What is BEPS 2.0?
In 2013, members of the OECD/G20 began to review the digital economy as part of the Base Erosion and Profit Shifting ("BEPS") Action Plan. Their primary aim was to allow the fair taxation of profits generated by businesses without a physical presence in the relevant market jurisdictions by introducing new nexus and profit allocation rules.
Since then, the digital economy has continued to evolve at a breakneck pace, with industry-agnostic functions from digital platforms to data analytics shifting value creation across international borders. This trend shows no signs of abating and is only accelerated by the latest Covid crisis, having expanded a presence into almost every industry which makes it increasingly challenging to ring-fence.
Following an interim report, on 29 January 2019, the OECD published a policy note on new proposals to combat the BEPS activities of multinational companies, which was referred to as „BEPS 2.0". One and a half years later, on 12 October 2020, after a series of policy notes and public consultations, the OECD published blueprints for Pillar One and Pillar Two, together with accompanying documentation including an economic impact assessment.
Pillar One aims at developing an approach for establishing taxable presence ("nexus") in the digitalised and consumer-facing economy. Pillar Two introduces the concept of a global minimum profit tax.
The updated blueprints provide detail on the technical design and features of each pillar, identify areas that require further technical work prior to finalization, and also highlight aspects where political agreement will be necessary. As the OECD documents make clear, the Blueprints do not reflect agreement by the member jurisdictions of the Inclusive Framework on BEPS, as there are political and technical issues that still need to be resolved. However, the cover statement of the Inclusive Framework refers to the Blueprint as a "solid basis for future agreement". It states that the member jurisdictions have agreed to swiftly address the remaining issues to bring the process to a successful conclusion by the ambitious deadline of mid-2021.
A broad consensus will be critical to avoid ongoing unilateral action by many jurisdictions. As will be noted, the scope of BEPS 2.0 is significantly broader than European Union-style digital services taxes ("DSTs"). Based on an impact assessment performed by the OECD, Pillar One and Pillar Two could increase global corporate income tax revenues by about US$ 50-80 bn per year, and up to US$ 100 bn taking into account the impact of the Global Intangible Low-Taxed Income (“GILTI”) regime in the US. While this may enable political consensus of governments to repeal DSTs, it may also increase pushback from businesses based in the administrative and tax costs envisaged.
Overview of Pillar One
The aim of Pillar One is to reach a global agreement on adapting the allocation of taxing rights on business profits in a way that expands the taxing rights of market jurisdictions. In order to achieve this, Pillar One contains three elements:
- Amount A: A new local market jurisdiction right to tax a proportion of (deemed) residual profits of a multinational enterprises group ("MNE") or segment of such a group associated with sustained and significant participation in that jurisdiction.
- Amount B: The standardization of the remuneration of related-party distributors that perform 'baseline marketing and distribution activities', aligned with the arm's length principle ("ALP").
- Tax Certainty: A dispute prevention/resolution mechanism, likely to require an 'innovative solution' to ensure agreement between tax administrations as to how Amount A applies to a group.
Pillar One – Amount A
The following building blocks have been identified as essential to the construction of Amount A:
- Scope: The new taxing rights under Amount A only apply to MNEs that fall within the defined scope of "activity tests" and "threshold tests":
- Activity tests capture those MNEs that can participate in "an active and sustained manner" in the economic life of a jurisdiction, with or without local physical operations. This covers MNEs with activities that fall in either or both automated digital services ("ADS"), and Consumer-Facing Businesses ("CFB").
- Threshold tests include the annual consolidated group revenue threshold (potentially EUR 750 million), and secondly, a local de minimis threshold for foreign in-scope revenue.
- New taxable presence/nexus: The new nexus rules determine entitlement of a market jurisdiction to an allocation of Amount A only, and does not create a nexus for any other purpose, e.g., customs duties or other taxes.
- Revenue sourcing: The revenue sourcing rules are aimed to determine the revenue that should be treated as derived from a particular market jurisdiction, including sourcing principles and defined hierarchies of indicators reflective of specific types of in-scope activities. They reflect the particularities of ADS and CFB.
- Tax base determination: The tax base will be quantified using an adjusted Profit Before Tax ("PBT") from the consolidated Profit and Loss statement, with adjustments such as adding back any income tax expense. The Blueprint also covers a loss carryforward regime to ensure only economic profit is reached, with an earn-out mechanism to offset past losses against future profits. Furthermore, for some MNEs, it may be necessary to compute the Amount A tax base on a segmented basis (segmentation by business line or geography).
- Profit allocation: Amount A will be determined based on a three-step formula approach that is not necessarily in line with the arm's length principle.
- Elimination of double taxation: The new taxing right and existing profit allocation rules will be reconciled by identifying the relevant jurisdictions in order to apportion Amount A tax relief among market jurisdictions equitably. In addition, the Blueprints envisages potential safe harbors to reflect situations where residual profits are already allocated, relying on existing ALP-based rules, thus avoiding double-counting issues.
Pillar One – Amount B
Amount B will standardize the remuneration of related party distributors that perform "baseline marketing and distribution activities" in the market jurisdiction. Further, the activities in scope are first defined by a 'positive list' of typical functions performed, assets owned and risks assumed at arm's length by routine distributors and vice-versa by 'negative list'. Quantitative indicators would further support the identification of in-scope activities.
It should be noted that Amount B is intended to approximate results determined in accordance with the ALP. Amount B will apply to entities or PEs with existing nexus, and as such is not related to the new nexus rules of Amount A. Importantly, the scope limitations of Amount A relating to the activity tests and threshold tests are not applicable to Amount B.
Pillar One – Increased tax certainty
The Blueprint states that "tax certainty is a key component" of Pillar One and therefore, "innovative dispute prevention and dispute resolution mechanisms" are necessary. For this reason members of the Inclusive Framework agreed that in the event a dispute (i) related and (ii) beyond to Amount A might arise, appropriate mandatory binding dispute resolution mechanisms would be made available to MNEs.
Who will Pillar One affect?
Whilst certain details on thresholds and application are still to be confirmed, companies can already foresee how the rules may impact them and prepare accordingly. The following elements should be considered:
- Companies with revenues above the CbCR threshold: Pillar One will likely apply a threshold for application, for instance, a consolidated group revenue of EUR 750 million after an initial higher threshold. A minimum foreign source in-scope revenue of EUR 250 million is also likely to apply.
- Companies with automated digital services: These are companies with online advertising services, sale of user data, online search engines, social media platforms, online intermediation platforms, digital content services, online gaming, standardized online teaching services, and/or cloud computing services.
- Consumer-facing businesses: These are companies with revenues from the sale of types of goods or services commonly sold to individual consumers and/or businesses that license or otherwise exploit intangible property connected to such goods or service. These include companies operating through third-party intermediaries, via franchise models, and/or by way of licensing arrangements.
Pillar I will likely exclude companies in the extractive industries, financial services, infrastructure (including residential real estate), international air and shipping. The FinTech and pharmaceutical sectors may potentially remain in scope
How will companies be impacted by Pillar One?
Pillar One is expected to reallocate taxing rights to income of over US$ 100bn of profits between jurisdictions. Based on the latest blueprints, it could have the following implications:
- Relocation of taxable revenues from investment hubs and high income jurisdictions to lower income economies: Based on the latest prognosis from the OECD, the additional revenue allocated to market jurisdictions from Pillar One would likely result in a reduction in revenues and allocated profits to investment and principal hubs. Conversely, on average, low and middle-income economies would gain relatively more revenue than advanced economies from Pillar One.
- New nexus rules could impact companies with limited presence: Companies with ADS would be subject to tax under Pillar One regardless of local presence (or lack thereof), if they meet a revenue threshold, currently suggested at EUR 5m. For CFBs, this would also require "physical presence" in the form of a subsidiary or permanent establishment ("PE") in the market jurisdiction, as well as additional activities linking activities of the group to market revenues. These could include facilitating billing and payment in the local currency, collecting indirect taxes and duties, transportation, maintenance of local stock, cross border delivery, after-sales support, etc.
- Companies may require additional capabilities to track and segment source revenues: MNEs would need to identify different revenue streams for ADS and CFB, and then determine their source location. MNEs would be required to apply lists of specific indicators (e.g., geolocation, IP address, country code of user’s phone number) in a strict hierarchical fashion. Information would be regarded as unavailable if it is not in the MNE’s possession and reasonable steps have been taken to obtain it, without success.
Overview of Pillar Two
The Pillar Two Blueprint presents details on the design of global minimum tax regimes which operate independently to ensure minimum levels of taxation for MNEs:
- A global minimum tax regime referred to as the Global Anti-Base Erosion ("GloBE”) proposal is applied through the Income Inclusion Rule ("IIR") and Undertaxed Payment Rule ("UTPR"), with support from the Switch-Over Rule ("SOR") as required.
- The Subject to Tax Rule ("STTR") ensures a minimum level of tax on a payment-by-payment basis between related parties, where the recipient country has a nominal tax rate less than a minimum tax rate.
These are covered in further detail below:
- GloBE - Income Inclusion Rule: This operates as a global minimum tax to reduce the incentive to allocate income to low taxed entities. It will apply a "top-up" tax to the parent company based on taxable income of foreign subsidiaries and permanent establishments if that income was subject to tax at an effective tax rate ("ETR") below a "minimum rate".
Whenever a jurisdiction has been identified as undertaxed, the difference between its ETR and the minimum rate, expressed as a percentage, would be applied to the share of the undertaxed income of the parent company.
- GloBE - Undertaxed Payments Rule: This targets so-called 'undertaxed payments'. It is intended to complement the IIR (which has priority) by protecting the source payer’s jurisdiction from base eroding payments. It denies deductions or imposes source-based taxation (incl. withholding taxes) for payments to a related party if that payment was not subject to tax at a "minimum rate".
- GloBE - Switch-Over Rule: The SOR would enable countries to overturn treaty obligations which exempted amounts attributable to a foreign permanent establishment. This would result in exempt branches being viewed as constituent entities under the GloBE rules, ensuring that their taxable income could not be 'blended' with the higher-taxed income in the 'Head Office' jurisdiction. Applied with the IIR, in the case that no entity in the chain of ownership is resident in a territory that has implemented the IIR, taxing rights of the branch could be allocated to the head office jurisdiction.
- Subject to Tax Rule: This is applied between connected parties and to a defined set of payments (i.e. interest, royalties, and "high risk service payments"). It disallows tax treaty benefits if the item of income was not subject to tax at a minimum rate.
The Blueprint recognizes that there may be member jurisdictions that will not implement the Pillar Two rules, but that all jurisdictions which do are expected to apply them consistently. It also notes the importance of the STTR to a large number of member jurisdictions, particularly developing countries, and states that such a rule will be an integral part of a Pillar Two agreement.
The Blueprint calls out the need to reach agreement on the basis on which the US GILTI rules are to be treated as a Pillar Two compliant income inclusion rule. The Blueprint further indicates that the Inclusive Framework recognizes that agreement on the co-existence of the GILTI rules and the GloBE rules need to be part of a political agreement on Pillar Two. Further consideration will be given to the technical aspects of the coordination between these rules, which will include consideration of the GILTI rules to US intermediate parent companies of foreign groups that are headquartered in countries that apply the IIR.
The Blueprint notes that the treatment of the GILTI rules as compliant with Pillar Two will need to be reviewed if legislative or regulatory changes were to materially narrow the GILTI tax base or reduce the tax rate. Concerning the UTPR that is intended to operate as a backstop to the IIR under Pillar Two, the Blueprint further notes that the Inclusive Framework "strongly encourages" the US to limit the operation of the Base Erosion and Anti-abuse Tax ("BEAT") in the case of payments to entities that are subject to a Pillar Two income inclusion rule.
The Blueprint acknowledges that both the STTR and the SOR would require changes to existing bilateral tax treaties. These could be implemented through bilateral negotiations and amendments to individual treaties or more efficiently through a multilateral instrument. Mutual agreement procedures could then apply to any disputes arising.