The first part in this series looked at the OECD's work in relation to BEPS 1.0 and introduced the subsequent work undertaken by the Inclusive Framework under BEPS 2.0, specifically the Pillar One and Pillar Two proposals. The second part of this series looks at the Pillar One proposal in greater detail.
The OECD proposed a “unified approach” to Pillar One in October 2019, and this approach was endorsed by the Inclusive Framework in January 2020 as the basis for a consensus-based solution. Pillar One is concerned with nexus and profit allocation, which present particular challenges for the international tax system. The Inclusive Framework has therefore sought to develop a new nexus for profit allocation that is less reliant on physical presence and instead places a greater emphasis on the user/market jurisdiction.
The unified approach under Pillar One is designed to expand the taxing rights of market jurisdictions, which, for some business models, is the jurisdiction where the user is located. Taxation by reference to the user/market jurisdiction is also expected to be less susceptible to base erosion and profit shifting activities as users/consumers are less mobile.
In particular, Pillar One proposes to allocate profit under a three-tier mechanism represented by Amount A, Amount B and Amount C. Each of these tiers is discussed in further detail below
Amount A (the new taxing right) represents the share of residual profit allocated to market jurisdictions using a formulaic approach. Amount A will be limited in its application so as to only apply to large multinational enterprise groups (MNE groups) that are within scope and meet a new nexus test.
A business may be within the scope of Amount A where it generates revenue from the provision of “automated digital services” that are provided on a standardized basis to a large population of customers or users across multiple jurisdictions (such as online search engines, social media platforms and online market places). Consumer-facing businesses that generate revenue from the sale of goods and services will also be within scope.
Extractive industries and regulated financial services (including insurance activities) are not expected to be within the scope of the new taxing right; however, the Inclusive Framework has noted that further consideration may need to be given to unregulated aspects of the financial services sector or particular aspects such as peer-to-peer lending platforms.
Amount A will also operate subject to a number of thresholds. For example, it is proposed to be limited to MNE groups that meet a certain gross revenue threshold (potentially EUR 750 million, being the country-by-country reporting threshold under BEPS Action 13). Further carve-outs are also being considered where the total aggregated in-scope revenues are below a certain threshold and where the allocated total profit would not meet a certain de minimis amount.
A business will also be required to have a “significant and sustained engagement with market jurisdictions” in order to require a potential allocation under Amount A. The Inclusive Framework considers that the generation of in-scope revenues in a market jurisdiction over a period of years would be the primary evidence of such a nexus. However, consideration may be given to other factors such as a physical presence in relation to certain business activities.
The calculation of Amount A will require consideration of the appropriate tax base for the computation of Amount A and an “allocation key” for determining the distribution of Amount A among eligible market jurisdictions.
The Inclusive Framework has identified various issues for further consideration, including the elimination of double taxation as Amount A will require and allocation of profits in addition to the existing allocation of profits under the arm's-length principle. Further consideration is also required to be given to the interaction with Amount B and Amount C. These issues are expected to be considered as part of the development of a consensus-based solution.
Amount B aims to standardize the remuneration of distributors (whether constituted as a subsidiary or a permanent establishment) that provide “baseline marketing and distribution activities” to related parties. Amount B is expected to provide a fixed remuneration based on the arm's-length principle and would be neither optional nor a safe-harbor. Baseline distribution activities will likely include arrangements with routine levels of functionality, no ownership of intangibles and no, or limited, risks.
In providing for a fixed return, Amount B is intended to simplify the administration of transfer pricing rules for revenue authorities and lower compliance costs for taxpayers. This in turn is expected to allow revenue authorities to focus on high-risk cases. However, particular consideration must therefore be given to the determination of the appropriate fixed percentage and how Amount B will differentiate between industries and regions. Baseline activities remunerated under Amount B should also not give rise to double remuneration for such activities under Amount C. While the Inclusive Framework has set out the broad structure for determining the fixed remuneration of baseline activities under Amount B, a number of key technical aspects will require detailed consideration and international negotiation in order for a consensus-based solution to be reached.
The return under Amount C is intended to capture additional profit where in-country functions exceed the baseline activity compensated under Amount B. The precise scope of Amount C is still being discussed by the Inclusive Framework, although Amount C is considered as a critical element in reaching an overall agreement on Pillar One.
The Inclusive Framework has noted that a key aspect of Amount C is the emphasis it gives to the need for improved dispute resolution processes. Given the potential for disputes as to amounts allocated under Amount A to affect the allocation of profits in multiple jurisdictions, bilateral dispute resolution mechanisms are not considered appropriate for the resolution of disputes arising under the new taxing right. Instead, the Inclusive Framework is considering the establishment of representative panels which would aim to provide early certainty in relation to Amount A. To the extent that disputes still arise, new mandatory binding dispute resolution mechanisms are expected to be developed. The fixed rates of return are expected to limit disputes in relation to Amount B.
While the proposals for the allocation of profits under Pillar One have received considerable attention, there is still a great deal of detailed work to be undertaken in order for Pillar One to be adopted in practice. This will require further international co-operation and negotiation between members of the Inclusive Framework in order for a consensus-based solution to be agreed.
The next part in this series will look to the proposals under Pillar Two.
Originally published by Cadwalader, July 2020
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