OECD pillar one and two blueprints

In October and November 2019, the OECD released discussion drafts as part of BEPS Action 1 on taxation in the digital economy. The proposals of the OECD consisted of two main “pillars”. Initially, the OECD intended to release final reports in October 2020. However, OECD member states have not yet been able to reach agreement on a final system. It is now expected that the OECD will first release “blueprints” for both pillars.

Although the release of these blueprints is not expected until October 2020, draft versions of both blueprint reports distributed to the delegates are already circulating on the internet. These draft versions were drafted in August 2020 and give a helpful insight in the current status of the discussions within the OECD.

In this blog, we will highlight some elements that are relevant from a transfer pricing point of view.

Pillar 1 – points of attention

Pillar 1 concerns the introduction of new profit allocation and nexus rules. The idea is that part of the profit of the MNE will be allocated to the countries where the customers of the MNE are located. In other words, part of the profit will be allocated to the country where the MNE has market presence. The background of this proposal is to enable countries to tax part of the profit of MNE groups that do not have physical presence in certain countries, but nevertheless have significant digital presence in those countries as they realize most of their profits through internet sales.

In this respect, pillar 1 deviates from the traditional – and continued – arm’s length approach where the profit is allocated in accordance with the functions performed, risks assumed, and assets used. In the new approach, countries with large digital home markets (i.e. the larger countries) will benefit the most from this allocation. Smaller countries will receive a smaller piece of the pie. Also, the countries where the MNE is based may ultimately suffer from this allocation.

From a transfer pricing point of view, the following attentions points can be identified:

• In the first place, the Pillar 1 blueprint mentions that globalization and digitalization challenge the traditional arm’s length approach. Therefore, new profit allocation and nexus rules are required in addition to the arm’s length principle.
• Pillar 1 consists of three main components:
  • the introduction of a new taxation right, that allocates part of the residual profit of an MNE to market jurisdictions. This is called “amount A”.
  • determination of a fixed return for certain (routine) marketing and distribution activities that take physically place in a market jurisdiction. This is called “amount B”.
  • finally, Pillar 1 introduces processes for dispute resolution and resolution mechanisms. This should solve disagreement between market jurisdictions on the allocation of profit amounts.
• It should be noted that the calculation of amount A deviates from the traditional application of the arm’s length principle, as it allocates part of the MNEs profit to market jurisdictions, even if the MNE does not have key functions, assets or risks in this jurisdiction.
• Key design features of the “amount A” rule include:
  • A gross revenue threshold, i.e. the rules only apply to MNEs that exceed a certain revenue threshold. The level of the threshold has yet to be determined
  • A de minimis foreign in-scope threshold, i.e. the rules only apply to MNEs that exceed a certain revenue level in a foreign jurisdiction.
  • Scoping rules, that apply the new taxing right to automated digital services (ADS) as well as to certain consumer-facing businesses (CFB). The precise scope of these categories yet has to be determined. For ADS, a positive and negative list is proposed, indicating which services do or do not fall within the scope.
  • Nexus rules to identify which jurisdictions are entitled to receive part of amount A.
  • Loss carry forward rules.
  • A marketing and distribution safe harbor. This rule provides a cap to the allocation of amount A to market jurisdictions to which an MNE already allocates part of its residual profit under existing TP rules. If the allocated profits already exceed the safe harbor, the MNE would not pay amount A, or a mechanism to eliminate double taxation applies.
• Key design features of the “amount B” rule include:
  • The amount B rule provides a standardization of the remuneration for related party distributors that perform “baseline marketing and distribution activities”. These activities include:
    • Distributors that buy from a related party and resell to an unrelated party and
    • Have the profile of a routine distributor.
  • A positive list and a negative list indicate which functions should or should not be considered as “baseline marketing and distribution activities”.
  • Amount B will be calculated in accordance with the (traditional) arm’s length principle, with application of the TNMM. Benchmarking reference sets will be determined for baseline marketing and distribution activities on a regional basis. This will lead to a fixed return for activities performed in each specific region.
• Introduction of new documentation rules: the MNE must keep documentation to substantiate its types of revenue for each specific jurisdiction. Also, the relevant indicators for the various revenue categories must be documented.
• Processes are introduced to prevent and solve disputes between tax administrations, including improvements to MAP procedures and voluntary mediation. Also, a binding dispute resolution mechanism is discussed in the Pillar 1 blueprint.

Finally, the blueprint contains extensive flowcharts that illustrate the various steps for the calculation of amount A.

Pillar 2 – points of attention

The Pillar 2 blueprint concerns the development of a coordinated set of rules to address profit shifting by MNEs to low-tax jurisdictions. The proposed measures intend to ensure that MNEs will pay at least a certain minimum level of profit tax. This proposal is also referred to as the “Global Anti-Base Erosion” or “GloBE” proposal. The GloBE proposal consists of four rules: the three main GloBE rules and a subject-to-tax rule that complements the GloBE rules.

The GloBE rules are the following:

1. a) an income inclusion rule: this rule taxes the income of a foreign branch or a controlled entity if that income was not subjected to an effective minimum tax.
2. b) an undertaxed payments rule: this rule concerns related party payments that were not subject to a minimum tax level. According to this rule, the deduction of the payment will be denied or a taxation at source (e.g. withholding tax) will be applied to the payment.
3. c) a switch-over rule: this rule is intended for tax treaties. The rule would allow the jurisdiction of residency to switch from an exemption for income to a credit method, if the income is attributable to a permanent establishment (PE) or is derived from immovable property and such income is not subject to a minimum tax level.

These rules are complemented by the subject-to-tax rule. This rule focuses on the application of tax treaties. According to this rule certain payments that are not subject to a minimum tax level, would be subject to a taxation at source (e.g. withholding tax) or the eligibility for treaty benefits could be adjusted.

The Pillar 2 blueprint concludes with a set of examples that illustrate the application of the various rules.

Our thoughts

The application of the rules proposed in the Pillar 1 and 2 blueprints is far from evident. If the OECD member states will indeed adopt rules that are in line with these blueprints, MNEs will carefully have to verify whether they fall under the scope of the proposed new rules, and if so, what the potential impact could be for their tax and transfer pricing position in the various countries.

In particular, the complexity of the calculation of amount A will require close monitoring by the MNEs tax department in order to keep track of revenue and profit flows. Implementation of a system that traces and allocates results in accordance with the proposed new taxing rights, will become essential to determine the tax consequences for the group.

As for the calculation of amount B, the proposed rules seem at first sight to reduce the compliance burden for an MNE. However, these rules can also mean that the MNE will lose flexibility to apply a remuneration system that is fully tailored to the specific situation of the MNE.

Given the potential impact of the proposed rules, MNEs therefore must follow any developments in this respect closely.

Of course, Quantera Global will keep you updated on new developments.

If you need support in updating your transfer pricing documentation or if you have any other questions, please reach out to your Quantera Global contact person or send an e-mail to info@quanteraglobal.com.