Transfer Pricing News Issue 40 - September 2022

OECD holds public consultation on Pillar One Progress Report

The role of withholding taxes imposed by a receiving jurisdiction in the calculation of Amount A emerged as a potentially significant impediment to the finalisation of the Pillar One rules during an OECD public consultation held Sept. 12 to discuss the comments received from stakeholders on the Progress Report on Amount A of Pillar One.

Some of the key themes discussed in the comments regarding both the previously released building blocks of Amount A and the newly released ones include:

  • Scope: Requests for an additional exclusion for domestic-oriented businesses, and requests for averaging on a permanent basis.
  • Revenue sourcing: Support for a longer transition period and request for more specific guidance.
  • Tax base determinations: Requests for further alignment of the tax bases and modifications to certain adjustments.
  • Elimination of double taxation: Questions regarding the appropriateness of the “Return on Depreciation and Payroll” (RODP) metric and support for the exemption method to eliminate double taxation, as well as calls for simplification.

Commenters also welcomed the updated timeline for completing the work on Pillar One and emphasised the importance of stabilising the international tax framework, expressing strong support for the commitment to withdraw unilateral tax measures.

Alan McLean of BIA called the Progress Report an important milestone and emphasised the importance of three principles -- simplicity, clarity and certainty -- for what he described as “extraordinarily complex rules.”

Marketing and distribution profits safe harbour

The Progress Report introduced the concept of a “marketing and distribution profits safe harbour,” which is intended to prevent double taxation when a multinational entity (MNE) group has already established a taxing right in a jurisdiction through physical presence, and the residual profits to be reallocated are already taxed in the jurisdictions of the end consumers. The amount of the MDSH is deducted from the initial amount of profits reallocated to a market jurisdiction (but cannot reduce profits below zero).

However, presenters at the consultation and other commenters said the MDSH would not operate as intended. Thomas Quatrevalet, Deputy Head of Tax at Air Liquide, noted that, based on initial modelling using the Progress Report rules, there were situations that resulted in significant residual allocations of Amount A from one country to another without any connection between the two countries, and despite the fact that the residual profit is already taxed locally.

The MDSH could also result in “odd and counterintuitive” outcomes, because group profitability ratios and country-by-country profitability ratios often differ significantly as a result of variations in cost levels, capital investments, market size and profitability.

For example, early modelling exercises resulted in situations whereby Asian countries surrendered Amount A to the U.S. and Germany, with no business or policy rationale for such a result.

Quatrevalet and other presenters also discussed what may be the most controversial topic arising out of the consultation – the role of withholding taxes imposed by a receiving jurisdiction in the calculation of Amount A. The Progress Report did not address this issue, which has emerged as a significant stumbling block to finalizing the Pillar One rules.

Allison Lobb of Deloitte UK explained that the political agreement calls for the MDSH to apply “where the residual profits of an in-scope MNE are already taxed in a market jurisdiction.” The challenge in relation to withholding taxes is that source taxation, such as withholding taxes on royalty payments, already taxes residual profits in market jurisdictions. Ignoring withholding taxes, as the MDSH does, could lead to double taxation in those market jurisdictions.

Lobb proposed a solution: allow withholding taxes to be levied in line with domestic law and tax treaties, but credit local withholding taxes against any local Amount A liability to mitigate double taxation. This would result in in-scope MNEs paying the higher of withholding taxes or Amount A in market jurisdictions. This, she added, is “not the only solution, but it’s perhaps the simplest.”

Tom Roesser, Tax Policy Counsel for Microsoft, concurred that Amount A should be reduced or eliminated to the extent jurisdictions are already taxing residual profits through transfer pricing, withholding taxes or other taxes. Moreover, he argued, the rules should not incentivise jurisdictions to impose new withholding taxes or make aggressive transfer pricing adjustments when Amount A already provides an internationally agreed allocation of profits.

Roesser recommended that Amount A be capped when the total amount of profits allocated to market jurisdictions under Amount A, the transfer pricing rules and withholding taxes exceeds 25% of total system profits, arguing that doing so would remove the incentive for tax authorities to take aggressive transfer pricing positions and impose withholding taxes.

Abdul Chowdhury, Senior Program Officer at South Centre, an intergovernmental organisation of developing countries, disagreed, and said developing countries had “already compromised too much” in agreeing to the allocation to market jurisdictions of 25% of residual profit -- defined as profit in excess of 10% of revenue – in the October 8, 2021, “Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy.

Chowdhury argued that the inclusion of withholding taxes in the Amount A allocation mechanism had not been politically agreed upon and could in fact constitute a deal breaker for many developing countries, because it could lead to the erosion of existing taxing rights. Had developing countries known that withholding taxes would be included in the calculation of Amount A, he said, “they would have demanded more than 25%.”

Elimination of double taxation

Article 9 of the Progress Report addresses the allocation of the obligation to eliminate double taxation with respect to Amount A profit and sets out rules to determine the extent to which a specified jurisdiction is treated as a “relieving jurisdiction” with respect to a covered group.

The Article 9 rules provide that the obligation to eliminate double taxation that would otherwise be incurred by an MNE with respect to Amount A will be allocated among countries using a quantitative approach designed to ensure that the obligation is borne by the countries in which the MNE earns its residual profits. Those countries will be divided into tiers based on the MNE’s profitability (measured by reference to the RODP) in each country relative to the overall profitability of the MNE, and double taxation would first be relieved by countries identified in the highest profit tiers. Thus, double taxation is eliminated first by countries in Tier 1 (those with an RODP exceeding 15 times the overall MNE’s RODP) using a "waterfall" approach according to which the country with the highest RODP relieves double taxation on the amount of profit that would reduce its RODP until it is equal to the RODP of the country with the second highest RODP. These two countries then relieve double taxation on an amount of profit that would reduce their RODP until it is equal to the RODP of the country with the third highest RODP. This process continues until either the obligation to relieve double taxation with respect to the Amount A profit of the MNE has been fully allocated, or the RODP of countries in Tier 1 has been reduced to 15 times the RODP of the MNE.

But some of the presenters expressed doubts that the rules as drafted would achieve the intended purpose of relieving double taxation. Franck Lerat, Global Head of Tax at Sanofi, said the proposal, despite being formulaic, is highly complex, and that the waterfall approach leads to highly distortive outcomes, such as market jurisdictions transferring tax base to other market jurisdictions, or investment hubs transferring tax base to unrelated market jurisdictions.

Lerat also focused on the RODP concept and argued that it is not a relevant metric because it does not account for differences in profitability between markets, business lines and business models.

Huynh and other presenters stressed the need for the rules to include more examples to illustrate the application of the concepts to different business operating models.

Next steps

Gaël Perraud, co-chair of the OECD’s Task Force on the Digital Economy (TFDE) said the group will soon release another consultation document on the remaining Pillar One Amount A issues -- tax certainty, administration, and the removal of unilateral tax measures.

Laurie Dicker