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.


Continue Reading Tax Challenges Arising From Digitalisation, Report on the OECD’S Pillar One Blueprint: Scope of Amount A

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.


Continue Reading DEMPE Functions

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.
Continue Reading Tax Challenges Arising from Digitalisation, Report on the OECD’s Pillar One Blueprint: Executive Summary

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 use of a cash pool is popular among multinational enterprises as a way of achieving more efficient cash management by bringing together, either physically or notionally, the balances on a number of separate bank accounts. In a typical physical pooling arrangement, the bank account balances of all the pool members are transferred daily to a single central bank account owned by the cash pool leader. In a notional cash pool, some of the benefits of combining credit and debit balances of several accounts are achieved without any physical transfer of balances between the participating members’ accounts. As cash pooling is not undertaken regularly, if at all, by independent enterprises, the application of transfer pricing principles requires careful consideration. According to the OECD, a cash pool is likely to differ from a straightforward overnight deposit with a bank in that a cash pool member with a credit position is not depositing money as a transaction with a view to a simple depositor return. Rather, the cash pool member is likely to be participating in providing liquidity as part of a broader group strategy, in which the member can have a credit or debit position. The appropriate reward of the cash pool leader will depend on the functions performed, the assets used and the risks assumed in facilitating a cash pooling arrangement. A cash pool leader may perform no more than a coordination or agency function with the master account being a centralized point for a series of book entries to meet predetermined target balances of pool members. Under these circumstances, the cash pool leader’s remuneration as a service provider will generally be limited. Where a cash pool leader is carrying on activities other than coordination or agency functions, the pricing of such transactions would be adjusted appropriately. The remuneration of the cash pool members will be calculated through the determination of the arm’s length interest rates applicable to the debit and credit positions within the pool. This determination will allocate any synergy benefits arising from the cash pool arrangement amongst the pool members and it will generally be done once the remuneration of the cash pool leader has been calculated.

Continue Reading OECD on Cash Pooling

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. In general, a financial guarantee provides for the guarantor to meet specified financial obligations in the event of a failure to do so by the guaranteed party. There are various terms in use for different types of credit support from one member of an MNE group to another. At one end of the spectrum is the formal written guarantee and at the other is the implied support attributable solely to membership in the MNE group. Here we use guarantee to mean a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation. The situation likely to be encountered most frequently in a transfer pricing context is that in which an associated enterprise (guarantor) provides a guarantee on a loan taken out by another associated enterprise from an unrelated lender. From the borrower perspective, a financial guarantee may affect the terms of the borrowing. For instance, the existence of the guarantee may allow the guaranteed party to obtain a more favorable interest rate since the lender has access to a wider pool of assets, or to increase the amount of the borrowing. From the perspective of the lender, the consequence of an explicit guarantee is that the lender’s risk would be expected to be reduced by having access to the assets of the guarantor in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed rating. A number of methods can potentially be used to value guarantees. The yield approach calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. The cost method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another instrument and pricing the alternative, for example treating the guarantee as a put option and using an option pricing model to price the put option. The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default.

Continue Reading OECD on Financial Guarantees

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. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible. For example, treasury may act as the contact point to centralize the external borrowing of the MNE group. External funds would then be made available within the MNE group through intra-group lending provided by the treasury. In considering the commercial and financial relations between the associated borrower and lender concerning intra-group loans, both the lender’s and borrower’s perspectives should be taken into account. In particular, it is important to consider the risks that the funding arrangements carry for the party providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of related party transactions. Arm’s length interest rates can be sought based on consideration of the credit rating of the borrower or the rating of the specific issuance, taking into account all of the terms and conditions of the loan and comparability factors. The widespread existence of markets for borrowing and lending money and the frequency of such transactions between independent borrowers and lenders may make it easier to apply the CUP method to financial transactions than may be the case for other types of transactions.

Continue Reading Intra-Group Loans

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.

According to the OECD, before attempting to apply the pricing guidelines that are the primary topic of the Guidance, it may be necessary to determine whether a purported loan should be regarded as a loan, since the balance of debt and equity funding of a borrowing entity that is part of an Multinational Enterprise (“MNE”) group may differ from that which would exist if it were an independent entity operating under similar circumstances. In accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances: the presence or absence of a fixed maturity date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the loan is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement. The accurate delineation of financial transactions may require an analysis of the factors affecting the  performance of businesses in the industry sector in which the MNE group operates. The contractual arrangements between independent enterprises may not always provide information in sufficient detail, and it may therefore be necessary to look to other documents and the actual conduct of the parties to define the relationship. Accurate delineation of the transaction may include an identification of the economically relevant characteristics of the transaction, including the functions performed; assets used and risks assumed; the characteristics of the financial instruments; the economic circumstances of the parties and of the market; and the business strategies pursued by the parties.


Continue Reading Accurate Delineation of Financial Transactions