The August 2020 draft reports of the OECD containing the blueprints of Pillar I and Pillar II have been circulated on the Internet ahead of their intended publication in October 2020. These documents draw on the work conducted by the Steering Group of the Inclusive Framework on BEPS since January 2020 and elaborate on the technical aspects of the different building blocks and the political decisions still needed. These documents were originally circulated for comments and were discussed at the Steering Group of the Inclusive Framework on BEPS meeting on September 7 – 10, 2020. A second round of comments is expected to take place, after which the final documents are planned to be published in October 2020.
Please find below a short overview of the highlights prepared by Dentons’ Amsterdam tax team, comprising text excerpts from the documents, which allow you to quickly understand and get an idea of what is to come without having to dive into the blueprints themselves. Note that certain variables and thresholds are not yet filled in, presumably because no consensus over the amounts has been reached or because further research is required.
The ideas behind Pillar 1 and Pillar 2 are radical and we expect that they will become game changers for the international tax community if and once they gain traction, not in the least given the ambition to implement these plans on a global scale using further multilateral instruments. Actual implementation will not come overnight, but the course has been set.
Pillar 1 – Automated digital services and consumer-facing businesses
Pillar 1 seeks to adapt the international income tax system to new business models through changes to the profit allocation and nexus rules applicable to business profits. Within this context, it expands the taxing rights of market jurisdictions (which, for some business models, are the jurisdictions where the users are located) where there is an active and sustained participation of a business in the economy of that jurisdiction through activities in, or remotely directed at, that jurisdiction. It also aims to significantly improve tax certainty by introducing innovative dispute prevention and resolution mechanisms. Pillar 1 seeks to balance the different objectives of Inclusive Framework members and result in the removal of relevant unilateral measures aimed at taxing highly digitalized businesses (e.g. digital service taxes).
The key elements of Pillar 1 can be grouped into three components: a new taxing right for market jurisdictions over a share of residual profit calculated at a multinational enterprise (MNE) group (or segment) level (Amount A); a fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction, in line with the ALP (Amount B); and processes to improve tax certainty through effective dispute prevention and resolution mechanisms in case of disagreements on the amounts of profit allocated to market jurisdictions.
The new taxing right (Amount A) applies broadly and is not limited to a small number of MNEs in a particular industry. However, the need to keep the number of MNEs affected at an administrable level is recognized, and thresholds and a phased implementation are considered. The key design features of the new taxing right include:
- A phased gross revenue threshold starting with gross revenue at a higher level of [€XX billion], gradually reduced to [€XX million] over a five-year term, coupled with a phased de minimis foreign in-scope revenue carve-out starting at [€XX million] and reduced over the same give-year term to [€XX million].
- Scoping rules covering automated digital services (ADS) and more broadly consumer-facing businesses (CFB). This avoids ringfencing the rules to a small group of digital businesses, and includes all those business that are able to develop active and sustained interactions with customers and users in a market jurisdiction.
- The use of a new nexus rule to identify market jurisdictions eligible to receive Amount A. The nexus rules balance the interests of smaller jurisdictions, in particular developing economies, in benefiting from the new taxing right with the need for low and proportionate compliance costs, while avoiding spill-over effects in other tax and non-tax areas. Therefore, the new taxing right relating to ADS will be limited to a per jurisdiction threshold of no less than €X million aggregate annual revenue. For CFB, the nexus will include a market revenue threshold of €X million coupled with plus factors. Where CFB revenue exceeds €X in a jurisdiction, it is deemed to meet the nexus standard. Special consideration may apply to small developing economies. Jurisdictions would remain free to establish higher thresholds.
- The nexus rules are supported by detailed sourcing rules that are reflective of the particularities of digital services and balance the need for accuracy with the ability of in-scope MNEs to comply. This is achieved through due diligence rules subject to a clearly defined hierarchy, likely to be of particular importance in connection with third-party distribution.
- A loss-reallocating residual profit. Eligible market jurisdictions will receive a portion of (X%) of residual profit (income exceeding an agreed level of profitability of (Y%)) using a formula. To strike a balance between simplicity and accuracy, the calculation of the relevant measure of profit will rely as much as possible on published consolidated financial accounts.
- A marketing and distribution profits safe harbor will cap the allocation of Amount A to market jurisdictions where an MNE already leaves residual profits under the existing ALP-based profit allocation rules. Conceptually, it considers the income taxes payable in the market jurisdiction under existing taxing rights and Amount A together, and adjusts the quantum of Amount A taxable in a market jurisdiction, limiting it where the residual profit of the MNE is already taxed in that jurisdiction as a result of the existing profit allocation rules. Under the safe harbor, groups that already allocate profits to a market jurisdiction in excess of the safe harbor return would not pay Amount A or would apply the mechanism to eliminate double taxation and thus would remain subject to the current rules.
- The mechanism to eliminate double taxation will have two components: (i) identification of the paying entities; and (ii) the methods to eliminate double taxation. To identify the entity or entities that will bear the Amount A tax liability, the “paying entities”, a four-step process will be applied. First, a qualitative activities test to identify entities that earn residual profit using a positive and negative list of indicia (which will be applied based on existing transfer pricing documentation). A profitability test will then be applied to ensure these entities have the ability to pay Amount A. As a priority rule, the Amount A tax liability for a market jurisdiction will first be allocated to paying entities that are connected to a market jurisdiction. But, where the paying entities connected to a market do not have sufficient profits to bear the full liability, any outstanding liability will be apportioned between other paying entities (not connected to a market) on a pro-rata basis. Having identified the entity or entities that will bear an Amount A tax liability, a residence jurisdiction will then use the exemption or credit method to relieve double taxation.
- Where an MNE is subject to the new taxing right, a simplified administrative process is in place to minimize the complexity, burden and cost of filing and payment, which will benefit tax administrations and taxpayers alike.
- The new Amount A taxing right will be implemented through changes to domestic law, and by way of public international law instruments, in particular, a multilateral convention. The domestic law and multilateral convention will be supplemented by guidance and other instruments where necessary.
The purpose of Amount B is two-fold. First, it is intended to simplify the administration of transfer pricing rules for tax administrations and lower compliance costs for taxpayers. Second, Amount B is intended to enhance tax certainty and reduce controversy between tax administrations and taxpayers.
Amount B will standardize the remuneration of related party distributors that perform “baseline marketing and distribution activities”. The definition of baseline marketing and distribution activities covers distributors that (i) buy from related parties and resell to unrelated parties; and (ii) have a routine distributor functionality profile.
Further, the activities in-scope are first defined by a ‘positive list’ of typical functions performed, assets owned and risks assumed at arm’s length by routine distributors (based on a narrow scope, akin to limited risk distributors). A ‘negative list’ of typical functions that should not be performed, assets not owned and risks not assumed at arm’s length by routine distributors are also used to qualitatively measure the additional factors that would deem a distributor as being outside the scope of Amount B. Certain quantitative indicators are then used to further support the identification of in-scope activities.
Amount B will be determined in accordance with the arm’s length principle (ALP), therefore based on comparable company benchmarking analyses under the Transactional Net Margin Method (TNMM), with the quantum varying by industry, as well as region, provided any such variation is supported by the relevant benchmarking analysis. As a result Amount B will have a number of fixed points.
While there is consensus on the potential benefits from Amount B, in terms of tax certainty and as a simplification of the ALP, there remain divergent views on the range of baseline activities that should be included in its scope. This blueprint assumes that in-scope distributors are to be identified based on a narrow scope of baseline activities, which is a view shared by many Inclusive Framework members. There is interest, however, by some members to explore the feasibility of broadening the scope of Amount B.
Pillar 2 - the GloBe and substance to tax rules
The GloBe rules
The income inclusion and undertaxed payments rules (together, the GloBE rules) provide a systematic solution that is designed to ensure that internationally operating businesses pay a minimum level of tax regardless of where they are headquartered or the jurisdictions they operate in. As for Country by Country Reporting (CbCR), the application of the GloBE Rules is confined to MNE groups that have total consolidated group revenue above €750 million or equivalent in the immediately preceding fiscal year of the group. Investment funds, pension funds, sovereign wealth funds, government bodies, international organizations, and non-profit organizations are out of scope of these rules. Currently, it is still debated whether shipping companies will be out of scope.
To determine an MNE’s effective tax rate (ETR) under the GloBE rules, the MNE first determines its income for GloBE purposes and the covered taxes on that income. In the event that an MNE’s ETR is below the agreed minimum rate then the MNE will be liable for an incremental amount of GloBE tax that is sufficient to bring the total amount of tax on that income up to the minimum rate. To ensure transparency and a level playing field, the GloBE tax base is uniform across jurisdictions and will start with the financial accounts as prepared by the MNE in the jurisdiction of its headquarters. The minimum rate is not yet defined in this draft. The report addresses what constitutes a tax for the ETR calculation, the tax base, how to deal with government grants and credits, proposals for a formulaic substance-based carve-out based on payroll and tangible assets, whether the minimum ETR is determined on an entity or jurisdiction-level basis, how to deal with timing differences, how to calculate the ETR and proposals for exemptions.
The difference between an MNE’s actual ETR in a low-tax jurisdiction and the agreed minimum rate is referred to as the “top-up tax percentage” and the constituent entities located in the low-tax jurisdiction are referred to as “low-tax constituent entities”. Once the low-tax jurisdictions have been identified and the low-tax income and top-up tax percentage have been determined for each of those jurisdictions, the Income Inclusion Rule (IIR) and the Undertaxed Payments Rule (UTPR) operate to attribute that low-tax income and corresponding top-up tax to another constituent entity under the IIR or to determine the amount of adjustment to be made in respect of a taxpayer applying the UTPR.
- The IIR applies at the level of the parent jurisdiction and levies top-up tax on the low-tax income of those foreign constituent entities that are directly or indirectly controlled by the parent entity. The UTPR operates as a backstop to the IIR while also providing jurisdictions with a tool to protect themselves from the effect of base-eroding transactions. The rule operates by way of a limitation on the deduction of intra-group payments or through an equivalent incremental adjustment.
- The amount of the adjustment under the rule is calculated by reference to remaining pools of low-tax income that arise within the MNE group and are not subject to tax under the IIR. This low-tax income could include, for instance, profits made by those constituent entities that are located in the parent jurisdiction if the MNE’s jurisdictional ETR in the parent jurisdiction is below the minimum rate. To ensure that the UTPR does not result in overtaxation the UTPR is coordinated with other applicable UTPRs in other jurisdictions. Such coordination is achieved by way of allocating top-up tax to UTPR taxpayers on the basis of their intra-group payments.
Rules are proposed to scope out special situations such as joint ventures.
The subject-to-tax rules
The GloBE rules are designed to ensure large MNEs pay a minimum level of tax on their income globally. The subject-to-tax rule complements these rules, but focuses on the bilateral context of tax treaties and the ability of source jurisdictions to protect themselves from the risks posed by BEPS structures which take advantage of low-tax outcomes in the other contracting jurisdiction. The subject-to-tax rule will incorporate the following design components:
- Applied to payments. The subject-to-tax rule is a standalone treaty rule and, consistent with the way bilateral tax treaties operate, will apply to payments between residents of two contracting states. This payments-based approach means that the rule will not apply jurisdictional or entity blending, but will instead operate by reference to the tax applicable to an item of income. Consistent with the scope of application of the GloBE proposal, however, it will not apply to payments made to or by individuals.
- Applied between connected persons. The rule will apply to payments between connected persons. The definition of connected persons is based on the definition of “closely related” persons in Article 5(8) and 5(9) respectively of the OECD and UN model tax conventions. Under this test, two persons are treated as “connected” if one has control of the other or both are under the control of the same person or persons. While the test is based on a de facto control relationship, these control requirements are automatically met where one person possesses directly or indirectly more than 50 per cent of the beneficial interests in the other or if a third person possesses directly or indirectly more than 50 per cent of the beneficial interests in both.
- Covered payments. The rule will apply to a defined set of payments giving rise to base erosion concerns.
- Excluded entities. Consistent with the scope of application of the GloBE, the subject-to-tax rule will not apply to certain entities that are outside the scope of the income inclusion and undertaxed payments rules (where certain conditions are met). The entities that are currently envisaged as being excluded from those rules are: investment funds; pension funds; sovereign wealth funds; government bodies; international organizations; and non-profit organizations.
- Materiality threshold. In order to ensure that the subject-to-tax rule is focused on those structures that pose the most material profit-shifting risks, it will be subject to a materiality threshold.
- Adjusted nominal rate trigger. The rule will be triggered when a payment is subject to a nominal tax rate in the payee jurisdiction that is below the minimum rate, after adjusting for certain permanent changes in the tax base that are directly linked to the payment or the entity receiving it. This approach is consistent with the design of a payments-based rule; applying an effective tax rate test to each payment would be prohibitively complex to administer and comply with.
- Using a top-up approach. The effect of the rule will be to allow the payer jurisdiction to apply a top-up tax to bring the tax on the payment up to an agreed minimum rate and one that interacts in a coordinated manner with any existing withholding rate in the treaty. Because the rule applies to the gross amount of the payment, the top-up tax will be limited to avoid excessive taxation.
The OECD considers preparing model legislation or a multilateral instrument that is a standalone public law instrument which ensures consistent, coordinated and comprehensive application of the GloBE /subject-to-tax rules. This instrument would exist alongside the Multilateral Instrument and the current bilateral treaties.