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The Likely Effects of the Global COVID-19 Crisis Highlight the Need for the OECD to Hit the Pause Button on the Inclusive Framework Digital Project

As this article is being written, coronavirus (COVID-19) infections, serious illness and deaths are expanding globally. Mandatory travel restrictions, quarantines, "social distancing", shelter- in- place mandates and closures of non-essential businesses designed to halt the spread of COVID-19 are having an unknown detrimental effect on global economic activity, which most economists think is heading towards a major recession. In the midst of these major public health and economic crises, the OECD inclusive network continues work on its Digital Pillar 1 and Pillar 2 proposals with the goal of agreeing a consensus-based approach by the end of 2020. Without major revisions to the framework agreed in January 2020, the COVID-19 led recession will exacerbate flaws that already existed in the agreed Pillar 1 framework. These flaws arise from a lack of coordination between the calculation methods for determining Pillar 1's amounts A, B and C due to the different problems sought to be solved by the separate parts of Pillar 1.

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 taxing businesses that commercially exploit a market through new digital business models.

Amount A would apply broadly 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
    • Automobiles

The new Amount A taxing right is intended to apply only to enterprises above a certain revenue floor and above a certain level of pre-tax profit. 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.

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. 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) a reduction in controversies 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.

As is the case with Amount A, Amount B is to be determined without regard to the actual taxable profit 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).

Pillar 1's Amount C and the Arm's Length Standard

Amount C is intended to apply to situations where a taxpayer has a taxable presence under traditional tax nexus rules and the functions performed are other than routine distribution and marketing. Normal arm's length transfer pricing rules will apply to the determination of taxable income attributable to the jurisdiction where the Amount C activities take place.

Pillar 1 Overlap and Over or Undercounting Amount A and C Profits

Amount C is intended be determined under normal arm's length principles. 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 included within the scope of Amount C functions, 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 calculation of the Amount A taxable amount will include both a minimum pre-tax profit level as well as a formula to divide the pre-tax profit above the minimum level among Amount A and Amount C jurisdictions. In effect, the minimum pre-tax profit level (which will be an arbitrary number) is designed to cover the combined return to routine functions (in Amount B and C jurisdictions), while the formula for dividing the excess pre-tax profit is designed to allocate the non-routine intangible returns between jurisdictions where assets are used, economic risks undertaken and DEMPE functions performed to create the income attributable to the intangibles at issue (Amount C countries) and the "source" jurisdictions where the Amount A intangibles are deemed to be exploited. In substance, Amount C jurisdictions will cede part of their BEPS-related taxing rights to Amount A jurisdictions. However, because Amount A is calculated based on consolidated pre-tax profit (under which individual country profits and losses are netted) and Amount C is calculated either by reference to local country profit/loss (under TNMM/CPM) or actual combined profit/loss (under a profit split), the calculation of Amount A and Amount C taxable income can result in overtaxing (some Amount A countries) or under taxing (some Amount C countries) intangible income in specific countries.

Pillar 1 and Recession: Killer B

Because Amount A taxable income will not arise until a lower limit of pretax profit has been surpassed, Amount A tax should not arise during a taxable year when a digital or consumer facing business has losses or until the post-recession business has recovered enough to exceed the minimum Amount A pre-tax profit level. However, as currently drafted, there is no loss (or low profit) exception to the Amount B mandatory tax level. Amount B minimum tax would apply in cases where the routine distributor and the group of which it was a part had legitimate losses caused by business interruptions due to the current COVID-19 crisis, and its aftermath. Although Amount B is said to be based upon arm's length principles, imposing an income tax when there is no income is not an arm's length result.

Some Modest Proposals

In substance, the new taxing rights for Amount A countries will be the result of a decision by Amount C countries where DEMPE functions are being performed to cede part of their current (post-BEPS) rights to tax intangible income created through these functions. Country-level bargaining over primary taxing rights is at the heart of what income tax conventions have always been about. However, avoidance of economic double taxation is also a bedrock principle of income tax conventions. In order to be true its long-standing core principles, the OECD needs to coordinate the taxable income determination provisions of Amounts A and C to eliminate double economic taxation as much as possible and to provide for innovative controversy procedures to eliminate actual economic double taxation as it occurs.

Without some suspension of its provisions during the time businesses are recovering from the expected economic effects of the COVID-19 pandemic, the imposition of the Amount B mandatory taxation of routine distribution and marketing activities will result in massive economic double taxation for companies with routine distribution and marketing affiliates. While trying to reduce administrative burdens associated with transfer pricing enforcement is a laudable goal, imposing a tax cost on top of real economic losses is an unjustified result.

At best, application of the TNMM/CPM, which lies at the heart of the Amount B proposal, is a tool to administer rough tax justice. In the author's experience, the rough justice application of TNMM/CPM is the primary reason why there is a high level of global tax controversy over taxable income from routine distribution and marketing activities. A compromise solution that would partially achieve the goals sought by Amount B would be to make the published minimum taxable income amounts a safe harbor. There would also appear to be no reason in principle why similar Amount B safe harbors could not be established for routine services (like the US "White List" simplified cost method) and for routine manufacturing functions.