On October 9, 2019, the Secretariat of the Organisation for Economic Cooperation and Development (OECD) released a consultation document outlining a "Unified Approach" for nexus and profit allocation rules under Pillar One of the Programme of Work (PoW) on the Taxation of the Digitalization of the Economy approved by G20 in June 2019. The proposals in the consultation document were discussed by the Task Force on the Digital Economy (TFDE) at its meeting on October 1, 2019 and have been released for public comments.
The consultation document describes the “Unified Approach” in the following areas:.
- Scope – the approach covers a broad range of businesses, including highly digital business models but also consumer-facing businesses in general. The initial proposal is to carve out extractive industries, but other industries such as financial services may follow, taking into account tax policy rationale as well as other practicalities. Specific considerations are also contemplated for supply of goods and services through intermediaries, the supply of component products and the use of franchise arrangements.
- New Nexus – for businesses within the scope, the approach creates a new taxing right for countries based on sales. It is anticipated that this new nexus would be introduced as a standalone rule in tax treaties in addition to the permanent establishment rule. Sales carried out remotely as well as those carried out through a distributor (related and non-related) are expected to contribute to the creation of this new taxing right in market/user jurisdictions.
- New Profit Allocation Rule – under the "Unified Approach", new profit allocation rules will allocate a portion of deemed residual profit (Amount A in the consultation document) of an in-scope multinational group to market and user jurisdictions irrespective of whether they have a permanent establishment or separate subsidiary, or sell via unrelated distributors. The profit allocation rules will largely retain the current transfer pricing rules based on the arm’s length principle (Amount B) but will complement them with formula-based solutions in areas where tensions in the current system are the highest (Amount C).
The "Unified Approach" is an attempt by the OECD Secretariat to lay the grounds for the members of OECD BEPS Inclusive Framework to agree on the way forward to achieving a global consensus by 2020. Global businesses would be interested to find that extractive industries have been carved out from the proposed rules and more industries, such as commodities and financial services, could be excluded. The consultation document signals that exclusions may apply to other industries and business models for tax policy and practicalities reasons. We believe examples of businesses where their value drivers are typically not found in market and user jurisdictions may include distributors of agricultural products and commodities, consumer goods and high fashion, to name a few, as well as traditional franchise models where specific know-how and services are well-known value drivers. These businesses need to make themselves heard, and should do so as soon as possible.
For in-scope multinational groups, it is important to recognize that a portion of deemed residual profit in their global profit will be allocated to market and user jurisdictions. In this regard, the Secretariat has contemplated that this new taxing right will be embedded in tax treaties. However, as it is typically not possible to create tax rights in tax treaties, domestic law of these market and user jurisdictions may have to be amended to establish the corresponding source taxing right. This will likely be a time-consuming process to implement and monitor.
The new profit allocation rule proposed by the Secretariat would allow market and user jurisdictions to measure the deemed residual profit in a multinational group based on consolidated financial statements. This approach may be modified based on business lines, geographical regions or market segments where residual profit may vary significantly. Even so, it is questionable whether such an approach would lead to a measure of deemed residual profit that fairly represents the value purported created by market and user jurisdictions. The deemed residual profit in a group may be attributable to a large number of factors that are not connected with the market and user jurisdictions. Furthermore, the Secretariat proposal is silent on whether losses in the group could be allocated to the market and user jurisdictions.
Surprisingly, although the Secretariat proposal recognizes that the traditional arm's length approach works well for routine transactions, there is an explicit recognition that, in addition to the new taxing right over a portion of the MNE group's deemed residual profit (referred to as Amount A), market jurisdictions may have more taxing rights (referred to as Amount C) where there are more functions in the market jurisdictions than have been accounted for under the arm's length principle (referred to as Amount B). In practice, Amount A that will be attributed to market jurisdictions would likely have a significant overlap with Amount C, and allowing market jurisdictions to tax both would significantly increase the risk of double taxation.
Although the risk of double taxation and the need to provide certainty are well-recognized issues in the PoW approved by G20, it is not clear from the Secretariat proposal which country should provide double tax reliefs for the profits allocated to the market and user jurisdictions. The absence of any detailed proposal in this regard is understandable as this aspect is clearly also related to the proposals in Pillar 2. Any attempt to resolve double taxation issues in Pillar 1 without taking into account the impact of Pillar 2 would be counter-productive. Whatever double tax relief methodology is proposed eventually, we believe mandatory arbitration needs to be a non-negotiable component of the new tax system.
That being said, the challenge of resolving the double taxation problem is likely to be exacerbated by the proposed approach of identifying the deemed residual profit on a group basis, rather than on a transactional basis. In the example outlined for consultative purposes, an MNE group (with a parent entity based in country 1) that provides streaming services through a subsidiary (based in country 2) in country 2 and country 3 may have new taxes under the proposed rules in country 2 and country 3. It is not clear whether country 1 is obliged to provide tax reliefs for both taxes collected in country 2 and country 3, or whether country 2 is responsible for relieving the taxes collected in country 3. In our view, a transactional approach would work better, as the new taxing right in country 3 ought to come at the expense of country 2, since distribution into country 3 comes from the distributor in country 2, not the group parent entity. At the same time, the group parent entity in country 1 distributes into country 2 and thus country 1 should provide double tax reliefs for any new taxing right in country 2. This transactional (and bilateral) approach fits better in existing dispute resolution mechanisms in bilateral tax treaties and is more likely to resolve double taxation concerns under the "Unified Approach".