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A step towards new market jurisdiction taxation rights

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Cyril Maucour and Jessica Benchetrit of DS Avocats evaluate the effectiveness of the OECD’s new unified approach, which provides market jurisdictions greater taxing rights over residual profits.

The Inclusive Framework (IF) on base erosion and profit shifting (BEPS) is composed of 137 countries and territories, and leads the discussions around several pillars identified in the action plan that aims to address the challenges of the digital era.

The proposals published as part of the public consultation appear to be moving away significantly from the arm's-length principle and, sometimes, appears to be taking a clean break from the advice previously provided by the OECD in its report on transfer pricing.

In October 2019, the IF secretariat published a public consultation document proposing a new unified approach. This approach aims to take into account the components of all three options described in the Programme of Work adopted in June 2019 by the IF on BEPS.

In the context of an increasingly digitalised economy, and in particular given the increase in the number of companies in close contact with consumers and engaged in distance selling, the OECD sought in its report to adapt the original rules governing the allocation of profits by proposing a new approach.

This unified approach thus introduced a new nexus and new profit allocation rules that goes beyond the arm's-length principle by granting taxation rights to market jurisdictions, i.e. states where the consumers are located.

Approach summary

The IF specified that the unified approach will not only apply to companies with a strong digital component, but to all companies that have close contact with consumers.

The OECD has, therefore, significantly broadened the scope of this approach by including companies that do not engage exclusively in digital activities but carry out consumer-linked activities, such as marketing or distance distribution.

The OECD then specified that only large companies will be subject to this new approach and that an agreement will be reached during future discussions on restrictions based on company size, in particular by introducing a turnover threshold that is used for country-by-country reporting (CbCR).

New allocation rules

The challenge faced by the jurisdictions that have taxation rights, if they are considered market jurisdictions, will be to determine the amount of profit they will be allocated.

The proposed approach aims to grant jurisdictions the right to tax companies even in the absence of a physical presence. As it stands, companies subject to this approach do not carry out any activities, use any assets or incur any risks in the market jurisdiction and, therefore, cannot apply current regulations to identify the amount corresponding to a portion of profits that should be allocated to them.

The OECD is proposing a new profit allocation method that goes beyond the applicable fundamental principles, such as the arm's-length principle, that apply to transfer pricing.

It maintains the existing principles for a portion of the profits (in particular Amount B) and suggests a new approach for the remaining profits (Amount A and Amount C). The OECD has suggested a three-tier mechanism:

  • Amount A: A share of deemed residual profits of the multinational company group that falls within the scope of application described above will be subject to taxation by the market jurisdiction. This residual profit will correspond to the remaining profit after the routine profit is allocated to the jurisdictions where the group is engaged in distribution and marketing activities and where it has a physical presence as defined in relation to Amount B below. This share of residual profit that is left over after routine activities are remunerated will then be divided between the various jurisdictions identified as market jurisdictions.

The OECD indicates in its report that profit will then be allocated to these jurisdictions using a formula based on sales.

As taxing this amount will be independent of where the company in question is located and/or where it has its place of residence, this approach will tackle the issues related to taxing digital activities, in particular distance sales without a physical presence, which will allow the jurisdictions where consumers are located to exercise taxation rights.

  • Amount B: Profits resulting from simple routine functions (in particular distribution and marketing functions) through a physical presence will continue to be remunerated in accordance with existing regulations but by means of a fixed return, or by various appropriate fixed returns based on the sector and region.

By proposing a fixed return amount, the OECD aims to limit the number of disagreements and believes that this approach will reduce the risk of double taxation and prove beneficial to both taxpayers and tax authorities.

Companies that carry out distribution and marketing activities considered routine will therefore be taxed locally, and the taxable amount will be determined by applying a fixed return rate to the total sales.

In practice, this means subjecting these activities to a method resembling the transactional net margin method, by applying a return on sales.

  • Amount C: The OECD proposes that a share of the residual profits should be allocated to companies that carry out distribution and marketing functions as defined under Amount B if the activities carried out by the company exceed the baseline activities and can, therefore, justify a profit greater than the fixed amount allocated under Amount B, or if the group carries out other commercial functions unrelated to marketing functions.

This share of profits allocated to the company and remunerative activities that exceed simple routine activities will be taxed in the market jurisdiction.

International corporate groups that are sufficiently large and that have close contact with consumers will therefore have to first determine the Amount B and compensate for activities that are deemed to be 'routine activities', and then compensate for activities exceeding baseline activities, if any, by applying the Amount C. Once these functions have been remunerated, groups will then have to allocate the remaining profits between the various jurisdictions deemed to be market jurisdictions on a pro-rata basis and by using a formula based on total sales.

Approach analysis

The approach presented by the OECD in its report provides an effective solution to the challenges of allocating taxation rights by allowing jurisdictions to tax profits generated by a group that does not have a physical presence in the country.

This approach does, however, raise several problems, both in terms of existing fundamental principles, such as the arm's-length principle, but also in terms of practical implementation.

Infringing the arm's-length principle

The usual reasoning that applies to transfer pricing, and involves carrying out a functional analysis and a value chain analysis, becomes impossible in the context of the new approach proposed by the OECD because the companies subject to this new approach do not have a physical presence in the jurisdiction where they will be taxed.

The introduction of a fixed rate of return for routine activities as provided for under Amount B poses numerous problems and further contributes to widening the gap between this approach and the principles already set out by the OECD in its previous reports.

The amount meant to remunerate routine activities would correspond to the application of a fixed rate of return that will be determined on the basis of sales and depending on the identified sectors and regions. According to the OECD, applying a fixed rate could provide companies with a source of legal certainty.

However, applying a fixed rate to some activities also seems like an infringement of the arm's-length principle. All companies belonging to the same sector that potentially carry out different functions or are positioned in different markets (such as niche markets), would be subject to the same return.

The OECD has already considered and proposed the application of a fixed rate in its previous reports on the remuneration of low value-added services by proposing that this type of service be remunerated at a rate between 3% and 10%. At a European level, the EU Joint Transfer Pricing Forum has also identified arm's-length ranges that apply to each type of service (marketing, research and development, IT, etc.)

In France, for example, and in practice, tax authorities require even low value-added services to be documented by means of an economic analysis and only very rarely accept the application of a fixed rate without documentation, despite the principles set out by the OECD, which are simply proposals that members are not necessarily required to apply.

As part of the new proposed approach, members will have to agree on the fixed rates they will apply, which seems very complicated in practical terms.

Implementation difficulties for companies

The challenge for multinational companies that fall within the scope of application imposed by the OECD will first be to determine if the activity it is carrying out constitutes exclusively a routine activity and to what extent the scope of the functions can be remunerated under Amount C. At this stage of the discussions shared by the OECD, the IF has not provided any additional clarifications on the methods or elements to be used to define the notion of 'routine activity'.

Companies will then have to determine the amount of residual profit to be paid under Amount A. This is a new measure that has not been fully clarified, as is the portion of profit that can be potentially allocated under Amount C.

As such, the OECD advises companies in its report to ensure that profit already allocated under Amount A is not allocated a second time, either partially or entirely, to the market jurisdiction under Amount C.

Potential avenues for improvement

In conclusion, the new approach proposed by the OECD raises numerous questions and seems to call into question the fundamental principles set out by the OECD and already applied by many jurisdictions.

Integrating the notion of markets as intangible assets into the existing profit allocation methods

In its June 2018 report, the OECD amended the instructions already issued in October 2015 on the transactional profit split method, and specified that the transactional net margin method does not apply if there are no high value-added intangible assets. On the other hand, in case of high value-added intangible assets, then the profit split method should be given priority.

The residual profit split method, which allows routine activities to be remunerated and residual profit to be allocated to companies that carry out entrepreneurial activities and have high value-added intangible assets, appears to be the method most frequently applied in practice. It does not, however, allow for sufficient remuneration of the jurisdictions where the marketing operations are carried out, and even less so in the context of distance selling or digital services, where the jurisdictions are not remunerated at all.

The new approach proposed by the OECD generally comes close to this method by not allocating the residual profits to the company that has high value-added intangible assets but instead to the market jurisdiction.

Questions have been raised over whether it is possible to combine the approach proposed by the OECD with existing methods. If we consider that the market (consumers, a country's purchasing power, etc.) constitutes an intangible asset, then a solution could be to determine the value of this asset and take it into account when applying the residual profit split method, for example, in order to allocate an additional remuneration on this basis.

Introducing a tax separate from corporation tax based on turnover

In order to avoid infringing the arm's-length principle and continue to comply with the principles that apply to transfer pricing, one solution could be to introduce a tax separate from corporation tax that will not be subject to transfer pricing but will be based on the turnover generated in a jurisdiction. This tax will, therefore, be similar to the 'GAFA' tax on digital services – an acronym of the US companies it targets: Google, Apple, Facebook and Amazon – which came into effect in France in 2019.

This tax could take the form of a withholding tax, which would be deducted directly in the market jurisdiction, i.e. the state where the customers are located, in line with the main idea of the OECD's unified approach, which was to allocate part of the taxable benefit to this market jurisdiction. Any instances of double taxation would be dealt with by bilateral mechanisms (exemption or allocation, as provided by bilateral agreements based, most notably, on the OECD model).

This form of taxation could be an alternative that allows the fundamental transfer pricing principles, disrupted by the OECD's unified approach, to be upheld.

Cyril Maucour



DS Avocats

Tel: +33 1 53 67 50 00

Cyril Maucour is a tax partner at DS Avocats. He is known for his expertise in international taxation and transfer pricing, and regularly accompanies French companies in their international operations and assists foreign groups in their activities in France.

He is often involved in the structuring and documentation of their cross-border operations. He holds a master's degree from Paris Nanterre University and a LLM from Golden Gate University.

Jessica Benchetrit


Senior associate

DS Avocats

Tel: +33 1 53 67 50 00

Jessica Benchetrit is a senior associate with DS Avocats.

She holds a master's degree in tax law. After several internships in international taxation at EY and CMS Francis Lefebvre Avocats, she began her career as a lawyer within Bignon Lebray. She joined DS Avocats in 2019 and she regularly works on international taxation and transfer pricing issues.

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