Pillar One Simplified: Reallocating Profits

Pillar One is an important initiative under the Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project. It aims to address the challenges posed by the digitalization of the economy. The digital economy has enabled businesses to operate across borders without a physical presence, leading to concerns about base erosion and profit shifting. Pillar One seeks to reallocate taxing rights and ensure that multinational enterprises (MNEs) pay taxes where they conduct significant economic activities and generate profits, regardless of where they are located physically.

Framework of Pillar One

The framework of Pillar One consists of three main building blocks:

1. Amount A: This represents the new taxing right for market jurisdictions over a share of residual profits.
2. Amount B: This provides a fixed return for baseline marketing and distribution activities in a market jurisdiction.
3. Tax Certainty: This encompasses processes to improve tax certainty, including dispute prevention and resolution mechanisms.

Key Features of Pillar One

Pillar One introduces several key features that define nexus and profit allocation rules:

1. Group Taxation: Pillar One shifts the focus from individual entities to the MNE group level. Taxable profits, referred to as Amount A, are determined at the group level, recognizing the interconnected nature of MNE operations.
2. Group Assessment: Instead of each jurisdiction conducting separate assessments, the taxable income (Amount A) is calculated for the entire MNE group. This streamlines the process and ensures consistency in the application of tax rules.
3. Group Dispute Resolution: Disputes arising from the implementation of Pillar One will be resolved by a representative panel. This mechanism aims to provide efficient and binding dispute resolution, reducing uncertainty and promoting tax certainty for MNEs.
4. Taxing Rights without Permanent Establishment (PE): Traditionally, taxing rights were linked to the physical presence of a business in a jurisdiction. Pillar One breaks this link by giving the taxing rights to market jurisdictions on Amount A even if the MNE does not have a physical presence (PE) in that jurisdiction. This recognizes that MNEs can generate significant profits in a market without a physical presence due to digitalization.
5. Revenue Sourcing Rules: Pillar One introduces revenue sourcing rules that attribute revenue based on the location of the end customer rather than the payer. This aligns taxation with the location where value is created and consumed, ensuring a fairer distribution of taxing rights.
6. Formula-Based Approach: Amount A, the portion of residual profits allocated to market jurisdictions, is determined using a formula based approach.

Threshold Test

To be within the scope of Pillar One, MNE groups engaged in Automated Digital Services (ADS) or Consumer-Facing Businesses (CFB) must meet two threshold tests:

1. Global Consolidated Revenue Threshold: This threshold is applied at the MNE group level and is based on the group's consolidated financial statements. The current threshold is set at 20 billion euros in global annual revenue.
2. Foreign In-Scope Revenue Threshold: This threshold applies to the MNE group's foreign revenue from in-scope activities. The specific threshold for foreign in-scope revenue is still under discussion and may be subject to change.

These threshold tests ensure that Pillar One applies to MNEs with a significant global presence and substantial foreign revenue from in-scope activities.

Covered Businesses

Pillar One covers a wide range of businesses, including both ADS and CFB. However, certain sectors are excluded from the scope of Pillar One. These exclusions include extractive industries, regulated financial services, construction, residential property, and international airline and shipping businesses. The exclusion of these sectors is based on various factors, such as the unique nature of their operations, existing regulatory frameworks, and the potential for double taxation.

Amount A: A New Taxing Right

Amount A is a new taxing right that allows market jurisdictions to tax a portion of the residual profits of multinational enterprises (MNEs). It applies to MNEs with global annual revenue exceeding 20 billion euros and profitability above 10%. The calculation of Amount A involves several steps:

1. Identification of Non-Routine Profits: The first step is to determine the routine profitability of the MNE group. This is typically done using a simplified convention, such as a fixed percentage of profit before tax to revenue. Profits exceeding this threshold are considered non-routine profits. The Pillar 1 Blueprint proposes a routine profitability threshold based on a profit before tax (PBT) to revenue ratio. All profits above this percentage would be considered non-routine profits.
2. Applying Reallocation Percentage: A predetermined reallocation percentage is applied to the total non-routine profits. This percentage can vary depending on the type of business activity (e.g., Automated Digital Services or Consumer Facing Businesses). The reallocation percentage is the portion of the identified non-routine profits to be allocated to market jurisdictions. The Pillar 1 Blueprint suggests that different reallocation percentages could be prescribed for each type of activity.
3. Profit Allocation to Market Jurisdictions: The final step is to allocate the resulting Amount A to eligible market jurisdictions. This allocation is based on a revenue-based allocation key, which considers the revenue generated by the MNE in each jurisdiction. The revenue-based allocation key is used to determine the proportion of Amount A to be allocated to each eligible market jurisdiction.

Amount A Safe Harbour

• Marketing and Distribution Profits Safe Harbour: To avoid double taxation, a safe harbour mechanism is in place. It compares the profits already allocated to the market jurisdiction under existing rules with a safe harbour return. This safe harbour return includes Amount A and a fixed return for routine marketing and distribution activities. If the existing profits exceed the safe harbour return, no further Amount A allocation is made.
• Elimination of Double Taxation: The elimination of double taxation is a crucial aspect of Amount A. It involves identifying the entities within the MNE group that will pay Amount A and the jurisdictions responsible for providing relief (exemption or credit) to avoid taxing the same income twice.

Amount B: Routine Return for Marketing and Distribution

Amount B aims to standardize the remuneration of related party distributors performing baseline marketing and distribution activities in a market jurisdiction. It simplifies transfer pricing rules and reduces compliance costs. The calculation of Amount B typically involves:

1. Defining In-Scope Activities: A positive list outlines the typical functions, assets, and risks associated with baseline marketing and distribution activities. A negative list excludes activities not typically performed by routine distributors. The positive list includes activities like importation, purchase for resale, sales and marketing activities, logistics, and administration. The negative list excludes activities that indicate a distributor is performing more than just baseline activities.
2. Determining the Fixed Return: A fixed return is assigned to these baseline activities, often expressed as a return on sales. This return can vary across regions and industries, requiring separate benchmarking for each. The fixed return is determined using the Transactional Net Margin Method (TNMM), a transfer pricing method. It could vary based on region and industry, requiring separate benchmarking analyses.

It's important to note that both Amount A and Amount B calculations are subject to ongoing discussions and refinements within the OECD Inclusive Framework. The goal is to achieve a fair and consistent approach to taxing the digitalized economy.

Activity Test

The activity test is a crucial step in determining the scope of Amount A. It categorizes businesses into two types:

1. Automated Digital Services (ADS): These are services provided over the internet or an electronic network with minimal human involvement from the service provider. Examples include online advertising, search engines, social media platforms, and cloud computing services.
2. Consumer-Facing Businesses (CFB): These businesses supply goods or services commonly sold to consumers or license intellectual property related to such goods or services.

The activity test determines whether an MNE's activities fall under ADS or CFB, which has implications for the application of Amount A.

What is ADS and CFBs?

Automated Digital Services (ADS)

Automated Digital Services (ADS) are at the heart of the digital economy, characterized by their ability to deliver services with minimal human intervention through digital platforms. Pillar One recognizes the unique challenges these services pose to traditional tax systems and aims to establish a framework that ensures fair taxation in the markets where they generate value.

Defining ADS

The OECD defines ADS through a three-step approach:

1. Positive List: This list includes specific services that are automatically considered ADS, such as online advertising, sale of user data, online search engines, social media platforms, online intermediation platforms, digital content services, online gaming, standardized online teaching services, and cloud computing services. If a business falls under this list, it satisfies the activity test for ADS.
2. Negative List: This list includes services that are explicitly excluded from ADS, such as customized professional services, customized online teaching services, online sales of non-ADS goods and services, revenue from physical goods sales (even with IoT connectivity), and internet access services. If a business falls under this list, it does not satisfy the activity test for ADS.
3. General Definition: If a business doesn't fit into either list, it's assessed against a general definition. To be considered ADS, the service must be automated (minimal human intervention once set up) and digital (provided over the internet or an electronic network).

Key Characteristics of ADS

• Scale without Mass: ADS can reach a global audience without the need for physical infrastructure or a large workforce in each market.
• Importance of Intangibles: ADS heavily rely on intangible assets like software, algorithms, and data, making it difficult to determine their value and allocate profits for tax purposes.
• Role of User Data and Participation: User data and participation are often key drivers of value creation in ADS, raising questions about how to attribute profits to the jurisdictions where users are located.

Consumer-Facing Businesses (CFB)

Consumer-Facing Businesses (CFB) represent a broad category of businesses that directly or indirectly interact with consumers. Pillar One recognizes that CFBs, while not purely digital, can have a significant economic presence in a market without a physical establishment, especially through online channels.

 Defining CFB

A business is considered CFB if it meets one or both of the following criteria:

1. Supplies Goods or Services to Consumers: This includes businesses that sell, lease, license, rent, or deliver goods or services commonly purchased by consumers. This can be done directly or indirectly through intermediaries like brokers, agents, or online platforms.
2. Licenses Intangible Property Connected to Consumer Goods/Services: This includes businesses that license or exploit intellectual property rights (e.g., trademarks, copyrights) related to goods or services commonly sold to consumers.

Key Considerations for CFB

• Indirect Sales: Even if a CFB doesn't sell directly to consumers but uses distributors or intermediaries, it can still be considered a CFB if it owns the consumer product/service and holds the rights to the connected intangible property.
• Franchisors and Licensors: Franchisors and licensors are considered CFBs if their franchisees or licensees sell goods or services to consumers.
• Exclusions: Certain businesses are excluded from the CFB definition, including natural resources, financial services, construction, residential property, and international airline and shipping businesses.

Nexus

Nexus refers to the connection or link between an MNE and a jurisdiction that gives the jurisdiction the right to tax the MNE's profits. Traditionally, nexus was established based on physical presence, such as having a permanent establishment in a jurisdiction. However, Pillar One introduces a new concept of nexus that does not require physical presence.

• Nexus for ADS: For automated digital services, nexus is established if the MNE has in-scope revenue exceeding a certain threshold in a market jurisdiction. This means that even without a physical presence, an MNE can have a taxable presence in a jurisdiction if it derives significant revenue from that jurisdiction through digital services.
• Nexus for CFB: For consumer-facing businesses, the nexus determination is more complex. While exceeding the revenue threshold is a necessary condition, additional factors may be considered, such as the physical presence of a subsidiary or a permanent establishment in the market jurisdiction. The aim is to ensure that the MNE has a significant and sustained interaction with the market jurisdiction, even without a traditional physical presence. Unlike ADS, where nexus is primarily determined by revenue thresholds, CFBs require additional factors to establish nexus in a market jurisdiction. These factors include:
• Physical Presence: Having a subsidiary or permanent establishment in the market jurisdiction can establish nexus for a CFB.
• Deemed Engagement: If the CFB's in-scope revenue from a market jurisdiction exceeds a higher threshold, it is deemed to have significant engagement with that jurisdiction, establishing nexus even without a physical presence.

Revenue Sourcing Rules

Pillar One proposes detailed revenue sourcing rules to determine the jurisdiction to which revePillar One is an important initiative under the Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project. It aims to address the challenges posed by the digitalization of the economy. The digital economy has enabled businesses to operate across borders without a physical presence, leading to concerns about base erosion and profit shifting. Pillar One seeks to reallocate taxing rights and ensure that multinational enterprises (MNEs) pay taxes where they conduct significant economic activities and generate profits, regardless of where they are located physically.

In conclusion, Pillar One represents a great effort to reform the international tax system to address the challenges of the digital economy. While progress has been made, however successful implementation of Pillar One will depend on striking a delicate balance between the interests of different jurisdictions, ensuring fairness, and minimizing complexity.