Luxembourg: How BEPS 2.0 Unified Approach Will Revolutionize Business Models

Last Updated: 4 November 2019
Article by Sophie Boulanger

With its new proposal (published October 9), the OECD tries to answer one burning question:

How can profits and corresponding taxing rights on cross-border activities performed by multinationals be (re)allocated to cope with the ever-changing business models of the 21st century?

The OECD's objective is to build a consensus by the end of 2020 on international tax challenges arising from the digitalization of the economy and the remaining BEPS issues. This proposal is set to change some fundamentals of the current international tax system, in particular, the notion of permanent establishment and the arm's length principle.

Will your company be impacted?

Most likely, yes! As the proposal recognizes that transfer pricing and profit allocation are of broader relevance beyond that of digitalized business models, these changes in the tax system will affect more than just highly digitalized multinationals so that all taxpayers may be targeted by this initiative.

For the first time, the Proposal addressed the possibility to carve out certain industries such as financial services (which will undoubtedly be on the Luxembourg market's radar). With no consensus yet, however, the question remains: Will already highly regulated asset managers, banks and insurance companies be exempt?

Unified Approach – a radical paradigm shift

Key to understanding the impact of the "Unified Approach" is to recognize that while the three solutions (User Participation, Marketing Intangibles and Significant Economic Presence) in Pillar One of the initial consultation paper seemed different at first glance, there was a clear consensus on the following points:

  • Intent to reallocate taxing rights in favor of market jurisdictions
  • Creation of a new nexus rule that no longer depends on physical presence in the local market
  • Solutions that go beyond the arm's length principle
  • Drive for simplicity and increased tax certainty for multinationals

Three aims of the Unified Approach

  • A new sales-based nexus that could impact all sectors

A company which sells in a local jurisdiction without physical presence today will be taxed tomorrow. Take, for instance, industrial companies that provide customers with a direct online ordering system to improve their lead to delivery and enlarge their distribution capabilities.. While they currently have no physical presence in their customers' markets, the new nexus will likely recognize value (and therefore a taxable basis) in those countries.

  • A new profit allocation rule that departs from the arm's length principle

The arm's length principle requires functions, risks and assets in order to allocate certain profits to a jurisdiction. The Unified Approach departs from this notion and would also be applicable to taxpayers selling to consumers without a distribution or marketing presence through a permanent establishment or subsidiary, or selling via third-party distributors and intermediaries. This is an interesting point to monitor for the financial sector that mainly work as intermediaries.

So, what would the impact of fintech be on the distribution model within the asset management industry? And would the use of digital investment platforms trigger new taxation based on this new rule if financial services are not carved out?

  • Increase certainty via a three-tier mechanism for profit allocation

The proposal suggests a group's residual profit allocation portion (“Amount A”) to market jurisdictions and a fixed remuneration approach to baseline marketing and distribution activities (“Amount B”), along with enhanced dispute prevention and resolution mechanisms for all elements including other profit allocated under the existing arm’s length standard (“Amount C”). In practice, where a number of limited risk distributors earn a positive but low return today, they will most probably earn a higher return tomorrow. For all business models working already with profit-splits, the impact may be lower.

Large consumer-facing businesses

The concept still needs to be defined.

In Luxembourg, we still see a number of insurance companies marketing their life insurance products in EU Member States (through related or non-related parties and digital platforms) without recognizing a KERT function locally, and therefore currently allocating only a mark-up over costs to market jurisdictions. Would these companies be considered consumer-facing? And how would this cope with the potential carve-out of the financial sector?

This is just the beginning

The OECD's high-level proposal is just the prologue to significant future work (e.g. proper definitions and exemptions, discussions of formulas depending on sectors and business lines, access to double tax treaties for companies with no presence in the market jurisdictions, treatment of losses when the residual profit of a group is actually a loss, or use of fixed returns per industry and/or regions).

Despite the number of pending questions, the strong political will to spread these new rules quickly on an international scale is crystal clear. Whatever the outcome, the way we view value creation, marketing intangibles and economic presence on a market has already begun to change and it is definitely time to tackle the topic head-on.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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