An Article 9 Analysis of the OECD’s Pillar One Amount B

The OECD and the Inclusive Framework are finalizing Pillar One Amount B, which aims to provide limited-risk distributors (LRD) performing baseline marketing and distribution functions with a minimum return on sales (ROS). Details of the design have been slow to come. The purpose of this article is to discuss the Article 9 implications of Amount B. The guidance concerning Article 9 is found in the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, or TPG.

Chapter 9 of the OECD TPG

According to Chapter 9 of TPG, “business restructuring refers to the cross-border reorganization of the commercial or financial relations between the associated enterprises.” It is a broad definition that catches a wide range of transactions. So does the implementation of Amount B cause a business restructuring within the meaning of Chapter 9?

Transfer of Value Caused by Amount B

The implementation of Amount B results in a reallocation of risk and a transfer of value to the LRD. The value transferred is in the form of a guaranteed minimum ROS. That value is of a derivative nature and is a function of the year-end ROS achieved by the LRD, which may or may not cause a payment from the manufacturer to the LRD at this point. The transfer of value is clear, but its measure is not because of its derivative nature, which requires the use of a derivative pricing technique, which is explained below.

Prior to Amount B implementation, consider an LRD receiving from a manufacturer, a guaranteed yearly ROS strictly greater than zero and not greater than some agreed upper value—i.e., 1% to 3%—for performing baseline marketing and distribution services in-scope Amount B. The LRD experiences some limited volatility in its ROS; the same reasoning applies in the absence of volatility.

The derivative analysis is straightforward. From an economic standpoint, Amount B is equivalent to the manufacturer writing a series of put options on the date Amount B is implemented, granting the LRD on Dec. 31 of each subsequent year the right, but not the obligation, to sell its actual ROS for the strike price equal to the Amount B ROS. The manufacturer is short the put options, and the LRD is long the put options. Purchasing a put option achieves the same result as purchasing an insurance policy.

The put options have economic value because the probability that they end up in the money is strictly positive, and the probability they lose money is zero. The value of the Amount B guarantee is the sum of the prices of these put options—the Black and Scholes (1973) equation can be used to obtain these prices. The put options have zero value when the LRD is already guaranteed a ROS exceeding the Amount B ROS. Leaving the slightest amount of volatility with the LRD always gives the put options extrinsic value (time value to get ITM) regardless of their intrinsic value (difference between spot and strike price).

The Application of Article 9

Under Chapter 9, changes in the commercial or financial relationship between affiliates causes a business restructuring transaction. As discussed above, the implementation of Amount B reallocates risk and transfer value. The implementation of Amount B necessarily changes the financial relationship between affiliate in-scope Amount B. Therefore, under Article 9, affiliates in-scope Amount B must recognize and price the transfer of value caused by Amount B—even if, in any given year, the LRD’s year-end ROS exceeds the Amount B minimum ROS.

It is the provision of the guaranteed return in the form of Amount B on the date of its implementation that causes the exchange of value between affiliates rather than the actual exercise, on Dec. 31 of each subsequent year, of the LRD’s right to exchange a lower ROS for a greater ROS. The liability of the LRD to the manufacturer is born on the date Amount B is implemented, which causes an arm’s length compensation to be due at that date and either paid on that date or deferred to a later date with arm’s length interests accrued.

Conclusion

Pillar One Amount B causes a change in the commercial or financial relationship between affiliates. Tax planning initiated by a taxpayer causes a Chapter 9 business restructuring that calls for arm’s length consideration. So does tax planning concerning that taxpayer’s affairs initiated by the OECD and IF.

Amount B is designed outside the transfer pricing rules. Chapter 9 of the OECD TPG does not condition its applicability on the party that initiated the business restructuring. Moreover, I do not see in Article 9 or any other chapters of the OECD TPG, any exception to the requirement that the change in the commercial and financial relationship of affiliates caused by Amount B be priced at arm’s length. It is important to recognize that Amount B causes payments that derive value from the underlying stochastic (with volatility) or non-stochastic (without volatility) ROS of the LRD requiring a derivative pricing technique.

The technique to use is straightforward. It is easy to see that the arm’s length value of Amount B is the sum of the prices of put options written on the ROS of the LRD, striking at the Amount B ROS, with expiration one year from issuance on year one of Amount B implementation, two years on year two, and so forth.

The implementation of Amount B is akin to the manufacturer writing a series of put options with expiration dates of one year, two years, three years, and so forth, from the date at which Amount B becomes effective. The manufacturer is short the puts (sells); the LRD is long the puts (buys). The options are exercised if and only if the LRD’s ROS is below the Amount B ROS at year-end. In the alternative, they expire as worthless. Therefore, the value of Amount B can be measured by the Black and Scholes (1973) European option pricing equation as the sum of the prices of the series of put options written by the manufacturer. The OECD and IF need to tell us what the strike price will be so that we can meet our Article 9 obligations on the date Amount B is implemented.

Failing to price and document that change in the commercial or financial relationship between the parties under the guidance of Chapter 9 is arguably in contravention of Article 9.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Philippe G. Penelle is a managing director at Kroll Inc. and a retired principal from Deloitte Tax LLP.