Digitalisation of the global economy has led to significant tax challenges, triggering concerns about fairness and transparency in the global tax architecture. As recent events have unfolded, it has become quite clear that these challenges could not have been addressed by unilateral measures undertaken by a tax jurisdiction. They have required a coordinated effort for more than 10 years, with G20 countries taking up the cause and tasking the OECD with crafting a package to:
Improve the coherence of tax rules across borders;
Reinforce substance requirements; and
Enhance transparency and certainty.
The BEPS package is an outcome of that effort.
Taxation of the digital economy, given its growing importance and the accompanying extra challenges, was identified for separate action, and after considerable international deliberations, there is now a two-pillar solution in place, with the objective to move beyond arm’s-length pricing and reallocate taxing rights based on factors other than physical presence.
Pillar one is intended to capture the value created in a jurisdiction by a business through specific nexus/source/substance to the jurisdiction, while pillar two is designed to ensure that global income is taxed at a minimum effective tax rate.
At this stage of discussion, pillar one would apply to large multinational enterprises (MNEs) with turnover of at least €20 billion. These MNEs would be required to reallocate certain amounts of taxable income (25% of profits exceeding a 10% consolidated return), called amount A, to market jurisdictions using a formulaic approach. The MNEs would also have to ensure a fixed baseline return (amount B) for the jurisdictions where related parties are engaged in a marketing and distribution function, based on the arm’s-length principle.
Pillar two is designed to ensure that large MNEs, with consolidated group revenue of over €750 million, pay a minimum level of tax (i.e., 15%). The pillar two rules require that transactions between group entities are to be priced consistently with the arm’s-length principle.
MNEs’ likely strategy
The guidance on the computation of amounts A and B, and pillar two is likely to impel large MNEs to consider if the present transfer pricing between group companies needs to be revised. Quite likely, MNEs may already be evaluating whether pillar one and pillar two guidance can be integrated with the present arm’s-length principle.
One challenge that may crop up for concerned MNEs until the time all jurisdictions accept the standardised principles and guidance from the OECD on the computation and determination of amounts A and B is the acceptability of the computation and determination of the amounts in the jurisdictions in which the MNEs operate. If not, the MNEs would face challenges in demonstrating intercompany pricing during transfer pricing audits. This may increase litigation for MNEs.
Given the above likelihood, MNEs may consider:
Revisiting their intercompany pricing and assessing whether their pricing policy complies with pillar one and pillar two guidelines, and if so, to what extent?
Consider protecting themselves through dispute prevention mechanisms such as applying for advance pricing agreements (APAs)/mutual agreement procedures (MAPs), to minimise transfer pricing litigation and uncertainty in their cashflows.
As it stands, tax jurisdictions are taking time to evaluate their overall tax position as a result of the standardised framework, and that creates uncertainty for MNEs. It will be interesting to examine how tax jurisdictions blend the OECD standardised framework with their existing regulations and agree on a consensus. A few possibilities emerge, as a first thought:
Would the standardised framework act as a safe harbour in the tax jurisdictions?
Would the present formulaic approach blend appropriately with the separate entity approach and arm’s-length principle, which is the core of the present OECD transfer pricing guidelines?
Would the tax jurisdictions prefer to accord a weightage to the local benchmarking/jurisdiction to create a specific advantage?
Would amount B (the baseline arm’s-length return for a marketing and distribution function) be differently assumed by tax jurisdictions?
Would existing bilateral APAs under MAP provisions of tax treaties be impacted?
Would MNEs consider opting for dispute redressal mechanisms such as multilateral APAs/MAPs, considering the involvement of multiple jurisdictions?
Would unilateral measures in the form of, for example, a digital service tax be scrapped? Also, what is the guarantee that such measures would not ‘morph’ through other forms? That may threaten to break the present well-crafted digital taxation architecture.
It is commonly expected that the present participating jurisdictions would agree to a framework/standardised principles for the computation of amount A and the determination of amount B. Based on the present guidance, it appears that while the computation of amount A would largely be formula driven, the determination of amount B would be based on an extensive transfer pricing exercise. It would thus be interesting to see what factors would be considered for determining amount B and if there would be any standardisation in the computation of this amount as well.
Outcome in the offing
Assuming a consensus is reached among participating jurisdictions, on pillar one, a fallout of such consensus would be a reporting requirement in all participating jurisdictions (for reporting the computation of amounts A and B). The BEPS Action 14 minimum standard, which includes timely and complete reporting of MAP statistics, is accepted by all member jurisdictions, which have been sharing the annual statistics of MAPs with the OECD. The OECD has been publishing jurisdiction-based MAP data for each year. The OECD also publishes the outcome of a peer review on country-by-country reporting.
Such collaborative efforts by the OECD have resulted in not only effective collation of data by jurisdictions, they have also led to a reduction in the delay in finalising MAPs, with a certain transparency in the process that the data assures. With this transparency and collaboration, and improved outcomes, a reporting requirement for amount A – akin to the country-by-country reporting requirement framework, i.e., detailed filing in the main jurisdiction while notifying other participating jurisdictions – would help to ease the compliance burden for large MNEs.
Furthermore, the OECD also announced that MAPs would be simplified to address the challenges arising out of the pillar one and pillar two framework. These simplifications would also assure revenue to source countries at a relatively low administrative cost, given the transparency it would lead to.
While the OECD and the participating countries have put in significant efforts to develop the framework, work on detailing and streamlining the computation of amounts A and B remains. This information is crucial as governments understand the outcome and would be able to better calibrate their fiscal systems. MNEs would also be able to achieve business certainties and improve on their commercial decisions for more investments.
As we continue to watch how the pillar one and pillar two framework pans out, its acceptability among participating jurisdictions would be a key aspect, considering some of the aspects discussed above.
The article was supported by Nandita Salgaonkar of Deloitte India.
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