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Policy Proposals  Business Law Comments on the Public Consultation Document Secretariat Proposal for a "Unified Approach" under Pillar One

November 12, 2019

Tax Policy and Statistics Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development

Comments on the Public Consultation Document
Secretariat Proposal for a "Unified Approach" under Pillar One

1. Introduction

Keidanren welcomes the proposal for a Unified Approach and thanks the OECD for its expeditious work examining the tax challenges of the digitalization of the economy under the Inclusive Framework. To address those challenges, a growing number of jurisdictions in Europe and elsewhere are moving to impose new taxes on online advertising and other businesses. However, such measures will inevitably lead to double taxation and should be avoided. Jurisdictions are called on to refrain from unilateral action until a consensus is reached on a long-term solution, and to abolish measures already implemented once consensus is reached.

The current redesign of international taxation principles will prove ineffective unless all jurisdictions cooperate and adopt common rules. Should only a limited number of jurisdictions adopt those rules, the risk of double taxation will rise. The OECD and the G20 should firmly urge individual jurisdictions to refrain from imposing unilateral taxes, and to abolish any existing unilateral taxes and create an environment conducive to the adoption of common rules.

It is of paramount importance to ensure tax certainty for businesses. The rules proposed under Pillar One would amend the principles of international taxation both for taxpayers with and without physical presence in a market jurisdiction. The proposal acknowledges taxpayers' interests, but still risks an excessively broad scope and disproportionate profit allocations to market jurisdictions. Taxpayers may add to these concerns increased double taxation risk and compliance burdens.

To ensure wide participation, the rules should follow the principle of proportionality. The scope should be narrow and the profits allocated to market jurisdictions should be modest; profit allocations under the existing framework should not greatly change. The rules must be simple and should strive to minimize compliance burdens. Furthermore, to ensure enforcement, the rules must include legally binding and effective dispute prevention and resolution mechanisms, thereby avoiding and eliminating double taxation.

In light of these viewpoints, we present below our responses to the questions posed.

2. Responses to the Questions

(1) Scope: consumer (including user) facing businesses

It is imperative that the meaning of consumer-facing business is defined clearly and precisely.

a. Interaction with consumers/users

The definition of consumer-facing businesses must be unambiguous and must avoid arbitrary interpretation among jurisdictions. The definition should provide a clear method to determine whether an undertaking is within the scope; businesses that do not interact with consumers should be excluded. Finally, to ensure certainty for taxpayers and tax administrations alike, certain businesses should be explicitly carved out. (See (1)e below for details.)

b. Defining the multinational enterprise (MNE) group

If an MNE group's profits to be allocated are identified based on its consolidated financial statements, the scope of the MNE group should naturally be the same as that used in those statements; in principle, the scope should be determined on the basis of 50% majority ownership. The definition should also be consistent with existing rules, such as country-by-country reporting (CbCR) and the OECD Model Tax Convention.

c. Covering different business models (including multisided business models) and sales to intermediaries

Sales to intermediaries may cause a business to fall under the definition of consumer- facing businesses. In such cases, consideration should be given to the calculation of sales, as explained later.

d. Size of the MNE group, taking account of fairness, administration, and compliance cost

The scope of the rules must be further narrowed, otherwise MNE groups could suffer unreasonable tax compliance burdens. The €750 million revenue threshold applied to CbCR requirements may be used as a reference, but should not necessarily be regarded as a predetermined condition. MNE groups subject to CbCR obligations are said to account for 90% of global corporate revenues on a gross basis. As the principle of proportionality does not require such extensive coverage to address the digitalization of the economy, it may make sense to adopt a narrower scope.

e. Carve-outs that might be formulated (e.g., for commodities)

A clear line should be drawn. At the very least, businesses not interacting directly, or clearly not dealing, with consumers should be excluded from the scope. Most notable examples of such businesses include the following:

  • The manufacture and sale of intermediate goods, such as raw materials, machine parts and original equipment manufacturer (OEM) products, that are processed and assembled into finished products, with the exception#1 of intermediate goods that have gained brand recognition to such an extent that they are used to market the finished products.
  • The manufacture and sale of products belonging to categories that are evidently not intended for consumers (e.g., machinery and other industrial equipment),

#1 The exception needs to be clearly defined to avoid arbitrary interpretation

As suggested in the public consultation document, extractive industries, commodities, and financial services such as banking, insurance and securities should be carved out from the scope. As for the commodities sector, it needs to be clearly defined by specifying the products and businesses considered within this sector.

The prescription drug sector should also be carved out from the scope as the majority of prescription drugs are supplied to medical service providers; the ways of supplying and advertising drugs to consumers are strictly regulated.

Likewise, the following businesses should be carved out from the scope: the provision of products to service providers whose businesses then interact with consumers (e.g., the manufacture and sales of passenger ships, railcars, aircraft, and medical equipment); the provision of products and services to the central or local governments of the market jurisdiction (e.g., infrastructure businesses and construction projects); the offering of products and services that are of a highly public nature, legally regulated in the market jurisdiction, and required to be provided directly by subsidiaries domiciled therein (e.g., telecommunications services); and businesses that are subject to a special treatment under the OECD Model Tax Convention (e.g., real estate, shipping and air transport).

When determining whether an entire MNE group is consumer-facing, one possible approach is to make the determination based on the share or amount of consumer- facing businesses in the group as a whole, after taking into account the carve-outs listed above. Attention should be paid to the fact that marketing and branding are discussed in the public consultation document and that Pillar One itself is aimed at revising the rules on profit allocation among jurisdictions. Additional consideration may need to be given, among other things, to the possibility of limiting the scope to MNE groups whose advertising expenses reach a certain percentage or amount, or whose overseas sales ratio exceeds a certain threshold.

(2) New nexus

It is proposed that the determination of a new nexus be dependent on sales and not physical presence, but more thought must be given to the definition of sales. In addition, the new nexus rule is designed to allocate profits to market jurisdictions under the framework of corporate taxes alone, and as such should not result in new regulations governing indirect taxes, such as value-added tax (VAT), and other non-tax matters.

a. Defining and applying country-specific sales thresholds

It would be unrealistic to determine country-specific sales in the jurisdiction where the final consumers of products or services are located. The jurisdiction where a sales subsidiary is resident does not always coincide with the one where the consumers are located. Products may also be supplied via multiple intermediaries to the market jurisdiction where the final consumers are located. In such cases, it would be impossible or overly burdensome to grasp the entire process of transactions.

To limit the compliance burden, if an MNE group has no sales subsidiary in a market jurisdiction but sells there via unrelated distributors, there is no option but to treat sales to the unrelated distributors as the group's sales in that market jurisdiction. Where intermediaries are used, the rules should prevent taxes from being imposed both on the group's sales to the intermediaries and on the intermediaries' sales to consumers and others. The definition of sales should be clear and simple for taxpayers to apply.

The method for calculating sales requires further discussion and should consider sector- specific characteristics. For example, in the case of logistics transactions where sales are recognized on a net basis, it is impracticable to obtain and recognize the corresponding gross turnover.

In advertising businesses, accurately tracking user information is difficult. It is therefore desirable that the jurisdiction in which the advertisers (i.e., the taxpayer's customers) are located is treated as the jurisdiction where sales are made.

b. Calibration to Ensure that jurisdictions with smaller economies can also benefit

If MNE groups were required to file tax returns in all jurisdictions that represent a fractional share or volume of the group's overall transactions, compliance burdens would be unreasonable. We understand the need of employing indicators that take into account each jurisdiction's economic scale. However, consideration should be given to the use of a fixed monetary threshold (to ensure, for example, that an MNE group whose sales in a jurisdiction are below a certain amount is not required to determine the nexus in that jurisdiction).

(3) Calculation of group profits for Amount A

The following should be taken into account when considering metrics and other matters:

a. What would be an appropriate metric for group profit?

Accounting profits should be the basis of profits to be allocated so as to minimize compliance burdens. Onerous adjustments would increase complexity and disputes between taxpayers and tax administrations. It makes sense to use operating profit reported in the group's audited consolidated financial statements, considering that this represents profits from regular business operations and that the transactional net margin method (TNMM) has been widely adopted as a transfer pricing method.

When calculating operating profit based on IFRS, non-operating and extraordinary profit/loss items, such as interest, dividends, and goodwill impairment losses, should be excluded in order to identify profits relating to regular business operations only. For the same reason, investees' shares of profits or losses under the equity method should also be excluded. As jurisdictions may disagree on which items should be included in operating profit, those items should be specified in guidelines and other tools, with definitions standardized among countries.

When calculating profit margins, the denominator should be sales as it correlates strongly with profits. However, as explained in (2)a above, consideration should be given to logistics providers that function as agents and recognize sales on a net basis. Profit margins based on gross sales may otherwise be artificially high.

b. What, if any, standardized adjustments would need to be made to adjust for different accounting standards?

The accounting standards for which adjustments are made should not be restricted to IFRS and US GAAP; accounting standards deemed equivalent should also be respected. Indeed, in 2008 the European Commission recognized Japanese GAAP and US GAAP as equivalent to IFRS, the standard adopted by the European Union.

c. How can an approach to calculating group profits on the basis of operating segments based on business line best be designed? Should regional profitability also be considered?

As Amount A aims to allocate a portion of an MNE group's deemed residual profit to market jurisdictions, there is little need for region-by-region calculations. Moreover, as regional profitability is not reported in consolidated financial statements, computing it would impose an additional compliance burden. For these reasons, calculating regional profitability would be impracticable.

Whereas profitability by operating segment is disclosed in consolidated financial statements, an MNE group's consumer-facing business does not always correspond perfectly to a particular operating segment. It is not only that some MNE groups do not allocate head office and corporate expenses to individual business-line segments in practice, but also that there is no established method to do so. An MNE group should be basically allowed to determine whether it is appropriate to prepare numbers for separate business lines for the purpose of Amount A.

Where there is no other option other than business-line segmentation, profit margin data based on an MNE group's voluntary segmentation must be respected as much as possible. Allocations of head office and corporate expenses to each segment should be based on the decision of the group as far as the formula adopted by the group is reasonable and used continuously. The existing business lines disclosed in a financial statement reflect the managing approach and appropriately describe business operations. Denying existing business line segmentations and compelling taxpayers to segment or fragment business lines differently (e.g. segmentation by consumer facing business) would deviate from the reality of corporate management and we cannot guarantee the reasonableness of that data.

(4) Determination of Amount A

We welcome a clear and simple approach in order to secure tax certainty for both tax administrations and taxpayers.

Step 1: Determining total profit

As stated in (3) above, an MNE group's total profit should be determined on the basis of its operating profit.

Step 2: Excluding deemed routine profit (defining deemed residual profit)

As suggested in the public consultation document, following the principle of proportionality and from the perspective of simplifying the rules, it makes sense to set a fixed deemed routine profitability threshold and treat as taxable only the excess portion. The threshold should be the group's operating profit to sales ratio from their consolidated financial statement and be set at well over 10% (e.g. 15 % or 20%).

Step 3: Allocating a portion of deemed residual profit

At many MNE groups, research and development activities conducted in the parent company's jurisdiction play a significant role in creating value. In view of this, the contribution of market jurisdictions should not be overvalued, and the portion of deemed residual profit to be allocated to market jurisdictions must be limited to modest levels. We consider even 10% to be a level that could constitute an excessive profit allocation. In principle, and with simplification in mind, it would be desirable to use an internationally agreed fixed percentage, in principle.

Step 4: Allocating the relevant portion of the deemed residual profit among market jurisdictions

It does not seem unreasonable to base this allocation on sales. It should be noted, however, that defining sales entails the issues outlined in (2)a above.

With respect to profit allocation to market jurisdictions, it may be possible that a threshold incorporating customer-related elements is employed in cases where the number of customers can be counted. To enable the use of such a threshold, however, the customer jurisdictions should be readily identifiable in accordance with a clear, simple, and internationally agreed rule. The rule for determining customer locations, as contained in the VAT rules for electronically supplied services, may provide useful guidance, although this is not applied universally. An appropriate transition period should be implemented to allow companies time to prepare for the new system, which will require investment.

If an MNE group's residual profit is allocated to market jurisdictions, the treatment of the losses (and cases where there is no residual profit) should also be considered, otherwise the parent jurisdiction would bear the risk of losses and market jurisdictions would be excessively rewarded. A company may incur losses due to product life-cycles or investment. Appropriate measures should be considered to account for these factors, balanced against the additional compliance burden.

Furthermore, it should be explicitly stated and agreed that the new profit allocation rules are designed solely to adjust for corporate taxes, and thus do not constitute deemed payment among group members and have no bearing whatsoever on VAT and other indirect taxes, withholding tax, other taxes or custom duties.

(5) Elimination of double taxation in relation to Amount A

In terms of tax certainty, it is imperative to eliminate double taxation in relation to Amount A. Consideration should be given to material issues, such as ways to identify relevant taxpayers and eliminate double taxation.

a. Identifying relevant taxpayer(s) entitled to relief

It would be impracticable for one entity in an MNE group to file tax returns and pay taxes concerning Amount A for the entire group and handle tax audits in all market jurisdictions. To simplify the compliance process, one option could permit the parent company to file a return on behalf of all group companies and pay taxes in respect of Amount A, with the tax administrations of the eligible jurisdictions later allocating the taxes paid and settling cash balances among themselves. MOSS (Mini One Stop Shop) of the EU may be of use as a reference when considering this kind of scheme. While the relevant taxpayer should in principle be the parent, a subsidiary owning residual profit or significant intangibles, if any, could also be considered.

If the MNE group has a local subsidiary in a certain market jurisdiction, it may also be worth considering a system that allows the local subsidiary to file a tax return in the jurisdiction on behalf of the parent (or other company). Even in this case, there should be no obligation other than filing a tax return concerning Amount A, as stated in (4)

b. Building on existing mechanisms of double tax relief, such as tax base corrections, tax exemptions, or tax credits

In the interest of ensuring simplicity and eliminating double taxation, tax base corrections are preferable to foreign tax credits. But in order to prevent disputes among tax administrations, guidelines and other tools that bind countries would need developing to clarify which jurisdiction's tax base should be corrected. It is again important that tax base correction does not give rise to other tax obligations including base erosion and anti-abuse tax (BEAT). Foreign tax credits are complicated and risk being detrimental to taxpayers where sufficient tax credits are not available due to ceilings applied.

We oppose the withholding tax mechanism for two reasons. Firstly, it poses a problem as to who should act as withholding agent. It is practically impossible to apply withholding tax on B to C transactions. For an MNE group that has no sales subsidiary in a market jurisdiction and sells there via an unrelated independent distributor, it is uncertain whether the distributor can serve as the withholding agent; and even if the distributor may do so, it is impossible to ensure that the distributor pays the amount withheld to the tax administration. For example, the profitability of a group fluctuates year on year, and it is hard for the distributors to determine whether the group earns residual profit. The distributors may be confused by the withholding tax under Amount A and other withholding tax.

Secondly, as the withholding tax mechanism requires subsequent settlement procedures (i.e., claiming refunds or paying additional taxes), it would run counter to simplifying the compliance process and is thus undesirable. Moreover, claiming refunds takes a great deal of time or effort in some jurisdictions.

c. Ensuring that existing mechanisms for eliminating double taxation continue to operate effectively and as intended

If a jurisdiction's tax audit results in an adjustment relating to Amount A but other interested jurisdictions disagree with the audit conclusions, eliminating double taxation in an efficient manner would become difficult. Therefore, any adjustment relating to Amount A needs to be predicated on consultation and agreement with the relevant jurisdictions.

Rules should be designed through which a parent (or other entity's) jurisdiction is entrusted by other jurisdictions to exert sole authority of conducting tax audits with respect to Amount A, instead of each jurisdiction individually carrying out audits.

(6) Amount B

Amount B is designed to guarantee to the market jurisdiction a certain portion of sales derived from the baseline activities of sales subsidiaries, regardless of whether they are consumer-facing or not. While we understand the intention of this rule in the context of tax certainty, some issues remain, including how this rule relates to the allocation to market jurisdictions under Amount A and what theoretical rationale exists for taxation.

a. Need for a clear definition of the activities that qualify for the fixed return

Amount B appears to have been introduced in haste, which seems inappropriate. For cross-border related party transactions such as those involving routine distributors, the TNMM and other one-sided transfer pricing methods generally work well. In view of that, there is little rationale for changing the existing approach by introducing Amount B. Determining a return using a fixed percentage is fundamentally unsuitable for corporate marketing and distribution activities as they are carried out under circumstances that vary depending on the industry. Before any further work is done, the need for a new rule should be thoroughly discussed. The conclusion should not be rushed.

If Amount B is introduced, the next step should be to define the term "baseline activity" in such an unambiguous manner that no difference in interpretation could arise among jurisdictions. In principle, baseline activity is considered to be the marketing and distribution activities that are carried out in accordance with the parent company's strategy or policy and are suitable for applying the TNMM. Baseline activity is understood to mean a series of endeavors that includes surveying markets, developing potential customers, negotiating sales terms with customers, and taking substantial risks associated with price fluctuations, inventory, and credit.

It should be noted that significantly low-margin businesses, such as those using the Berry ratio, are not suitable for guaranteeing a minimum right under Amount B; thus, the carve-out of such businesses needs to be considered.

b. Determination of the quantum of the return (e.g., single fixed percentage; a fixed percentage that varied by industry and/or region; or some other agreed method)

In light of the limited functions performed by distributors in the value creation process, a fixed cap (e.g., a fixed percentage of the group's consolidated operating profit) should be set on the total amount of returns allocated to market jurisdictions as Amount B. It is inconceivable that this fixed percentage would exceed 50%, particularly for MNE groups that are financially healthy.

In some cases, an MNE group may have multiple companies in its value chain that perform marketing and distribution functions, for example where the group sells its products to a distributor in a market jurisdiction via another sales subsidiary overseeing the region from another location. In these cases, efforts should be made to avoid Amount B being applied in an overlapping way.

Considering the relationship with Amount A, we feel that a level of 2% of profit for Amount B in any market jurisdiction would be too high; it should be around 1% of profit at most. As the percentage need not to be common across industries, careful consideration should be given to the allocation, which should seek to be consistent with the profitability indicators under the existing transfer pricing regime. In addition, if an MNE group posts a loss on a consolidated basis, either the loss should be allocated to Amount B or the allocation to Amount B should be zero. If a parent company posts a loss due to income allocation under Amount B, the net operating loss of the parent company should be certainly carried forward. It may be worth considering a range set by the OECD rather than a fixed percentage, allowing MNE groups to avoid adjustments under Amount B where the multi-year average of the distributors' profit margin is within this range.

Any dispute over Amount B should also be subject to a legally binding dispute resolution mechanism to ensure the elimination of double taxation.

(7) Amount C, and dispute prevention and resolution

Amount C aims to apply transfer pricing rules to an MNE group's functions that exceed the baseline activity in a market jurisdiction. However, there is risk of double taxation between Amounts C and A, the latter being aimed at taxing the portion of the group's profits that exceeds its deemed routine profit. In light of this risk, the extra functions subject to Amount C should be limited to functions other than marketing and distribution, and detailed guidelines should be developed to prevent jurisdictions from imposing taxes arbitrarily. We should like the OECD to confirm that market specific characteristics including "market premium" are reflected when identifying comparables and therefore not used to justify additional income allocation to market jurisdictions under Amount C.

If Amounts A to C are introduced, individual jurisdictions must be subject to legally binding dispute prevention and resolution mechanisms, including arbitration, to ensure the prevention and elimination of double taxation. This is a fundamental premise for the introduction of new taxation rules addressing the digitalization of the economy. The introduction of new rules without guaranteeing the prevention and elimination of double taxation would expose corporations to high tax uncertainty. If market jurisdictions receiving reallocated profits are not subject to a legally binding mechanism to prevent and eliminate double taxation but may enjoy the benefit of increased tax revenue, there is a risk that jurisdictions may selectively apply the new rules, which would be unacceptable to taxpayers.

To handle multilateral disputes effectively, one option would be to create an independent central body for dispute resolution. Moreover, the OECD must continue monitoring individual countries' efforts to prevent and resolve disputes, and must urge underachieving countries to redouble their efforts.

a. Unilateral or multilateral advance pricing arrangements (APAs)

Although bilateral APAs can be effective in preventing and resolving disputes, it is impossible for corporations to implement and conclude bilateral APAs for all cross- border related party transactions, particularly given the compliance burden and the resources required. We therefore hope that the use of multilateral APAs will increase. However, even reaching an agreement on a bilateral APA often takes several years, resulting in considerable time and effort for taxpayers. Furthermore, as parties to APAs are not obliged to reach agreement, some cases go unresolved, with each side asserting their own views and refusing to compromise. Dispute resolution through binding arbitration should be mandatory for cases where agreement cannot otherwise be reached.

b. International Compliance Assurance Programme (ICAP)

We expect ICAP to develop further and play a significant role. To function as a more inclusive dispute prevention framework, ICAP should encourage all market jurisdictions including non-OECD economies to participate and should coordinate their interests.

c. Mandatory binding Mutual Agreement Procedure (MAP) arbitration

To allocate tax revenue under Amounts A to C, it is essential to introduce binding arbitration in the settlement of disputes. Tax administrations are called on to respond in good faith to requests for consultation and explanation from other jurisdictions during arbitration proceedings, and once the decision is delivered, to allocate tax revenue without delay. It would also be necessary to create an independent central body for auditing and dispute resolution.


Subcommittee on Taxation

Business Law