Blueprint on Pillar One—What’s New and Important

On Oct. 12, 2020 the OECD released a 232-page report entitled “The Report on Pillar One Blueprint”. Pillar One is focused on creating a more fair taxing system and has the objective of shifting profits from the home country of the multinational to the markets where they sell. The accompanying updated economic impact analysis by the OECD states that reallocated profits to market jurisdictions could reach up to $100 billion each year under Pillar One.

To put it bluntly, Pillar One is a revolutionary change in transfer pricing and will be bad news for American companies in that (1) will depart from the venerable arm’s-length standard which dates back to the 1920s, (2) enormously increases administrative and filing burdens, and (3) increases the overall amount of foreign tax paid by American companies in high-tax jurisdictions such as China and Japan.

Not surprisingly then at the public hearings on Pillar One held last November, the biggest wish of multinationals was to be left out of the scope. Moreover, in their corner was the U.S. Treasury Secretary who stated that Pillar One should be optional and a safe harbor.

This article discusses the new features of the Blueprint and deals with the two biggest questions our clients have:

• Is my company in scope?
• How much profit (and tax) would be due under the formulae laid out in the Blueprint?

Two Categories in Scope

The proposed scope, while not finalized, is still limited to Automated Digital Services (ADS) and Consumer Facing Businesses (CFB). The limited scope will be good news to industrial companies. There had been strong calls for expanding scope. For example, Amazon had stated that “the new tax rules should not ring fence the digital economy” and Unilever had argued that “Amount A should be extended to all businesses not just consumer-facing businesses—and regardless of size of business.”

The Blueprint according to the OECD “tries to bridge the gap between those members seeking to focus Pillar One on a narrower group of digital business models and those insisting that a solution should cover a wider scope of activities.” The OECD states that “considerable technical work has been done on how these categories could be defined, but to date political agreement has not been reached on the use of these categories, and the scope issue is not yet solved. The scope of Amount A remains to be settled upon.”

Automated Digital Services

The definition of ADS is comprised of a positive list of ADS activities; a negative list of non-ADS activities; and a general definition.

The general definition of ADS is built on two elements: (1) automated, i.e. once the system is set up the provision of the service requires minimal human involvement, and (2) digital, i.e. provided over a network. The approach to defining ADS recognizes that these services can be provided remotely to customers in markets with little or no local infrastructure.

The positive ADS list currently contains the following nine categories of services:

1. Online advertising services,
2. Sale or other alienation of user data,
3. Online search engines,
4. Social media platforms,
5. Online intermediation platforms,
6. Digital content services,
7. Online gaming,
8. Standardized online teaching services, and
9. Cloud computing services.

The list of nine services that per se qualify as ADS is significantly broader than European Union-style digital services taxes (DSTs), and includes cloud services and first-party provision of digital content. The expansion in scope may be necessary to entice governments to repeal their DSTs.

The proposed negative list currently contains the following five categories of services:

1. Customized professional services;
2. Customized online teaching services;
3. Online sale of goods and services other than ADS;
4. Revenue from the sale of a physical good, irrespective of network connectivity (Internet of things); and
5. Services providing access to the Internet or another electronic network.

In summary, a company would be in ADS if:

• The service is on the positive list; or
• The service is not on negative list and meets the general definition of being (1) automated, and (2) provided digitally.

Consumer Facing Businesses

Unlike ADS, there is no CFB list. There is only a broad definition that CFBs are businesses that generate revenue from the sale of consumer goods or services or that do franchising and licensing.

A multinational enterprise (MNE) would be regarded as being a “consumer-facing business” if the MNE is the owner of the consumer product/service and holder of the rights to the connected intangible property (including franchisors and licensors). This is the MNE whose “face” is apparent to the consumer. In addition, the “retailer” would also be in scope, as they have a direct relationship to the consumer. Other third party MNEs, such as manufacturers, wholesalers, and distributors, which have no relationship with the customer are therefore not in scope.

Once a good or service meets the test of being of a type commonly sold to consumers, all sales of goods or services of that type of product will be entirely within scope. This remains true, even if the product is sold to a business customer. These are “dual use” products that can be sold to both consumers and businesses. For example, passenger cars, personal computers, and some medical products (such as blood pressure monitors) fall in this category.

The Blueprint does not list examples of CFB but the definition above would apply to the list provided earlier which included:

• personal computing products (e.g. software, home appliances, mobile phones);
• clothes, toiletries, cosmetics, and luxury goods;
• branded foods and refreshments;
• franchise models, such as licensing arrangements involving the restaurant and hotel sector; and
• automobiles.

The OECD states that franchising would also be in scope. To quote, “Where the franchised rights are connected to a good or service commonly sold to consumers (e.g. burgers), the franchisor is in scope as the owner of the brand being monetized (via the intangible property made available to the franchisee), and the franchisee is in scope as the seller of the consumer product.”

The Blueprint discusses various approaches to dealing with pharmaceuticals in particular over-the-counter (OTC) drugs with no final conclusions made

Exclusions from Scope

When it comes to exclusions, the specific “exclusions” laid out in the blueprint are:
1. Natural resources;
2. Financial services;
3. Construction, sale and leasing of residential property; and
4. International airline and shipping businesses.

The exclusions do not list Industrials and Capital Equipment, but it does appear multinationals in these sectors would be excluded. To quote from Article 99. “Businesses selling intermediate products and components that are incorporated into a finished product sold to consumers would be out-of-scope. Examples include wood pulp, steel rods, bulk fabric, and electrical parts within a laptop or phone.”

The New Taxing Rights

Blueprint Drops Amount C: The original Pillar One (Oct. 9, 2019) set up three taxing rights for the market economies: Amounts, A, B, and C. The Blueprint for Pillar One drops Amount C and so now there is only Amounts A and B.

Amount A is the controversial new taxing right whereby a portion of the global residual profits will be allocated to market economies. An MNE can only be subject to Amount A if it is in two sectors (ADS and CFB) and exceeds two thresholds: the MNE’s consolidated revenue is above a certain threshold (such as 750 million euros); and its aggregate foreign source revenue exceeds a de-minimis amount (such as 250 million euros).

New Nexus Rule: Not all market jurisdictions are eligible to receive Amount A. Very small markets would not be eligible. The market revenue threshold for nexus would be applied separately for ADS and CFB. Unlike ADS, CFBs are less able to participate remotely in market jurisdictions, and so the Blueprint indicates that a higher nexus standard could apply to CFBs. The nexus revenue threshold remains to be determined, but it expected to be less than 5 million euros.

Formula for Amount A: To simplify matters and in response to the feedback on the earlier draft, OECD has laid out a formula to calculate Amount A using a 3-step approach: (1) A profitability (profit before taxes (PBT) to revenue ratio) threshold to isolate the residual profit, (2) a reallocation percentage to identify an appropriate share of residual profit that can be allocated to market jurisdictions under Amount A (allocable tax base), and (3) an allocation key to distribute the allocable tax base amongst the eligible market jurisdictions.

Amount B is to provide an arm’s-length guide to an allowable fixed return for marketing and distribution activities. It is anticipated that Amount B could be based on a return on sales, together with potentially differentiated fixed returns to account for the different geographic locations and industries of the in-scope distributors. The use of return on sales would be of concern to those MNEs who use the Berry ratio. The blueprint states that further technical work is necessary to develop potentially different industry-based returns. These are likely to include: pharmaceutical, consumer products, automotive, and information and communication technology (ICT).

Sales Agents: Commissionaires, sales agents, and other businesses that perform non-baseline marketing and distribution activities would not be within the scope of Amount B. Some members of the Inclusive Framework want them included and OECD states that further technical work will be carried out to evaluate this issue.

Further Technical Work on Amount B: The OECD blueprint identifies three areas for further work: (1) Finalizing the profit level indicator to be applied, (2) determining the regions and industries to which differentiated returns should, apply and (3) conducting the benchmarking to set the required returns using the agreed basis.

Safe Harbor: U.S. Treasury Secretary, Steve Mnuchin had asked for a safe harbor and for Pillar One to be optional. OECD has sort of responded on safe harbor stating that Amount A should not be allocated to a market jurisdiction where (for its in-scope activities) an MNE group already leaves sufficient residual profit in the market. Thus, it would not be a traditional safe harbor, but would instead “cap” the allocation of Amount A to market jurisdictions that already have taxing rights over a group’s profits under existing tax rules.

How to Compute Amounts A, B, and Safe Harbor—Case Study for Apple

The computational process is complicated and so we illustrate it using Apple as an example. Please note all this information is from public domain sources.

In computing Amount A, the bulletin has not yet finalized the profitability threshold but suggests 10% as a likely choice. This means that any global profit in excess of 10% should be regarded as residual. The bulletin also suggests a reallocation percentage of 20% which means that 20% of the residual profit would be allocated to market jurisdictions

Apple Information: The exhibit presents the simplified income statement of Apple for fiscal year (FY) 2019 extracted Apple’s 10-K for FY2019, page 29.

Step 1: Compute Group Residual Profit: Determine Apple’s residual profit (RP) by subtracting 10% from the PBT margin (P/R).

RP = P – (R * 10%)
RP = 65,737 – 260,174 * 10%
RP = 39,720 (15.27% of total Apple revenue)

Step 2: Compute Allocable Tax Base: Determine Apple’s allocable tax base (TB) by multiplying residual profit (RP) by 20%.

TB = 20% * RP
TB = 20% * 39,720
TB = 7,944 (3.05% of total Apple revenue)

Step 3: Compute Allocation to China: Allocation key is the ratio of China sourced revenue (S) to total revenue (R). According to Apple’s Form 10-K for FY2019, page 20, of Apple total revenue in FY2019 which is $260.17 billion, $43.678 billion is from (Greater) China. This step provides for the quantum of Amount A to China (A) and is calculated as follows:

A = TB * (S / R)
A = 7,944 * (43,678 / 260,174)
A = 1,334 (3.05% of China sourced revenue)

Step 4: Calculation of the Safe Harbor Return: The safe harbor return (SH) = Amount A + Amount B (which is a fixed return for in-country routine marketing and distribution activities). Here it is assumed that Amount B to China (B) equals 5% of China sourced revenue (S)

SH = A + B
SH = A + S * 5%
SH = 1,334 + 43,678 * 5%
SH = 3,518 (8.05% of China sourced revenue)

Step 5: Determine Potential Cap to Amount A: Compare the safe harbor return with the existing marketing and distribution profits, to determine a potential cap to the Amount A allocation and hence the quantum of Amount A taxable in China.

Where the existing marketing and distribution profit exceeds the safe harbor return, there will be no allocation of Amount A to China.

Safe Harbor Return to Apple

Implementation

Securing tax certainty is an essential element of Pillar One. The Pillar One solution would contain a new multilateral tax certainty process with respect to Amount A. The new Amount A taxing right would be implemented through changes to domestic law, and by way of public international law instruments, in particular, a multilateral convention would be required.

Amount A would be administered through a self-assessment system. An Amount A coordinating entity (the AACE) within an MNE group will file a single self-assessment return and documentation package on behalf of the entire MNE group with its lead tax administration (the “LTA”) by an agreed filing deadline. The LTA will review and validate these materials, and will exchange them with the tax administrations of jurisdictions where the MNE has a constituent entity and those where it has market revenues that meets the applicable threshold or did so in the previous year (affected tax administrations, or “ATAs”). The ATAs and the LTA would then be free to audit the Amount A return and propose adjustments.

Timeline

• On Oct. 9. 2019, the OECD releases the Unified Approach on Pillar One while the GloBE consultation on Pillar was released on 2 Nov 2, 2019.
• On Nov. 21-22, 2019, the OECD hosted a day and a half-long public consultation meeting. The OECD received over 300 comment submissions on the Consultation Document.
• On Dec. 3, 2019, the U.S. Treasury Secretary, Steven Mnuchin, sent OECD Secretary General Ángel Gurría a letter, which proposed that Pillar One be implemented on a ‘safe harbor’ and optional basis.
• On Oct. 12, 2020, the OECD released the blueprints which are discussed here. The blueprints provids more details but acknowledges that the scope of Pillar One and computation of Amount A are still unresolved and there are pending political issues.
• The blueprints were discussed at the 14-15 October virtual G20 Finance Ministers’ Meeting. Based on the documents sent to the G20, the Finance Ministers will likely offer an extension of time to negotiate a consensus political agreement until sometime in 2021.
• The Pillar One and Pillar Two blueprints will be subject to a public consultation to run from Oct. 12 through Dec. 14, with a virtual consultation to take place in January 2021.
• OECD targets to bringing the process to a successful conclusion by mid-2021 and to resolve technical issues, develop model draft legislation, guidelines, and international rules and processes as necessary to enable jurisdictions to implement a consensus-based solution.

Conclusions

The U.S. position in the negotiations remains uncertain. However, expect it to be negative as the U.S. is the major payor of the new taxes since it globally dominates the ADS space and is the leader in CFB. President Trump has already condemned and retaliated against the French DST and even under a Biden administration, one can expect pushback.

In the meantime, American companies should continue to make their positions known both within OECD by participating fully in the comment process and by communicating concerns to the U.S. administration where they are likely to receive sympathy and support. And they should plan for the impacts of Pillar One because it appears inevitable that it will come out in some form and grant the market economies new taxing rights.

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

Author Information

Glenn DeSouza is a national transfer pricing leader at Dentons China based in the firm’s Shanghai office. Glenn may be reached at Glenn.Desouza@dentons.cn.