On February 19, 2024, the OECD Inclusive Framework on BEPS published its long-awaited final report on Pillar One – Amount B.[i] The report details guidance on the “simplified and streamlined approach” (formerly known as Amount B) for applying the arm’s length principle to certain “baseline marketing and distribution activities.” While offering some potential benefits in terms of reducing the need for comparables analyses and avoiding some disputes about comparables selection and adjustments, it is nevertheless narrow in scope, complex in application, and will likely give rise to inconsistencies in implementation throughout the world and more controversy.
Qualifying Transactions Eligible for the Simplified and Streamlined Approach are Narrow in Scope
The simplified and streamlined approach potentially applies only to certain buy-sell and distribution transactions and sales agency and commissionaire transactions involving tangible goods (“qualifying transactions”).
Such “qualifying transactions” are then subject to four additional scoping criteria that must be met for the simplified and streamlined approach to be applicable.
First, “[t]he qualifying transaction must exhibit economically relevant characteristics that mean it can be reliably priced using a one-sided transfer pricing method, with the distributor, sales agent or commissionaire being the tested party.” As a practical matter, this means that the burden is on the taxpayer to affirmatively demonstrate that a two-sided method, such as the profit split method, is not the best or most appropriate method. This requires proving that the tested party (i) does not own unique or valuable intangibles or make other unique and valuable contributions to value create (e.g., DEMPE functions); (ii) does not operate in a highly integrated manner in relation to its counterparties; or (iii) assume economically significant risks. In many cases, meeting and documenting compliance with this requirement could require a full-fledged functional analysis and qualitative judgment calls.
Second, there is a need to apply a quantitative criterion (an operating expense to sales ratio) to verify that the tested party in the qualifying transaction is in scope. To satisfy this scoping criterion, the tested party must not incur three-year weighted annual operating expenses lower than 3% of sales, or higher than 20% to 30% of sales, the latter to be determined by each participating jurisdiction when the simplified and streamlined approach is originally implemented. While the application of this criterion may be straightforward and mechanical in some cases, in other cases there could be at least some uncertainty, such as if there are material costs with uncertainty as to how they should be characterized (as operating or otherwise), or the need to allocate operating expenses between the tested transaction and other business activities.
Third, if the tested party carries out non-distribution activities in addition to the qualifying transaction, such transaction will be considered out of scope “unless the qualifying transaction can be adequately evaluated on a separate basis and can be reliably priced separately from the non-distribution activities.” For these very common situations where a distributor performs other business activities, it will be necessary to factually demonstrate why principles of aggregation should not apply, as well as to perform financial statement segmentation as necessary.
Fourth, the approach scopes out any otherwise qualifying transactions involving any non-tangible goods (e.g., digital goods), services or commodities. This scope-out substantially narrows the purview of the approach and removes a wide range of otherwise routine transactions.
Applying the Simplified and Streamlined Approach is a Complex Multi-step Process
Once it is determined that a qualifying transaction is in-scope, it is then necessary to apply a multi-step process to determine the applicable return on sales point within the pricing matrix. The first three steps, which are relatively straightforward, require determinations of (1) the relevant industry grouping(s) of the tested party, (2) the relevant factor intensity classification of the tested party (including the operating asset intensity and operating expense intensity ratios), and (3) the applicable point in the matrix based on steps 1 and 2. Depending on the industry grouping and the factor intensity of the qualifying transaction, the applicable return on sales can range from 1.50% to 5.5%. A range of plus or minus 0.5% around the return on sales percentage will generally indicate compliance.
The first three steps, however, are not the end of the analysis. Once a point in the pricing matrix has been identified, a four-step operating expense cross-check then has to be performed as a guardrail. This cross-check requires one to (1) calculate the equivalent return on operating expense derived from the tested party’s return on sales, (2) determine the applicable operating expense cap-and-collar range (the collar is 10%, the cap ranges from 40%-70% depending on factor intensity, or 45%-80% in the case of certain qualifying jurisdictions), (3) check whether the equivalent return on operating expense fits within the cap-and-collar range, and (4) adjust the return on sales, if necessary, to ensure that the equivalent return on operating expense is within the cap-and-collar range. If the equivalent return is below the collar rate, the return on sales will have to be increased; if the equivalent return is above the operating expense cap rate, the return on sales will have to be reduced.
But that is not all. If the tested party is located in a “qualifying jurisdiction” (an undefined term presumably intended to cover certain developing jurisdictions for which limited data is available), a further upward adjustment will need to be made to the applicable return on sales. That adjustment is calculated as the product of (i) the net risk adjustment percentage corresponding to the sovereign credit rating of the qualifying jurisdiction of the tested party applicable on the first day of the relevant fiscal year, and (ii) net operating asset intensity percentage of the tested party for the relevant fiscal year, not to exceed 85%.
Complying with Simplified and Streamlined Approach Will Require Vigilance
Compliance with the simplified and streamlined approach will require vigilance, which in some cases, may be greater than that necessary to manage tested party margins than under the CPM/TNMM. While a routine application of the CPM/TNMM with an operating margin profit level indicator might typically support an arm’s length returns on sales between 2% and 5%, with no further adjustments required by the taxpayer if the tested party’s actual results fall anywhere within that range, under the simplified and streamlined approach, the same taxpayers may need to manage tested margins within a narrow +/-0.5% band around the return on sales percentage derived from the pricing matrix. This means that taxpayers that previously had more flexibility by reason of wider arm’s length ranges may now need to manage transfer pricing more closely during the year to avoid the need to make a large year-end adjustment. Furthermore, taxpayers who used to rely on profit level indicators other than the return on sales (e.g., a Berry Ratio or a Gross Margin) would have to adapt the return on sales as their target benchmark.
Simplified and Streamlined Approach Will Likely Result in Globally Inconsistent Implementation
Although the simplified and streamlined approach has been incorporated in the OECD Transfer Pricing Guidelines with the view towards becoming effective January 1, 2025, it is not self-executing but requires local law implementation in each jurisdiction. Individual jurisdictions have the option to implement the approach (i) on a mandatory basis, (ii) on a taxpayer-elective basis (akin to a safe harbor), or (iii) not at all. Almost certainly, in the coming months jurisdictions will join each of these three camps, while others may take a wait-and-see approach. Indeed, since the report was published, the United States Treasury has indicated that it is in further discussions for mandatory implementation by tax administrations,[ii] while at least one country has indicated that it should be optional and at least one other has indicated that it does not intend to adopt the approach. Moreover, India has expressed a number of reservations to the report that will need to be addressed before India can support the approach—including the lack of definitions of “low-capacity jurisdictions” and “qualifying jurisdictions” and various other design aspects.
And further, the approach is generally non-binding in the jurisdiction of the counterparty to the tested party, unless the approach is applied by one of the “low-capacity jurisdictions” (an undefined term) expected to be named by March 31, 2024. While the report indicates that all members of the Inclusive Framework—140+ in all—are expected to respect the application of the simplified and streamlined approach by low-capacity jurisdictions, how exactly this will be enforced in the absence of a mutual agreement procedure (“MAP”) is uncertain.
Complicating matters further, the report indicates that in the case of a MAP regarding an in-scope transaction where one jurisdiction has not adopted the approach (and the exception for low-capacity jurisdictions does not apply), the “remainder” of the OECD Transfer Pricing Guidelines will provide the framework for resolution. In practice, this means that in many cases, multinationals may still need to prepare corroborating CPM/TNMM analyses to support results under the simplified and streamlined approach in non-adopting jurisdictions. This is precisely the type of compliance burden that Amount B was intended to avoid in the first place.
This complexity and uncertainty as to implementation may make it tempting for some multinationals to opt out of the simplified and streamlined approach as if it were never published and continue to prepare annual benchmarking analyses for their distribution arrangements. But opting out across the board may not be an option either, since some jurisdictions may adopt it on a mandatory basis. Reporting results under a traditional transfer pricing method that produce less taxable income than the simplified and streamlined approach in a mandatory jurisdiction could be flagged for audit and result in potential adjustments and double taxation.
In light of all of the foregoing, it will be important for multinationals to track the timing and manner of implementation in relevant jurisdictions in the coming months and develop a customized plan for implementation and compliance in light of the geographic footprints of their related party distribution networks.
Conclusion
For multinationals with qualifying distribution transactions in jurisdictions that have implemented the simplified and streamlined approach, the approach may reduce certain compliance burdens, such as the need for annual comparables benchmarking updates, and may reduce some unproductive disputes over comparables selection and comparability adjustments. These are certainly real benefits which, for some multinationals, could mean one less thing to worry about. But unfortunately, these benefits are offset by various other limitations on the approach’s applicability and new types of compliance burdens. Overall, the approach is narrow in scope, complex in application and contains traps for the unwary that may give rise to uncertainty and potential for dispute. Further, multinationals accustomed to applying a distributor transfer pricing policy based on an interquartile range may now need to more carefully manage transfer pricing within a much narrower +/- 0.5% band around a return on sales point. And perhaps most significantly, inconsistencies in implementation by jurisdictions around the world could require multinationals to continue to prepare corroborating benchmarking analyses to comply in non-adopting jurisdictions while facing potential disputes and double taxation when the tested party’s and the counterparty’s jurisdictions take different approaches to implementation.
[i] The OECD’s prior Pillar One Blueprint was the subject of an earlier blog post.
[ii] See Vella and Mehboob, US Treasury Pushing for Mandatory Global Transfer Pricing Rules, Bloomberg Law (Feb. 21, 2024).