The U.S. 'Safe Harbor' Proposal: Rocking the OECD’s Pillar 1 Boat?
How and to what extent U.S. Treasury Secretary Steven Mnuchin’s suggested “safe harbor” approach could accomplish the goals of pillar 1 of the OECD’s digital economy work is unclear, according to practitioners.
Mnuchin’s December 3 letter to OECD Secretary-General José Ángel Gurría claimed that the OECD’s proposals would represent a departure from the arm's-length principle and nexus standards of the existing international tax system, a fact explicitly acknowledged by an OECD policy note released in January. However, Mnuchin’s letter added that “we believe that taxpayer concerns could be addressed and the goals of pillar 1 could be substantially achieved by making pillar 1 a safe-harbor regime.”
Tax Notes understands that Mnuchin was suggesting that companies be able to opt into or out of the “unified approach” under pillar 1. The unified approach, which the OECD published October 9, proposes a three-tiered profit allocation method applied to consumer-facing multinationals on three groupwide profit categories in market jurisdictions — amounts A, B, and C.
Mnuchin’s suggestion caused alarm and confusion among practitioners and OECD officials, especially in light of the project’s tight timeline in 2020. The letter created the need for “unplanned and urgent meetings,” according to Pascal Saint-Amans, director of the OECD Centre for Tax Policy and Administration, while Gurría in his response noted that Mnuchin’s letter was the first time a safe harbor approach had been proposed.
Gurría said the OECD had already held two public consultations, and the idea of making pillar 1 a safe harbor regime never came up.
“We raise this concern, as it may impact the ability of the [135-plus] countries that are now participating in this process, to move forward within the tight deadlines we established collectively” in the inclusive framework on base erosion and profit shifting, Gurría added.
“I’m not totally surprised that the United States is putting the brakes on the pillar 1 work, given the lukewarm response of Treasury when the discussion paper was issued in October,” said Jefferson VanderWolk of Squire Patton Boggs and former chair of the OECD’s Working Party 6.
However, the idea of a safe harbor approach was previously not under consideration at all, according to Brian Jenn of McDermott Will & Emery. Jenn, who served as deputy international tax counsel for the Treasury Department until September and as co-chair of the OECD Task Force on the Digital Economy until August, noted that Mnuchin had been noncommittal in his previous public remarks, and the letter was his first substantive contribution to the project.
“Clearly, pillar 1 was going in the direction of mandatory, so to speak, changes to the permanent establishment rules and to the arm’s-length principle, or at least rules that would change the outcome that you get under existing nexus standards and transfer pricing rules,” Jenn said. “And the OECD has been clear about that throughout this process — that the changes that are being developed would not be constrained by the arm's-length principle or by existing standards for whether there's a taxable nexus. And so it's fairly well into the process that . . . Mnuchin is introducing this idea.”
New Taxing 'Right'?
Multilateral guidance generally reflects a common understanding of “safe harbors” as optional regimes allowing taxpayers to apply some fixed value — for example, a markup or operating margin — instead of undertaking a full transfer pricing analysis. Once disfavored by the OECD, safe harbors have drawn increasing interest as a way to reduce tax administration and compliance costs for routine transactions, avoid disputes and double taxation, and deter use of the controversial profit-split method when comparables are unavailable. Examples include the U.S. services cost method, the OECD’s simplified method for low-value-adding services, and India’s regime for research and development and information technology services.
While noting that they do not fully meet the definition of a safe harbor, the OECD transfer pricing guidelines also recognize “rebuttable presumptions” as administrative simplification options that stipulate a value while allowing taxpayers the option to support a different value. However, the guidelines emphasize that a rebuttable presumption regime should not affect taxpayers’ ability to apply the traditional arm's-length principle. “Under such a system, it would be essential that the taxpayer does not bear a higher burden to demonstrate its price is consistent with the arm’s-length principle than it would if no such system were in place,” the guidelines say.
The OECD secretariat’s unified approach under pillar 1 would use stipulated percentages to define and reallocate taxing rights over what it calls amounts A, B, and C. Instead of using a case-by-case profit split, the unified approach defines amount A as an allocated percentage of profit exceeding some deemed routine return. The approach would also use fixed returns to calculate amount B, which represents the return on routine distribution activities performed by a subsidiary or permanent establishment.
However, unlike under a safe harbor and rebuttable presumption, use of these percentages would not be elective. Consistent with the OECD’s stated purpose of reallocating taxing rights to market jurisdictions, these values would be binding on both taxpayers and tax administrations. The possibility of converting pillar 1 into a safe harbor regime raises a wide range of questions not addressed in Mnuchin’s two-page letter, including its compatibility with pillar 1’s objectives and how it could operate in practice.
Certainly, it’s unclear how to make pillar 1 a safe harbor regime that’s optional for companies under U.S. tax law, according to Carol Doran Klein, vice president and international tax counsel for the U.S. Council for International Business. She pointed to reg. section 1.901-2(a)(2)(i), which defines a foreign levy as a tax if it requires a compulsory payment under the authority of a foreign country to levy taxes.
“It is possible to have some optionality — taxpayers can elect different methods of accounting or accelerate taxable income like under section 338 — in a tax that qualifies as an income tax and the determination depends on whether the predominate nature of the levy is that of a tax,” Doran Klein said. “This is a complex determination with many different elements, so whether the payment would be considered compulsory would depend on the details, which are not clear.”
VanderWolk speculated that the United States’ pillar 1 safe harbor proposal could allow a company to avoid profit reallocation to a market country under amount A if it is already reporting taxable profits in that country that are equal to or exceed an objective metric tied to sales revenue arising from customers there. A company could then show that its return from actual marketing and sales activities in a given country would be less than the fixed return under amount B, he added.
According to Doran Klein, one thing is for certain. “The OECD wants a global agreement and getting the U.S. into that agreement is critical. Other important economies are also critical for a successful global solution,” she said.
Staying the Course
Top officials involved in the ongoing negotiations at the OECD remained optimistic at a December 9 public consultation on pillar 2 of the digital economy work, which focuses on minimum taxation.
Martin Kreienbaum, chair of the OECD’s Committee on Fiscal Affairs and chair of the inclusive framework, said the key message from the exchange of letters was that “all countries remain committed to the OECD and inclusive-framework-led process, and everybody is committed to seek a coordinated international solution.”
Will Morris, deputy global tax policy leader at PwC and tax committee chair for Business at OECD, also remained optimistic. “It is my very strong belief that this does actually represent a re-commitment by the U.S. to this process,” he said. “And I think that we should continue to be committed to this process.”
Even if a safe harbor approach wouldn't give countries any enforceable new taxing right that's enforceable on taxpayers, it may still reallocate a significant portion of taxable profit to the extent that companies opt into the regime. The specific amount would be highly dependent on the safe harbor percentages selected — a high deemed routine return, a low percentage for allocating residual profit to market jurisdictions, or both could effectively exclude all profit from reallocation even for companies that opt in — and other quantitative features of the regime. Estimating this amount and its political acceptability is difficult, according to Jenn.
“You don't know exactly how many companies are going to elect in, and for the ones that do, how much that's going to [increase their] tax liability because they're moving income from lower-tax jurisdictions to higher-tax jurisdictions. It’s very hard to determine, but you have to figure that overall, not as much income is going to be reallocated under an optional system as under a mandatory system,” Jenn said. “And that could be a serious issue in terms of reaching any consensus agreement at the OECD because some countries clearly are looking to expand their existing taxing rights and probably aren't going to settle for something that may not give them additional taxing rights, at least with any degree of certainty.”
Mnuchin’s letter complicates the role of the Treasury officials who have been participating in the negotiations throughout 2019, according to Jenn. However, there is at least some chance that Mnuchin’s direct involvement will provide the spark necessary to move negotiations forward, he added.
“I think their role in the process changes with this development, and at some level that's appropriate,” Jenn said. “These are really fundamental questions for businesses, for countries, and for the world economy, and those types of questions should ultimately be the responsibility of elected politicians.”