The US is urging countries to agree to new international tax rules that would allocate a limited amount of additional profit and related taxing rights to countries where a multinational’s customers or digital users reside. In exchange for these additional taxing rights, countries must commit to new rules that provide multinationals with greater certainty about what their tax bills will be and also improve cross-border tax dispute resolution mechanisms, US officials say.
Speaking June 3 in Washington at the 2019 OECD International Tax Conference, Treasury Deputy Assistant Secretary for International Tax Policy L.G. “Chip” Harter said that worldwide agreement on new profit allocation rules is essential to stop the international tax system from descending into chaos as countries increasingly adopt unilateral measures. He said that many countries will not agree to proposals sought by market countries to dramatically alter the profit allocation rules, though, and therefore less ambitious proposals should be considered.
Harter’s comments followed the release last week of a work plan, approved by a 129-country coalition known Inclusive Framework, which provided broad proposals, work streams, and timelines to advance the goal of reaching worldwide consensus on new international tax and transfer pricing rules by the end of 2020.
The work plan will be presented for approval at a G20 finance ministers meeting in Japan this weekend where the different proposals will be discussed.
While the work plan presents three proposals for allocating additional taxing rights to market jurisdictions, Harter said that only one of these “pillar one” proposals has a chance of being adopted. This proposal, the “modified residual profit split method,” would allocate to market jurisdictions a portion of an MNE group’s non-routine profit based on an allocation key. If the MNE has no non-routine profits, the market country gets no additional taxing rights.
In comparison, work plan’s “fractional apportionment method,” favored by India and other G24 nations, would allocate to market jurisdictions a portion of all MNE profits irrespective of whether there are any above normal profits, based on an allocation key. The third pillar one proposal, on “distribution based approaches,” also allocates profits to market countries irrespective of whether non-routine returns are earned. This method, based on a Johnson & Johnson proposal, allocates a baseline profit to the market jurisdiction for marketing, distribution, and user-related activities and then increases or decreases the allocated profit based on the MNE’s overall profitability.
Harter said, however, that it would be a “very heavy lift politically” to get countries to agree to forgo normal returns on activities actually performed in the country. Thus, he said market jurisdictions’ additional taxing rights should be limited to a portion of a multinational’s “above normal returns.”
Harter acknowledged that such an allocation would not dramatically change existing transfer pricing outcomes for global enterprises in “many, many cases” because, depending on how the term is defined, most MNEs may not have above normal returns.
The method does have the benefit of addressing situations where the current rules do not function very well, though, Harter said, such as where valuable intangibles drive MNE profits significantly above normal levels and the multinational locates those intangibles in countries that reduce its tax liability.
To achieve tax certainty, countries could agree to a set of safe harbor margins to be applied to routine distribution functions that are actually performed in the market country, Harter said. The margins could vary by industry and would provide a base amount that the market jurisdiction could tax.
A normal return would be imputed to functions that go beyond routine distribution functions and the margin would be based on a facts and circumstances analysis. A very robust dispute resolution mechanism – probably mandatory binding arbitration – would be agreed to by countries for disputes arising from those the fact-based determinations, Harter said.
Once the actual activities are compensated, one can then can determine whether some portion of the profits belonging to a global line of businesses that derives significant above normal profits could also be allocated to the market jurisdiction. Harter said this would likely be computed using a formula. The data would need to be publicly available or available through a country-by-country reporting mechanism. Still to be negotiated would be the percentage over the normal return threshold that would be subject to the new allocation and the additional margin applied to sales to the local jurisdictions, Harter said.
Harter said that while these provisions may not apply to all industries, the US will insist they apply to more than just digital businesses.
“The essence of the bargain with the market jurisdictions is that in exchange for giving them somewhat more taxing jurisdiction they have to be providing international enterprises with much much greater levels of certainty of tax outcomes,” Harter said. He said that absent such an agreement, headquarters and export jurisdictions would not have an incentive to engage in the process.
Pascal Saint Amans, Director of the Centre for Tax Policy and Administration at the OECD, said that adoption of a pillar one proposal will require the approval of virtually all countries. This will be achieved by making sure that all concerns are taken into consideration, he said.
Saint Amans added that if two or three zero tax counties do not agree to a pillar one agreement, the solution may still go forward. The bargain will be more taxing rights to emerging economies in exchange for greater certainty, he said.
Saint-Amans noted that the Inclusive Framework steering group, which leads the effort to achieve consensus on international tax rules, is comprised of 24 countries that broadly represent the different sensitivities of nations, including countries from the G20, G7, non-G20/OECD countries, developing countries, and small, open economies. Steering group members include Jamacia, Senegal, Ivory Coast, Georgia, Belgium, the Netherlands, Singapore, and Sweden, he noted.
Pillar two, which is a proposal for a global minimum tax and for the denial of deductions where a related payment is undertaxed, can be adopted without full consensus, Saint-Amans said. All that is needed is for a cluster of countries to adopt the global minimum tax and another cluster to adopt the undertaxed payment rule. Even if a few large countries do not join, the impact of the measures will be felt, he said. Common rules would make pillar two more effective, though, he said
Saint-Amans also said that new tax treaty nexus rules will be needed to implement any agreement under pillar one. He said it will probably be better to draft an entirely new nexus provision than to change the existing permanent establishment definitions to avoid spillovers.
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