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Policy Proposals  Business Law Comments on the Public Consultation Document on the Amount B under Pillar One

January 25, 2023
Business Infrastructure Bureau, KEIDANREN

We thank you for the opportunity to submit our comments.

This document is submitted by Keidanren's Business Infrastructure Bureau and is based on the discussions held by the International Tax research project of the 21st Century Public Policy Institute.#1

1 Research project consisting of tax managers from Japanese MNEs, academics and practitioners.

1. General comments

We welcome the release of the public consultation document on the details of Amount B. The purpose of Amount B is to simplify transfer pricing rules and contribute to the prevention and resolution of disputes. Japanese businesses support this objective. However, some of the content presented in the public consultation document does not necessarily contribute to simplification, but rather raises concerns that tax may be levied that diverges from the reality of the transactions. In addition, it cannot be assessed that sufficient measures have been presented to ensure tax certainty. The introduction of Amount B may instead increase disputes between countries that insist on conventional transfer pricing methods and those that insist on Amount B. There needs to be sufficient consensus-building among countries. While we agree with the objective of simplification and streamlining considering the conditions of low-capacity jurisdictions, there is a risk that the system may be unstable unless the benefits of implementing Amount B are also appreciated by the tax authorities and taxpayers in other jurisdictions.

Accordingly, the application of Amount B should be a safe harbour, left to the choice of the taxpayers, as detailed below. For simplification purposes, additional documentation burdens should not be imposed. To eliminate double taxation and increase the credibility of the system, tax certainty mechanism should be ensured in all jurisdictions if Amount B is selected to apply. Regarding the pricing methodology, it will take time for the system to operate stably and accurately reflecting the realities of the transaction. The first step would be to establish the foundations of the system by introducing a safe harbour for the application of Amount B and ensuring tax certainty.

In addition, implementing Amount B will take time and will require the revision of transaction prices between the manufacturer and distributor in a group. A preparation period of at least one year should be allowed after the final agreement on Amount B is enacted in each country.

A wide range of companies are potentially subject to Amount B and many of them have an interest in this project. Conducting a further public consultation is also worth considering. We would appreciate a continued exchange of views with business.

Based on these perspectives, we express our views below.

2. Scoping criteria

Regarding the scoping criteria, the nature of Amount B needs to be clarified first. It is not clear whether Amount B is mandatory or an option where the scoping criteria are met. As differences may arise, depending on companies, as to whether Amount B is consistent with the commercial reality of the transactions, the application of Amount B should be positioned as a safe harbour that taxpayers can choose to apply. In other words, if the taxpayer chooses to apply Amount B, the authorities should not be able to deny it. By positioning Amount B as a safe harbour, Amount B could be applied in a wider scope. This would meet companies' expectations of simplification and certainty through Amount B, as well as reducing the burden of low-capacity jurisdictions. From this perspective, companies should not be uniformly excluded from Amount B even if they do not meet the requirements of the current scoping criteria (para 18) but should be able to choose to apply Amount B even if they have multiple functions, or if the ratio of annual operating expenses over annual net sales is below the lower limit.

On the other hand, even if the taxing authority requests the application of Amount B, as stated in the public consultation document, Amount B is a rebuttable assumption. If the taxpayer has indicated that it has applied the most appropriate method, it should be allowed to negotiate with the authority based on that most appropriate method. Given that the Amount B methodology is still a work in progress, it should also be clarified that even if the requirements for the application of Amount B under para 14 and para 18 of the public consultation documents are met, the taxpayer's side should still be able to defend its arrangements based on its determination of the most appropriate method.

The following discussions of the in-scope transactions and scoping criteria are provided in a limited and conditional manner, considering the case where the safe harbour is not guaranteed and the application of Amount B is mandatory or required by the authorities. Clarification of the definition is also essential in order to eliminate differences in application in various jurisdictions.

2.1. Qualifying transactions (para 14 and Box 3.1)

Sales agency and commissionaire arrangements should be excluded from scope. These transactions differ from buy-sell transactions in terms of functions and risks. Revenues are recorded as cost-based commissions, making it difficult to determine gross sales from financial statements and accounting data. This also makes it difficult to calculate gross sales as scoping criteria and return on sales (ROS) as a profit indicator. In addition, even if a transaction is formally a buy-sell transaction, if the associated functions and risks are equivalent to those of sales agency and commissionaire arrangements, the transaction should be excluded from the scope of Amount B for the same reasons.

If such exclusions are not allowed under Amount B, sales agency and commissionaire transactions could be subject to Amount B, provided that Amount B is applied as a safe harbour for taxpayers by choice. However, if these transactions remain in scope, different profit level indicators (PLI), such as the Berry Ratio, would need to be set, as described in 3.3 below.

In addition, where a single tested party's suppliers and customers are a mix of related and unrelated parties and the amount or percentage of transactions subject to Amount B overall is minor, all such transactions should be excluded from Amount B, considering the additional burden of documentation. Where basic marketing and distribution activities are shared between related parties located in different jurisdictions, the functions and risks are considerably more limited than if these activities were carried out by a single entity. These cases do not perform a baseline function and their exclusion from Amount B should also be contemplated.

It may also be appropriate to provide exclusions for entities with specific circumstances, such as start-ups before their business is fully operational, or corporations that have been loss-making for consecutive years for legitimate reasons. If the profit margin of the group is less than the profit margin of Amount B, this would result in income creation and should therefore not be eligible for Amount B.

Retailers are not subject to Amount B. However, it would be reasonable to apply Amount B to the retail sector if Amount B is positioned as a safe harbour, as described above. It may not be appropriate for the retail sector to be subject to mandatory application, as profit levels are highly dependent on competitive conditions and economic fluctuations.

2.2. Details of scoping criteria (para 18)

In order to ensure simplification and certainty by preventing disputes, the application of Amount B should not be required by the tax authority in cases where a tested entity has multiple functions. Nevertheless, to achieve simplification through Amount B, companies should be able to decide whether to apply Amount B testing on a transaction-by-transaction basis under the concept of a safe harbour, even in cases where there are tested parties with multiple functions. Where distributors offer rebates or other incentives to individual retailers at their own discretion, the functions/risks are not limited and the application of Amount B should not be mandatory.

The definition and details of the items listed below from para 18 should be clarified.

(c)(ii) Research and development activities. The scope of eligible research and development activities should be determined based on whether the company incurs research and development expenses, as described in the public consultation document.

(c)(iii) and (iv) Procurement activities and financing activities. It should be clarified, for example, whether financing activities include holding loan receivables, trade finance and inventory holding finance. It is inappropriate to deem a deposit into cash pooling as a loan in cases where the distributor participates in intra-group cash pooling and effectively utilises those funds within the group.

(h) [X%] of the threshold for ancillary activities and transactions. For simplification, it should be clearly stated that the determination of this [X%] should be based on data not from current year but from previous years.

(i) The ratio of annual operating expenses over annual net sales of the distributor is in the range of [X]% to [X]%. Although related to the discussion of in-scope transactions, the application of Amount B should not be required by the tax authority for this lower limit of X% if it is less than [10%]. Transactions with a low SG&A ratio are transactions with a low rate of return, which may not function as the "baseline" envisaged by Amount B, and may result in a profit that deviates from the commercial reality of the transaction. However, in relation to the application of Amount B as a safe harbour, if the taxpayer chooses to apply Amount B, even if the range is less than 10%, for example 5%, the application of Amount B should be permitted from the perspective of simplification. Another idea may be to set the upper limit at 25%, as in most cases where the distributor's operating expense ratio ([X%]) is above 25%, this function may exceed basic sales and marketing activities.

(j) Requirement that the distributor does not assume economically significant risks beyond a limited level. Consideration should be given to including in Amount B those distributors that eliminate credit risk or other external business interruption risk through means such as insurance or factoring and bear the cost of hedging such risks.

(k) Marketing intangibles. What constitutes the possession of marketing intangibles should be further specified, including clarification on quantitative criteria. It is undesirable for authorities in market countries to claim high profit margins based on subjective claims that Amount B is inapplicable due to the existence of marketing intangibles. It may be appropriate to set quantitative criteria based on sales and advertising costs.

2.3. Exclusion from the scope based on APAs (para 19-21)

Where there is a bilateral APA, we support the exclusion of Amount B. APAs should be respected from the perspective of tax certainty. From this perspective, it may be useful to allow exclusions or some guarantees for unilateral APAs.

One concern is that on expiry of the term of the APA, the renewal of the APA may not be granted if the conditions may be less favourable for the authorities than for Amount B. The taxpayer should be able to ensure tax certainty in such cases. One option is that Amount B should not be a precedent to be referred to in the negotiation of future APAs.

2.4. Exemption when there are local market comparables (Box 3.2 para 10-16)

If a taxpayer files a return based on Amount B, the tax authority should not request an exemption based on local market comparables but should allow the taxpayer to decide. Taxpayers and tax administrations frequently have a limited number of comparables and, as a result, often require comparability adjustments that require detailed information on financial statements. Requiring such adjustments would be contrary to the simplification objective of Amount B. Nevertheless, if the tax authority requests the application of Amount B, it is appropriate to grant taxpayers an exemption on local market comparables, as the taxpayer is permitted to argue that there are other more appropriate methods.

If the definition of local comparables is not clarified, there is a risk of arbitrary implementation in each country. In addition, secret comparables should be excluded from such local comparables to avoid a surprise on the part of the taxpayer.

2.5. Product-based exclusions (Box 3.2 para 17-29)

With regard to non-tangible assets (software and digital goods), clarification is needed on the treatment of software embedded in products. If software were to be included in the scope of Amount B, it should be clarified whether the product in question is treated as product-embedded software (tangible assets) or as separate software (non-tangible assets).

Likewise, the application of Amount B should not be mandatory for provision of services. However, as stated in 1.1 above, it should be assumed that the application of Amount B is positioned as a safe harbour that taxpayers can choose to apply. For example, companies wishing to apply Amount B to digital goods should be able to do so.

3. Pricing methodology

Regarding the pricing methodology, it is important that the method should be designed in a way that ensures simplicity and certainty, which is the purpose of Amount B. In addition, prices should be calculated based on the function of the transactions so that they do not deviate from the commercial reality. For example, while the wording of the contract indicates a buy-sell transaction, due consideration should be given to the fact that there are transactions that are practically similar to sales agent or commissionaire transactions by eliminating risk as much as possible.

3.1. Key design features of pricing methodology

With regard to the publication and periodic updates of transfer pricing results (para 47), the profit margin used in Amount B should be agreed and published before the start of the covered year and fixed throughout the year. Nevertheless, the database needs to be updated to promptly reflect changes in ALP levels in the event of unforeseen circumstances, such as a worldwide epidemic such as Covid-19, escalation of geopolitical risks, or a severe natural disaster. In relation to periodic updates, clarity should also be provided on the years covered by the database, the timing of publication and the year in which application starts. It may be appropriate to allow for a multi-year weighted average approach to be applied, assuming inflation and a time lag between the database and actual application.

Asset Intensity (para 57) should be explicitly stated as an indicator using only fixed assets as these are more closely related to profit. Some transactions provide a financing function and may result in a relative increase in accounts receivable and inventories, but such an increase in current assets does not directly contribute to higher profit margins, so current assets should be excluded from the definition of an ‘Operating Asset’.

3.2. Pricing matrix and mechanical pricing tool

Controversy may arise regarding the taxpayer's choice of criteria as for the pricing matrix approach. Specific criteria should be provided or the system should be designed in such a way that the tax authorities cannot deny a taxpayer's choice.

On the other hand, the mechanical pricing tool approach is effective in that it prevents arbitrariness by calculating prices mechanically, but there is concern that the results may not reflect substance. For this reason, it appears that the OECD will develop a database and provide it at no cost, but the OECD should also make public the logic underlying the mechanical pricing tool.

As the appropriate profit level indicator (PLI) is likely to vary by industry, a pricing matrix/mechanical pricing tool should be developed not only for ROS but also for different PLIs, such as Berry Ratios. In doing so, consideration should be given to the impact on buy-sell transactions and sales agency/commissionaire arrangements of differing financial reporting standards across jurisdictions. Also, while balancing simplicity and certainty, where there are differences in profit margins reflecting industry and regional characteristics, these tools will need to seek to set profit margins that reflect these differences. For example, in the durable goods manufacturing industry, where the value chain is long, the profit margin of the end distributor is often very limited, approximately 1-2%.

3.3. Profit level indicator (PLI)

For sales agent or commissionaire arrangements as well as buy-sell transactions with only similar risks, the PLI should be the Berry Ratio if these transactions are in scope for Amount B. These transactions are often allocated profit based on operating expenses rather than on sales value, so that sales and profit are not linked. Applying indicators that use sales figures (e.g. ROS) to transactions involving commodities with significant fluctuations in prices, such as natural resources, may result in inappropriate indicators due to significant distortions caused by fluctuations.

The PLI indicator should be treated as a rebuttable presumption. As mentioned above, taxpayers should be able to argue, for example, that if profits are allocated according to operating expenses, the appropriate PLI is BR rather than ROS.

Pricing based on multiple profit indicators should be avoided as it is difficult to demonstrate that the pricing methodology is appropriate, and the implementation would be complicated.

It should also avoid making the profit level of Amount B a lower limit for transactions that are not in the scope of Amount B.

3.4. Range

The prices compared when applying Amount B should be a range rather than a fixed point. If it is a fixed point, the sales price determined by various commercial factors must also be corrected. The tax system should be neutral to business and the comparative prices need to be a range in order to mitigate the impact of Amount B on business. Moreover, it would be unreasonable from the perspective of tax certainty. Currently, no corresponding adjustments can be made between jurisdictions that do not have tax treaties. Thus, if the comparative price is a point and a profit margin other than that point is fixed, double taxation would occur and there would be no means of resolution. Even using a range, a downward adjustment would be required if the upper limit of the range were to be exceeded. For this reason, measures to ensure tax certainty, discussed below, are important.

As the profit margins of the end distributors vary depending on the industry structure, it is appropriate to set a wider range than is normally allowed for distributors under the TNMM. For this reason, it should not be a 'very narrow range,' but should be appropriately broad.

3.5. Other practical issues

For cases where Buy-Sell, Commissionaire and Sales Agent transactions coexist within a single entity and the entity deals in products from multiple industries, the question is whether Amount B should be applied and tested separately by transaction or whether Amount B should be applied and tested as a single entity if each transaction is similar in terms of function and risk. While transfer pricing is usually determined by the type of transaction, the most appropriate method for simplification can vary depending on the form of company, industry, and other factors. If multi-functional corporations are uniformly excluded from Amount B, there would be no subsidiaries eligible for Amount B at all, even if simplification is sought through Amount B. For this reason, one option may be for taxpayers to apply and test Amount B either on a transaction-by-transaction or company-by-company basis at their discretion, on the assumption that Amount B can be applied as a safe harbour.

In the case of a transaction-by-transaction test, it should be clearly stated what adjustment is necessary for each transaction.

4. Documentation

It seems that many of the documentation requirements introduce additional burdens. This is contrary to the objective of Amount B, which is to simplify and streamline transfer pricing. At a minimum, it is inappropriate to require more detailed requirements than those of the current local file.

From a simplification and streamlining perspective, it should be sufficient to document only the necessary minimum information relating to scoping criteria and pricing methodology. Other documents should be supplementary materials that are not mandatory. Setting some thresholds by the amount of transactions may also contribute to reducing the burden of documentation.

Overlapping of documentation with the Local File should be avoided. The documentation requirements for Amount B should be substitutable with the submission of local files. In addition, if the documentation requirements are met, it is desirable to provide long-term certainty from the perspective of simplification, e.g. by not requiring another documentation for three years.

Furthermore, the items in para 87 below should be excluded from documentation requirements.

(b) “a breakdown of (i) financial information by key customer type (e.g. government entities, government contractors, large customers); (ii) sales made to associated enterprises and third party customers per product and jurisdiction; and, (iii) sales to end-customers and wholesalers/retailers.” It would be excessive to require documentation on these details for all subsidiaries to which Amount B applies.

(f) “Annual financial accounts of the taxpayer for the [three/five] fiscal years prior to the first fiscal year.” It is excessive to require information even for years not covered by Amount B.

(k) “written contract.” While the current transfer pricing documentation does not require the information to be attached in the form of a contract, preparing the required information in the form of a contract would impose a substantial additional administrative burden on the taxpayer.

5. Tax certainty

Tax certainty plays a critical role in Pillar 1 to ensure the reallocation of taxing rights between jurisdictions. However, it is difficult to conclude that the mechanisms presented in the public consultation document on Amount B would provide tax certainty beyond the already existing APAs and MAPs. If the tax authorities may levy tax based on the Amount B benchmark, while the taxpayer may only rely on the existing APA or MAP instruments, without any new tax certainty procedures for Amount B, the proposal lacks balance.

By its very nature, consideration should be given to introducing an additional tax certainty mechanism specific to Amount B, e.g., a mechanism such as the Dispute Resolution Panel in Amount A. Furthermore, the process is unclear when disputes arise between countries with which no tax treaties have been concluded. Clarification should be provided on how to resolve them. At the very least, given that Amount B is a transfer pricing issue, it would be possible to incorporate Amount B into the tax certainty framework for issues related to Amount A.

As the main purpose of Amount B is essentially to ensure simplicity and certainty, it is appropriate to establish a mechanism to limit to a certain extent the occurrence of disputes relating to Amount B. The Multilateral Convention (MLC) mechanism should be utilised to standardise the operation and interpretation of the Amount B in each jurisdiction. Even if disputes would occur, resolutions should be guaranteed at the MAP or other stages before arbitration.

Considering the burden arising from dispute resolution, a consultative process with both authorities prior to taxation may also be a viable option. For avoiding disputes, it is essential to establish an early certainty process like Amount A. In addition, where adjustments are made by means of cash payment or compensation due to the difficulty of making adjustments at the transaction price, companies in the sending country should be able to deduct such cash payment or compensation as a loss. In addition, it should not be allowed to tax such remittances with VAT or customs duties.

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