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Pillar 1 Carveout Chaos

Posted on Jan. 13, 2020

In December U.S. Treasury Secretary Steven Mnuchin stunned the international tax community when he urged the OECD to turn its pillar 1 proposal for new international corporate taxing rights into an optional safe harbor provision instead of a mandatory regime. Mnuchin’s suggestion is among the many competing voices generating chaos around the development of pillar 1.

Stakeholders are sharply divided over whether the OECD’s international tax overhaul should apply to all businesses, or whether some industries and sectors merit a carveout. It’s a debate that has been going on since the OECD released the first part of its multilateral project, and a glance through hundreds of responses from the international tax community reveals divergent opinions that may never be fully reconciled.

The OECD is thinking about reallocating taxing rights for consumer-facing businesses, including both highly digital businesses and more traditional entities. The organization is also thinking about excluding non-consumer-facing sectors like commodities and extractives and requested stakeholder input on whether carveouts are necessary and what they might look like.

Some stakeholders are fine with a consumer-facing plan; others believe that business-to-business transactions should be included in the spirit of a truly inclusive overhaul. Some see merit in carving out sectors that have minimal base erosion and profit-shifting issues; others see carveouts as an invitation to undermine the OECD’s entire plan. Irrespective of the approach, a broad consensus is that the OECD cannot truly tackle the carveout question without clearly defining its underlying rationale and focus.

The proposal under consideration is not a consensus document among OECD members, and purposefully so: The OECD wanted to give stakeholders wide latitude to share their opinions and then use that feedback to shape a more coherent plan. However, the result has been feedback all over the place, particularly as commentators jockey for particular interests. The emerging plan could turn pillar 1 into a different animal with stakeholders convening at the OECD in January to negotiate.

The Heart of Pillar 1

The OECD is hoping to craft a unified approach to international taxation under the first part of its two-pillar project. Pillar 1 introduces a new nexus rule that looks largely at sales, not physical presence. New profit allocation rules extend beyond the arm’s-length principle and would allow market jurisdictions to apply formulas in cases in which the arm’s-length principle doesn’t work.

Specifically, the OECD is advocating a three-tier profit allocation mechanism that would allow market jurisdictions to tax multinationals on three different amounts, designated A, B, and C.

Amount A creates a new taxing right and allows market jurisdictions to tax a portion of a multinational group’s deemed residual profit via a reallocation scheme. That residual profit is the profit left over after allocating a deemed routine profit to the countries in which the group performs activities. For purposes of determining future carveouts, this new taxing right, its underlying rationale, and overall goal are extremely important.

Amount B is a fixed return on baseline distribution and routine marketing activities in a jurisdiction. Amount C is any amount that exceeds the fixed return under amount B — this allows market jurisdictions to tax activities that extend beyond the baseline, under the arm’s-length principle.

Pillar 1 is targeting large, consumer-facing businesses, but the OECD hasn’t fully defined what that means. The contours are up for discussion, and there are many that affect how potential carveouts may be defined, including whether and how franchise arrangements fit into that definition and how goods and services supplied through intermediaries and component product supplies might fit into the definition of consumer products or consumer sales. But the OECD has some initial ideas. It’s looking at companies that generate revenue from “customer engagement and interaction, data collection and exploitation, and marketing and branding.” That scope is large enough to capture highly digitalized businesses and businesses that rely on digital services to market their products and develop their consumer bases.

Suggested Carveouts and Concerns

Some industries and sectors may fall out of this consumer-facing scope, and the OECD is exploring what that might look like, although it has not provided substantial information about its rationales. The OECD says the extractive and commodities industries are assumed to be out of scope and that financial services may merit a carveout. In an October media call, OECD tax policy director Pascal Saint-Amans explained that a financial services carveout may be appropriate because the business-to-consumer portions of financial services pale in comparison to their business-to-business activity, and are “heavily regulated and not necessarily very profitable.”

No explanation has been offered for an extractives or commodities carveout, but they are presumably out of scope because source countries are the generally accepted taxing jurisdiction. That said, several commentators have highlighted flaws with this approach.

Yet to be explored is how potential carveouts for extractives and commodities and beyond may be gamed or negatively affect taxing rights. Martin Hearson of the International Centre for Tax and Development pointed out that potential extractives and commodities carveouts could serve as a double-edged sword for developing countries, because the carveouts may work in their favor in circumstances in which they do not have large consumer markets, but also blunt any new taxing rights. Nestlé SA questioned why mining companies, for example, should be considered out of scope when they may have opportunities to use businesses in low-tax jurisdictions to sell to their consumer markets instead of directly selling to local entrepreneurs in those destination markets.

Some commentators believe it is premature to discuss or assign carveouts until the rationale for amount A, and the OECD’s unified approach as a whole, is clear. As noted by PwC International, it appears pillar 1 is targeting highly digitalized businesses and business transactions in which the arm’s-length principle appears to be falling short.

“However, without further clarity about where the [arm’s-length principle] is considered not to be delivering the desired outcomes (i.e. is it related to generation of high profit margins, or is it related to the deemed value of the market?), there is a less principled basis for establishing carveouts,” PwC International said in its submission.

According to the Natural Resource Governance Institute, there are also design questions about how any carveout would apply to entities with multiple business activities, and whether it would encompass an entire value chain or would target a narrow portion, like extraction rights.

No Ring-Fencing

Others, like the Independent Commission for the Reform of International Corporate Taxation, are concerned that the OECD could ring-fence the economy by applying carveouts and focusing on business-to-consumer transactions instead of looking at all business transactions and sectors. That concern has united some parties with presumably differing interests. The South Centre, which is an intergovernmental organization of developing countries, believes that pillar 1 should apply to both the supply side and the consumer-facing side because both help generate profits. Furthermore, an inclusive approach may minimize administrative difficulties and reduce opportunities for disputes. Without that dual approach, developing countries stand to lose out on taxing rights because they host considerable production activities, according to the letter. Oxfam also believes that any special treatment will set up a de facto ring-fencing situation and lead to needless complexity, especially when multiple business lines are involved. Netflix said it cannot support an industry-specific carveout and cannot support a business-to-consumer carveout due to ring-fencing concerns and believes that neutrality would best be achieved by applying pillar 1 to all business transactions.

Special Treatment Is OK

On the other hand, several commentators believe that carveouts are necessary and appropriate if backed by the correct rationale. These commentators think the OECD could considerably broaden the carveout scope. The U.S. Chamber of Commerce suggested that the OECD extend carveouts to related activity, such as circumstances in which “substantially all” profits from a function come from a carved-out activity. The Tax Executives Institute suggested that the OECD consider whether business services in general, not just financial services should be carved out. Furthermore, scores of companies rose to the OECD’s call and explained why their sectors deserve carveouts from the unified approach. A sampling of those responses indicates that the arguments tend to fall into three buckets — the companies in question are not consumer-facing, already face high levels of regulation, or have a presence in the jurisdictions where they operate, by virtue of their business models.

Pharmaceutical

Many global pharmaceutical companies like AstraZeneca, Pfizer, Johnson & Johnson, and GlaxoSmithKline said prescription pharmaceuticals are so highly regulated that they cannot market in jurisdictions in which they do not have a physical presence. By and large, they also cannot directly advertise to consumers, except in the United States and New Zealand. Even in those countries, direct advertising does not necessarily drive sales, because the product must be appropriate for a patient’s medical needs and approved by an insurer, according to the companies. Additionally, governmental pricing regulations help drive pharmaceutical costs, not consumer demand. And the primary payers typically are insurers and government entities — not individual patients, as noted by GlaxoSmithKline. AstraZeneca added that research and development drives value creation, not marketing activities. These factors shift the pharmaceutical industry away from a typical consumer-facing industry and away from pillar 1, the companies said in respective letters.

“While the patient is of course key, they are neither the decision maker nor purchaser,” GlaxoSmithKline said. “In this way, the prescription pharmaceuticals business is ‘government-facing’ and ‘payer-facing,’ rather than ‘consumer-facing.’”

Commercial Vehicles

AB Volvo thinks pillar 1 should exclude commercial-facing businesses like the commercial vehicle industry because they tend to have a traditional physical presence in the jurisdictions in which they do business, and digital offerings tend to enhance and complement the traditional components of their businesses rather than usurping them. Ideally, consumer-facing businesses should fall under pillar 1 only when they have a lack of nexus in the jurisdictions in which they operate and rely on user data as an important value driver, according to the company, the parent of the Volvo Group.

Franchise Businesses

Fast food company Yum! Brands Inc. is very concerned about roping franchise businesses into pillar 1 because it believes that the business model meets international taxing standards. By their very nature franchisees like fast food restaurants cannot serve customers remotely and are subject to local taxes in the jurisdictions in which they are located, while Yum! is also subject to withholding taxes on royalties from franchisees. Requiring franchisors like Yum! to pay taxes under amount A combined with the withholding on royalties would cause double taxation, according to the company. InterContinental Hotels Group also flagged double taxation concerns vis-à-vis franchises.

Insurers

Several insurance industry groups argued that the sector’s business model and characteristics should also render it exempt from pillar 1. Some, such as Insurance Europe, believe the arm’s-length principle works appropriately as applied to insurers and reinsurers under OECD guidance. Insurance Europe and the Association of British Insurers wrote that the strict regulatory requirements and local nature of insurance and reinsurance work should qualify those businesses for an exemption. In the case of reinsurance, Insurance Europe noted that it is a service already subject to indirect taxation based on the location of risk.

Telecommunications

U.S. wireless industry association CTIA believes that enterprise telecommunications entities that provide services to businesses and governments should be exempt because they are not consumer-facing. Consumer telecommunications businesses should also be exempt because they are already highly regulated and must have a physical presence in the jurisdictions in which they operate, according to the organization. South Africa-based MTN Group also requested a carveout for telecommunications under the regulatory argument.

Semiconductors

The Semiconductor Industry Association (SIA) argued that its industry also deserves a carveout. SIA’s submission highlighted that the semiconductor industry — much like the commodities and extractive industries — has significant infrastructure requirements and very limited consumer-facing activities and sales. Even though some semiconductor companies do engage in consumer-facing activity, SIA believes the ultimate tax treatment should be based on the main nature of their businesses and qualify them for an exemption.

“Industries that are engaged in the manufacture of capital-intensive, tangible goods have not been the primary focus of the ‘digitalization’ of the economy,” SIA said.

What Constitutes Financial Services?

Although the OECD is considering a financial services carveout, it has not defined what “financial services” entails for pillar 1 purposes. The London-based International Banking Federation maintains that all regulated banking services should be excluded, including those that are consumer-facing, because their business models do not give rise to the tax issues presented by digital companies, like monetizing data from customers or creating sales in jurisdictions where they do not have licenses to do so, or regulatory oversight.

“While banks utilize technology to serve retail customers, it is not a business differentiator that generates abnormal profits that can be moved to low-tax jurisdictions,” the organization said in its submission. IBFD also urged the OECD to apply the carveout to more digital forms of regulated banking that arise in the future, like financial technology companies and other tech-dependent banking entities. The digital nature of such businesses is unlikely to pose tax problems given their regulatory scrutiny.

The British Private Equity and Venture Capital Association requested that any financial services carveout include private equity and venture capital businesses because investors in such funds are not consumers and do not receive goods and services from those vehicles — they receive interests in the entities. Even if the OECD decides against a financial services carveout, the definition of consumers for purposes of pillar 1 should exclude investors anyway, according to the organization.

Simplifying the Approach

Pillar 1 stresses the need for simplicity and neutrality, reflecting the OECD’s desire to implement the simplest solution possible. However, judging from the consultation responses, enumerated carveouts could betray that goal. If simplicity is an important policy agenda, the OECD may need to employ different tactics that could shift pillar 1 in a considerably different direction.

Some commentators advocate a local business exception: Unilever thinks the OECD should allow an exception in instances in which a business already files corporate tax returns in a jurisdiction, reports its taxable profits, and assumes full risk for its operations. Nestlé SA favors a business model approach in which business lines that operate in markets through local affiliates and recognize their activities and profits in those markets be excluded from amount A.

Oxfam and several other nongovernmental organizations favor a formulary apportionment approach in which:

  • full profits are allocated;

  • there is no distinction made between routine and non-routine profits; and

  • factors for profit allocation are assigned varying weights to accommodate differences among sectors.

If the OECD insists on sector-specific carveouts, some stakeholders have ideas as to how it can be enhanced. Nestlé SA believes that industries or entities that are carved out from the unified approach should also be excluded from any potential benefits, such as potential safe harbors, guardrails, or mandatory binding dispute prevention and resolution mechanisms.

“In other words, paying Amount A should be the condition to access those benefits,” Nestlé SA wrote.

Another option is to create a flexible list of factors that could justify a carveout, rather than a concrete list, according to the U.S. Chamber of Commerce. However, a flexible list could very well interfere with the OECD’s administrability and simplicity goals.

Several factors included in the U.S. Chamber’s suggested list strike at some of the supply chain issues raised by commentators, and include situations in which:

  • the taxpayer must have a physical presence for regulatory reasons;

  • the taxpayer legally cannot market directly to consumers;

  • the taxpayer sells a substantial amount to government programs at government rates, or is subject to legal restrictions on price changes;

  • the taxpayer directly sells industrial goods and services to entities that do not engage with individual consumers, like distributors, hospitals, other manufacturers, business entities, and governments;

  • substantially all profits from a particular line of business come from one jurisdiction;

  • the taxpayer’s product is a component of another product and as such, is not consumer-facing; or

  • the taxpayer’s customer is temporarily in the taxing jurisdiction and is relying on the taxpayer’s in-country supplier.

All these proposals and commentary leave a lot for the OECD to consider in the coming weeks and months, as the organization is working with a particularly tight deadline. The OECD is hoping to agree on the outlines of its unified approach this month in order to deliver a concrete solution by the end of 2020.

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