Valuation and consulting for financial reporting; federal, state and local tax; investment; and risk management purposes.
The “Pillar One Blueprint”, formally titled “Tax Challenges Arising from Digitalization–Report on Pillar One Blueprint”, was released by the OECD’s/G20’s Inclusive Framework (“IF”) on October 12, 2020. It is a non-consensus working document that presents the initial proposals from the OECD’s working group on how to change the international tax system to address tax challenges arising from digitalization of the global economy.
The current international tax system is built on the concept that physical or activity-based presence in a country creates a right to tax, also known as a tax “nexus” (addressed in Article 7 of the Model Tax Convention). The Pillar One Blueprint is intended to provide an internationally agreed-upon framework for an overlay to the existing international tax system to better address perceived inequity caused by modern business models, which can often involve exploitation of a country’s markets without significant (or any) local physical or activity-based presence (in turn leaving such countries without rights to taxation). The Pillar One proposals address this perceived inequity by proposing to expand the taxing rights of market jurisdictions that meet certain thresholds and introducing a formulaic taxable profit allocation mechanism to determine an appropriate amount of market-related profits that jurisdictions can tax.
Said differently, this would create a new taxing right in response to the reality that in-scope businesses can generate profits through participation in a jurisdiction with or without a physical presence and beyond the conclusion of sales. For example, a company physically located in one country may offer a social media platform to users globally. Access to the platform is free, but the users must sign up by providing certain personal data and/or answering specific questions. The social media company collects this valuable personal information from its users in countries all over the world and then sells that data to another company that uses it for marketing purposes. The social media company does not have a physical presence in the vast majority of the countries in which its users are located, nor has it sold anything to its users, yet it is still able to generate profits through participation in each local jurisdiction.
Pillar One comprises three key elements, which, taken together, effectively create a completely new international tax system that will overlay the existing system and be applied to certain types of businesses. These three key elements are summarized below:
Amount A: This is the mechanism through which market jurisdictions will be provided with a new taxing right over a share of residual profit calculated at the MNE group (or agreed segment) level based on adjusted consolidated financial results. At present, in-scope businesses are those that provide automated digital services (ADS) or that are characterized as customer-facing businesses (CFB); however, the specific boundaries within those categories are still being drawn (see below for definitions of CFB and ADS). Within the boundaries that do currently exist, there are several tests and thresholds that further attempt to identify which companies will be subject to Pillar One taxation and which jurisdictions will have associated taxing rights. The solution aims to follow the policy rationale and allocate a portion of the residual profit of in-scope businesses to marketer/user jurisdictions, thus rewarding those jurisdictions for their market contributions that are unrecognized under the current system.
Amount B: This element of the proposal is a safe harbor of sorts that aims to standardize the remuneration of related-party distributors that perform “baseline marketing and distribution activities” (“BMDA”). Amount B is defined as a fixed return for certain BMDA, physically performed in a market jurisdiction that is intended to align with the arm’s-length principle. Unlike Amount A, Amount B applies to all industries, not just those deemed as CFB or those performing ADS, and Amount B is elective by the taxpayer. The goal of Amount B is two-fold: (1) to reduce the compliance of transfer pricing rules for taxpayers, which, in turn, simplifies the administration of transfer pricing compliance for taxing authorities; and (2) enhance tax certainty by reducing controversy. At this point in time, it is unclear exactly how much benefit taxpayers may expect from Amount B because the two key design features that will determine the purview of Amount B, and are likely crucial to its success, are yet to be defined: (1) the specific services that will qualify as BMDA; and (2) the fixed level of remuneration for those BMDA.
Tax Certainty: Because the Pillar One proposals are an overlay to the existing (and fundamentally different) profit allocation system, the certain profits targeted by the proposals are likely already taxed in another jurisdiction (i.e., profits subject to the “new taxing right” in Amount A). Therefore, reconciliation between the new taxing right and the existing profit allocation system is of critical importance to avoid situations of double taxation. Recognizing this, the IF rightly includes several important mechanisms to resolve potential areas of double taxation and double counting of income; however, there is still work to be done around the design of these mechanisms. This is arguably the most important component to get right, as it will largely determine the perceived success of Pillar One. Regardless, there is little doubt that disputes will still arise. In further recognition of such potential disputes, the Pillar One Blueprint also proactively proposes dispute prevention and dispute resolution mechanisms around Amount A. It contains a framework for a mandatory binding prevention process that would be intended to resolve issues before tax adjustments are made, and would be embedded within the same multilateral agreement instrument that introduces the rules for Amount A such that one would not be implemented without the other. With respect to dispute rules beyond Amount A, the Pillar One Blueprint suggests improvements to the existing dispute resolution processes and mutual agreement procedure (“MAP”) and proposes a binding dispute resolution mechanism for Amount B.
The outline above summarizes the present thinking related to the design features of each component, which at this point is more of a loose framework than a comprehensive blueprint. Each component has several items that still need to be determined or addressed through the ongoing negotiations.
The net cast by Pillar One is potentially quite broad and has potential to affect all multinational taxpayers, though the extent of that impact can vary. At one end of the spectrum, if you are a multinational enterprise outside the umbrella of Amount A, the only impact of Pillar One may be the added flexibility to avail yourself of Amount B. As noted, Amount B is an elective measure where the taxpayer can use standardized remuneration to price BMDA activities. At the other end of the spectrum, if you are a large, profitable MNE that provides ADS or is considered a customer-facing business, you will be in the crosshairs of Amount A and will likely have to navigate the uncharted waters of this new tax system.
ADS companies are broadly thought of as those that can generate revenues “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.” A key defining factor for a service to be considered “automated” is the ability to scale up services with little or no human involvement (i.e., if the marginal cost to add new users is very small or zero). Pillar One refers to a positive and negative list of services that provide more clarity on the specific types of ADS that are the focus of Amount A. ADS companies include not only the expected list of online, digital content, social networking, gaming and marketplace companies but also online standardized teaching and cloud computing companies.
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 through intermediaries and by way of franchising and licensing.” A customer-facing business is therefore defined by the type(s) of product(s) it sells (i.e., products commonly used by consumers) as opposed to whether it sells directly to consumers themselves. Said differently, a wholesale distributor of “products commonly used by consumers” may find itself defined as a CFB, and therefore, in the line of fire with respect to Amount A. Within the CFB category, because the category is so broad, there is also further clarification on how Amount A applies to/within certain industries (e.g., pharmaceutical, franchising and licensing).
Lastly, the Pillar One Blueprint excludes certain sectors altogether from Amount A, including natural resources, financial services, construction, sale/leasing of residential property, and international air and shipping businesses. There are also threshold tests that include a global revenue test and a de minimis foreign in-scope revenue test, which are intended to target large multinational enterprises (measured by global sales) that derive a minimum threshold of in-scope income outside its domestic market.
As noted, the Pillar One Blueprint is a non-consensus working document. In the absence of final guidance, many countries have or are threatening to introduce unilateral digital sales taxes if there is no substantive progress toward an agreed solution this year. Following indications of increased engagement from the U.S. administration to find a solution, earlier this month, Pascal Saint-Amans, director of the OECD’s Center for Tax Policy and Administration, said that “[t]he stars are aligned …” for the 140+ participating members of the IF to find consensus and present its solution to the G20 in early July. Whether and how much consensus will be achieved in this time frame is unclear.
We note that the Pillar One Blueprint proposals are also accompanied by a Pillar Two Blueprint that introduces proposals for a separate international tax overlay to address any low-taxed income, which will also interact with the existing tax system and the Pillar One Blueprint proposals.
The complexities involved in the Pillar One design, the difficulties in reaching consensus among 140+ countries, and the likelihood of further public comments and refinement of the design, suggest that there are likely to be many more months remaining in the design phase. As we saw from other elements of the OECD BEPS initiative, the implementation phase will also require significant changes to treaties and domestic laws and related procedures and guidance to tax authorities and taxpayers. The OECD has learned from its experiences with BEPS, so it is likely to be more efficient, but the implementation process could still take years to complete, and it will probably incrementally grow in scope over time.
Pillar One and Pillar Two represent a significant overhaul of the international tax system, and therefore, all MNEs should follow the developments and, where possible, contribute to the process by providing comments to the OECD or through their applicable government representative. While some initial analysis of tax impact is possible based on the current Pillar One Blueprint proposals, as yet, there likely isn’t enough clarity around the specifics for any meaningful analysis to be undertaken. The next iteration of the proposals from the OECD, which is expected this summer, are likely to be more refined and provide a much clearer indication of the ultimate shape the guidance will take and the impact it will have on specific MNEs.
In-scope companies or businesses would be well-advised to assess their potential exposure to Pillar One (and Pillar Two) taxation in the near term, so they can start to more clearly socialize the potential for change within their organizations, begin to assess its impact on tax liabilities and the potential for double taxation, and consider any optimization strategies that might be available. However, any more concrete, quantitative analysis should likely begin after the next iteration of the proposals, which is expected this summer.
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