Taxation of Digital Businesses - Pillar 1 Proposals of OECD

Part I (Pillar 1) 

1. Opening

Imagine Google derives Revenue of USD 100 million from your Country. But Google has no physical presence in your Country. No cable network, no servers, no telecommunication towers, no branch offices – nothing. So, no Permanent Establishment of Google exists in your Country. And, therefore, the profit on Revenue of USD 100 million goes untaxed under the present Tax Treaty law.

How to tax this? How can the market jurisdiction tax the profit derived by digital businesses through remotely engaging with customers without setting up any physical presence? Is deriving of Revenue from a Country enough and sufficient to bring the remote functioning Digital business into the tax net of that source Country? Or is some form of physical presence necessary?

Answers to these questions have been explored by the OECD in its recent Pillar 1 Proposals which focus on nexus and profit allocation.

Of course, there are also Pillar 2 proposals which focus on global minimum tax. Pillar 2 deals with the problem of MNEs relocating their intangible assets, or intellectual property, to low tax jurisdictions and paying low overall tax on their total or consolidated profit.

This Article discusses the key components of Pillar 1 and Pillar 2 proposals made by the OECD.

First Part (Part I) of the Article discusses Pillar 1 proposals and Second Part (Part II) of the Article discusses Pillar 2 proposals. For discussion, reference has been made to (i) OECD Report (Dated 14 October 2020) on Pillar 1 and Pillar 2 Blueprints, and (ii) OECD Statement (Dated 1 July 2021) on the Two Pillar Solution.

2. Pillar 1

2.1. Objective

The objective of Pillar 1 is to reform the international tax system to address the tax challenges arising from the digitisation of the economy, restore stability to the international tax framework and prevent further uncoordinated unilateral tax measures like Digital Services Tax enacted by several Countries.

Amount A

2.2. The New Taxing Right of Market Jurisdictions (Amount A)

What is Amount A? It is the new taxing right of market jurisdictions. Amount A in total will be allocated to those market jurisdictions which qualify under the Nexus Rule (discussed below in Para 2.4.). Each qualified market jurisdiction will be allocated a portion of Amount A in proportion to revenue derived by the MNE from that particular jurisdiction (discussed below in Para 2.4.).

The new taxing right (Amount A) would be an overlay to the existing nexus and profit allocation rules. So, it is actually a reallocation of profit already allocated under the transfer pricing rules. Due to its innovative features, Inclusive Framework members have agreed to keep the number of MNEs affected by Pillar 1 at an administrable level and to consider thresholds and other features that help keep the approach targeted while minimising compliance costs.

2.3. Scope

In-scope companies (for Amount A) are the multinational enterprises (MNEs) with global turnover above 20 billion euros and profitability above 10% (i.e., profit before tax/revenue) with the turnover threshold to be reduced to 10 billion euros after a post-implementation review has been undertaken. The review will begin 7 years after the multi-lateral agreement to implement Pillar 1 comes into force, and the review will be completed in no more than one year. The revenue figure for determining whether the threshold is met will be drawn from the MNE group's consolidated financial statements.

Extractives and Regulated Financial Services are excluded from the scope of Amount A.

2.4. Nexus Test for the MNE in each Market Jurisdiction

The nexus rule applies solely to determine whether a jurisdiction qualifies for the Amount A allocation. The nexus rule will establish whether the MNE group has a significant and sustained engagement in a particular market jurisdiction. The nexus rule will be a revenue threshold.

The nexus rule will permit allocation of Amount A to a market jurisdiction when the in-scope MNE derives at least 1 million euros in revenue from that jurisdiction. For smaller jurisdictions with GDP lower than 40 billion euros, the nexus will be set at 2,50,000 euros. So, if a MNE group is in scope of Amount A and also derives at least 1 million euros (or 2,50,000 euros for small economy jurisdictions) from a market jurisdiction, then Amount A will be allocated to that market jurisdiction and the MNE group will have to pay tax in that jurisdiction. 

2.4.1. Revenue sourcing

How to determine how much revenue the MNE derives from a particular market jurisdiction? This will be based on revenue sourcing rules. Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed. To facilitate the application of this principle, detailed source rules for specific categories of transactions will be developed. In applying the sourcing rules, an MNE must use a reliable method based on the MNE's specific facts and circumstances.

In essence, revenue sourcing is based on a set of source principles for the relevant in scope revenue, supported by a factual indicator identifying the source jurisdiction for that type of activity. The indicators are in a hierarchy to provide clarity and flexibility to reduce compliance burdens as needed. The source rules would vary with the type of good or service involved.

2.5. Quantum: Amount of Profit to be Reallocated (Amount A)

For in-scope MNEs, between 20-30% of residual profit - residual profit defined as profit in excess of 10% of revenue - will be allocated to market jurisdictions with nexus using a revenue-based allocation key.

The relevant measure of profit or loss of the in-scope MNE will be determined by reference to financial accounting income, with a small number of adjustments.

2.5.1. Formulaic allocation of Amount A

The quantum of Amount A will be calculated through a formula that will apply to the tax base of a group, with three steps:

• A profitability threshold to isolate the residual profit potentially subject to reallocation. As a simplifying convention, this will be a profit before tax to revenue ratio.
• A reallocation percentage to identify the appropriate share of residual profit to be allocated to market jurisdictions under Amount A. This will be a fixed percentage.
• An allocation key to distribute the allocable tax base amongst the eligible market jurisdictions (i.e. where nexus is established for Amount A). It will be based on locally sourced in scope revenue.

2.5.2. Example – Allocation of Amount A to Market Jurisdictions

For the purpose of this example, it is assumed that the Amount A formula includes a 10% profitability threshold (step 1) and 20% reallocation percentage (step 2).

A. Facts

Group A is a large MNE group providing Automated Digital Services via an online platform. Group A has the following simplified income statement:

It is assumed further that the revenues are sourced - according to revenue sourcing rules - exclusively from three market jurisdictions.

Due to the strategic location and attractiveness of Market 1, Group A established a local subsidiary in that jurisdiction performing baseline marketing and distribution activities for the whole world. In contrast, Group A has no taxable or physical presence in Market 2 and Market 3, where services are supplied remotely by the subsidiary located in Market 1. For Amount A purposes, however, it is assumed that a new nexus will be created in Markets 2 and 3 (i.e. nexus revenue threshold exceeded).

B. Applying Amount A formula

Step 1: Profitability Threshold

Determine Group A's residual profit (W) by subtracting 10% from the PBT margin (P/R).

W = P – (R*10%)

W = 6,500 – (25,000 * 10%)

W = 4,000

Step 2: Reallocation percentage

Determine Group A's allocable tax base (A) by multiplying residual profit (W) by 20%.

A = 20% * W

A = 20% * 4,000

A = 800

Step 3: Allocation key

Allocation key based on the ratio of locally sourced revenue (S – determined as per Revenue Sourcing Rules) to total revenue (R). This last step provides for the quantum of Amount A taxable in each eligible market jurisdiction (M), as described in the below table.

2.6. Marketing and Distribution Profits Safe Harbour

Where the residual profits of an in-scope MNE are already taxed in a market jurisdiction, in the hands of an in-country distributor entity (subsidiary or permanent establishment), a marketing and distribution profits safe harbour will cap the residual profits allocated to the market jurisdiction through Amount A. The application of the marketing and distribution profits safe harbour would adjust (and in some cases reduce to zero) the quantum of Amount A allocated to market jurisdictions where an MNE group already has an existing marketing and distribution presence in the form of a subsidiary or a permanent establishment. This is to deal with potential double counting issues.

2.6.1. Example - The Marketing and Distribution Profits Safe Harbour

Group X is an MNE group in scope of Amount A. Under the marketing and distribution profits safe harbour proposal, the assumption is that the Amount A profit allocated to market jurisdictions, where the group does not have a physical presence, is a return on sales of 1.5% (Amount A only) and the Amount A profit allocated to market jurisdictions where the group has a physical presence is a return on sales of 3.5% (Amount A plus a 2% fixed return for routine marketing and distribution activities).

A. IP Owner (Jurisdiction 1)

Group X has a decentralised operating model, in which an IP Owner (resident in Jurisdiction 1) develops and owns the group's trade intangibles and licenses these intangibles to full-risk distributors in market jurisdictions in exchange for a benchmarked royalty.

B. Full-risk distributors (Jurisdictions 2, 3, 4 and 5)

The full-risk distributors (resident in Jurisdictions 2, 3, 4 and 5 respectively) combine these licensed intangibles with their own marketing and other intangibles, in products that are then sold to third parties.

The full-risk distributors realise the residual profits (or losses) from their respective markets. The group and entity-level financials for Group X are summarised below.

C. Application of the Safe Harbour

Group X would determine the safe harbour return due to each of these market jurisdictions under Amount A and the profits allocated to market jurisdictions under the existing profit allocation rules (shown in the table above). As Group X has a physical presence in each of the market jurisdictions it operates in, the safe harbour return would be 3.5%.

Finally, Group X would then determine in which markets it is eligible for the safe harbour and in which market it would be required to allocate Amount A:

• In Jurisdictions 2 and 5, Group X already allocates a return in excess of 3.5%. Therefore, it would be eligible for the safe harbour and hence would not pay Amount A in these jurisdictions.
• In Jurisdiction 4, Group X incurs a loss. Therefore, it would not meet the fixed return of the safe harbour and would, therefore, be ineligible for the safe harbour.
• In Jurisdiction 3, Group X would meet the fixed return of the safe harbour but not the cap. Therefore, it would only need to allocate profit equal to an additional return of 0.3% (being the difference between the profits already allocated to Jurisdiction 3 under the existing profit allocation rules and the cap of the safe harbour return) to Jurisdiction 3 under Amount A.

Under the proposed mechanism to eliminate double taxation, the IP Owner is likely to be identified as the paying entity and hence Jurisdiction 1 would be required to provide double tax relief (through the exemption or credit method) for the Amount A profit allocated to Jurisdiction 4 and 3.

2.7. Elimination of Double Taxation

Amount A allocated to market jurisdiction is in substitution of - not in addition to - arm's length profit allocated to those jurisdictions for any in-country marketing and distribution activities through a local Subsidiary or a Permanent Establishment. That is why Amount A is generally called as the reallocation amount.

Even if no local marketing and distribution exists in the market jurisdiction and so the arm's length profit allocated to that jurisdiction under transfer pricing rules is zero, portion of Amount A allocated to that jurisdiction may lead to double counting of profit of the MNE group.

However, the total consolidated profit – even after allocation of Amount A to market jurisdictions - realised by the MNE group will remain the same. Only the allocation of profit to various market jurisdiction will change as a result of Amount A allocation. So, the total profit of the MNE group will get reallocated on allocation of Amount A. To ensure that the total profit of the MNE group does not get increased by Amount A but only gets reallocated, it becomes necessary to (i) identify double counting of profit, (ii) identify paying entities and (iii) eliminate double taxation.

For example, if the ALP-Based profit allocation is 30:20:15:25:10:0 then the profit after Amount A allocation may get reallocated as 25:22:18:20:13:2. The total, however, will remain 100. So, Amount A does not add to the total consolidated profit realised by the MNE group but only gets allocated to market jurisdictions. To achieve that the paying entities of the MNE group are identified, and then jurisdictions of those paying entities have to relieve double taxation by applying either exemption method or credit method. On relief of double taxation in this manner the total consolidated profit realised by the MNE group gets allocated to market jurisdictions eliminating double counting.  

Amount A will apply as an overlay to the existing profit allocation rules. As the profit of an MNE group is already allocated under the existing profit allocation rules (under Transfer Pricing rules), it is necessary to put in place a mechanism to reconcile the new taxing right (i.e. calculated at the level of a group) and the existing profit allocation rules (i.e. calculated on an entity basis), to prevent double taxation. To reconcile the two profit allocation systems (Amount A and Profit as per Transfer Pricing rules), entity or entities (paying entities), within an MNE group, which bear the Amount A tax liability are identified. This determines which jurisdiction or jurisdictions need to relieve the double taxation arising from Amount A. This mechanism is based on two components: (i) the identification of the paying entity (or entities) within an MNE group; and (ii) the methods to eliminate double taxation.

2.7.1. Component 1: Identifying the Paying Entities

The entity (or entities) that will bear the tax liability of Amount A will be drawn from those that earn residual profit. The process to identify the paying entities could have up to four steps.4 These are to:

Step 1: Identify the entities within an MNE group that perform activities that make a material and sustained contribution to the group's ability to generate residual profits.

Step 2: Apply a profitability test to ensure the entities identified have the capacity to bear the Amount A tax liability.

Step 3: Allocate, in order of priority, the Amount A tax liability to the entities that have a connection with the market(s) where Amount A is allocated.

Step 4: Allocate, on a pro-rata basis, where no sufficiently strong connection with the market(s) is found, or where in spite of market connection the entities lack the necessary amount of profit.

2.7.2. Component 2: Methods to Eliminate Double Taxation

Double taxation of profit allocated to market jurisdictions will be relieved using either the exemption or credit method. So, the jurisdiction(s) in which the paying entity (or entities) are resident will provide relief for double taxation using the exemption or credit method.

2.7.3. Example – Elimination of Double Taxation

Say, Group A is an MNE group falling within the scope of Amount A. The group generated EUR 22,000 million in third party revenue and earned PBT of EUR 6,210 million, resulting in a profit margin of 28.22%. Assume 20% of profit in excess of 10% [20% of (18.22% of 22,000) = 802] is eligible for allocation to market jurisdictions as Amount A. This Amount A will be allocated to market jurisdictions in proportion to revenue sourced from those jurisdictions.

(This Amount A will be allocated to market jurisdictions over-and-above the arm's length profit already allocated for in-country marketing and distribution functions. So, there will be double taxation.)

Group A has a centralised operating model, in which a Principal (resident in Jurisdiction 1) owns the group's trade and marketing intangibles and realises the entire residual profit of the group. Jurisdiction 1 is a large market for Group A, generating EUR 10,000 million in third party revenues that are booked by the Principal.

The other entities in the group (resident in Jurisdictions 2 and 3) perform baseline marketing and distribution functions. Under the ALP-based (Transfer Pricing) profit allocation rules, these distributors are remunerated with a 3% return on sales.

Under the new taxing right of Pillar 1, Jurisdictions 1, 2 and 3 would all (as eligible market jurisdictions where nexus is established) be allocated Amount A. Jurisdictions 2 and 3 would also continue to be allocated profit under the existing ALP-based (Transfer Pricing) profit allocation rules. The results of these allocations are shown in the table below.

Prior to the elimination of double taxation, the full Amount A profit allocated to Jurisdiction 1 could be said to give rise to double counting because this market jurisdiction already exercised taxing rights over material residual profit under existing ALP-based profit allocation rules, i.e. profit amounting to EUR 6,000 million, that is, a profit margin on total sales of 30% exceeding the average return on sales of the MNE group (28.22%).

(Amount A is allocated based on revenue sourcing rules.)

* The total taxable profits exceed the taxable profits of Group B, as the double taxation arising from Amount A has not yet been eliminated.

In this example, the mechanism to eliminate double taxation will entirely net-off the potential for double counting in Jurisdiction 1 (i.e. EUR 547 million), by effectively reducing the profit for which income tax will be paid in Jurisdiction 1.

2.8. Paying Amount A to the Market Jurisdiction

The MNE group has to nominate a single entity to bear all of the administrative responsibility and legal liability for the payment of any and all tax due under Amount A. The payment and liability for Amount A tax could be at the level of the nominated coordinating entity, or, if the MNE prefers leveraging its local subsidiary in the market jurisdiction, at the level of that local entity.

2.9. Self Assessment and Early Certainty Process

To facilitate a consistent implementation of Amount A by MNE groups and tax administrations, a standardised Amount A self-assessment return and documentation package will be developed, for use in all jurisdictions. These will be used by MNE groups irrespective of whether a particular MNE group makes a request for early tax certainty. The self-assessment return will set out each stage of the MNE group's determination and allocation of Amount A between jurisdictions, including identification of relieving entities. The standard documentation package will be designed to contain sufficient background information and evidence to assess the MNE group's self-assessment of Amount A based on the information provided, while further information may be requested by tax administrations if needed.

Different documentation, different filing requirements, and audit and Mutual Agreement Procedure (MAP) involving potentially over 100 jurisdictions are not viable options. An innovative process (discussed below in Para 2.9.1. and 2.9.2.) is, therefore, sought to be laid down to provide certainty regarding the application of Amount A to MNE groups.

It is proposed that certainty should be provided to MNEs upon request, before tax adjustments are sought to be made, for all aspects of Amount A, including the delineation of business lines, the size of Amount A, the attribution of profit to market jurisdictions and determination of double taxation relieving jurisdictions.

2.9.1. Tax Certainty and Dispute Resolution

Two Panels are suggested to provide tax certainty.

First panel (review panel) will include a representative sample of tax administrations from jurisdictions where an MNE operates or has a market, including smaller and developing countries. All tax administrations affected by an allocation of Amount A will have the opportunity to object to the review panel's decision.

If the review panel cannot reach agreement or cannot accommodate objections from other tax administrations, questions will be referred to a determination panel that is required to reach a decision, which is binding on all tax administrations.

2.9.2. Dispute Resolution

Where an in-scope MNE group does not accept a panel conclusion the MNE will benefit from dispute prevention and resolution mechanisms, which will avoid double taxation for Amount A, including all issues related to Amount A (e.g. transfer pricing and business profits disputes), in a mandatory and binding manner. Disputes on whether issues may relate to Amount A will be solved in a mandatory and binding manner, without delaying the substantive dispute prevention and resolution mechanism.

Consideration will be given to an elective binding dispute resolution mechanism for issues related to Amount A for developing economies that are eligible for deferral of their BEPS Action 14 peer review and have no or low levels of MAP disputes.

Rules for dispute prevention and resolution could be embedded in the same multi-lateral instrument that introduces rules for the taxation of Amount A, ensuring that the new taxing right is linked to the availability of the new and enhanced tax certainty regime.

2.10. Implementation

According to OECD, the multi-lateral instrument, through which Amount A is proposed to be implemented, will be developed and opened for signature in 2022, with Amount A coming into effect in 2023.

2.11. Amount B

Having discussed above the key components of Amount A we now come to Amount B. Amount B of Pillar 1 is different from Amount A. Amount B is not directly related to allocation of profit of remote digital businesses to market jurisdiction. Rather, Amount B is about preventing disputes between businesses and tax authorities about application of the arm's length principle (under domestic transfer pricing rules) to in-country baseline marketing and distribution activities.

When a MNE group has a subsidiary or a permanent establishment in the market jurisdiction, application of the arm's length principle to in-country baseline marketing and distribution activities constitute an area of concern for tax administrations and taxpayers alike. Such activities frequently lead to domestic transfer pricing controversy. They are often the subject of dispute between businesses and tax authorities, and require settlement under the MAP provided for in bilateral tax treaties. For these reasons, many governments and businesses desire tax certainty in attribution of arm's length remuneration to in-country baseline marketing and distribution activities performed by a local subsidiary or a permanent establishment.

So, Amount B is intended to simplify the administration of transfer pricing rules for tax administrations and reduce compliance costs for taxpayers. Amount B is also intended to enhance tax certainty and reduce controversy between tax administrations and taxpayers. In these ways, Amount B has the potential to address certain challenges that tax administrations face in evaluating the arm's length nature of the pricing of distribution arrangements adopted by MNE groups.

Therefore, many governments and businesses view improvements in this area, through Amount B, as a key deliverable of Pillar 1. Basically, Amount B seeks to simplify application of arm's length standard to baseline marketing and distribution activities. The OECD states that the application of the arm's length principle to in-country baseline marketing and distribution activities will be simplified and streamlined, with a particular focus on the needs of low-capacity countries.

A pre-decided profit margin (Operating Profit/Sales) under Transactional Netprofit Margin Method (TNMM) will be put in place to determine remuneration due to local or domestic distributing entities. To such profit margin adjustments will be made for entities located in different regions and entities operating in different industries. Further work on in this area will be completed by the OECD by the end of 2022.

2.12. Administration

The tax compliance will be streamlined (including filing obligations) and allow MNEs to manage the process through a single entity.

2.13. Unilateral measures

The OECD's final package on taxation of digital businesses will provide for appropriate coordination between the application of the new international tax rules, and the removal of all Digital Service Taxes and other relevant similar measures enacted by several Countries.

[Here, Part I of this Article on Taxation of Digital Businesses - Pillar 1 and 2 Proposals of OECD ends. This Part discusses Pillar 1 proposals. The Article continues in Part II, which is the next part, where Pillar 2 proposals are discussed.]

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