As market participants evaluate their loan portfolios and implement strategies to transition away from the London Interbank Offered Rate (“LIBOR”), they must address not only third-party loans, but related-party loans as well.
Continue Reading LIBOR Phase Out – Tax Implications in the Context of Related-Party Loans
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.
Continue Reading OECD’s Pillar One Blueprint: Elimination of Double Taxation
Amount B aims to standardize the remuneration of related party distributors that perform baseline marketing and distribution activities in a manner that is aligned with the arm’s length principle. Its purpose is two-fold: First, Amount B is intended to simplify the administration of transfer pricing rules for tax administrations and reduce compliance costs for taxpayers. Second, Amount B is intended to enhance tax certainty and reduce controversy between tax administrations and taxpayers.
Pillar One assumes that distribution and marketing activities would be identified as in-scope based on a narrow scope of activities, set by reference to a defined “positive list” and “negative list” of activities that should and should not be performed to be considered in scope. Quantitative indicators would then be applied to further support and validate the identification of in-scope distributors. It is anticipated that amount B could be based on return on sales, with potentially differentiated fixed returns to account for the different geographic locations and/or industries of the in-scope distributors. Given the narrow scope of Amount B, there is currently no provision for Amount B to increase with the functional intensity of the activities of in-scope distributors. Amount B would not supersede advance pricing agreements or mutual agreement proceeding settlements agreed before the implementation of Amount B.
Under one proposal, the implementation of Amount B would operate under a rebuttable presumption, namely, that an entity that acts as a buy/sell distributor and performs the defined baseline marketing and distribution activities qualifying for the Amount B return would render it in scope, but that it will be possible to rebut the application of Amount B by providing evidence that another transfer pricing method would be the most appropriate to use under the arm’s length principle. While one group of OECD members prefers a narrow approach, another group prefers a broader approach that would also provide standardized remuneration for commissionaires or sales agents, or for distribution entities whose profile differs from the baseline marketing and distribution activities discussed below.
Overview. As discussed in prior blog posts, Amount A is a proposed new taxing right over a share of residual profit of MNE groups that fall within its defined scope. The calculation and allocation of Amount A will be determined through a formula that is not based on the Arm’s Length Principle (ALP). The formula will apply to the tax base of a group (or segment where relevant) and will involve three components: Step 1: a profitability threshold to isolate the residual profit potentially subject to reallocation; Step 2: a reallocation percentage to identify an appropriate share of residual profit that can be allocated to market jurisdictions under Amount A (the “allocable tax base”); and Step 3: an allocation key to distribute the allocable tax base amongst the eligible market jurisdictions (i.e. where nexus is established for Amount A). This three-step formula to determining the Amount A quantum could be delivered through two approaches: a profit-based approach or a profit margin-based approach. A profit-based approach would start the calculation with the Amount A tax base determined as a profit amount (e.g. an absolute profit of EUR 10 million) whereas a profit-margin approach would start the calculation with the Amount A tax base determined as a profit margin (e.g. a PBT to revenue of 15%). Both approaches would apply the three steps of the allocation formula similarly, and hence would deliver the same quantum of Amount A taxable in each market jurisdiction.
Continue Reading OECD’s Pillar One Blueprint: Profit Allocation
As discussed in prior blog posts, Amount A is a proposed new taxing right over a share of the residual profit of MNE groups that fall within its defined scope. The tax base is therefore determined on the basis of the profits of a group (rather than on a separate entity basis), and it is necessary to start with consolidated group financial accounts.
Continue Reading OECD’S Pillar One Blueprint: Tax Base Determinations
The Pillar One revenue sourcing rules determine the revenue that would be treated as deriving from a particular market jurisdiction. The rules would be relevant in applying the scope rules, the nexus rules and the Amount A formula. The sourcing rules are reflective of particularities of Automated Digital Services (ADS) and Consumer Facing Businesses (CFB) and more broadly were designed to balance the need for accuracy with the ability of in-scope MNEs to comply, without incurring disproportionate compliance costs. This is proposed to be achieved through the articulation of sourcing principles, supported by a range of specific indicators, subject to a defined hierarchy (likely to be of particular importance in connection with third party distribution). This approach of providing a range of possible indicators within the hierarchy recognizes the different ways MNEs currently collect information in the context of their business model, while still providing certainty to MNEs and tax administrations that the defined set of acceptable specified indicators can be relied upon to provide acceptable outcomes.
To source the relevant in-scope revenue to a market jurisdiction, a sourcing principle would be identified for each type of in-scope revenue, accompanied by a list of acceptable specific indicators an MNE will use to apply the principle and identify the jurisdiction of source. For example, for the direct sale of consumer goods, the principle would be to source the revenue based on the jurisdiction of final delivery of the goods to the consumer, and the acceptable indicator would be the jurisdiction of the retail store front where the consumer good is sold or shipping address.
The acceptable indicators would be organized in a hierarchy. The MNE should generally use the indicator that is first in the hierarchy, as this will be the most accurate. However, an MNE may use an alternative indicator that appears second in the hierarchy, if the first indicator was not reasonably available or if the MNE can justify that the first indicator was unreliable, and so on with the remaining indicators. This approach is intended to ensure that there is sufficient flexibility to accommodate the different ways that MNEs collect information. Information would be considered unreliable if it is not within the MNE’s possession, and reasonable steps have been taken to obtain it but have been unsuccessful. Information would be considered unreliable if the MNE can justify that the indicator is not a true representation of the principle in the source rule.
The MNE would need to justify and document its approach and include it in the standardized documentation package to be developed as part of the broader work on tax certainty. It is expected that an in-scope MNE would need to retain documentation describing the functioning of its internal control framework related to revenue sourcing, containing aggregate and periodic information on results of applying the indicators for each type of revenue and in each jurisdiction, and explaining the indicator used and, if relevant, why a secondary indicator was applied instead (such as the steps taken to obtain information or why a primary indicator was considered unreliable).
Continue Reading OECD’s Pillar One Blueprint: Revenue Sourcing Rules
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.
Continue Reading OECD’s Pillar One Blueprint: Nexus for Purposes of Amount A
The new taxing right established through Amount A of Pillar One[1] only applies to those multinational entity (MNE) groups that fall within the defined scope of Amount A. The scope of Amount A is based on two elements: an activity test and a threshold test.
According to the OECD, the definition of the scope responds to the need to revisit taxing rules in response to a changed economy. The existing international tax rules generally attach a taxing right to profits derived from a physical presence in a jurisdiction. However, given globalization and the digitalization of the economy, the OECD believes that businesses can, with or without the benefit of local operations, participate in an active and sustained manner in the economic life of a market jurisdiction through engagement extending beyond the mere conclusion of sales, in order to increase the value of their products, their sales and their profits.
In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation. The Guidance addresses specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, and guarantees. Those issues are the subject of separate posts. This post covers captive insurance.
The term “captive insurance” is intended to refer to an insurance undertaking or entity substantially all of whose insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs. The term “reinsurance” refers to a reinsurance undertaking or entity the purpose of which is to provide reinsurance policies for risks of unrelated parties that are in the first instance insured by entities of the MNE group to which it belongs.
Captive Insurers may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it and to appropriately reward that management.
In order to consider the transfer pricing implications of a transaction with a captive insurer, the initial question will be whether the transaction under consideration is one of insurance. This analysis requires consideration of whether the risk has been assumed by the insurer and whether risk diversification has been achieved. Where the captive insurer insures the risk and reinsures it in the open market, it should receive an appropriate reward for the basic services it provides.
With respect to pricing of premiums, comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurer has suitably similar business with unrelated customers, or there may be external comparables. Alternatively, actuarial analysis may be an appropriate method to independently determine the premium likely to be required at arm’s length for insurance of a particular risk. The remuneration of the captive insurer can also be arrived at by considering the arm’s length profitability of the captive insurer by reference to a two-staged approach, which takes into account both profitability of claims (the “combined ratio”) and return on capital.
Continue Reading OECD Guidance on Financial Transactions: Captive Insurance
In transfer pricing analysis, the determination of the entity or entities within a multinational enterprise that are entitled to share in the returns derived by the group from exploiting intangibles is crucial. A related issue is which entity or entities within the group should bear the costs, investments and other burdens associated with the development, enhancement, maintenance, protection and exploitation of intangibles. The Organization for Economic Cooperation and Development has addressed this topic as part of its 2017 Transfer Pricing Guidelines, and that guidance is the subject of this post. Although the legal owner of an intangible may initially receive the proceeds from exploitation of the intangible, other members of the legal owner’s group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. Members of the group performing such functions, using such assets and assuming such risks must be compensated for their contributions under the arm’s length principle.
Legal rights and contractual arrangements form the starting point for any transfer pricing analysis of transactions involving intangibles. The terms of a transaction may be found in written contracts, public records such as patent or trademark registrations, or in other communications between the parties. In identifying the legal owner of intangibles, an intangible and any license relating to that intangible are considered to be different intangibles for transfer pricing purposes, each having a different owner. While determining legal ownership and contractual arrangements is an important first step in the analysis, these determinations are separate from the question of remuneration under the arm’s length principle. For transfer pricing purposes, legal ownership of intangibles, by itself, does not necessarily confer any right ultimately to retain returns derived by the group from exploiting the intangible. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members, provides the analytical framework for identifying arm’s length prices and other conditions for transactions involving intangibles.
The arm’s length principle requires that all members of the group receive appropriate compensation for any functions they perform, assets they use, and risks they assume in connection with the development, enhancement, maintenance, protection and exploitation of intangibles. An important question is how to determine the appropriate arm’s length remuneration to members of a group for their functions, assets and risks within the framework established by the taxpayer’s contractual arrangements, the legal ownership of intangibles, and the conduct of the parties. The determination of arm’s length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of the intangible value, and the realistically available options of the parties. In assessing whether the compensation provided in the controlled transaction is consistent with the arm’s length principle, reference should be made to the level and nature of activity of comparable uncontrolled entities performing similar functions, the compensation received by comparable uncontrolled entities and the anticipated creation of intangible value by comparable uncontrolled entities.