"This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." Sir Winston Churchill.2
As this article is being written, the OECD inclusive network continues work on its Digital Pillar 1 and Pillar 2 Blueprint proposals with the goal of agreeing a consensus-based approach by middle of July 2021. Without major revisions to the Blueprint published in August 2020, the OECD work will mark the first time that the OECD has officially sanctioned material deviations from its previous acceptance of the arm's length standard as the agreed benchmark for taxing the results of controlled party transactions. Will adoption of the OECD Pillar 1 and Pillar 2 proposals mark the beginning of the end of the arm's length standard as the internationally accepted norm for taxing the results of controlled transactions or merely represent a limited exception to what previously has been accepted by the world's major tax authorities as the appropriate standard to evaluate and tax the results of related party transactions?
While Amount A of Pillar 1 can be viewed as a limited exception to the primacy of the arm's length standard, Amount B of Pillar 1 creates a slippery slope for a significant erosion of the arm's length standard applied to a much wider base of transactions that could result in the beginning of the end of the arm's length standard as the benchmark to evaluate controlled party transactions.
Pillar 1 Amount A and the New Taxing Rights
Pillar 1's Amount A creates a new taxing right ("nexus") for situations where a permanent establishment ("PE") would not exist under Article 5 of the revised OECD Model Treaty. The new Amount A nexus rules are designed to fix a problem with existing PE rules, which are said to be too restrictive in allowing taxation of businesses that commercially exploit a market through new digital business models.
As currently drafted, Amount A would apply to two types of businesses:
• Businesses that provide automated standardized digital services to a large and global customer or user base. Covered digital services include:
• online search engines;
• social media platforms;
• online intermediation platforms, including the operation of online marketplaces, irrespective of whether used by businesses or consumers;
• digital content streaming; online gaming; cloud computing services; and online advertising services.
• Consumer-facing businesses when customer engagement is carried out from a remote location, with active non-physical presence in the target market. Consumer facing businesses include:
• Personal computing products (e.g. software, home appliances, mobile phones, etc.);
• Clothes, toiletries, cosmetics, luxury goods;
• Branded foods and refreshments;
• Franchise models, such as licensing arrangements involving the restaurant and hotel sector; and
Besides applying to limited types of business enterprises, the new Amount A taxing right is intended to apply only to enterprises that exceed a certain revenue floor and exceed a certain level of pre-tax profit. The most discussed thresholds for applying Amount A are consolidated net revenues of €750 million and a minimum pre-tax profit of 10 percent of net revenues, with 20% of the pre-tax profit in excess of 10% being subject to the Amount A taxing right.
Once the minimum revenue and profit levels have been met, the Amount A taxable income will be determined by a formula applied to the taxpayer's consolidated financial statement "Amount A business" (which could be a segment of a broader business) pre-tax profit. The Amount A tax would then be divided among the Amount A tax jurisdictions based on an agreed formula.
The OECD Blueprint candidly admits that Amount A reflects a deviation from the arm's length standard. However, given the scope limitations of Amount A as well as the relatively high revenue and profit thresholds, Amount A will affect a relatively low number of companies, resulting in a limited exception to the use of the arm's length standard.
Pillar 1's Amount B and Mandatory Minimum Tax
Pillar 1's Amount B is intended to apply to situations where a business engages in "routine distribution and marketing" operations through a subsidiary or a PE. Unlike Amount A, there are no business scope, net revenue, or pre-tax profit limitations to application of Amount B. Rather than being aimed at taxing new business models of the digital economy, the problems Amount B are designed to address are: 1) a lack of transfer pricing enforcement resources among many of the approximately 140 countries participating in the OECD inclusive framework Digital project; and 2) reducing the number of controversies between inclusive framework member countries over profits attributable to routine distribution operations.
The Amount B proposal would require companies with routine distribution and marketing operations to compute taxable income based upon a minimum taxable income amount determined by reference to "comparables". Comparables could be determined by industry grouping and by geography or region. For example, Country X might analyze public data for EMEA based auto parts and electronic component distributors and require that auto parts distributors base taxable income on a minimum EBIT of 4% of sales revenues and electronics component distributors base taxable income on a minimum EBIT of 4.5% of sales revenues. However, unlike the current application of the arm's length standard, the "comparables" for Amount B and the profit targets would reflect a "one size fits all" approach to a wide variety of taxpayers without the opportunity for taxpayers to choose or adjust the comparables to reflect their own unique circumstances.
As is the case with Amount A, Amount B will be determined without regard to the actual local country taxable profit (or loss) of the entity being taxed. In substance, Amount B is a formulary amount based on a non- "facts and circumstances" application of the transactional net margin method ("TNMM" or CPM in the US). Because Amount B applies without business activity scope, net revenue, or pre-tax profit limitations, Amount B will have wide application.
Other Situations and the Arm's Length Standard
Under the Blueprint, situations where a taxpayer has a taxable presence under traditional tax nexus rules and the functions performed are other than routine distribution and marketing will be governed by normal arm's length transfer pricing rules, which will apply to the determination of taxable income attributable to the jurisdiction where business activities take place.
Since 2017 when the OECD Transfer Pricing Guidelines (the "Guidelines") were revised to reflect the BEPS project, normal arm's length transfer pricing rules have included the rules set forth in Chapter VI of the Guidelines, which are intended to align the profits attributable to intangible income (broadly defined) with the functions undertaken, assets used and economic risks assumed to create such income. Central to the functions defined in Chapter VI are the DEMPE functions to: Develop, Enhance, Maintain, Protect and Exploit intangibles that result in taxable income. Because DEMPE functions are not included within the scope of Amount B, all income attributable to non-routine intangibles would be allocated under normal arm's length principles to those entities (and jurisdictions) where assets are used, economic risks undertaken and DEMPE functions performed to create the non-routine income attributable to the intangibles at issue.
The Amount B Slippery Slope: Slip Slidin' Away
As previously explained, Amount B responds to two concerns raised by OECD inclusive framework member countries: 1) a lack of resources to administer the facts-and-circumstances based arm's length standard and 2) a desire to reduce controversy in a common transfer pricing situation. As documented in the annual reports published each year by the IRS APA Program, approximately 85% of the US APA cases involve controlled distribution, manufacturing or service transactions that are resolved using the CPM/TNMM. By definition, the TMNN/CPM does not apply to transactions involving exploitation of non-routine intangibles. Assuming that Amount B reflects a reasonable solution to the two tax administration concerns identified, it would seem that the scope of Amount B could be extended to include routine manufacturing and service transactions, thereby significantly eroding the base of controlled party transactions subject to normal arm's length principles and analysis.
Why Erosion of the Arm's Length Principle Matters
A fundamental principle underlying the arm's length principle is tax fairness, namely that controlled party transactions should be taxed as if the transactions were entered into by unrelated parties dealing with each other at arm's length. In arm's length transactions, unrelated parties do not always earn minimum levels of profit and can incur losses. However, profits below the mandated minimum or losses are not permitted under Amount B. Under such circumstances, the question becomes whether the expected gains in simplifying tax administration (by eliminating facts-and-circumstances based transfer pricing enforcement) and reducing tax controversies are worth the erosion of tax fairness. Before proposing Amount B, the OECD answer to the last question was, "no."
In order to preserve tax fairness that underlies voluntary tax compliance, it will be important for the OECD to leave room for application of a facts-and-circumstances exception to Amount B through APAs, rulings or similar administrative measures.
1 Mike Patton is a Partner in the Los Angeles office of DLA Piper (US) LLP. The opinion and conclusions expressed in this article are the author's and do not represent the views of DLA Piper (US) LLP.
2 Remarks to General Alexander after the General advised Churchill to "Ring out the bells" to celebrate the British victory in Egypt in 1942 over the Nazi German forces.