A&M Tax Advisor Weekly
Article featured on Thomson Reuters’ Taxnet Pro, February 2022.
On February 4th, the OECD released a public consultation document entitled “Pillar One – Amount A: Draft Model Rules for Nexus and Revenue Sourcing” (the Initial Amount A Rules), which represents one small step in the ongoing, intensive negotiation process by which the OECD/G20 “Inclusive Framework” has been striving to reform international tax rules. The multi-year effort has culminated in “A Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy,” released in October 2021 (discussed in more detail in our prior alert). The reference to the digital economy, however, is a bit of a misnomer because Pillar 1 has morphed into a set of rules that broadly apply to very large highly profitable companies, rather than limited to high-tech digital companies.
With the release of the Initial Amount A Rules, the OECD noted that it will be issuing Pillar 1 rules in stages and plans to consult with stakeholders over the coming months on both Pillar 1 and Pillar 2, for which most elements are targeted to be implemented in 2023. Regarding the second element of Pillar 1 (referred to as “Amount B”), which provides for a fixed return for baseline distribution and marketing activities that occur in the market jurisdiction, the OECD expects to release a public consultation document in mid-year. Regarding Pillar 2, which would establish a 15% global minimum tax, the OECD released model rules in December of 2021 that address the Global Anti-Base Erosion (GloBE) Rules designed to ensure that multinationals “pay their fair share” (highlighted in our previous alert.) Meanwhile, the timing of the US’s plans to revamp the global intangible low-taxed income (GILTI) rules, which would more closely align with the OECD’s Pillar 2 regime, remains uncertain, being seemingly linked to the fate of a slimmed down version of the proposed Build Back Better Act that has stalled in Congress.
As discussed below, the Initial Amount A Rules for Pillar 1, not yet approved by the Inclusive Framework of nearly 140 countries, could have financial consequences and impose undue burden on in-scope companies, which are large multinational enterprises with global turnover above €20 billion ($22.8 billion) and profitability above 10% (i.e., pre-tax profit/revenue). At a minimum, companies should be aware of this “work-in-progress” and might want to take advantage of the public comment period, which extends through February 18th, to identify issues and recommend alternative approaches that could be considered in the development of final nexus and revenue sourcing rules.
The remainder of this alert discusses the Pillar 1 nexus rules for identifying eligible taxing jurisdictions and initial observations on the detailed revenue sourcing rules, which adopt a transaction-by-transaction approach.
Pillar 1 would create a new nexus rule that would permit participating countries to impose a net income tax on their allocable share of a portion of the profits (known as “Amount A”) of in-scope companies that would not otherwise be subject to tax in the source country based on traditional rules of tax jurisdiction under income tax treaties and well-settled international norms. Thus, a portion of an in-scope company’s business profits could be taxed by a country even if the profits were not attributable to a permanent establishment of the enterprise in that country, and the countries now taxing such profits would have to make a corresponding reduction in their income taxes on the enterprise’s profits that they currently tax.
The proposed nexus rules look to the revenues of an in-scope company deemed to be sourced in the market jurisdiction. That is the starting point for determining whether a portion of Amount A might be allocated to a specific jurisdiction, and if so, would most likely be the basis for determining each eligible jurisdiction’s proportional share. The nexus threshold is stated as €250 thousand (approximately $285 thousand) for jurisdictions with annual GDP of less than €40 billion, and €1 million (approximately $1.14 million) for all other jurisdictions. The revenue threshold is currently denominated in a single currency, which, as noted in the Initial Amount A Rules, “raises a number of coordination issues related to currency fluctuations” that need to be addressed for purposes of the multilateral convention and will likely require “a re-basing mechanism” for domestic legislation in jurisdictions that would denominate the threshold in another currency.
The Initial Amount A Rules offer an approach for determining the allocations of Amount A for “participating jurisdictions” — those countries that adopt domestic legislation and sign onto one or more multinational agreements to implement the two-pillar solution. Amount A was previously, and some would argue, arbitrarily, determined by the Inclusive Framework to be 25% of “residual profit” defined as profit in excess of 10% of revenue. Because only participating jurisdictions will receive an allocation, Amount A will not necessarily be allocated to all countries in which an in-scope company has nexus under the new rule.
The Initial Amount A Rules propose a transaction-by-transaction approach with specific revenue sourcing rules for finished goods and their components, services (location specific, advertising, online intermediation, and transport), customer rewards programs, the provision of financing, consumer services, business to consumer and business to business services, licensing or sale of intangible property, revenues from real property, and other types of income.
A preliminary look at the proposed revenue sourcing rules reveals potential consequences and unexpected results. First, because many of these proposed rules do not align with US source rules, the taxes on Amount A would probably not be creditable under either the final foreign tax credit regulations released in December 2021 or the double tax article of many US income tax treaties. Second, the resulting allocation process appears to be every bit as arbitrary as the amount being allocated. One example, although not the only one, is how the source rules apply for transportation services. For air transportation of passengers, the revenue is sourced to the place of landing; while for air transportation of cargo, the revenue is sourced to the place of take-off or the place of landing. Lastly, the detailed source rules apply for virtually every kind of revenue and suggest that in-scope companies would be required to apply them to identify the market jurisdiction for every item of worldwide revenue. Theoretically, that would require in-scope companies to trace the chain of commerce for all their products and services, for which they could not be reasonably expected to have any knowledge. For example, an in-scope US company that manufactures equipment in the US that is sold to an unrelated UK distributer who re-sells the equipment to unrelated retailers all over the world, would be required to determine where the customers of those retailers take delivery of the equipment.
Fortunately, the proposed rules acknowledge that in many (and perhaps most) cases, in-scope companies will not have access to information to reliably determine the market jurisdiction(s) for their products or services. The proposed approach would impose an obligation on in-scope companies to obtain whatever reliable information they can, within reason (e.g., by requesting information from other companies in the chain of commerce for their product or services). However, in the absence of any such reliable information, in-scope companies would be required to determine the market jurisdictions using one of several arbitrary allocation keys supplied by the model rules. Perhaps the best example of arbitrariness is the so-called “global allocation key,” which could apply to several types of transactions and would source revenues based on each applicable jurisdiction’s proportional share of “final consumption expenditures” as published by the United Nations Conference on Trade and Development. If a final consumption expenditure amount is not available, a proxy would be determined based on the jurisdiction’s “population and the average ratio of final consumption expenditure to population for all Jurisdictions for which final consumption expenditure was available.” Under the knock-out rule, some jurisdictions would be excluded from the sourcing rules, such as when applying the global allocation key, if an in-scope company can prove that its revenues did not arise in one or more of the jurisdictions identified by the allocation key.
Uncertainty remains as to whether either pillar of the two-part solution will come to fruition and whether the US, given the current state of flux, would adopt the OECD approach if nearly 140 other jurisdictions implement the rules. Without the US’s participation, the proposed Pillar 1 model rules would lack cohesion and inevitably lead to greater levels of double taxation. Setting that aside, even if Pillar 1 culminates in model rules and a multilateral convention, the rules for allocating Amount A may significantly differ from those in the Initial Amount A Rules. So, in-scope companies should stay abreast of the ongoing developments, but it may not be worth immediately delving deep into the many complex source rules. Suffice it to say that in-scope companies would be saddled with an extremely cumbersome, complex, and costly compliance obligation, which is contrary to a prior release by the Inclusive Framework that said, “compliance costs ([including for] tracing small amounts of sales) will be limited to a minimum.” Although the rules “have been designed to balance the need for accuracy with the need to limit compliance costs,” it’s unclear what “reasonable steps” in-scope companies must take to identify a reliable indicator. For purposes of providing meaningful comments and recommendations, in-scope companies might want to conduct a high-level analysis to assess the feasibility of applying the sourcing rules and possible implications. Companies might prefer an approach with less reliance on reliable data and more reliance on arbitrary allocation keys to reduce compliance costs. As always, we are available to assist clients in understanding the OECD’s ongoing developments and potential implications for their businesses.