On January 31, 2020, the OECD/G20 Inclusive Framework on BEPS released an update on its efforts to effect major changes in international tax rules. The statement by the Inclusive Framework re-affirms the commitment of its more than 135 members to adopt by the end of this year a "consensus-based solution" to the challenges to existing tax systems created by digitalization. To meet that goal—and turn the conceptual approaches of "Pillar One" and "Pillar Two" into legal language—major policy decisions must be reached in the next four or five months and huge amounts of technical work must be accomplished during the remainder of 2020. The annexes to the January 31 statement accordingly set forth what the members of the Inclusive Framework identify as the issues needing to be resolved and the tasks remaining to be done, along with a detailed revised work plan to accomplish the ambitious goals.
The bulk of the update released on January 31 relates to Pillar One, the proposed changes to nexus and profit allocation rules to address changes in business models and activities wrought by what is often termed the "digitalization" of the economy. This subject matter has been historically the most difficult to address in the Inclusive Framework's ongoing Base Erosion and Profit-Shifting (BEPS) project. To move the process along, the OECD Secretariat developed a "Unified Approach" in the latter half of 2019 to address Pillar One. In its January 31 statement, the Inclusive Framework announces that it "endorses" a slightly revised version of the OECD Secretariat's Unified Approach as a "starting point" (i.e., "as the basis for the negotiations of a consensus-based solution to be agreed in 2020"). In keeping with the statement's fondness for cautious language and construction metaphors, this starting point is entitled the "Outline of the Architecture of a Unified Approach on Pillar One."
The Unified Approach generally
The goal of the Unified Approach to Pillar One is to expand the taxing rights of so-called market jurisdictions. The Unified Approach would carve out, from the income of a multinational group that meets the relevant nexus standard, three types of income that would be available only for market jurisdictions to tax.
Amount A: The first slice of income, Amount A, reflects the most fundamental change in taxation rights. The intent of Amount A is to divert part of the profit currently earned by a multinational group from the countries where it produces goods and services and manages activities to countries where its customers are located ("market jurisdictions"). A portion of this "residual profit" of a multinational group would be allocated to market jurisdictions using a formulaic approach applied at the group (or possibly a business line) level. It is supposed to represent "profits associated with the active and sustained participation of a business in the economy of a market jurisdiction, through activities in, or remotely directed at that jurisdiction."
Amount B: Amount B is the amount a market jurisdiction could tax due to a multinational group's distribution and marketing functions that take place in the market jurisdiction. Instead of using the arm's length standard to measure income, a fixed return approximating the arm's length standard would be used.
Amount C: Amount C is a second bite at the apple for market jurisdictions seeking to tax distribution and marketing functions. The return under Amount C is intended to cover any additional profit where in-country functions exceed the baseline activity compensated under Amount B.
Winners and losers
Many crucial details regarding Amounts A, B and C and their calculation remain in the development phase. Still, some winners and losers are clearly identified. Generally, those who produce and sell intermediate goods like cloth, steel, coffee beans and other raw materials would be spared from the new rules. Those who provide services or who sell clothing, automobiles, coffee and other finished products would be targeted by the new rules, depending on to whom they make sales.
- Extractive industries and other producers and sellers of raw materials and commodities. The Unified Approach would not apply to companies that sell or produce items (such as agricultural and forestry products) that it views as "generic goods." These are goods that are sold, and the prices of which are determined, on the basis of their inherent characteristics rather than due to any marketing or branding.
- Financial services The Unified Approach would not apply to companies in the financial services sector (including insurance), even if they have consumer-facing business lines such as retail banking or insurance within financial services businesses.
- Ships and aircraft in used in international traffic. These industries have historically been subject to special rules under tax treaties, and the members of the Inclusive Framework show no appetite for revisiting those rules.
- Businesses engaged in "automated
digital services." These are services that are provided on a
standardized basis to a large population of customers or users
across multiple jurisdictions. The definition of "automated
digital services" is broad enough to include
- Online search engines
- Social media platforms
- Online intermediation platforms, including the operation of online marketplaces, whether used by businesses or consumers
- Digital content streaming
- Online gaming
- Cloud computing services
- Online advertising services
- Consumer-facing businesses. These are
businesses that sell goods or services of a type commonly sold to
consumers, which the Unified Approach defines as individuals who
are purchasing items for personal use and not for commercial or
professional purposes. This definition of "consumer-facing
businesses" includes not only businesses that sell goods and
services directly to consumers but also those that sell consumer
products indirectly through third-party resellers or intermediaries
that perform routine tasks such as minor assembly and packaging.
Explicitly included in the definition of consumer products are:
- Personal computing products (e.g., software, home appliances, mobile phones)
- Clothes, toiletries, cosmetics, luxury goods
- Branded foods and refreshments
- Franchise models, such as licensing arrangements involving the restaurant and hotel sector
Awaiting the judge's decision
- Businesses that produce or sell items falling within the definition of consumer products, but that deal mostly with other businesses
- Multinational groups below a gross revenue threshold of €750 million
- Businesses that may deliver services to a customer online but involve a high degree of human intervention and judgement, including professional services such as legal, accounting, architectural, engineering and consulting
- Unregulated financial service entities, such as digital peer-to-peer lending platforms
Companies subject to pending or proposed digital services taxes also remain mired in a position of uncertainty. When the OECD Secretariat released its Unified Approach last autumn, some companies were critical that it did not require countries to withdraw or refrain from enacting digital services taxes or other unilateral measures aimed at the digital economy. In contrast, the update issued on January 31, 2020, states that "[i]t is expected that any consensus-based agreement must include a commitment by members of the Inclusive Framework to implement this agreement and at the same time to withdraw relevant unilateral actions." This statement acknowledges the issue without providing any real comfort to those who fear such taxes may remain. The sentence is phrased as an expectation rather than a commitment and, because it is written in the passive voice, we are not even sure whose expectation is referenced.
The revised Unified Approach released by the Inclusive Framework channels the unresolved Pillar One technical and policy issues into 11 work streams and identifies the OECD subsidiary bodies tasked with dealing with the specific technical and/or policy issues. Decisions on the relevance and feasibility of key policy features, such as defining the categories of business activities falling within the scope of the new market jurisdiction taxing rights and determining the appropriate thresholds for the percentage(s) of profit that will be reallocated under the new taxing rights, are to be settled by July 2020. A final report setting forth the technical details of the consensus-based solution to which the Inclusive Framework agrees would be released before the end of 2020.
The 11 specific work streams are summarized below:
- Scope of Amount A: This work stream will address the definitions of "consumer-facing businesses," "automated digital services" and other key terms. It will also develop appropriate revenue and profit thresholds, consider and define carve-outs and examine interactions with other elements of Amount A design and thresholds. It will be carried out by the OECD working parties responsible for tax treaties and transfer pricing.
- New nexus rules and related treaty considerations for Amount A: This work stream will work on the new nexus rule, which would be based on indicators of significant and sustained engagement with market jurisdictions rather than physical presence. It will also consider how to streamline filing obligations and avoid duplication; explore interactions with existing treaty provisions; develop a standalone rule for nexus to avoid unintended spill-over effects; and develop revenue-sourcing rules. It will be carried out by the OECD working party responsible for tax treaties.
- Tax base determinations: This work steam will examine a host of technical issues, including how to take into account differences in financial accounting standards and which other adjustments need to be made in consolidated financial accounts. It will also consider rules for business line and regional segmentation for the purposes of computing Amount A, explore the materiality and impact of regional differences in profit margins, address how to take into account losses and assess the administrability of possible simplification measures. It will be carried out by the OECD working party responsible for transfer pricing.
- Quantum of Amount A: This empirically-focused work stream will identify thresholds for the percentage(s) of profit that represents the deemed residual return and work on the applicable formula for determining the portion of residual profit allocable to market jurisdictions. This work stream will also explore digital differentiation and the possibility of resulting adjustments to the formulaic computation of Amount A, including different percentages applied to different businesses, and/or providing returns to market jurisdictions based on identified activities performed remotely or for the deemed performance of some activities in those jurisdictions. It will be carried out by the OECD working party responsible for transfer pricing.
- Revenue sourcing under Amount A: This work stream will design the rules that allocate revenues to specific market/user jurisdictions and consider ways to apply them to different business models and instances in which they should apply to sales through independent distributors. It will be carried out by the OECD working parties responsible for tax treaties and transfer pricing.
- Elimination of double taxation under Amount A: Acknowledging the need to prevent double (or multiple) taxation is easy; figuring out a way to prevent it is much harder. This work stream will consider issues such as how to identify the taxpayers deemed to own the taxable profit corresponding to Amount A and design methods to eliminate double taxation. It will also necessarily have to consider a new multilateral convention to accomplish these aspirational goals. It will be carried out by the OECD working parties responsible for tax treaties and transfer pricing.
- Interactions between Amounts A, B and C and potential risks of double counting: A frequently asked question is how Amounts A, B and C will interact, given the concern of double- or triple-counting both in their design and when adjustments are made to one or more amounts. This work stream will seek to design Amount A so that there is no impact or influence on other taxes (e.g., value-added taxes, excise taxes, customs duties, etc.), to design Amount B so it only remunerates baseline distribution and marketing activities, and to identify any other interactions, especially with existing tax treaties. It will be carried out by the OECD working parties responsible for tax treaties and transfer pricing.
- Features of Amount B: This work stream will address issues and options related to the design features of Amount B, including the definition of baseline distribution activities, the use of fixed percentage(s), appropriate profit level indicators, the impact of differences in profit margins across regions and industries, and possible Implementation issues to be considered include coordination with the current transfer pricing system without giving rise to double taxation or double non-taxation. It will be carried out by the OECD working party responsible for transfer pricing.
- Dispute prevention and resolution for Amount A: This work stream will require the right mixture of creativity and realism. It will consider how to enhance certainty and prevent and resolve tax disputes. It will require development of a new mandatory and binding approach that would work on a multilateral basis, with the goal of timely resolving disputes that arise. In particular, it will likely require development and wide-scale adoption of a new multilateral convention to address gaps in treaty coverage between multiple jurisdictions. This work will be carried out by the OECD working party responsible for tax treaties and the Forum on Tax Administration.
- Dispute prevention and resolution for Amounts B and C. Jurisdictions may also argue about which income properly belongs in Amount B and Amount C. This work stream will explore issues and options in connection with the development of effective dispute prevention and resolution procedures, including how such dispute resolution will interact with mechanisms developed to deal with Amount A. It will likely consider potential changes to existing rules on mutual agreement procedures to prevent potential disputes and/or facilitate their resolution. It will be carried out by the OECD working party responsible for tax treaties and the Forum on Tax Administration.
- Implementation and administration: Designing a brand new international tax regime will be moot unless it will be adopted by the relevant jurisdictions and properly administered and implemented. This work stream will explore the likely changes needed to domestic legislation and identify the changes necessary to tax treaties and exchange of information mechanisms; the design of a multilateral convention to deal with disputes that would not be covered by a relevant bilateral tax treaty; and measures to limit compliance and administrative costs and to maximize certainty. This work stream includes a volatile mixture of political and technical issues, and it will involve multiple OECD working parties.
Finally, not only does the design of the revised Unified Approach proposals involve politically sensitive decisions, but implementation of whatever the Inclusive Framework agrees to will require resolution of at least two make-or-break issues. The first will arise if the United States continues to insist on Pillar One being a "safe harbor" that multinational groups can choose to follow or not, rather than a mandatory approach. As the Inclusive Framework statement notes, the US-recommended voluntary or safe-harbor approach is not only unpopular among the other members of the Inclusive Framework, it also raises significant technical and policy issues that would have to be worked into the final Unified Approach.
The second politically charged issue will be whether, and on what terms, countries have to withdraw or modify unilateral measures they have taken regarding digital taxation. Given the controversy surrounding digital services taxes, this will likely be just as contentious a matter as the safe-harbor approach.
Companies operating internationally should pay close attention. What the Inclusive Framework calls a work stream could be a flash flood for an affected multinational group. Further, the 11 work streams described above are solely for developing the new rules under Pillar One. Annex 2 of the January 31 statement provides an update on the progress being made on the new global anti-base erosion (GloBE) proposals that make up Pillar Two. Those bear close watching (and responding) as well.
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