In February 2019 the OECD released a public consultation document draft titled “Addressing the Tax Challenges of the Digitalisation of the Economy”. The draft notes that back in 2015 the 2015 BEPS Action 1 Report on Addressing the Tax Challenges of the Digital Economy initially cited the challenges for international taxation which stemmed from the digital economy and that much of this consultation draft was to address these issues. It is in the February 2019 document in which the two pillar approach for addressing the digital economy was first introduced.
Pillar One focuses on the allocation of taxing rights and considers profit allocation and nexus rules. At this time three proposals for Pillar One were discussed:
1. User participation proposal: The proposal would modify current profit allocation rules to allocate profit based on where businesses’ active and participatory user bases are located, irrespective of whether those businesses have a local physical presence. The proposal notes that user participation is highly relevant for social media platforms, search engines and online marketplaces.
2. Marketing Intangible Proposal: This proposal would segment profit based on marketing intangibles in market jurisdictions. Marketing intangibles are defined as intangibles that aid in the commercial exploitation of a product or service and/or have an important promotional value for the product concerned. Some marketing intangibles it lists are brand, trade name, customer data, customer relationships and customer lists.
3. Significant Economic Presence Proposal: In this proposal companies would be taxed if they had significant economic presence in a country, generally defined as being involved in the “economic life of a country in a regular and sustained manner” even without having a physical presence in that country. This definition of a significant economic presence was presented in Section 7.6 of the 2015 BEPS Action 1 Report. The proposal goes on to state that they would determine a significant economic presence on the basis of factors that evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means. Six potential factors are listed which are:
a. the existence of a user base and the associated data input;
b. the volume of digital content derived from the jurisdiction;
c. billing and collection in local currency or with a local form of payment;
d. the maintenance of a website in a local language;
e. responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance;
f. sustained marketing and sales promotion activities, either online or otherwise, to attract customers.
For all three proposals under Pillar One, profit would be allocated on a residual non-routine profit type method, removing the impact of routine returns to determine the allocable profit base.
Pillar Two relates to reducing the actions of Multi-National Enterpises (MNEs) to shift profits to entities subject to no or very low taxation through the development of two inter- related rules: an income inclusion rule and a tax on base eroding payments. The proposal states that in the absence of multilateral action there is a risk of un-coordinated, unilateral action and the need to stop a global harmful race to the bottom with regards to taxes.
The OECD recognizes that Pillar Two is not limited in its impact to highly digitalised businesses. However, the goal for Pillar Two is to develop a systematic solution designed to ensure that all internationally operating businesses pay a minimum level of tax. Pillar Two was also to incorporate a co-ordination or ordering rule to avoid the risk of economic double taxation.
In May 2019 the OECD published a document titled “Programme of work to develop a consensus solution to the tax challenges arising from the digitalization of the economy”. This document provided additional details on Pillar One and Pillar Two and noted areas the OECD was going to further review.
The document described the modified residual profit split (MRPS) method which would be used to allocate to market jurisdictions a portion of an MNE group’s non-routine profit that reflects the value created in markets that is not recognised under the existing profit allocation rules.
Applying the MRPS would involves four steps: (i) determine total profit to be split; (ii) remove routine profit, using either current transfer pricing rules or simplified conventions; (iii) determine the portion of the non-routine profit that is within the scope of the new taxing right, using either current transfer pricing rules or simplified conventions; and (iv) allocate such in-scope non-routine profit to the relevant market jurisdictions, using an allocation key.
The document highlights some of the key issues regarding Pillar One which are still being decided. Some of these include:
-Fractional apportionment: How to determine the allocation of residual profit to the respective countries
-Distribution-based approaches: How to determine the profit attributable to marketing, distribution, and user-related activities.
-How to eliminate double taxation
The document also provides additional details on Pillar Two, which is composed of two inter- related rules: an income inclusion rule and a tax on base eroding payments. It notes that a minimum tax rate may be employed in relation to Pillar Two. It also discusses the implementation of an undertaxed payments rule which would deny a deduction for payments which were not subject to a minimum tax rate.
The document also notes that additional analysis will be done regarding revenue and economic analysis
In October 2019 the OECD published a Public consultation document titled Secretariat Proposal for a “Unified Approach” under Pillar One.
This document clarified some of the aspects of Pillar One. It stated that Pillar One would create a new taxable nexus, not dependent on physical presence but largely based on sales and that there may be country specific taxable thresholds for this taxable nexus. Pillar One would create a new profit allocation rule applicable to taxpayers within scope which would go beyond the arm’s length principle and may involve formulary apportionment type solutions.
The document details potential calculations to determine the profit pool to be allocated via the profit allocation rules. Of note is the discussion on the methods to calculate routine returns. The document notes that a simplified approach to determine these returns would be to agree to a fixed percentage(s), possibly with variances by industry. While the document did provide more details regarding Proposal One it did pose several questions for public comment regarding scope, nexus and calculation of profits among others.
In November 2019 the OECD released a public consultation document covering Pillar Two, also referred to as the Global Anti-Base Erosion Proposal (“GloBE”). The document layed out four components for Pillar Two.
The four component parts are:
a) an income inclusion rule that would tax the income of a foreign branch or a controlled entity if that income was subject to tax at an effective rate that is below a minimum rate;
b) an undertaxed payments rule that would deny deductions for payments taxed below the minimum rate
c) a switch-over rule that would in certain instances permit taxation of otherwise exempt profits
d) a subject to tax rule that would complement the undertaxed payment rule by subjecting a payment to withholding where the payment is not subject to tax at a minimum rate.
The OECD notes that these rules would be implemented by way of changes to domestic law and tax treaties and would incorporate a co-ordination or ordering rule to avoid the risk of double taxation. They also noted that the actual rate of tax to be applied under the GloBE proposal will be discussed once other key design elements of the proposal are fully developed.
The document also describes how the rule changes would impact financial accounts, blending, carve outs and financial thresholds and poses many questions for public consultation.
On January 31, 20202 the OECD released an Inclusive Framework on BEPS on the Two Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy outlining what is currently the agreed upon architecture of Pillar One and Pillar Two.
The Pillar One discussion focused on three types of taxable profit that may be allocated to a market jurisdiction, known as Amount A, Amount B and Amount C:
-Amount A: A share of residual profit allocated to market jurisdictions using a formulaic approach applied at an MNE group (or business line) level.
-Amount B: A fixed remuneration defined baseline distribution and marketing functions that take place in the market jurisdiction.
-Amount C: Any additional profit where in-country functions exceed the baseline activity compensated under Amount B.
Much of the discussion covers key issues which are yet to be resolved regarding Amount A, Amount B and Amount C.
For both Pillar One and Pillar Two the OECD restated a goal of reaching a consensus agreement by the end of 2020.
In February 2020 the OECD conducted a webinar titled “Update on the Economic Analysis and Impact Assessment” relating to Pillar One and Pillar Two. In this webinar and related document, the OECD stated Pillars One and Two would lead to a significant increase in global tax revenues, in the range of $100 billion USD. They noted the reforms were expected to lead to a significant reduction in profit shifting but failure to reach a consensus-based solution would lead to further unilateral measures and greater uncertainty. The OECD also re-affirmed their goal of reaching a consensus solution by the end of 2020.
On May 21, 2020 Achim Pross, head of the International Co-operation and Tax Administration Division at the OECD’s Center for Tax Policy and Administration stated the Pillar One and Pillar Two work was still on track for a 2020 timeline.
Where we stand today
Much work is yet to be done determining the exact approaches to use for Pillar One and Pillar Two and to received consensus agreement on these approaches. Refining these approaches and addressing questions and concerns by MNEs will also be a large undertaking. Either way, the implantation of Pillar One and Pillar Two will surely have a large and lasting impact on the international tax landscape.
Have a question? Contact Robert Bachmann.
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