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On 8^th October 2021, the OECD/G20 Inclusive Framework on BEPS issued a revised statement outlining, inter-alia, the Pillar One consensus plan, defining the scope for Amount A under Pillar One, which covers multinational enterprises (MNEs) with consolidated revenues above EUR 20 billion and 10% profit margins, with a 25% allocable quantum for MNEs’ excess profits to market jurisdictions. In an ideal scenario, this should not create an additional tax burden. However, based on OECD’s economic analysis estimate, the introduction of Pillar 1 could re-shift up to USD 100 billion to market jurisdictions.

Following the agreement reached in October 2021, the Inclusive Framework issued, on 4^th February 2022, Pillar One – Amount A: Draft Rules for Nexus and Revenue Sourcing (“Draft Model”). This is a public consultation document outlining the first building blocks under Pillar One, i.e. the nexus and revenue sourcing for which public input is solicited no later than 18^th February 2022. The Draft Model  is in a preliminary version which has not yet reached consensus, which is why stakeholder input is requested, with an aim to assist members of the Inclusive Framework to finalize the rules.

The nexus test is satisfied for a period (expected to be 12 months) if the revenues (derived from third parties) of the covered MNE arising in a market jurisdiction are equal to or greater than EUR 1 million for jurisdictions with annual GDP equal or greater than EUR 40 billion or EUR 250 thousand for jurisdictions with annual GDP less than EUR 40 billion. Revenues are defined as total revenues of an MNE group after the exclusion of revenues derived from exclusions of extractives and financial regulated services.

Important questions are still unanswered, such as how financial information will be adjusted to determine the tax base for the purpose of the Pillar One and what are the definitions of “extractives” and “regulated financial services” for purpose of the scope of Amount A. 

The Draft Model provides a sourcing principle for each type of revenue and a list of specific indicators to apply the relevant principle to identify the jurisdiction of the source. The basis of the revenue sourcing rules is to allow MNEs to determine the market jurisdictions from which revenue is sourced, based on the location where goods or services are used or consumed.

Details are provided to identify the end market revenues for specific categories of transactions, such as:

• Sale of finished goods
• Sale of digital goods
• Sale of components
• Provision of services (i.e., location-specific services, advertising services, online intermediation services, transport services, customer rewards services, financing, business-to-consumer services, business-to-business services)
• Licensing, sale, or alienation of intangible property
• Sale, lease, or alienation of real property
• Government grants
• Non-customer revenues

The place/market where revenues are sourced seems to be the location of the customer or consumer. For example, a lease of tangible property (situated in international waters or airspace) during the term of the lease, shall be deemed to generate revenues at the location of the customer where the service (using the tangible property) is performed. Similarly, revenues derived from provision of air transport services are deemed to arise in the destination jurisdiction.

Whilst the commentary is expected to explain the transaction-by-transaction approach, the intention of setting different rules for different categories of transactions is to allow MNEs to take their commercial context into account for revenue sourcing purposes, whilst also ensuring consistency and completeness from a policy perspective, in a manner that is applicable to all types of MNEs.  The transaction is the item that generates income, and to the extent that there are different items on one contract that generates income, the allocation must be in proportion with the revenue earned in each market, rather than the transaction split.  

In cases when transactional information is not available to the MNE or it would be very difficult and impractical to obtain it (for example in cases where sales are conducted through independent distributors, in the case of sales of components, and business-to-business services), the rules allow the use of allocation keys as a simplified way to approximate the end market and ultimately minimize compliance burdens. The allocation keys apply to the remaining portion of the revenue that cannot be sourced at transactional level. Revenues will be sourced using a ‘Reliable Method’ (using a Reliable Indicator – information that identifies the source of revenue, or an allocation key, if a Reliable Indicator is not available), based on the MNE’s facts and circumstances.

The Draft Model also states that the revenue sourcing rules will need to be supported by a detailed record-keeping process to facilitate a review of the MNEs’ approach to revenue sourcing, and therefore it is expected that the MNEs will implement internal controls on their approach to revenue sourcing, including data sourcing. 

Under Pillar One, profits will be allocated to market jurisdictions. Therefore, potentially, profits of MNEs headquartered in the Middle East (such as the UAE) could be reallocated to jurisdictions with higher tax rates, to the extent those are jurisdictions where the majority of customers/consumer of services/goods provided by these MNEs are located. For MNEs headquartered in the Middle East such as the UAE, if profits move out of the UAE due to the application of Amount A, this will likely result in a higher effective tax rate (“ETR”) for the MNE group. This may therefore trigger the need to consider long term contract pricing, existing transfer pricing models and/or whether it even makes economic sense to continue to service specific jurisdictions.

On the other hand, Amount A could also allocate further taxable profits of non-Middle East headquartered MNE groups to the Middle East, to the extent the Middle East is a high consumer of products/services.  

For a handful of Middle Eastern groups that are meeting the EUR 20b revenue threshold (including groups that operate in the oil & gas industry and have regulated financial services as part of their organization), it is important to monitor these developments, conduct impact assessments to understand whether they fall under these rules and how the revenues would be re-allocated to market jurisdictions, and prepare for their application. This will require careful review of the systems and internal control frameworks already in place to ensure, a practical approach can be taken where possible, rather than having to analyze revenue sourcing on a transactional line basis.

Moreover, MNE groups falling within the scope of Pillar 2 should also monitor developments carefully given the expectation that many tax authorities may seek to implement the principles of Pillar 1 into their future transfer pricing audits and challenges (for example, using formula apportionment principles).