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KPMG Study Casts Doubt on Key OECD Global Tax Deal Design Issue

Posted on Feb. 24, 2020

A new economic analysis from KPMG throws into question the need for differentiation in amount B of the OECD’s so-called unified approach for modernizing corporate tax rules for the digital age. 

According to the study, which Tax Notes obtained February 20, it “was commissioned by Microsoft to prepare a fact-based economic analysis using comparables data of the arm’s-length returns to sales, marketing, and distribution.”

Microsoft requested the analysis to contribute to the public debate about a proposed two-pillar global tax overhaul that some 140 countries in the OECD’s inclusive framework on base erosion and profit shifting are considering and to encourage more economic analysis to better inform policymakers, Tax Notes has learned.

That approach is meant to revise the corporate tax system to address the tax challenges of the digital economy, with pillar 1 focusing on revised profit allocation and nexus rules, while pillar 2 consists of a global anti-base-erosion proposal that would provide for global minimum taxation.

The pillar 1 unified approach, which the OECD published in October 2019, proposes a three-tiered profit allocation method applied to consumer-facing businesses and automated digital services companies on three groupwide profit categories in market jurisdictions — known as amounts A, B, and C. 

Amount A would represent a new taxing right for market jurisdictions, based on a new nexus linked to sales and allocation of an affected company’s non-routine profits, also known as residual profits. Amount B would provide fixed remuneration for baseline marketing and distribution activities occurring in market jurisdictions, and amount C would reflect local group functions beyond routine activities in amount B and would be determined under the arm’s-length principle.

Inclusive framework members in January formally adopted the unified approach as the basis for negotiations as they continue to work toward consensus on a solution by the end of 2020.

Under pillar 1, amount B represents an estimate of an arm's-length return on sales, marketing, and distribution functions. However, instead of basing the return on a traditional transfer pricing analysis, amount B would be a fixed percentage.

One of the outstanding technical issues listed in the inclusive framework’s statement endorsing the unified approach to pillar 1 as the basis for negotiations concerns “the degree to which there may need to be a differentiation in treatment between industries and regions in order to remain in broad conformity with the" arm's-length principle.

According to KPMG’s analysis, economic data provide little support for any such differentiation, either by geography or industry profitability. The analysis compares operating margins — operating profit divided by total revenue — drawn from 4,285 sets of five to 50 limited-risk distributors that perform routine sales, marketing, and distribution functions. 

The study reports that comparable sets for Europe, the Middle East, and Africa have an average median operating margin of 2.4 percent after applying a standard working capital adjustment. The corresponding averages for the Americas is 2.6 percent and 2.2 percent for the Asia-Pacific region. Returns were relatively consistent across the 18 represented industries as well, with a minimum of 1.8 percent for food products and a maximum of 3.3 percent for transportation equipment. The 2.3 percent median operating margin for technology services was slightly less than the average of 2.5 percent for all industries.

The study includes a separate analysis of value-added sales, marketing, and distribution functions using 1,583 sets of five to 50 companies. Although average operating margins were higher than for limited-risk distributors, they were similarly consistent across region and industry. The average median was 3.5 percent for Europe, the Middle East, and Africa; 3.8 percent for the Americas; and 3.6 percent for the Asia-Pacific region. With the exceptions of technology services and plastic products, most industries were closely clustered around the 3.6 percent global average.

The report contrasts the consistency of returns attributable to independent sales, marketing, and distribution functions in different industries and regions with the wide variation in overall industry regional profitability. The larger variations in returns across regions and industries showed no clear correlation with the variations in returns attributable to sales, marketing, and distribution.

“There is considerably more variability in the average operating margin of the public companies across industries than variability in the independent sales, marketing, and distribution comparables across industries. Since the returns to sales, marketing, and distribution are relatively stable, they decrease as a share of system profits in highly profitable companies,” the study’s executive summary says.

“Median returns to sales, marketing, and distribution do not increase as the average profitability of the industry segment increases,” the summary adds.

Both KPMG and Microsoft declined Tax Notes’ request for further comment.

The study, which Tax Notes understands was circulated widely among the business community, came just before the G-20 finance ministers' January 22-23 meeting in Riyadh under the Saudi Arabian presidency. The ministers were expected to approve the inclusive framework’s updated work program, which would give countries the green light to stay on track and continue designing and discussing the solution. 

The OECD hopes the inclusive framework will be able to reach political consensus on key components of the solution at its July meeting so G-20 leaders can consider it at their November summit. 

However, key obstacles remain, including a U.S. proposal to implement pillar 1 on a safe harbor basis, which could threaten the likelihood of multilateral consensus on the solution. Failure to reach consensus could open the door to the proliferation of unilateral measures, such as digital services taxes, sparking trade war fears.

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