Chand, V.

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1Kluwer International Tax Blog - 1 / 7 - 03.11.2021Kluwer International Tax BlogImpact of Pillar I on Centralized Consumer Facing (Goods)Business  Models:  An  Initial  Assessment  Through  anIllustrationVikram Chand  (Managing  Editor)  (Tax  Policy  Center  of  the  University  of  Lausanne,Switzerland) · Thursday, February 27th, 20201. Purpose of the contributionThe purpose of this contribution is to address the impact of the Pillar I debate onprincipal structures or centralized business models. The tentative assessment will bemade in light of the “ongoing work” of the OECD with respect to the digitalization ofthe economy[1].2. Illustration of a typical centralized business modelThe concept of a principal structure or centralized business model has already beendiscussed by the author in  another contribution.  A typical  structure that  is  usedrelates to a case where an MNE (MNE Group X hereafter), which has its parent in onejurisdiction,  sets  up  a  centralized  business  in  another  jurisdiction.  For  example,consider the situation of Company R in Country R that has developed all trade andmarketing intangibles. Company R sells its products in the State R market. For itsoverseas operations (for instance,  European operations)  Company R establishes acentralized business model (Company P – a principal entity) in Country P. Company Rlicenses its intangibles (IP) to Company P. Company P employs the intangibles for itsoperations  and  derives  business  income.  Company  P  then  pays  an  arm’s  lengthamount of royalties to Company R (other variants of such royalty arrangements arealso possible)[2].Further, assume that Company P, which makes use of toll manufacturers in othercountries to process its goods, sells its finished products in three countries. In countryS1, the products are sold on a remote basis. As a permanent establishment (PE) doesnot exist in that country (under the current nexus rules), Company P is not subject tocorporate taxation therein. In country S2, the products are sold through a limited riskdistributor (LRD). Assume that the arm’s length compensation of the LRD amounts to2% on sales. In country S3, the products are sold through a full-fledged distributor(FFD). For the purposes of this example, assume that the FFD reports a taxable profitthat amounts to 8% on local sales. This profit is at arm’s length. The structure isdepicted in the diagram below.2Kluwer International Tax Blog - 2 / 7 - 03.11.20213. Amount A of the Unified approachThe overall objective of the Pillar I debate is to allocate additional taxing rights tomarket countries. In our example, this would be Country R, S1, S2 and S3. This said,the sales made in Country R will not be analyzed in this contribution. In order to do so,three amounts are proposed in the unified approach viz, Amount A, Amount B andAmount C.Amount A, which is an add on to the existing nexus and profit allocation system, seeksto re-allocate profits on the basis of a pre-determined formula linked to MNE Groupprofits, including to countries where no physical presence exists. To understand theapplication of this approach, consider the following further facts of MNE Group Xwhich  operates  only  one  “in  scope”[3]  consumer  facing  business  line  such  asconsumer electronics.According to its consolidated financial statements for year 2020, MNE Group X has:(1)  consolidated  group  operating  revenue  =  $1  billion[4]  and  (2)  consolidatedexpenses = $600 million. Therefore, the Group profits (3) amount to $400 million. Thisamount (3) represents the Groups Earning or Profit Before Taxation (EBT or PBThereafter).Also, assume that the Group generates ten percent of its global revenue from CountryS1 ($100 million), twenty percent of its global revenue from Country S2 ($200 million)and thirty percent of its global revenue from Country S3 ($300 million). The balancerevenue  is  generated  from  Country  R.  Let  us  also  assume  that  MNE  Group  Xgenerates similar revenues during the past three years from each market jurisdiction.Moreover, it invests heavily in Advertising, Marketing and Promotion related activitiesin all  these jurisdictions.  Accordingly,  it  is  considered to satisfy the new “nexus”test[5] and is considered to have “significant and sustained engagement” in eachCountry. In order to allocate profits to market countries, the deemed residual profitsplit method[6] would apply as follows:Step 1: The Group EBT amounts to $400 Million and EBT margin amounts to 40%(EBT / operating revenues).3Kluwer International Tax Blog - 3 / 7 - 03.11.2021Step 2:  The deemed routine EBT margin is  fixed at  10% (through multilateralnegotiations) and thus 30% will be deemed to be non-routine EBT margin.Step 3: The non-routine EBT margin of 30% is split between production activities /intangibles (80%) and market activities / intangibles (20%). This split is also agreedthrough  multilateral  negotiations.  Essentially,  6%  of  the  EBT  margin  will  beallocated to market related activities. Step 4:  X Group’s market related profits is determined to be 6% of the overallrevenues, which amounts to $ 60 Million ($ 1 Billion*6%). The reallocation will workas follows: Country S1: As ten percent of the global sales are derived from Country S1 itwill be allocated USD $ 6 Million (60*100/1000 = 6) of that profit.Country S2: As twenty percent of the global sales are derived from CountryS2 it will be allocated USD $ 12 Million (60*200/1000 = 12) of that profit.Country S3: As thirty percent of the global sales are derived from Country S3it will be allocated USD $18 Million (60*300/1000 = 18) of that profit.Ideally, the Amount A deemed profit should be taxable at ordinary corporate tax ratesapplicable in each jurisdiction. However, given the fact that countries are sovereign, itmay well be possible that some countries could enact a higher tax rate for the AmountA profit or may not tax that deemed profit at all. This is one issue which the OECD willneed to look into.Also, with respect to Country S3, it should be noted that in the public comments, someMNEs (for instance, Johnson & Johnson) as well as other commentators have arguedthat Amount A should not be applicable in countries in which an MNE operates FFDsas those entities book a part of the residual profits[7]. Keeping that debate aside andassuming that  the amount  is  also  payable  in  countries  where FFDs operate,  thequestion then arises as to which Country would alleviate double taxation for the taxespaid in the market countries?The  first  issue  pertains  to  identification  of  the  relevant  taxable  person.  As  theobjective of Amount A is to reallocate a part of the residual profits to the marketcountries, we believe that the relevant taxpayer(s) to whom the Amount A liabilityshould be allocated is/are the entities in the MNE Group that book residual profitsunder the current transfer pricing rules[8]. In our example, two entities can surely beconsidered to be the owner of non routine or deemed residual profits as they will becharacterized as “entrepreneurs” for transfer pricing purposes. This would imply thatboth Country R (Company R) and Country P (Company P) could provide the relief forthe Amount A tax paid in Country S1, Country S2 and Country S3. The relief could bedivided in a predetermined proportion (based on sales or profit margins). This said,the FFD could also be characterized as an “entrepreneur” and there could be overlapsbetween Amount A and Amount C. The issue is addressed subsequently.The second issue pertains to which method should be used by Country R or Country Pto alleviate double taxation. Several commentators to the public consultation on PillarI argued for a corresponding adjustment system[9]. However, in our opinion, thatmethod is not suitable because “Amount A is not premised on there being identifiable4Kluwer International Tax Blog - 4 / 7 - 03.11.2021transactions between particular group entities”[10]. Thus, we express a preference fora  traditional  method such as  the  credit  method or  new methods  that  are  beingexplored such as “methods based on specific deductions or allowances that are notpremised  on  identifiable  transactions  could  be  contemplated,  such  as  exemptionmethods”[11].4. Amount B and C of the Unified approachAmount B seeks to determine a fixed return ‘based on the arm’s length principle’(ALP) for low risk baseline distribution and marketing activities in order to enhancetax  certainty[12].  In  fact,  such  an  approach  is  already  followed  by  the  taxadministration in Israel, albeit in the form of a safe harbour. Moreover, the Israeliapproach contains a detailed discussion on the type of activities that can be classifiedas low risk distribution and marketing activities. Thus, references could be made totheir guidance to derive a definition of distribution / marketing activities that could bewithin the scope of this proposal. In our example, Amount B is relevant for fixing thearm’s length remuneration for the LRD in State S2.Also,  contrary to the approach followed in Israel,  we are of the opinion that thedifferent margins need to be proposed for different businesses. In our experience, themargins applied for low risk distribution / marketing activities differ from industry toindustry and business to business. Thus, a range of arm’s length margins will need tobe put forward. It should be noted that these activities should not amount to i) ‘uniqueand valuable contributions’, especially, activities that create valuable local intangibles;ii) be classified as ‘highly integrated’ operations, or iii) lead to ‘shared assumption ofeconomically significant risks’ or ‘separate assumption of closely related risks’[13]. Ifthey do, then the activities need to be analysed under Amount C.Amount C seems to apply to FFDs. One could, once again, refer to the guidanceprovided by the tax administration in Israel to understand the concept of a FFD.Moreover, a reference could be made to the various ‘watch’ examples found in thetransfer pricing guidelines (Examples 8-13 – Annex to Chapter VI). In many situations,local FFDs could also be booking residual profits especially, a part of profits linked tomarketing intangibles (trademarks or tradenames) or market related features (marketpremiums as discussed in China). Thus, there could be an overlap between Amount Cand Amount A (which also seeks to reallocate a part of the residual profits to themarket countries)[14].Coming back to our example, in Country S3, the products are sold through a FFD,which reports an arm’s length operating margin of 8% on sales (this amount could bebased on a comparability study or could have been agreed in an Advance PricingAgreement). Based on the above example, the Amount A taxable base in Country S3 isUSD 18 million. The Amount C taxable base, as per the current transfer pricing rules,is equal to 8% on local sales. This amounts to USD 24 Million (300*8/100 = 24).To a certain extent there is an overlap between Amount A and Amount C. Thus, inorder to reduce this overlap, one possibility would be to start with Amount C (USD 24Million). Amount A (USD 18 Million) could then be compared to the Amount C. As thelocal entities actual taxable profit, which also includes a part of the residual profit, is5Kluwer International Tax Blog - 5 / 7 - 03.11.2021higher than deemed taxable profit no taxes will be required to be paid on Amount A.Another possibility is to reduce from Amount A, an amount that is linked to nonroutine margins. Assume that routine ALP margin for low risk distribution / marketingfunctions is fixed at 4% on sales (Amount B). Thus, the amount that will be reducedfrom Amount A will be linked to the non routine margin, that is, 4% on Country S3sales which amounts to USD 12 Million (300*4/100=12). Thus, the taxable amountunder Amount A in Country S3 amounts to USD 18-12 = USD 6 Million[15].To summarize, the situation of the centralized business model will be as follows postthe Pillar I re-allocation exercise (tentative assessment):5. Dispute prevention and resolutionWith respect to Amount A, we strongly believe that the focus should be on disputeprevention mechanisms. For instance, multilateral competent authority arrangementsshould be developed which would reflect a common understanding of several issues inthe proposal. This said, the proposal will also need to be backed by a mandatorybinding  arbitration  system  for  issues  that  will  not  be  resolved  by  the  disputeprevention mechanism[16]. The mandatory binding arbitration system will need to beaccepted by both developed and developing countries.With respect to Amount B and C, the focus should also be on enhancing the existingdispute prevention framework such as by encouraging the use of multilateral APAs orenhancing  the  participation  of  countries  in  the  ICAP  project.  Overall,  efficientprevention and dispute mechanisms will need to be developed in order to ensure thatthe proposal is successful. The author would like to thank Mr Stefaan De Baets (PwC) for his inputs on thiscontribution. The author would also like to thank Gabriel Candil, Yvan Mollier andFabio De Angelis (all working with large MNEs) for their comments. 6Kluwer International Tax Blog - 6 / 7 - 03.11.2021[1]  For  a  more  recent  update  on  this  topic,  see  OECD/G20,  Statement  by  theOECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address theTax Challenges Arising from the Digitalisation of the Economy, January 2020.[2] For example, Company R could also own a Group IP Holding Company. The IPHolding company, which performs the DEMPE related activities, could then licensethe IP to Company P.[3] The proposal is applicable to businesses that carry out Automated Digital Services(ADS) or businesses that are consumer facing businesses. For a discussion on thescope, see OECD/G20, supra n. 1, paras. 14-32.[4]  It  is  expected that Amount A will  only apply to MNE Groups whose revenueexceeds Euro 750 Million. For a discussion on the revenue threshold, see OECD/G20,supra n. 1, para. 35.[5] For a discussion on the new nexus, see OECD/G20, supra n. 1, paras. 36-41.[6] For a discussion on Amount A, see OECD/G20, supra n. 1, paras. 42-47. For adetailed discussion on this method, see V.Chand,  Allocation of Taxing Rights in theDigitalized Economy: Assessment of Potential Policy Solutions and Recommendationfor  a  Simplif ied  Residual  Profit  Split  Method,  Intertax  available  onhttps://www.kluwerlawonline.com/abstract.php?area=Journals&id=TAXI2019106[7] Public Comments, Johnson and Johnson, p. 5; See Public Comments, Skadden, p. 4.[8] For a discussion on relief from double taxation, see OECD/G20, supra n. 1, paras.48-52.[9] Public Comments, Uber, p. 10; Public Comments, Amazon, p. 8; Public Comments,Nestle, p. 12; Public Comments, Skadden, p. 6; Public Comments, Digital EconomyGroup, p. 5; Public Comments, KPMG, p. 13; Public Comments, EY, p. 13. Thesec o m m e n t s  a r e  a v a i l a b l e  o nhttps://www.dropbox.com/s/3pb98p1o3qnz3me/oecd-public-comments-secretariat-proposal-unified-approach-november-2019.zip?dl=0[10] See OECD/G20, supra n. 1, para. 50.[11] See OECD/G20, supra n. 1, p. 15.[12] For a discussion on Amount B, see OECD/G20, supra n. 1, paras. 58-64.[13] OECD, Revised Guidance on the Application of the Transactional Profit  SplitMethod, OECD/G20 Base Erosion and Profit Shifting Project (OECD 4 Jun. 2018).[14] See OECD/G20, supra n. 1, paras. 56-57.[15] Also see Public Comments, Skadden, p. 4.[16] See OECD/G20, supra n. 1, paras. 65-82.7Kluwer International Tax Blog - 7 / 7 - 03.11.2021________________________To make sure you do not miss out on regular updates from the Kluwer InternationalTax Blog, please subscribe here.This entry was posted on Thursday, February 27th, 2020 at 3:37 pm and is filed underDigitalization, OECD, Pillar IYou can follow any responses to this entry through the Comments (RSS) feed. 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Impact of Pillar I on Centralized Consumer Facing (Goods) Business Models: An Initial Assessment Through an Illustration

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Impact of Pillar I on Centralized Consumer Facing (Goods) Business Models: An Initial Assessment Through an Illustration

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