Implications for Transfer Pricing: BEPS 2.0 and U.S. International Tax Reform Proposals
Multinational Enterprises (MNEs) Need to Prepare For Changes in Tax Rules
By Mandy Li, Transfer Pricing Managing Director at MGO, and Shuang Feng, Transfer Pricing Senior Manager at MGO
Multinational enterprises (MNEs) need to prepare for the changes in tax rules that are coming as soon as mid-year. The Organization for Economic Co-operation and Development (OECD) is working on the global tax rules overhaul of the Base Erosion and Profit Shifting (BEPS) 2.0. The Biden administration is also rolling out new tax proposals in the United States. The result of all these changes means a challenging tax environment for the foreseeable future.
OECD BEPS 2.0 overview
The OECD/G20 Inclusive Framework on BEPS released Blueprints on Pillar One and Pillar Two. The Blueprints address the tax challenges of the digitalization of the economy and propose fundamental changes to global tax rules. All multinational businesses will feel the impact of the changes.
BEPS 2.0 contains two parallel elements: Pillar One would revise profit allocation and nexus rules to allocate more taxing rights to market countries. Pillar Two would establish new global minimum tax rules to ensure that all business income is subject to at least a minimum level of tax.
The application of Pillar One rules is limited to MNEs that have a consolidated revenue above €750 million ($914 million) and also have in-scope revenues outside the domestic market above a threshold that is not yet defined. The three basic elements of Pillar One:
• A new taxing right for market jurisdictions based upon a share of a business’ residual profits (Amount A)
• A fixed return for certain distribution and marketing activities physically in a market jurisdiction (Amount B)
• Enhanced dispute prevention and resolution mechanisms to improve tax certainty
What is Amount A?
Amount A grants market jurisdictions new taxing rights using a formula that is not based on the arm’s length principle. Taxing rights are based on an active and sustained engagement in a market jurisdiction rather than a company’s physical presence. The two broad sets of businesses subject to Amount A are consumer-facing businesses (CFB), and automated digital services (ADS).
The Amount A formula is made up of three distinct components:
• A profitability threshold will isolate residual profits potentially subject to reallocation.
• A reallocation percentage will define the share of residual profits (actual profits minus the profitability threshold) or allocable tax base of the market jurisdictions.
• An allocation key will be used to allocate the tax base among the eligible jurisdictions.
The Blueprint does not yet define the profitability threshold or reallocation percentage threshold, but these will be determined through additional work by the Inclusive Framework.
What is Amount B?
Amount B has two goals. First, it is intended to simplify transfer pricing rules for tax administrations and reduce compliance costs for taxpayers. Second, it is intended to reduce disputes between tax administrations and taxpayers.
Amount B attempts to set a standard baseline return for routine marketing and distribution activities. The transactional net margin method will be used to determine Amount B and the remuneration for the baseline activities. Amount B would be implemented through domestic law, and the Blueprint indicates that existing treaties can resolve disputes, but where there is no treaty in place, a new treaty-based dispute resolution mechanism may be required.
New rules establish a framework of minimum taxation for multinationals
Pillar Two Blueprint introduced several new rules to establish a global framework of minimum taxation, which only apply to MNE groups with a total consolidated revenue above €750 million.
• The income inclusion rule (IIR) operates as a top-up tax when income of controlled foreign entities is taxed below an effective minimum tax rate.
• The switch-over rule (SoR) complements the IIR by removing treaty obstacles in situations where a jurisdiction uses an exemption method that could frustrate the application of a top-up tax to branch structures.
• The undertaxed payments rule (UTPR) serves as a backstop to the IIR through application to certain constituent entities; the top-up tax computation is the same as under the IIR.
• The subject-to-tax rule (STTR) would help countries protect their tax base by denying treaty benefits for deductible payments made to jurisdictions with low or no taxation from related parties of the same consolidated group of businesses.
Biden international tax proposals
The Biden administration has responded to the OECD BEPS 2.0 and has also proposed changes for U.S. tax policy. Biden’s proposals were aimed at helping fund his $2.25 trillion infrastructure plan with a big focus on clean energy. Clearly, they were also an attempt to stabilize the international tax architecture. The proposals call for raising the current tax rate on global intangible low-tax income (GILTI), to 21% from 10.5% and ending a tax break for companies exporting U.S.-manufactured goods, known as foreign derived intangible income (FDII).
The United States has proposed to OECD a simple profitability threshold to determine which companies are subject to Pillar One rules. The U.S. proposal would replace the complicated definitions the current OECD proposals use to determine which industries and business models are affected. It would affect fewer companies than the OECD proposals, without reducing how much corporate profit is reallocated. According to the U.S. proposal, it would apply to no more than 100 multinationals. For Pillar Two, the United States recently proposed a 15% global minimum tax which would put pressure on negotiators in the OECD discussion to move higher than the 12.5% they were expected to agree on.
Transfer pricing implications for MNEs
A lot of uncertainties remain. COVID-19 has had fundamental impacts on how we live, work, and do business. COVID-related spending and other economic challenges may prompt increased scrutiny from tax authorities. But some businesses may be able to turn these challenges into opportunities. Here are some strategies and practices that can make a difference:
• Plan for uncertainty. The economic and regulatory environments remain fluid, so it is critical for companies to review their business operations and transfer pricing policies more regularly and adjust along with these changes. The proposed tax rules may affect incentives regarding the location of profits and investments. MNEs should plan ahead by modeling the potential tax impacts of these new rules to quantify the effects. Reviewing financial results and making adjustments only for the year-end may trigger customs and corporate tax audits.
• Supply or value chain restructuring. Businesses need to consider both temporary and permanent impacts of COVID-19 and the new tax rules. This is critical time to review how to adapt business structure to the changing consumer behavior, supply chain dynamics, and tax policy updates. It’s also time to evaluate the digitalization of business and its tax implications.
• Add more rigor to compliance. Meeting the requirements for documentation is more critical. To minimize audit risks, it is extremely important for taxpayers to ensure consistency in intercompany agreements, transfer pricing policies, and documentation. Businesses should have intercompany agreements in place and keep them up-to-date. Appropriate transfer pricing policies and documentation should reflect the new economic and business environment.
• Talk to your tax advisors. Transfer pricing analysis can begin a healthy discussion that identifies business challenges and opportunities. Exploring your business and tax structures can help you plan for economic and regulatory uncertainties and minimize your risks.
MGO’s specialized transfer pricing team offers you the resources you need to develop a solution that is designed to meet the specific needs of your business. Contact us for more information about transfer pricing.