The new taxing right established through Amount A of Pillar One1 only applies to those multinational entity (MNE) groups that fall within the defined scope of Amount A. The scope of Amount A is based on two elements: an activity test and a threshold test.
According to the OECD, the definition of the scope responds to the need to revisit taxing rules in response to a changed economy. The existing international tax rules generally attach a taxing right to profits derived from a physical presence in a jurisdiction. However, given globalization and the digitalization of the economy, the OECD believes that businesses can, with or without the benefit of local operations, participate in an active and sustained manner in the economic life of a market jurisdiction through engagement extending beyond the mere conclusion of sales, in order to increase the value of their products, their sales and their profits.
Activity Test. The OECD has proposed that the scope for the application of Amount A be based on an activity test. According to the OECD, the definition of in-scope activities reflects the types of activities where the policy challenge is most acute: Automated Digital Services (ADS) and Consumer-Facing Businesses (CFB).
Automated Digital Services. According to the OECD, its approach to defining ADS recognizes that certain MNEs can generate revenue from the provision of ADS that are provided on an automated and standardized basis to a large and global customer or user base and can do so remotely to customers in markets with little or no local infrastructure.
Comment: Disregard of physical presence is, of course, a substantial departure from traditional rules of taxation, which typically rely on notions of physical presence to the exclusion of other possible bases for taxation.
The definition of ADS is comprised of a positive list of ADS activities; a negative list of non-ADS activities; and a general definition. The general definition of ADS (which also informs the positive and negative lists) is built on two elements: (1) automated, i.e. once the system is set up the provision of the service to a particular user requires minimal human involvement on the part of the service provider; and (2) digital, i.e. provided over the internet or an electronic network. A general feature of the concept of "automated" is whether there is an ability to scale up and provide the same type of services to new users with minimal human involvement. The concept of "digital" distinguishes ADS from other service provision methods, such as the on-site physical performance of a service.
The positive list includes online advertising services; sale or other alienation of user data; online search engines; social media platforms; online intermediation platforms; digital content services; online gaming; standardized online teaching services; and cloud computing services.
Online advertising services means online services aimed at placing advertisement on a digital interface, including services for the purchase, storage and distribution of advertising messages, and for advertising monitoring and performance measurement.
Sale or other alienation of user data means licensing or otherwise alienating to an unrelated third party customer user data generated by users of a digital interface. The definition of a digital interface is intended to be broad, and would cover internet-connected interfaces embedded in a physical good (i.e. the internet of things) regardless of whether the sale of that good itself is within the scope of Amount A. User data includes information such as a user's habits, spending, location, environment, usage of services, hobbies, or personal interests, including anonymized and aggregated data.
Online search engines means making a digital interface available to users for the purpose of allowing them to search across the internet for webpages or information hosted on digital interfaces. Many online search engines are monetized through online advertising services and/or services transmitting data about users. To the extent these services are funded via online advertising or the sale of data, such revenue would be treated under those respective categories.
Social media platforms mean making a platform available on a digital interface to facilitate the interaction between users or between users and user-generated content. This category would include a range of activities that rely on an active and engaged user base to create value, such as social and professional networking websites, video or image sharing platforms, online dating websites and online messaging platforms.
Online intermediation platforms mean making a platform available on a digital interface to enable users to sell, lease, advertise, display or otherwise offer goods or services to other users. It does not include the online sale of goods and services of the platform's own inventory (which may however be captured under CFB).
Digital content services mean the automated provision of content through digital means, whether by way of online streaming, accessing or downloading digital content (e.g. music, books, videos, texts, games, applications, computer programs, software, online newspapers, online libraries and online databases), whether for access one time, for a limited period or in perpetuity. Highly customized software that has been designed for a particular business's needs would not be included as ADS.
Online gaming means making a digital interface available for the purposes of allowing users to interact with one another in the same game environment.
Standardized online teaching services means the provision of an online education program provided to users, which does not require the online presence of an instructor or significant customization on behalf of an instructor to a particular user or group of users.
Cloud computing services means the provision of network access to on-demand standardized information technology (IT) resources, including infrastructure as a service, or software as a service, platforms as a service, or software as a service (such as computing services, storage services, database services, migration services, networking and content delivery services, webhosting, and end-user applications and software).
The negative list of non-ADS activities includes customized professional services; customized online teaching services; online sale of goods and services other than ADS; revenue from the sale of a physical goods irrespective of network connectivity ("internet of things"); and services providing access to the Internet or another electronic network.
Customized professional services includes such services whether provided individually or as a firm, such as legal, accounting, architectural, engineering and medical services. These services are not automated and require more than minimal human involvement on behalf of the professional individual or firm.
Customized online teaching services means live or recorded teaching services delivered online, where the teacher customizes the service (such as by providing individualized, non-automated feedback and support) to the needs of the student or limited group of students and the Internet or electronic network is used as a tool simply for communication between the teacher and student.
Online sale of goods or services other than ADS means the sale of a good or service completed through a digital interface where the digital interface is operated by the provider of the good or service, the main substance of the transaction is the provision of the good or service, and the good or service does not otherwise qualify as ADS. This category would apply to sellers who use a digital platform to sell their own non-digital goods and services to customers.
Comment: Activities such as online sale of goods and services that would appear to be excluded from Amount A based on the negative list of non-ADS activities may still be caught in the CFB net, as discussed below.
The exclusion for revenue from the sale of physical goods, irrespective of network connectivity ("internet of things"), applies irrespective of the network connectivity of the physical good, provided that there is no separately identifiable ADS revenue stream attached to that physical good. However, beyond the sale of the physical good, such goods can be monetized with a customer through different revenue streams and those revenue streams are captured by existing ADS categories on the positive list such as sale or other alienation of user data, online advertising services, and other ADS, such as streaming music through a personal assistant device. This would be captured under the relevant ADS category (e.g. digital content services).
The exclusion for services providing access to the Internet or electronic network applies to the provision of access (i.e. connection, subscription, installation) to the Internet or electronic network, irrespective of the delivery method. Excluding such services is consistent with the policy of Amount A as the provision of such services typically requires a degree of local infrastructure and is subject to local telecommunication regulations.
Where an MNE is engaged in multiple activities, and those are clearly identifiable as separate stand-alone services by reference to revenue streams, the definitions apply to each activity separately.
Consumer Facing Businesses. According to the OECD, the inclusion of a broader group of CFB in the scope of Amount A recognizes that the ability to participate in an active and sustained manner in the economic life of a market jurisdiction goes beyond businesses that provide ADS. The OECD believes that CFB are able to engage with consumers in a meaningful way beyond having a local physical presence and can thereby substantially improve the value of their products and increase their sales. This significant and sustained engagement is able to take place and create value for consumer facing MNEs because of the broader digitalization of the economy.
Comment: Whether or not they concurred, no doubt many OECD member states understood the goal of Pillar One to be establishing a new nexus standard for Automated Digital Services, which might be viewed as relatively new forms of commerce. To the extent that this was a common understanding, some member states may find the focus on Consumer Facing Businesses to be an attempt to modify tax rules for certain transactions the taxation of which had long been thought to be settled.
CFBs are defined as those businesses that generate revenue from the sale of goods and services of a type commonly sold to consumers, including those selling indirectly to consumers through intermediaries and by way of franchising and licensing. The definition can be broken down into a few elements. "Consumer" means an individual (whether or not the direct purchaser) who acquires a good or service for personal purposes, rather than for commercial or professional purposes. A good or service is "of a type commonly" sold to consumers if the nature of the good or service is such that it is designed primarily for sale to consumers. "Sold to" includes sale, lease, rent or delivery, whether directly or indirectly (e.g. through a broker, agent, intermediary or representative). CFBs are (i) the MNE that is the owner of the consumer product/service and holder of the rights to the connected intangible property (including franchisors and licensors) i.e. the MNE whose "face" is apparent to the consumer; and (ii) the MNE that is the retailer or other contractual counterparty of the consumer (if separate from the owner) as they have a direct relationship to the consumer (including franchisees and licensees that sell the consumer product directly). It does not include other third party MNEs, such as manufacturers, wholesalers and distributors, which have no relationship with the customer - whether contractual or otherwise.
CFB sectors not in scope of Amount A include certain natural resources; certain financial services, such as banking, insurance and asset management; commercial and infrastructure construction; construction, sale and leasing of residential property (except for platforms intermediating offers of real estate); and international air and shipping business. The Report on the Pillar One Blueprint discusses the application of the definition of CFB to particular sectors and business models, as described below.
With respect to drugs, the government can regulate the prices at which drugs can be sold and prices are not exclusively based on consumer demand. According to the OECD, however, this does not change the fact that the products are sold to and used by consumers and that these products are generating substantial profits for pharmaceutical MNEs. This governmental regulation does not by itself take pharmaceuticals out of scope. The OECD's analysis identifies two possible approaches for considering the extent to which pharmaceuticals would be in scope of Amount A as a CFB: (1) all drugs that are sold or administered to a consumer are in scope; or (2) the scope is based on whether the drugs are sold over the counter or by prescription. Under the second approach, prescription drugs would be out of scope and non-prescription drugs would be in scope. Proponents of including prescription drugs within the definition of CFB assert that it would be counter-intuitive to exclude such products that have been the subject of aggressive international tax planning while including only OTC drugs, which pose lesser risk of base erosion and profit shifting.
Comment: Given the substantial resources devoted to applying the ALS to the pharmaceutical and medical device industries over the past 40 years, through litigation and otherwise, some will no doubt assert that a bright-line rule will conserve resources and is therefore welcome. Others will note that, given this long history of applying the ALS, it is difficult to argue that pharmaceuticals are the type of product to which a digital services model should be applied.
The proposed scope of Amount A would extend not only to businesses that sell goods and services directly to consumers but also those that sell consumer products indirectly through third-party resellers or intermediaries. For this reason, franchise models and licensing arrangements in respect of consumer goods and services are included within the scope of Amount A. For example, where an international chain of restaurants operates through a franchising model, the local restaurant franchisee would be in scope as being a directly consumer-facing business. The MNE that is responsible for the franchising and earning franchise fees would also be in scope as a CFB.
Comment: As with the pharmaceutical industry, a fast food franchise business would seem to have little to do with the digital economy, which is the purported rationale underlying Pillar One.
Once a good or service meets the test of being of a type commonly sold to consumers, all sales of goods or services of that type of product will be entirely within scope. This remains true even if the product is sold to a business customer. Businesses selling intermediate products and components that are incorporated into a finished product sold to consumers would be out of scope.
Comment: The United States has proposed that Pillar One be implemented on a safe harbor basis. Under such a safe harbor implementation, MNEs could elect to have all the components of Pillar One apply to them on a global basis, including the Amount A allocation, the Amount B fixed margin mechanism and the mandatory binding dispute prevention and resolution procedures. By allowing MNEs to elect to apply Pillar One, the need to resolve contentious scoping issues, including the definition of ADS and CFB, would potentially be reduced. Other jurisdictions have expressed skepticism about an elective approach.
Threshold Tests. In addition to the activity test, the second element of defining the scope is the threshold test. An MNE can only be in scope of Amount A if it meets the activity test described above and two thresholds: the MNE's consolidated revenue is above a certain threshold; and its in-scope revenue earned outside its domestic market is also above a certain threshold. In defining the MNEs that are in scope of Amount A, there is a recognition that below a certain overall size threshold, a cost-benefit analysis does not justify the imposition of the rules required to apply Amount A.
Regarding the global revenue test, the OECD believes that gross revenue would seem to be the easiest metric to use for determining size. A gross revenue test would allow excluding smaller MNEs on the basis of the annual consolidated group revenue, as shown in the consolidated financial statements. The OECD believes that, considering the costs and benefits, there may be little advantage in using a threshold below the current EUR 750 million threshold that is used for the purposes of Country-by-Country reporting (CbCR). First, the impact assessment shows that there may be very little increase in the residual profit that would be allocated to market jurisdictions from using a lower figure. Second, it substantially increases compliance and administrative costs.
The second threshold relates to MNEs that exceed the gross revenue above, but only have a small amount of foreign source in-scope revenue. In such cases, the total profit to be allocated under the new taxing right would not be material relative to the costs to businesses and tax administrations arising from the application of the Amount A rules. The threshold for de minimis foreign in-scope revenue would be set at an absolute number, rather than being relative to the size of a given MNE's domestic business. This test would have two steps. First, an MNE would apply the activities test to determine whether the group earned more than the de minimis foreign in-scope revenue threshold amount from ADS or CFB activities. Second, the MNE would then need to determine whether it earned more than the de minimis foreign in-scope revenue threshold amount from "foreign" in-scope activities.
1. For general background regarding Pillar One, please see our prior blog post.
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