to determine the rate at which profits allocated under Amount A had been taxed. Under the credit method, tax applied to Amount A in the market jurisdictions would be available as a tax credit to the paying entity or entities. The available credit would then be capped at the lower of the tax applied in the market jurisdiction and the tax that would have been paid on the Amount A allocation in the relieving jurisdiction. The OECD contemplates that the credit approach could potentially be applied either jurisdiction by jurisdiction or using a blended approach. Jurisdictions applying a blended cap will typically provide a higher level of relief for double taxation on Amount A than those operating a per jurisdiction cap. One of the main benefits of applying the credit method for relieving jurisdictions is that secondary taxing rights remain available to the residence state. However, the value of such a right is expected to be relatively limited as it is expected that the average rate applied to Amount A would be relatively high. Another argument made in favor of the credit method over the exemption method is that the exemption method could put taxpayers in a better position than before if the profits allocated to market jurisdictions were taxed at a lower rate in the market jurisdiction. Another consideration when using the credit method to relieve double taxation on Amount A is that more information is required by the jurisdiction providing the double tax relief in relation to the treatment of Amount A in the market jurisdiction. Allowing jurisdictions to select which of the two methods they would apply to relieve double taxation would introduce some additional complexity.
Application of the marketing and distribution profits safe harbor. The application of the marketing and distribution profits safe harbor would adjust (and in some cases reduce to zero) the quantum of Amount A allocated to market jurisdictions where an MNE group has an existing marketing and distribution presence. This may give rise to the question of whether an MNE group could choose to adjust their transfer pricing in order to access the safe harbor and use their transfer pricing system as an alternative mechanism to eliminate double taxation. In addressing this question, it is important to emphasize that the marketing and distribution profits safe harbor is not an alternative way to allocate Amount A to a market jurisdiction but rather a method to determine whether allocating Amount A to a market jurisdiction would give rise to double counting. Correspondingly, where an MNE group already allocates the safe harbor return to a market jurisdiction under the existing profit allocation rules, there would be no allocation of Amount A, and hence no need to apply the mechanism to relieve double taxation. The safe harbor would not permit a group to use transfer pricing to allocate profits to a market in excess of an arm’s length amount. For example, where MNE groups have adopted limited risk distribution structures, it may not be feasible to increase the profits of such entities so that the quantum of Amount A would be allocated through the transfer pricing system, as the entity characterization and transfer pricing method would not allow for non-routine profits to be allocated to a limited risk distribution entity.