An analysis of Pillar 1 & 2 OECD recomendations

An analysis of Pillar 1 & 2 OECD recomendations by Prof. Pasquale

Pillar 1 – Unified Approach

PROF PASQUALE PISTONE

Prof Pasquale Pistone graduated cum laude in law at the Federico II University of Naples in 1990, obtained his doctoral degree in 2000 cum dignitate publicationis at the University of Genoa. He is Associate Professor of Tax Law at the University of Salerno and (since 2005) Professor at the WU Vienna University of Economics and Business, where he currently holds an EU Jean Monnet ad Personam Chair on European Tax Law and Policy. For his research activity on European and international tax law he has received several international awards. He is fluent in seven languages, frequent speaker at international tax conferences, editor of twenty six books, author of two monographic studies, as well as over one hundred and twenty articles on various tax issues written and/or translated in nine languages.

1. In your opinion what is the absolute scope that is trying to be reached under Pillar One – Unified Approach?

The ultimate scope of Pillar One is to adjust international tax nexus and allocation to the (new) business models, which rely on global value chains, decide where to create value and can operate largely on a remote basis. In line with such models, MNEs in fact operate like stateless entities across the globe, challenging the validity of the criteria that determine liability to tax in the different jurisdictions. During the first phase of the BEPS Project, it seemed as if this phenomenon was necessarily associated with base erosion and profit shifting and only concerned digital business.

However, the analysis conducted in the past few years has shown that the true challenge of Pillar One is to rethink international taxation and the exercise of taxing jurisdiction across the world in the framework of coordinated action that reflects global value creation and apportions it consistently among the countries.

The political struggle among winning and losing countries (in terms of collected revenue) proves that this is easier said than done.

This becomes especially clear if one considers the unprecedented alignment between tax policy reform supported by some OECD and non-OECD countries (such as for instance some EU Member States, Colombia and India) on the one hand, and other countries, on the other hand, including in particular the US.

This context has generated the proliferation of unilateral levies on digital services as a reaction to the loss of revenue by some countries, which can potentially undermine the efforts of decades of international tax coordination. This is what the OECD is trying to avoid wit its promise

to deliver a comprehensive reform with worldwide acceptance by 2020. The OECD has high international credibility as the real engine of international tax reforms, due to its enormous success with the coordination of tax transparency and the fight against base erosion and profit shifting. However, this is a much harsher challenge, which should be handled in the framework of a global political compromise including also Pillar Two.

2. In light of considerations with respect to the financial services industry do you predict future complexities under the Unified Approach?

Just like all other global players, the financial industry is not immune from future complexities, at least insofar as the structure of Pillar One remains the one that has been envisaged by the OECD in its last draft proposal and to the extent that the financial industry does not succeed in getting a dedicated carve-out.

Together with my co-authors of the IBFD Task Force on the Digital Economy, we have been pleading against carve-outs in our academic writing, published and submitted to the OECD. Our proposal is to limit the scope of lobbying, normally associated to the establishment of a carve-out, and rather act by means of a lower allocation of taxable income to the market countries in the presence of a limited exercise of function in such countries.

However, there are two more risks for the financial services industry. First, the uncoordinated levying of taxes on turnover from digital activities. Insofar as such taxes do not fall within the scope of tax treaties, in the absence of a permanent establishment in the State of the recipient of the digitally supplied financial service,

there will be taxation on turnover in such country on top of the one of profits in the State of residence. The negative effects of this scenario can exponentially grow insofar as each country applies a different concept or structure for this tax (which is the reason for favouring an EU harmonized approach in this respect). Second, taxes on financial transactions levied in some countries could alter the conditions for tax neutrality with other global competitors in some parts of the world, such as for instance the European Union.

Overall, the biggest risk for the financial services industry is the legal uncertainty that prevents a proper planning of successful strategies, for which a stable and coordinated international tax framework is absolutely indispensable.

3. The threshold for creating nexus should be made as simple but relevantly effective as possible. What are your views on the appropriate methods for determining nexus in today’s world of business and trade?

I agree that nexus should be simple and just find it hard to accept that this may not be achieved with a corresponding amendment of the PE concept, along the lines of the digital or virtual permanent establishment, which we had proposed at IBFD with one of our studies in January 2015. Adding a new nexus on top of permanent establishment for taxing digitalized business just makes the applicable treaty framework unnecessarily more complicated, since some players would be forced to apply two different set of rules for determining how their crossborder profits and income from digital services should be linked and allocated to a taxing jurisdiction.

Besides, I am very sceptical about any form of ring-fenced solutions, which create are a structural source of biases and complexity. Unfortunately, the current OECD proposal on Pillar One is not just complicated, but also in fact endorsing the use of ring-fenced solutions for highly digitalized business and consumer-facing business. I wonder whether this is really desirable from a global tax policy perspective and in line with what had been previously suggested with the 2003 Ottawa Framework Conditions for Taxation, which seem to have fallen into oblivion.

4. The Consultation Document notes that the starting point for the determination of Amount A with respect to an MNE group would be the identification of the MNE group’s profits, which could be derived from the MNE group’s consolidated financial statements. The Consultation Document notes, however, that the starting point could instead be group profits calculated on a business-line-by-business-line basis, in order to address individual company profits, e.g., a situation in which a group may have one highly profitable line of business and one loss making business. A majority of practitioners believe that determining group profit on the basis of a group’s consolidated financial statements would be a significantly more administrable approach, and would avoid complexity that could lead to disputes- in this regards what would be your opinion?

This is a difficult question to answer. On the one hand, the calculation of profits on a business-by-business-line basis achieves a more accurate result; however, on the other hand, it can be more burdensome to handle and may lack a genuine link between parts of the residual group profit and the taxing jurisdiction of a country. As indicated in our academic writing on this point, we believe that the right approach is to use some margins for preventing the issues of compensation between highlyprofitable and loss-making lines of business. This solution may achieve a satisfactory balance and help protecting the interest of the market country from excessive foreign losses that leave no residual profit to allocate under Amount A.

The Global Anti-Base Erosion proposal under pillar two is being crudely dissected into three sections; A) The Tax base determination B) Blending C) Carve-Outs

However it is only on the profound understanding of each section that all three sections may be appreciated individually as well as collectively. As an Academic Researcher what are your reflections upon the various elements mentioned in (A), (B) and (C)

The overall goal of GLOBE is to prevent a global race to the bottom, while establishing some level of common rules and standards for taxation of profits of multinational enterprises. It is in fact pretty much what the Scrivener Plan achieved in respect of the VAT common system within the European Union two decades ago.

I am very favourable to the establishment of common rules for the tax base determination, but the unreasonable delay of the CCTB project in the European Union may lead to wonder whether the OECD can manage where the EU Commission has failed for long. If we were to move towards common rules for determining business profits, the IFRS rules could be a good reference, taking into account their broad international acceptance.

As for blending, I would favour its narrowest form, since the other solutions would not remove low-taxation of some group companies and thus run against the overall goals of GLOBE.

My adversity for carve-outs should not prevent me from endorsing de minimis thresholds and a geographical carve-out for the least developed countries, the latter being an indispensable complementary measure to use taxes for securing sustainable development in line with the goals established by the UN.

However, an overall assessment of Pillar 2 and the GLOBE proposal requires some clarifications on critical issues concerning the scope. From such perspective, it is still largely unclear whether GLOBE only covers harmful tax practices, or applies on an overall basis. The latter option can enhance a smooth functioning, but it could also raise problematic issues. This would occur if the minimum rate for GLOBE were established at two-digit levels (insofar as one believes

that a de facto discriminatory compensation of lower taxation across the borders could be incompatible with the principles of the EU internal market), but also in the presence of at a too low rate (since it would be largely ineffective).

The application of GLOBE on an overall basis can in fact go as far as fading out the right of countries to use taxes for pursuing genuine regulatory purposes. I believe that States have the power to do so, at least insofar as they accordingly amend the nexus for the exercise of their taxing sovereignty, going beyond what already happens with CFC legislation. However, the required changes would necessarily have to address “tax sparing” clauses contained in tax treaties and other measures that are incompatible with such development.

However, solving technical issues is perhaps not enough in the absence of a strong political compromise, which involves a large group of countries, even if not necessarily all. The right approach is in my view to bundle together Pillar 1 and 2 in the framework of a holistic solution to the problems of reforming international taxation, which could level out the consequences for winning and losing countries, ensuring an obligation to secure international tax coordination and a consistent exercise of taxing powers, also regulating digital services taxes and similar unilateral levies.

The Unified Approach under Pillar 1: An Economic Exposition of the Methodological Approach

SIMON BUGEJA

OVERVIEW OF PILLAR 1

The digitalization of the world economy has brought significant progress in our modern world. However, this phenomenon has also brought new challenges in terms of the alloca tion of taxing rights to appropriate jurisdictions. As part of the Base Erosion and Profit Shifting (BEPS) project, the Inclusive Framework for BEPS (IF) has now proposed the adoption of a unified approach in taxing not only automated digital services but also all multinational enterprises (MNEs) with consum er-facing businesses. Automated digital services include not just the three expected types of business (online search engines, social media platforms and online marketplaces) but also digital content streaming, online gaming and cloud computing. Consumer facing businesses will have to have a significant and sustained engagement (directly or indirectly) with their markets to be caught.

The exercise aims not only to reallocate taxing rights but also to increase the tax take by adding new taxing rights on top of the ex isting system. The outline of the methodology borrows from the world of transfer pricing. It is referred to as a three-tier system as there is ref erence to three amounts A, B and C:

1. Amount A: This refers to the new taxing right over deemed residual profit based on a $750 million revenue threshold from country-by-country reporting. 2. Amount B: For amount B one applies the arm’s length principle (ALP) from transfer pricing to an extra layer of deemed residual profit to be divided up according to a new methodology between all the countries where the MNE operates and to any permanent establishment that the MNE has in other jurisdictions 3. Amount C: In several ways, this amount is a realistic acknowledgment by the IF that the new formula will not be perfect, and leaves room for jurisdictions to grab a bit more where there is more going on in-coun try under the ALP than amount B recognizes. Amount C is rather difficult to compute and leaves a wide field of potential disputes open.

Impact assessment of Pillar 1

The IF has also been working on the impact assessment of Pillar 1 on the tax revenues gained/ lost in each of the IF’s jurisdictions through a 3 step methodology described below. Figure 1 sum marizes the method with which Pillar 1 will determine a jurisdiction’s profit allocation and the respective change in its taxing rights.

Step 1: Determining the residual profits to be apportioned

First, the determination of a jurisdiction’s taxing right entails the determination of the glob al residual profits to be apportioned globally. Residual profits in this case refer to profits earned by Multinational Entities (MNE’s) in a particular jurisdiction, which are in excess of an agreed threshold. Any profits which exceed this threshold are deemed to be earned outside the jurisdiction in question. These thresholds are usually based on accounting ratios such as EBIT to turnover.

Once the residual profits of each jurisdiction are determined, these are then pooled together to form global residual profits. Of these global residual profits, the necessary carve-outs need to be determined in order to identify the scope of this exercise. Some propositions include the carve-out of those MNE’s who earn less than a certain turnover threshold (currently around $750 million), in order to avoid burdening smaller MNE’s with additional administration costs in assessing these residual profits. Thus, for automated digitalized businesses, this revenue threshold will apply and once the threshold is crossed, an MNE is within scope of this exercise. The amount in scope is then further subjected to a fraction of residual profit to be allocated to the market. This parameter is still to be determined by the IF. Step 2: Determining the effective tax rate on the share of global MNE sales

The second step is to determine both the amount of residual profits to be allocated to a particular jurisdiction and the corresponding tax rate to be applied. In order to determine a jurisdiction’s share of the pool of global residual profits, the IF proposes various allocation keys such as number of persons employed and the presence of fixed assets. The IF seems to be more inclined towards using destination-based sales as an ideal alloca tion key (through turnover exports). The jurisdiction’s share of global destination-based sales is then multiplied by the effective tax rate on its received residual profits.

Step 3: Determining the tax rate currently applied on residual profits which have yet to be apportioned

The third step entails the determination of the tax rate currently applied to the residual profits which are yet to be apportioned. First, a jurisdiction’s share of global residual profits is arrived at by taking profits by companies which are in excess of the EBIT to turnover threshold, as a share of global residual profits. This amount is then multiplied by the tax rate with which these profits are currently being taxed in this jurisdiction.

Concluding remarks

Even though the IF has made great strides in formulating a way to distribute taxing rights across jurisdictions based on the location of the economic activity in question, discussions are still ongoing. Some problems arising from this exercise involve the number of simplified assumptions related to the determination of the residual profit threshold, the carve outs definitions, and the appropriateness of using destination-based sales as an allocation key. Furthermore, double taxation still poses as an important issue which needs to be addressed. These limitations leave room for much discussion on a way forward in trying to achieve a consensus between jurisdictions.

Simon Bugeja is an Economist at Economic Policy Department within the Ministry for Finance and Financial Services. The author acknowledges the contribution of Mr. Aldo Farrugia, Director General (Legal & International) at the Office of the Commissioner for Revenue in preparing this article.