The ABCs of BEPS Pillar One explained

29 April 2020
Over the past half dozen years, a number of countries have implemented laws to account for the evolving digitalised economy.

Often known as Google taxes, these country-specific measures seek to capture tax revenues from online companies that generate profits in the respective jurisdictions, but don’t have traditional tax presences there. Some examples include Australia’s diverted profits tax, France’s digital services tax and the UK’s diverted profits tax.

These laws are broadly similar, but each is unique. Most lawmakers and tax experts agree, moreover, that implementing a patchwork system of country-specific laws will not be effective in overcoming the challenges of taxing the digital economy, particularly its technology sector.

Digital taxation: Developing a standardised approach

In order to address concerns about how and where the profits of large tech companies should be taxed, the Organisation for Economic Co-Operation and Development and G20 member countries are developing a standardised approach. This coordinated effort essentially seeks to ensure that taxing rights over the profits of multinational technology entities are shared fairly between relevant tax jurisdictions. The recommendations arising from this project are known as Pillar One and Pillar Two.

As we explained in an October 2019 post, Pillar One is a group of proposals examining taxing-rights allocation, profit allocation and nexus rules. Essentially, Pillar One addresses how to tax large multinational groups that generate profits in certain jurisdictions where they do not have a taxable presence under current international tax rules. At the time of our October post, the OECD had recently announced new rules for public consultation known as the Secretariat Proposal for a “Unified Approach" under Pillar One. Further details of Pillar One were expected to be released in January 2020.

As expected, in January the OECD Inclusive Framework on BEPS working group released a statement setting out the proposed approach to Pillar One. This post summarizes some of the critical elements of Pillar One as described in the January statement. The post is meant to help multinationals understand the current state of this critical, evolving initiative that's shaping international tax rules. The initiative is significant to say the least — it now involves 137 countries and jurisdictions — and has massive tax implications for multinational groups.

(For information on Pillar Two, see our post BEPS Pillar Two reflects radically changing world of corporate taxation.)

Additional background on OECD objectives

The OECD/G20 BEPS program aims “to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment.” The program addresses the following key elements of taxation:

  • How taxing rights are allocated between jurisdictions
  • What the digital economy means for traditional measures of taxable presence and intercompany transactions
  • How to minimise the complexity of any proposed changes, for both taxpayers and tax authorities

In order to achieve these objectives, the OECD considered how new and evolving business models — such as the internet and cloud services — challenge traditional physical-presence-based tax principles and how taxing rights can be extended to tax these new business models in a fair way.

Once agreement is reached, new rules governing digital taxation will likely first apply only to very large international groups, such as those with group annual revenues of more than 750 million euros.

The ABCs of Pillar One

Pillar One addresses nexus rules (or where tax will be paid) and new profit-allocation rules (or what portion of a multinational group’s profits will be taxable). The January 2020 statement clarifies that the unified approach on Pillar One “is designed to adapt taxing rights by taking into account new businesses models and thereby expand the taxing rights of market jurisdictions (which, for some business models, is the jurisdiction where the user is located).” This should in turn create a more stable international tax system.

In order to fulfil this goal, the approach on Pillar One suggests that three kinds of taxable profit may be allocated to a market jurisdiction, calling these Amounts A, B and C. I’ll address these now in order.

Amount A

Amount A is the apportionment of group profits and will occur even when there is no physical presence or product in the country. This is a significant departure from existing international tax principles.

Taxable Amount A profits are likely to be assessed on companies with significant foreign revenues where a new nexus (i.e. a taxable presence) may require group profits to be allocated between different jurisdictions according to a special formula.

The Amount A profit allocation formula will likely attempt to measure the degree to which there is an “active and sustained participation of a business in the economy of a market jurisdiction” through (largely automated) sales to individuals.

As the Amount A profit allocation formula will focus on automated online activity with individuals as the end user (specifically search engines, social media, cloud services and online marketplaces), exemptions will likely exist for professional services and certain business-to-business activities.

Amount B

Amount B is the taxation of in-country marketing and distribution arrangements through the application of a fixed, taxable profit margin. This is a departure from current practise, as these types of activities do not typically create a taxable presence and are therefore not typically subject to tax.

The calculation of Amount B will be based on established international tax concepts (such as the arm’s length principle) and will take the form of a fixed return on expenditure. While a “fixed return” has not been defined in this case, it is likely to be a cost-plus on in-country costs.

Amount B will potentially affect multinational companies with local sales teams that are not generating taxable profits in those countries.

Amount C

Amount C is an extension of Amount B and covers in-country activities other than marketing and distribution. This category will help clarify the treatment of certain activities that are now considered grey areas in terms of whether a taxable presence is created.

The calculation of Amount C will be made on an arm’s-length basis, taking into account the factors that make the activity “non-standard” (and therefore not included in Amount B).

This will potentially affect multinational companies with specialist local teams that are not currently generating taxable profits in those countries and not covered by Amount B.

Practical implications of Pillar One’s ABCs

In practise, there are not many multinational groups whose turnover will place them within Pillar One. As a result, few companies will be subject to the Amount A profits.

Multinationals should keep in mind, however, that few tax laws remain static. Once Pillar One recommendations are adopted by the OECD and various countries begin to legislate for the changes (and repeal any interim measures such as the various digital service taxes), Pillar One will almost certainly start to apply to multinational groups with lower annual revenues.

Some multinational groups may find that rules introduced to impose Amount B and Amount C taxable profits have little impact, especially if a group already conducts in-country activity on a cost-plus basis through a subsidiary or a branch.

When the inclusion of Pillar One amounts would result in double taxation under existing tax treaties, these treaties will need to be updated. This risk — and possible ways in which it can be mitigated — is under ongoing OECD review.

Additional key features of Pillar One are expected to be announced in July 2020, with a final report issued by the end of 2020. Multinational groups should as soon as possible review their existing activities in key markets in light of the January statement. They’ll then be in a good position to make informed decisions when the final Pillar One proposals are released at the end of the year.

Tom Blessington, Manager, International Tax Advisory, contributed to this article.