OECD publishes Blueprints for Pillar One and Pillar Two

The OECD has been forced to delay its timeline for implementation of significant changes to the international tax landscape in the context of the digitalisation of the world economy. In publishing two blueprints for reform of the international tax rules for public consultation, it is clear that the OECD/G20 Inclusive Framework on BEPS (Inclusive Framework) (involving some 137 countries) has abandoned its end 2020 deadline and now hopes to see agreement reached by the middle of 2021 on its Pillar One and Pillar Two proposals. Nevertheless, it is also clear that significant hurdles to progress remain and that agreement is far from certain. Clearly much progress has been made, but issues remain over fundamental features of the new rules and political will (and compromise) will be needed to get them over the line. The new timeline proposed by the OECD - mid 2021 - still appears ambitious rather than realistic.

The Unified Approach under Pillar One requires a broadening of the recognition of a market jurisdiction's taxing rights when there is active and sustained participation of a business in its economy, irrespective of any physical presence. To deal with this wider concept of tax nexus, new profit allocation rules are required which will need to go beyond the existing arm's length principle and apply a formulaic approach to profit recognition in certain aspects. As with the Pillar One proposals, the Pillar Two proposals have the potential to fundamentally change the international tax landscape for MNEs by introducing (in essence) minimum rates of tax.

There will be reservations and concerns over the scope and detail of these proposals and the administrative burden that new rules will create. However, against that must be set the alternative prospect of a plethora of individual and jurisdiction-specific rules targeted at the digital economy which are starting to be introduced and becoming effective in a significant number of countries.

Furthermore, the OECD argues that the current COVID-19 pandemic makes the need for a solution even more compelling as it has increased public pressure on governments to ensure that large, international businesses pay their fair share of tax and do so "in the right place". Increased government spending on healthcare and unprecedented levels of financial support to both businesses and workers means that governments will eventually need to put their finances back on a fair and sustainable footing.

Background

Despite determining in its final Report on BEPS Action 1 that it would not be feasible to ring-fence the digital economy for tax purposes, international pressure has continued to mount over the tax treatment of the digital economy as a number of jurisdictions have concluded that more is needed to ensure fair taxation of digital business. Impetus for an international consensus has continued to mount since - the EU Commission put forward proposals to address the tax treatment of companies operating in the digital economy and several jurisdictions have commenced implementation of unilateral, domestic measures, such as France's and the UK's Digital Services Taxes.

This continued political pressure led to the publication of a Policy Note in January 2019, followed by a Public Consultation which set out a number of proposals for reform, grouped under two "pillars": revised profit allocation and nexus rules (Pillar One); and a global anti-base erosion proposal for a minimum level of taxation (Pillar Two).

A Public Consultation document was published in October 2019 to assist the Inclusive Framework Member States with reaching international consensus on the scope of taxation of the digital economy and methods to determine what digital income would be subject to tax. The document, "Secretariat Proposal for a "Unified Approach" under Pillar One", put forward a proposal to define the scope, tax nexus and a new profit allocation rule for public comment. A public consultation document on Pillar Two, seeking solutions to the ongoing risks from structures which allow MNEs to shift profits to low tax jurisdictions through additional global anti-base erosion (GloBE) proposals, was published in November 2019.

Most recently, on 31 January 2020, the OECD delivered an update, "Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy", setting out the progress that had been made as well as the very significant challenges still to be overcome for the solutions to be implemented by its end 2020 deadline. It has now been forced to admit that the 2020 deadline is unrealistic and is instead pushing for a mid 2021 implementation timeline.

Pillar One

Pillar One concerns the need for a revised approach to "nexus" for tax purposes, stemming from the perception that the current approach to the allocation of profits (based on physical presence and the "permanent establishment" definition) can no longer be the exclusive method in a digital age as it fails to recognise value created (remotely) in a market jurisdiction. The October 2019 public consultation put forward a "Unified Approach" to addressing these issues and subsequent reports have built on this proposal.

The Inclusive Framework has now published the Report on the Pillar One Blueprint (running to 234 pages) for public consultation. The Blueprint is the result of further extensive technical work however it is important to not that no agreement has yet been reached. It is hoped that the Blueprint will provide a foundation for a future agreement.

Pillar One seeks to adapt the international income tax system to new business models through changes to the profit allocation and nexus rules applicable to business profits. It expands the taxing rights of market jurisdictions (the jurisdictions where the users are located) where there is an active and sustained participation of a business in the economy of that jurisdiction through activities in, or remotely directed at, that jurisdiction. Ultimately, Pillar One seeks to balance the different objectives of Inclusive Framework members and, crucially, result in the removal of unilateral measures.

The key elements of Pillar One can be grouped into three components:

• a new taxing right for market jurisdictions over a share of residual profit calculated at an MNE group (or segment) level (Amount A);
• a fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction, in line with the ALP (Amount B); and
• processes to improve tax certainty through effective dispute prevention and resolution mechanisms.

The Blueprint reflects a number of essentially agreed fundamental features of the eventual solution to be adopted under Pillar One:

• identification of in-scope businesses by designing new nexus rules - under the broader proposal this would not be targeted at any particular narrow industry or sector (unlike some unilateral measures that have been adopted);
• the solution would allocate a portion of the residual profit of in-scope businesses to the market/user jurisdictions ("Amount A");
• the solution would be targeted and build in thresholds so that it minimises compliance costs for taxpayers and keeps the administration of the new rules manageable for tax administrations;
• Amount A would be computed using consolidated financial accounts as the starting point, contain a limited number of book-to-tax adjustments and ensure that losses are appropriately taken into account;
• in determining the tax base, segmentation would be required to appropriately target the new taxing right in certain cases, but with broad safe-harbour or exemption rules from segmentation to reduce complexity and minimise burdens for tax administrations and taxpayers alike;
• the solution would contain effective means to eliminate double taxation in a multilateral setting;
• the work on Amount B will be advanced, (a fixed rate of return on base-line marketing and distribution activities intended to approximate results determined under the arm's length principle) recognising its potentially significant benefits including for tax administrations with limited capacity as well as its challenges;
• the Pillar One solution would contain a new multilateral tax certainty process with respect to Amount A, recognising the importance of using simplified and co-ordinated administrative procedures with respect to the administration of Amount A;
• a new multilateral convention would be developed to implement the solution, recognising that it would offer the best and most efficient way of implementing Pillar One.

However, the Report recognises that fundamental differences remain. In particular, it reports that there is a clear divergence between 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. As a result, two categories of activities to be included in the scope of the new taxing right created by Pillar One were identified: Automated Digital Services (ADS) and Consumer Facing Businesses (CFB). However, to date political agreement has not been reached on the use of these categories and the scope issue is not yet resolved.

The Inclusive Framework will now focus on resolving the remaining political and technical issues, including issues around scope, quantum, the choice between mandatory and safe harbour implementation and aspects of the new tax certainty procedures.

Pillar Two

The Inclusive Framework has also approved the Report on the Pillar Two Blueprint (running to 249 pages) for public consultation. It is designed to provide a solution that would address remaining base erosion and profit shifting (BEPS) challenges and sets out rules that would provide jurisdictions with a right to "tax back" where other jurisdictions have not exercised their primary taxing rights or a payment is otherwise subject to low levels of effective taxation. These rules are designed to ensure that all large internationally operating businesses pay at least a minimum level of tax. Pillar Two essentially acknowledges that jurisdictions are free to determine their own tax systems, including whether they have a corporate income tax and the level of their tax rates, but also recognises the right of other jurisdictions to apply an internationally agreed Pillar Two regime where income is taxed below an agreed minimum rate.

Again, no agreement has been reached on the Pillar Two proposal but the Inclusive Framework hopes that the Blueprint will provide a basis for future agreement on the elements to be included in the eventual Pillar Two solution. In particular, these would include:

• an Income Inclusion Rule (IIR). This is in many ways similar to a traditional controlled foreign company (CFC) rule and triggers an inclusion at the level of the shareholder where the income of a controlled foreign entity is taxed at below the effective minimum tax rate. It is complemented by a switch-over rule (SOR) that removes treaty obstacles from its application to certain branch structures and applies where an income tax treaty otherwise obliges a contracting state to use the exemption method;
• an Undertaxed Payment Rule (UTPR). The UTPR is a secondary rule and only applies where an entity is not already subject to an IIR. As such, the UTPR serves as back-stop to the IIR; and
• a Subject to Tax Rule (STTR). The STTR is intended to complement these rules. It is a treaty-based rule that specifically targets risks to source countries posed by BEPS structures relating to intragroup payments that take advantage of low nominal rates of taxation in the jurisdiction of the payee. It allows the source jurisdiction to impose additional taxation on certain payments up to the agreed minimum rate.

Other necessary features would include provisions around rule order, the calculation of the effective tax rate and the allocation of the top-up tax for the IIR and the UTPR, including the tax base, the definition of covered taxes, mechanisms to address volatility and the substance carve-out.

The aim is to include IIR and UTPR as a common approach, including an acceptance of the right of all members of the Inclusive Framework to implement them as part of an agreed Pillar Two regime. It would nevertheless be recognised and accepted that there may be members that are not in a position to implement these rules. However, all those implementing them would apply them consistently with the agreed Pillar Two vis-à-vis all other jurisdictions that adopt this approach.

The latest report also recognises that the adoption of an STTR is particularly important to developing countries and therefore should be an integral part of a consensus solution on Pillar Two.

It will also be necessary to determine the  basis on which the United States' Global Intangible Low Taxed Income Regime (GILTI) would be treated as a Pillar Two compliant income inclusion rule as set out in the Report on the Blueprint on Pillar Two.

Administrative features of Pillar Two include the development of model legislation, standard documentation and guidance, design of a multilateral review process if necessary and exploring the use of a multilateral convention, which could include the key aspects of Pillar Two.

Public Consultation

The Inclusive Framework has now opened the design of Pillar One and Pillar Two for public consultation. Responses to questions set out in the Public Consultation document are invited no later than Monday 14 December 2020, by email to cfa@oecd.org in Word format. They should be addressed to the "OECD Centre for Tax Policy and Administration".