Taxpayers in scope of the formulary approach to residual profits would face a three-tier mechanism for profit allocation. Market jurisdictions would get greater taxing rights over residual profits based on a formulaic system, while the arm’s-length principle (ALP) continues to apply to routine profits.
However, the OECD has stressed this is a consultation document and not a new set of recommendations. “This is a sketch of a blueprint of a new architecture,” said Pascal Saint-Amans, head of tax at the OECD’s Centre for Tax Policy and Administration.
After years of work, the OECD has proposed a “unified approach” to pillar one in a bid to secure more time to flesh out the details and build a consensus through 2020. “We will not be able to get a solution in 2020 if we don’t have a unified approach,” Saint-Amans said.
The approach aims to complement the ALP with a formula-based solution for market jurisdictions and leave the existing transfer pricing rules in place. This would mean the proposal would be a second layer on top of the existing TP regime.
At the same time, the OECD hopes the offer of binding and effective dispute prevention and resolution mechanisms will stabilise the international system. “Countries like India understand that we can’t go ahead without seriously improving tax certainty,” Saint-Amans said.
If this sounds familiar, it’s because the mechanisms would be the equivalent of mandatory binding arbitration but redesigned and repackaged to be more palatable to countries fearing a loss of sovereignty.
“If you want to benefit from the reallocation of taxing rights, you must have an effective binding dispute resolution mechanism in place,” Saint-Amans said.
“It doesn’t have to be arbitration, but it must be equivalent to it,” he added. “That’s the price to pay to get more taxing rights for your market.”
Many developing nations fear arbitration on tax will go the same way as trade tribunals. No doubt, the business community will want its voice heard as well. So the OECD has called a fresh consultation ahead of its November meeting in Paris.
Three tiers for certainty
The OECD’s ‘unified approach’ is a compromise designed to bring as many stakeholders on board as possible. However, this has to be palatable for businesses and not just governments from all over the world. Companies in scope would encounter three-tiers for profit allocation as follows:
- Amount A – a share of deemed residual profits allocated to the market jurisdictions using a formulaic approach, i.e. the new taxing rights;
- Amount B – a fixed rate of remuneration for baseline marketing and distribution functions that take place in the market jurisdiction;
- Amount C – binding and effective dispute prevention and resolution mechanisms relating to all parts of the proposal, including any extra profits where in-country functions exceed the baseline activity compensated under Amount B.
The OECD’s three-pronged approach to profit allocation depends on how to interpret financial data drawn from consolidated accounts. The starting point for determining the profitability of the company would be the net operating margins – what is reported to financial regulators, not tax data.
Next comes the crucial distinction between residual and routine profits. The mechanism would set a bar for making this distinction clear for the sake of practicality. The key test would be how much of the profits were drawn from sales and there would be a cut-off point for routine profits.
For example, company X has a profitability rate of 35%. “It has 100 sales and 35% of consolidated profit worldwide,” Saint-Amans said. “Let’s say for the sake of example, up to 10% we don’t reallocate profit but after 10% we reallocate.”
“If your profitability is 35%, you have 25% of deemed residual profit and you need to reallocate a percentage of that to the market jurisdiction,” he said. “Let’s say it’s 20%. You would reallocate 20% of 25%, which is 5% of the global profit of the company.”
The 5% would go to the market depending on its size. So if the UK has 10% of the company’s sales, the country would get taxing rights on 0.5% of the total profits of the company. These figures are just what Saint-Amans used to explain what the proposal means for a company. The numbers are open to negotiation.
What is clear is that it would have to be a formula-based solution to ensure sales are given enough weight and not a bottom-up approach. This is supposed to prevent gamesmanship over what counts as routine and residual profit.
Finding common ground
The OECD has based this approach on what it sees as the common ground between the three pillar one proposals: user participation, marketing intangibles and significant economic presence.
Pillar one was even more contentious than pillar two. Each of the three proposals has its own constituencies. Significant economic presence has wide support among developing and emerging economies, particularly India, while the UK favours a user participation model.
Marketing intangibles has become increasingly prominent since Johnson & Johnson (J&J) intervened in the debate in the March consultation. The J&J proposal caused quite a stir among tax professionals, and the OECD decided to craft its own version.
One head of tax at a pharmaceutical company suggested the policy experts might lose out to stronger political forces in the end. “Whenever politics and policy collide, you should bet on politics every time,” said the head of tax.
Others were hopeful that the OECD’s search for common ground would mean more compromise and, ultimately, a more reasonable outcome for businesses. However, the concern remains that the solution will create winners and losers.
“Any consensus on taxing the digital economy is not going to be radical for it to work,” said one tax director at a software company.
“It will likely mean considerable change to the international tax rules we’ve had for 100 years and the G7 stand to lose out as they have the largest share of multinationals,” said the tax director.
The pillar one proposals may vary in how they address digitalisation, but the common focus is how highly profitable, online businesses are able to operate in a market remotely.
All the proposals aim to reallocate taxing rights in favour of the market jurisdiction. As a result, all the proposals require a new nexus rule that would not depend on physical presence in the market jurisdiction. This means rethinking permanent establishment (PE).
The OECD has made it clear the same scope for country-by-country reporting (CbCR) would apply as part of the new rules. Meaning corporate turnover of €750 million ($822 million). The focus would also be on highly digital business models, but not exclusively.
There would be no strict ring-fencing, but the scope would cover consumer-facing businesses with some carve-outs yet to be decided, while excluding pure B2B companies and extractive industries.
“It would apply to companies like Uber and Google, for example,” Saint-Amans said. “The scope includes digital, but it’s broader than digital.”
“There is a question mark on the scope over the financial industry because it’s largely B2B but also B2C to some extent, albeit not very profitable given the state of interest rates,” he explained.
Businesses within the scope will face a new nexus rule, not dependent on physical presence but on sales. The sales threshold would have to be adjusted to take into account smaller economies, but it would be designed as a self-standing treaty provision. This would be adjusted depending on the size of the economy.
“There is a recognition and agreement that the existing PE rules does not capture all business models, especially those operating without a physical presence in the market,” Saint-Amans said.
“We wanted something simple,” he said. “If you’re not present in the market physically, your sales are what bring you within scope.”
The OECD is taking the proposal to the G20 finance ministers on October 17, where it hopes the “unified approach” will unlock real negotiations about a concrete plan. In other words, the race to tax the digital economy is turning into a marathon.
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