INSIGHT: What Does BEPS 2.0 Mean for Your Business?

With endorsement from both the G-20 and the G-7, the Organisation for Economic Co-operation and Development’s (OECD) project on addressing the tax challenges of the digital economy—commonly referred to as “Base Erosion and Profit Shifting 2.0” or “BEPS 2.0”—has an ambitious workplan for revising existing profit allocation and nexus rules and developing new global minimum tax rules. A target deadline of 2020 is set for final agreement.

The challenges of taxing the digital economy were identified as one of the areas of focus of the BEPS project initiated in 2013, leading to the issuance of the 2015 BEPS Action 1 Report. This report found that the entire global economy is digitalizing and, as a result, it would be difficult, if not impossible, to ring fence it for special tax treatment.

See below the key milestones in addressing the tax challenges of the digitalization of the economy:

• March 2018: The OECD’s taskforce on the digital economy released an interim report under a mandate from the G-20 finance ministers in March 2017 for additional work following the 2015 BEPS Action 1 Report.
• January 2019: The OECD issued a short policy note that announced agreement on the way forward for developing a long-term solution to the tax challenges of digitalization of the economy.
• February 2019: The OECD released a public consultation paper to seek comments on a proposed two-pillar project to develop a solution for addressing the tax challenges of the digital economy. More than 200 submissions were received within an extremely short time frame from businesses, labor groups, non-governmental organizations and academia.
• March 2019: The OECD hosted a public consultation of one and a half days.
• May 2019: The OECD released its Programme of Work (PoW) on the process for achieving a consensus-based solution. The PoW was endorsed by the G-20 in June 2019 and by the G-7 in July 2019.
• January 2020: This has been set as the target date for agreement to be reached on the outlines of the architecture of the solution.
• End of 2020: This has been set as the target date for full consensus agreement on the details of the solution.

It is a common misconception that the proposals contemplated under BEPS 2.0 affect only digital businesses. The proposals are wide-ranging and will affect multinational enterprises (MNEs) across industries, without regard to their level of engagement in the digital economy. The changes being considered will have significant implications for all MNEs. Companies should be watching these developments closely and analyzing the potential effects on their business structure and tax profile.

The Two-pillar Construct

The PoW encompasses two pillars. The first pillar involves revisions to existing profit allocation and nexus rules to redistribute taxing rights to market jurisdictions. The second pillar involves the development of new global anti-base erosion rules to ensure that all business income is subject to at least an agreed minimum level of taxation.

The proposals represent marked departures from current international taxation standards and would change fundamental elements of the longstanding global framework for taxing international businesses. The PoW lays out an aggressive timeline for developing these proposals into a consensus agreement and reflects input from the OECD, G-20 and the Inclusive Framework, which currently has 134 participating jurisdictions.

Pillar One—Revised Profit Allocation and Nexus Rules

Pillar One seeks to allocate more taxing rights to the jurisdiction where the customers or users are located and to expand the nexus rules in the absence of physical presence in a market.

The OECD public consultation document discusses three proposals, namely the user participation proposal, the marketing intangibles proposal and the significant economic presence proposal.

Alternative Proposals for Profit Allocation

User Participation Proposal

This proposal focuses on digitalized business models such as search engines, social media platforms and online marketplaces where users contribute significantly to the value through user generated content, data and market power. The mechanism of this proposal would involve a portion of the MNE’s residual profits being allocated to the market jurisdictions. The allocation key could be based on revenue, with a portion of the residual profits allocated to a market jurisdiction regardless of whether the MNE has a physical presence there.

Marketing Intangibles Proposal

This proposal is broader than the first proposal and applies to any business model that uses marketing intangibles, such as trademarks, trade names or customer relationships. As a result, the proposal goes beyond digitalized business models and would affect both MNEs with limited in-country functions such as the use of limited risk distributors and MNEs that operate through remote participation in the market with no physical presence.

This proposal involves reallocating to market jurisdictions a portion of the MNE’s residual profits attributable to marketing intangibles, regardless of who bore the risk to develop the market and its associated intangibles.

Significant Economic Presence Proposal

This proposal involves any situation where there is sustained interaction with a jurisdiction, such as a user base that generates data, billing or collection in the local country, a local language website, or in-country sales and marketing activities.

It deviates from the first two proposals, whereby the total profits, as opposed to the residual profits of the MNE, are allocated to market jurisdictions using a fractional apportionment method based on key allocation metrics. Potentially these allocation metrics could include employees, sales, assets or users.

Potential Methodologies for Profit Allocation

The OECD PoW describes three methodologies that could be used under any of the three alternative proposals for revising existing profit allocation rules:

• Modified residual profit split: Under this method, a portion of the MNE’s residual profit would be allocated to market jurisdictions and then among such jurisdictions to reflect the value attributable to accessing the market jurisdiction.
• Fractional apportionment: This method would allocate a portion of overall profits without a distinction between routine and residual profits, with the apportionment based on employees, assets, sales or users.
• Distribution based approaches: This method would calculate a baseline profit for the market jurisdictions, with potential adjustments to reflect characteristics of the MNE group such as its overall level of profitability. This method could be structured to function as a minimum or maximum.

Nexus

The PoW focuses on the development of a new remote taxable presence concept together with a new set of standards for identifying when such a remote presence exists. The new standards will involve the determination of sustained and significant involvement in the economy, based on a sustained local revenue threshold and a range of additional indicators of a link with the local economy beyond mere selling. The new standards could be structured as amendments to Articles 5 and 7 of the OECD model tax convention or as a new standalone provision to be incorporated in the model.

Next Steps

The working group of the OECD and the Inclusive Framework is currently focused on developing more concrete principles to:

• determine how the profits that are subject to the new taxing rights are to be calculated and allocated;
• design new nexus rules that do not rely on the current permanent establishment physical presence rules; and
• develop all the mechanics for imposition of the new taxing rights.

The PoW notes that the three alternative proposals for profit allocation must be narrowed to one approach as part of the agreement on the solution architecture that is to be reached by January 2020.

It appears that some progress was made in that regard during the G-7 Finance Ministers and Central Bank Governors meeting in July 2019.

Reports from the meeting indicate that the G-7 countries were able to address what had been some significant differences among themselves and bridge the gap between the user participation proposal’s focus on highly digitalized business models and the marketing intangibles proposal’s focus on valuable intangibles and distribution models more generally.

According to the French chair of the meeting, the G-7 countries have agreed on an approach that would use the marketing intangibles proposal as the starting point but would include specific rules for highly digitalized business models in addition to addressing other valuable intangibles and distribution models. While significant additional support for this approach will be needed in order to take it forward, the establishment of this common ground among the G-7 countries is an important step in advancing the project.

Future of the Arm’s Length Principle and International Taxation Framework

Pillar One’s proposals seek to allocate greater taxing rights to the market jurisdictions. This aims to address perceived flaws in capturing the value derived from user participation under the current taxation framework.

Assigning greater taxation rights to market jurisdictions goes hand-in-hand with developing a new standard for nexus without physical presence (remote taxable presence). This creates a shift from the current framework of allocating profits and taxing value where it is created, moving instead toward taxation where value is exploited or consumed. These proposals also deviate from the current entity-by-entity approach of allocating profits, moving instead toward allocating profits on a group-wide basis.

From a practical standpoint, we have seen arguments for enhanced allocation to markets being used by tax authorities in Asia-Pacific, for example in China and India, as part of transfer pricing reviews and audits.

These tax authorities assert some form of “market premium” or locally generated marketing intangibles to argue for a larger share of profit allocation to these territories. However, the international tax community welcomed the OECD’s acknowledgment in the 2015 BEPS Actions 8–10 Final Report on transfer pricing for intangibles that such local marketing features are merely comparability factors that do not automatically result in a premium being allocated to the local jurisdictions.

Yet, just within a few years after the OECD’s release of that final report, the current OECD project is now clearly contemplating a future proposed framework that would go beyond the historic approach to transfer pricing, which has been based on the allocation of value and profits through an analysis of the value chain, including the location of DEMPE (Development, Enhancement, Maintenance, Protection and Exploitation as outlined in BEPS Actions 8–10 Final Report) functions, assets and risks. Instead, the current OECD proposals appear to call for a fundamental deviation from the arm’s length principle in order to allocate additional profits to market jurisdictions.

The possible methodologies described all involve the use of parameters in a formulary approach that would need to be agreed across countries. If countries such as Singapore view the parameters as being arbitrary in nature, they may find themselves caught in a complex tax controversy cycle across a matrix of countries seeking to defend their tax bases.

Pillar Two—Global Anti-base Erosion Proposal

Pillar Two involves two sets of interlocking rules that are intended to work together to safeguard against the risk from structures that continue to shift profits to low or no-tax entities. It provides countries with a right to “tax back” where other jurisdictions have not exercised primary taxing rights or a payment is otherwise subject to low levels of effective taxation. Pillar Two is intended to ensure that a minimum level of tax is imposed on all business income. As such, it is expected to put significant pressure on incentive regimes.

Interlocking Rules

Rule One—Income Inclusion Rule

The income inclusion rule focuses on a parent company with a controlled entity or branch that is subject to low or no tax. This rule is somewhat similar to controlled foreign corporation rules, whereby the tax authority of the parent company would be allowed to tax the parent company on income of a controlled foreign entity to top up the tax on such income either to an agreed minimum tax rate or to the parent company country’s headline corporate tax rate.

This effectively ensures that an MNE would be subject to tax on its global income at a tax rate of at least the agreed minimum rate, regardless of where it is headquartered or where it operates.

Rule Two—Tax on Base Eroding Payments

Rule two would complement the first rule, granting the payer country’s tax authority the option to deny a deduction for a related party payment to an entity that is not subject to a minimum rate of tax or to deny treaty benefits with respect to such payment.

Perspectives on Extending Anti-BEPS Concepts to Core Taxing Rights

For many countries, Pillar Two may be viewed as an erosion of their sovereign right to determine their taxation framework, including their tax rate, based on their own particular economic and fiscal circumstances.

There are significant political-level issues that would need to be resolved in order to reach agreement on Pillar Two rules. First and foremost is the minimum tax rate. In addition, prioritization of the two rules would also need to be clearly defined, in order to avoid double taxation for MNEs whose geographic footprint includes countries that adopt both rules. Failure to establish clear prioritization would lead to significant tax uncertainty and the potential for taxation far in excess of the agreed minimum tax rate. There is a significant political dimension to the issue of prioritization.

Countries with a higher percentage of parent companies are more likely to be arguing for the income inclusion rule to have priority, while developing countries with a higher proportion of entities making outbound payments are likely to favor the tax on base eroding payments as the primary rule.

Pillar Two also has significant technical issues that need to be carefully considered. In this regard, it would be necessary to identify a common standard for measuring the tax base to be used to determine the effective tax rate. Other details that need to be ironed out include timing differences and which country’s tax rules should apply in such measurements.

Currently, there is significant variance in corporate tax regimes and rates across the world. Without global consensus to harmonize these taxation systems for the purposes of measuring the effective tax rate and applying the new rules, taxpayers risk facing differing interpretations from countries with different political agendas—leading to double taxation, long-drawn tax disputes and uncertainty.

Further, consideration should be given as to whether there should be carve-outs from new minimum tax rules, including for incentive regimes that have been determined not to constitute harmful tax practices under BEPS Action 5, for example, and whether there should be related party transaction thresholds that must be surpassed before the rules kick in.

What Companies Need To Do

The aim of Pillar One is to allocate additional profits, and therefore additional taxing rights, to market jurisdictions. This incremental allocation would need to come from somewhere else, which likely will be headquarters’ jurisdictions and other jurisdictions where activities traditionally considered as value driving such as intellectual property development and risk management and assumption are located. Small countries with competitive business environments such as Singapore may be significantly affected as they may have relatively limited user or customer bases as compared to other countries.

The arm’s length principle, while not an exact science, is based on sound economic principles that aim to allocate profits by assimilating pricing conditions in the free market. Experience from countries that apply a formula-based approach either domestically (e.g., the U.S. and Canada) or internationally (Brazil) suggest that achieving sufficient coordination to avoid double taxation may be difficult.

Without strong governing principles on how a formula-based approach can be applied consistently across the world, a departure from the global tax framework based on the arm’s length principle could give rise to significant tax uncertainty, tax disputes and double taxation on a widespread basis. This runs counter to the OECD’s historical support for facilitating international trade and investment.

Pillar Two would also be a significant departure from the global tax framework, with a new set of harmonized tax rules and agreed minimum tax rates. This can be viewed as an erosion of tax sovereignty. Without clear rules and consensus, partial implementation or differing positions would likely result in double taxation and tax disputes, ultimately increasing the compliance burden for taxpayers.

Corporate groups exist to take advantage of synergistic effects in order to achieve economies of scale and derive efficiencies and value. Companies operating in countries with competitive business and tax environments such as Singapore will need to seriously evaluate the practical impact of these proposals for the business climate and the overall economy. Would the role of regional hubs to capture these synergistic effects continue to make sense? The future of tax incentives that encourage business investment is also unclear.

These proposals signal a path toward a fundamental change in how the international tax framework will operate. Given the sheer complexity of issues and amount of work required to reach a consensus, the 2020 timeline is aggressive. It puts significant pressure on the OECD to choose the right path from the outset and to find a way early on to reconcile the key concerns and considerations of multiple stakeholders whose interests may not be entirely aligned.

It is therefore imperative that MNEs stay informed about developments in BEPS 2.0 and consider actively participating in the global dialogue by providing feedback to the OECD and to the tax policymakers in the countries where they operate. The final outcome of this project could dramatically change the current international tax and transfer pricing landscape, so now is the time for businesses to weigh in with feedback reflecting their profile and experience.

Taxpayers should also assess, simulate and evaluate the potential impact of these far-reaching changes. To wait to begin this work until a final consensus is reached would already be too late.

Barbara Angus is EY Global Tax Policy Leader and Principal at Ernst & Young LLP. She may be contacted at barbara.angus@ey.com.

Luis Coronado is EY Asia-Pacific Transfer Pricing Leader and Partner at Ernst & Young Solutions LLP. He may be contacted at luis.coronado@sg.ey.com.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.