The OECD’s two-pillar solution to address the tax challenges arising from the new economy is expected to raise tax revenues significantly for many countries around the world. Pillar one is set to be the key driver of the increase due to the fundamental shift in taxing rights. In this regard, an international agreement on the final details of pillar one has been much more difficult to settle than for pillar two because of its complexity and the potential implications for the global transfer pricing policies of companies in scope.
Although the timeline has been delayed substantially, reasonable progress has been made by the OECD/G20 Inclusive Framework on BEPS (the Inclusive Framework). Design details of amount A and amount B are being finalised and the multilateral convention (MLC) is scheduled to be signed in the coming months.
On July 17 2023, the Inclusive Framework released a public consultation document containing updated elements for amount B of pillar one, which outlined a simplified new process for pricing baseline marketing and distribution activities in accordance with the arm’s-length principle.
In October 2023, the Inclusive Framework published a draft of the MLC, together with an explanatory statement and the Understanding on the Application of Certainty for Amount A of Pillar One, which reflected the consensus achieved so far among members on the building blocks of amount A.
Amount A of pillar one reallocates 25% of corporate residual profits to jurisdictions in which consumers and users are located (Market Jurisdictions), and it is applied to multinational enterprises with consolidated revenues exceeding €20 billion and a profitability greater than 10%.
Recognising that there remains plenty of work to resolve the outstanding differences of opinion, the Inclusive Framework announced an extended timeline in December 2023 to finalise the text of the MLC by the end of March 2024 and to hold a signing ceremony by the end of June 2024.
Background of amount B
The intent of amount B is to simplify and streamline the application of the arm’s-length principle to baseline marketing and distribution functions that take place in the Market Jurisdiction. By doing so, it aims to enhance the tax certainty and thereby reduce the compliance costs of taxpayers and the administrative burden of low-capacity tax jurisdictions dealing with transfer pricing disputes; for example, tax audits, appeals, and mutual agreement procedures (MAPs).
Qualifying transactions and scoping criteria
Unlike amount A, the scope of amount B is not limited to the largest and most profitable businesses but applies to all businesses. It will apply to the following types of ‘qualifying transactions’:
Buy-sell marketing and distribution transactions where the distributor purchases goods from one or more associated enterprises for wholesale distribution to third parties (net retail sales not exceeding 20% of total sales); and
Sales agency and commissionaire transactions where the entity contributes to one or more associated enterprises’ wholesale distribution of goods to third parties.
Moreover, to fall within the scope of amount B, the following criteria need to be met:
The transaction can be reliably priced using a one-sided transfer pricing method (such as the transactional net margin method), with the distributor, sales agent, or commissionaire being the tested party;
The transaction meets certain quantitative filters based on the three-year weighted averages of operating expenses (not below 3%) and net sales (greater than 30% or 50%, which is to be resolved);
The transaction does not involve the provision of services or distribution of commodities; and
The tested party does not carry out non-distribution activities (for example, manufacturing) that cannot be reliably priced and evaluated separately under the general principles of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD TP Guidelines).
Pricing matrix
In-scope transactions will be priced according to the pricing matrix that provides the agreed returns (return on sales, or ROS) on the marketing and distribution activities, except for situations where internal comparable uncontrolled prices are available. The pricing matrix comprises two dimensions:
Three industry groupings; and
Five factor intensity ranges (for example, a combination of operating asset to sales and operating expense to sales intensity).
In summary, there are 15 ROS outputs in the pricing matrix, ranging from 1.5% to 5.5%, and each output is allowed a variance of 0.5% up or down.
In addition, several mechanisms and adjustment factors are being considered, which include:
A modified pricing matrix for qualifying jurisdictions where geographical differences materially influence the profitability of baseline marketing and distribution entities;
A data availability mechanism used for entities in countries where there is insufficient data in the global data set and high country risk that may influence the arm’s-length return;
A local pricing matrix that is determined by the relevant local tax authorities but verified by the Inclusive Framework; and
A Berry ratio cap-and-collar approach as a corroborative mechanism that is applied to all industries (floor 1.05 to ceiling 1.50).
The pricing matrices will be updated every five years in general, and other financial data, including country risk adjustment percentages under the data availability mechanism and the Berry ratio cap-and-collar range, will be updated annually.
Documentation requirements
The consultation paper indicates that documentation requirements for amount B should be largely satisfied if the existing local file contains the relevant content. Nevertheless, it is important to note that jurisdictions could require taxpayers applying amount B to commit for a minimum of three years and to submit a written consent accordingly. If a shorter term is needed due to a significant change in business, an explanation should be provided to the tax authorities.
Anticipated timeline in South Korea
In December 2022, South Korea was the first country to pass domestic legislation regarding pillar two global minimum tax rules, and the rules became effective for fiscal years beginning on or after January 1 2024. There had been considerable criticism and concerns regarding such an early adoption when other major jurisdictions are still measuring the pros and cons of the new rules and trying to ascertain the best timing for the introduction, but the Korean Ministry of Economy and Finance (MOEF) pushed through and adopted the rules into the Law for the Coordination of International Tax Affairs.
In the press release on December 18 2023, the MOEF also announced that it plans to actively participate in the remaining discussions, and the National Tax Service has launched a new specialised team in January 2024 to support the implementation and administration of pillar one and pillar two.
The timing of adopting pillar one into the local regulation may depend on the result of the Korean tax authorities’ assessment of the net tax revenues derived from pillar one after the final agreement at the OECD level. But, in light of the pillar two case, there is a strong possibility that South Korea would be one of the first movers to codify pillar one into its domestic legislation. Since South Korea tends to adopt the OECD TP Guidelines without much alteration, the MOEF may propose the related tax amendments with an effective date as early as 2025, as the Inclusive Framework aims to finalise pillar one reports for incorporation in the OECD TP Guidelines by June 2024.
Implications for businesses
Even though significant open items are pending and need to be finalised by the Inclusive Framework in detail, the clock may be ticking faster for businesses in South Korea compared with businesses in other jurisdictions, as highlighted above. What are the implications for businesses and how should they start preparing for amount B?
Firstly, businesses need to fully evaluate whether amount B is applicable to any of their associated enterprises, meaning whether there are any qualifying transactions that are in scope of amount B. If a transaction is within the scope of amount B, there are potential benefits to taxpayers:
Easier and more effective transfer pricing management by obtaining upfront certainty on arm’s-length returns; and
A reduction of the tax uncertainties arising from international transactions with foreign associated enterprises.
Thus, it is highly recommended to perform a detailed planning study on the applicability of amount B and expected amount B returns under the current pricing framework and to compare the returns with those under existing transfer pricing policies. After analysing the potential impacts, businesses may take the option to restructure the functional and risk profile of certain associated enterprises in line with the guidance found in Chapter IX of the OECD TP Guidelines and establish a new global transfer pricing policy in accordance with the pillar one rules and business strategy.
More specifically, companies that are not in scope of amount B can optimise their transfer pricing policy by changing functional profiles and/or financial positions to fall into amount B if they see the application of amount B is advantageous in terms of business strategy and risk minimisation.
Secondly, businesses need to set up a new management system (solution) for amount B. To minimise potential transfer pricing risks, the following items need to be monitored and reviewed continuously:
The testing of qualifying transaction and scoping criteria (baseline marketing and distribution activities, operating expenses to net sales ratios, etc.);
The applicability of adjustment mechanisms to a standard pricing matrix based on a global data set (modified pricing matrix, data availability mechanism, local pricing matrix, etc.); and
Verification of the Berry ratio cap-and-collar approach.
Therefore, setting up and maintaining an internal monitoring system (solution) and obtaining professional support from outside advisers to review, analyse, and recommend strategies to make the process more effective and efficient can make it easier to successfully defend challenges from the relevant tax authorities.
Lastly, as the consultation document provides, existing tax dispute prevention and resolution mechanisms such as bilateral advance pricing arrangements and MAPs approved/concluded prior to the adoption of amount B will continue to be valid. However, disputes and double taxation arising between businesses and tax authorities in relation to the application of amount B would not be completely eliminated due to the differences in interpretation of the scoping criteria and in the stance between jurisdictions that favour, or do not favour, amount B, and they will be subject to negotiations and corresponding adjustments through a MAP in general.
The Inclusive Framework has not yet provided details regarding the ability of new bilateral or multilateral advance pricing agreements (APAs) to agree to apply results that diverge from amount B to transactions that would otherwise be in scope. Consequently, for transactions that are assessed to have potentially high transfer pricing risks based on the size of revenues and intercompany transaction amounts, it is advised to consider APAs to strategically manage such risks, especially when it is practically difficult to change the transfer pricing policy of those entities.
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