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OECD Digital Tax Update: Pillar One, Beyond The Arm's Length Principle

On October 9, 2019, the Organization for Economic Cooperation and Development (“OECD”) published a public consultation document addressing the tax challenges of the digitalization of the economy. The purpose of the 21-page document is to advance the public discussion of the OECD Secretariat’s newly revised “Pillar One” proposals, in an attempt to achieve a consensus approach by January 2020 and remain on track to complete the digital tax project by the end of 2020.

The principle objectives of Pillar One are consistent with the OECD’s Programme of Work (“PoW”), released on May 31, 2019, and discussed in more detail in a previous blog post

Digital Nexus

The public consultation document further develops the concept of digital nexus, which would apply when a company has a “significant and sustained economic involvement” in a country. In contrast to traditional nexus, digital nexus does not require a physical presence. The term “involvement” encompasses both physical and digital interaction with customers (e.g., online marketplace) or users (e.g., social media).

The OECD also confirmed its position that digital nexus should not replace the current nexus rules in existing tax treaties. Rather, it is expected to be a complementary, standalone provision. 

Profit Allocation

While there is broad support for expanding the nexus rules, the way in which taxable profits are subsequently allocated across members of a multinational enterprise (“MNE”) remains a source of debate. 

The OECD’s May 31 PoW included three competing proposal for allocating profits to jurisdictions in which digital nexus has been established.

  1. User Participation (residual profit allocation, limited to highly digital companies).
  2. Marketing Intangible (residual profit allocation, applicable to digital and non-digital companies).
  3. Significant Economic Presence (total profit allocation using a fractional apportionment method).

Each of these approaches would achieve the OECD’s stated goal of migrating taxable income away from product intangibles and toward market and user jurisdictions. But the scope and application of the three approaches would result in very different “winners” and “losers.” 

In the Oct. 9 public consultation document, the OECD has attempted to bridge the divide by creating what it refers to as a “Unified Approach.” The Unified Approach, which is explained in more detail below, draws from each of the profit allocation approaches set forth in the May 31 PoW.

The Unified Approach separates the global consolidated profits of an MNE into three categories, referred to as Amount A, Amount B, and Amount C.  

* Amount A is a “deemed” residual profit allocated to market jurisdictions using a fixed formula. Amount A would apply irrespective of whether a company has a physical presence in a jurisdiction.

* Amount B is a “fixed remuneration” for baseline marketing and distribution functions performed in a market jurisdiction. This profit percentage would effectively replace traditional transfer pricing benchmarking analysis. This fixed return may vary by industry and/or region.

* Amount C comprises additional profit that may be allocated to a market jurisdiction where in-country functions exceed the baseline activity assumed in calculating Amount B. Unlike Amounts A and B, Amount C will not be determined using a pre-agreed formula.  It will be based on a facts and circumstances test, with the the profit allocation percentage open to interpretation.

The OECD is proposing binding dispute prevention and resolution mechanisms to avoid possible double taxation arising from disagreements among countries over the validity and/or quantity of an Amount C profit allocation.

Together, Amounts A, B, and C will represent a sizeable shift in taxable profits to market jurisdictions.

Key Takeaways

By design, the Unified Approach is not highly prescriptive. But we can glean some important facts from the Oct. 9 public consultation document and subsequent comments by OECD representatives.

  1. Despite the nomenclature, the Unified Approach does not represent a consensus view of the 134 members of the Inclusive Framework. The OECD intends for it to serve as a starting point for discussions and negotiations, which will continue into January 2020.
  2. Despite the nomenclature, the new “digital” tax will target more than just digital companies. It will affect nearly all large consumer-facing businesses.
  3. If the framework of the current OECD proposal is enacted, the arm’s length “limited risk distribution” model will be replaced by formulary apportionment. Controlled distributors will earn a fixed base return plus a fixed percentage of residual profit attributable to their local marketing intangibles. They may also be subject to an additional profit allocation under Amount C.
  4. Where non-physical nexus has been established and no distribution functions exist within a given market, a deemed residual profit attribution under Amount A will apply.
  5. Digital nexus will apply to both remote and physical involvement in a country. So, companies will not be able to avoid the formulary tax by (i) setting up a legal entity in a market jurisdiction and compensating it based on a traditional arm’s length transfer pricing analysis; or even (ii) setting up a third party distribution arrangement in a market jurisdiction, 
  6. Certain industries, such as extraction and commodities, are expected to be explicitly carved out of the scope of the new tax. The OECD is also considering other exemptions (e.g., financial transactions).
  7. The OECD has discussed a possible nexus revenue threshold to exempt certain companies from the digital tax. Although the public consultation document references the country-by-country reporting threshold of EUR 750 million as an example, during an Oct. 9 webcast OECD Senior Tax Adviser Richard Collier clarified that a specific revenue threshold amount has neither been agreed nor proposed.
  8. The OECD is still hopeful that binding arbitration will be part of a final agreement. Some developed countries have demanded tax certainty in exchange for ceding a portion of their tax base. But other countries remain opposed to binding arbitration. This is perhaps the most controversial issue that will need to be resolved in order to achieve consensus.
  9. The future of the arm’s length principle is now officially in doubt. The OECD acknowledges that the Unified Approach goes beyond the arm’s length and separate entity principles, but views this as a necessary step to ensure a “fair” and politically viable outcome. As fairness increasingly replaces the arm’s length principle as the generally accepted transfer pricing framework, practitioners and taxpayers are left to wonder what might come next.

Next Steps

Interested parties are invited to submit their comments by e-mail in Word format to by 12 pm (CET) on Tuesday, November 12, 2019.  The OECD will hold a public consultation on November 21-22, 2019.

A separate public consultation document will be issued for Pillar Two in November 2019 with a hearing to be scheduled in December 2019.

The OECD is tentative planning to publish a more detailed proposal in conjunction with the next Inclusive Framework meeting in January 2020.


The views expressed in this article are those of the author and do not necessarily represent the views of Valentiam Group or its partners.

Topics: Transfer pricing, Pillar One, OECD