Two major initiatives from the Organisation for Economic Co-operation and Development (OECD) could have a significant impact on companies with transfer pricing requirements. In our fourth quarter 2019 transfer pricing update, we’ll take a closer look at how these updates could affect international reporting.
Impact of OECD Proposal to Rewrite International Profit Allocation Rules
In October 2019, the OECD published the Pillar 1 Unified Approach (Pillar 1), which is an effort to bring together three proposals for consideration by the 134 countries under the OECD/G20 “tax challenges of the digitalization of the economy project.”
If Pillar 1 is agreed upon, it will significantly alter the international tax regime and impact a large number of consumer facing businesses. The overall goal of Pillar 1 is to allocate a greater share of taxing rights to the countries where consumers are located, regardless of a business’ physical presence there.
The main Pillar 1 approach recommends a departure from the arm’s length principle (ALP) in certain situations and circumstances, which could also simplify the ALP for some routine activities. The existing ALP would be supplemented with two formulaic measures – one based on traditional ALP concepts and the other a new approach – and would be achieved via one new rule and two modifications to the existing rules as follows:
- New formulaic allocation of a portion of deemed global residual profit in excess of an agreed-upon baseline and financial statements;
- Among countries where customers are located regardless of where the businesses’ physical activities are located;
- Would apply equally to both profits and losses although percentages have not been confirmed in the OECD consultation document.
- Fixed percentage return allocated to some routine functions such as marketing and distribution;
- Would simplify and standardize a distribution return to market countries.
- Would apply where a businesses’ activities in a country are deemed greater than routine functions under Amount B;
- A country could seek to assess additional amounts if warranted, similar to the existing transfer pricing system.
While it is not a defined term, the changes are focused on “large, consumer-facing” businesses that interact remotely with users or engage and interact with customers from a remote location. Local nexus thresholds will also need to be determined through revenue thresholds. Situations in which non-paying users aren’t located where revenues are booked will also need to be taken into consideration.
Financial services, commodities, and certain business-to-business (B2B) situations may be subject to Pillar 1, but clarification is needed as to whether different business lines within a group will be segmented. Financial accounting standards and reporting requirements could be an option.
General policy, technical, and administrative issues have been raised by the Pillar 1 approach and comments were requested from stakeholders by Nov. 12, 2019, followed by a consultation meeting in Paris.
The OECD seeks agreements on the proposed changes by the end of the month.
OECD Releases Pillar 2 Consultation Document
In November 2019, the OECD released a public consultation document “Global Anti-Base Erosion Proposal – GloBE” (Pillar 2).
This document is the second part of the OECD’s efforts to develop a two-pronged solution to rewrite profit allocation rules for large, consumer facing businesses (Pillar 1) and address tax challenges that result from globalization and digitalization (Pillar 2).
Unlike Pillar 1, the Pillar 2 consultation document includes minimum tax rules that would apply to large international businesses in all sectors and could significantly increase tax and compliance costs for a wider range of businesses.
The consultation document only addresses part of the Pillar 2 issues as outlined in the May 2019 Programme of Work and focuses primarily on the development of an income inclusion rule, which seeks to regulate the foreign taxes paid by a business’ overseas branches or controlled entities. The starting point for this calculation appears to be financial accounts, but is still open to consideration and discussion.
The three, key technical areas covered by the Pillar 2 consultation include the following:
- Given the differences between accounting standards and tax bases, there is a balance to strike in identifying truly low taxed profits;
- For differences that would not even out over time, such as non-taxable income or non-deductible expenses, the consultation recommends removing certain amounts as standard;
- For differences that would even out over time, such as profits recognized in different years for tax and accounting purposes, three options have been suggested – carrying forward excess taxes paid for offset in future years, using IFRS deferred tax accounting standards instead of cash tax recognized in accounts, or averaging over multiple years.
- The consultation seeks views on blending – i.e. whether groups could consolidate taxes at an entity, jurisdiction, or worldwide basis to determine if the effective taxes paid on profits are high enough;
- Factors under consideration include the cost of compliance, impact on volatility, and allocation of profits and taxes between entities and jurisdictions.
- Carve-outs may be required and the consultation notes indicate that there is often a trade-off between certainty and complexity;
- No specific industries or regimes are identified for carve-outs, but broad questions have been raised for consideration such as whether carve-outs are appropriate on the basis of a group’s global size or industry, the scale of local presence, and the potential behavioral impacts that carve-outs may have.
What OECD Updates Mean for International Companies
In summary, the Pillar 1 proposal and Pillar 2 consultation document seek to address fundamental concerns that the Base Eroision and Profit- Shifting (BEPS) Project did not provide a proper solution to the risks of activities and profits being moved to low or no tax jurisdictions. The potential impact should be noted by all international businesses, including those that are already subject to U.S. Global Intangible Low Taxed Income (GILTI) rules.
While there is fairly broad support for the total package and the OECD is operating on the basis that both pillars would be agreed upon together, enthusiasm for Pillar 2 appears to be mixed. Taxpayers will want to analyze the potential impact of the prospective tax liability and increased compliance and filing burden on their businesses and make their views known to the OECD.
The OECD will seek political agreement among the members of the Inclusive Framework on the proposed changed in January 2020 so technical work on the execution and mechanics of both Pillars can occur throughout 2020.
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