OECD’S PILLAR ONE PROPOSAL – A SOLUTION TRAPPED IN A WEB OF COMPLEXITIES

The
digital revolution has improved business processes and bolstered
innovation across all sectors of the economy. With technological
advancements, businesses can operate in multiple countries remotely,
without any physical presence. However, the current international tax
system, which dates back to the 1920s, is primarily driven by physical
presence and hence is obsolete and incapable of effectively taxing the
DE1.

In the absence of efficient tax rules, taxation of DE has
become a key Base Erosion and Profit Shifting (BEPS) concern all over
the world. While the Organisation for Economic Co-operation and
Development’s (OECD) BEPS 1.0 project resolved several issues, the
project could not iron out the concerns of taxation of the DE. Hence,
OECD and G20 launched the BEPS 2.0 project wherein OECD along with 135
countries is working towards a global consensus-based solution under the
ambitious ‘Pillar One’ project.

2. BLUEPRINT OF PILLAR ONE PROPOSAL – A DISCUSSION DRAFT TO BE WORKED FURTHER
OECD’s
Pillar One project proposes to modify existing profit allocation rules
in such a way that a portion of the profits earned by a Multinational
Enterprise (MNE) group is re-allocated to market jurisdictions (even if
the MNE group does not have any physical presence in such market
jurisdictions), thereby expanding the taxing rights of market
jurisdictions over MNEs’ profits.

As part of the Pillar One
project, a report titled ‘Tax Challenges Arising from Digitalisation –
Report on the Pillar One Blueprint’ (referred to as ‘Blueprint’ or
report hereafter) was released in October, 2020 which represents the
extensive technical work done by OECD along with members of the BEPS
inclusive framework (BEPS IF)2 on Pillar One.

Being a Blueprint,
it is more in the nature of a discussion draft. It does not reflect
agreement of BEPS IF members who participated in the discussion on
Pillar One proposals and there are many political and technical issues
which still need to be resolved. However, this Blueprint will act as a
solid basis for future discussions. Further, BEPS IF members have agreed
to keep working on Pillar One proposals reflected in the Blueprint with
a view to bring the process to a successful conclusion by mid-2021.

1   https://www.europarl.europa.eu/RegData/etudes/STUD/2016/579002/IPOL_STU(2016)579002_EN.pdf

3.  EVENTUAL IMPLEMENTATION OF PILLAR ONE REPORT – A CHALLENGING TASK

The
implementation of Pillar One proposals, if and when concluded, will
require modification of domestic law provisions by member countries, as
also the treaties signed by them. The proposal is to implement ‘a new
multilateral convention’ which would co-exist with the existing tax
treaty network. However, the architecture of the proposed multilateral
convention is still being developed by OECD and is not discussed in this
Blueprint.

4. OVERVIEW OF PILLAR ONE REPORT

The Pillar One report primarily focuses on three proposals:

(a) Amount A – New taxing right:
To recollect, Pillar One aims to allocate certain minimum taxing rights
to market jurisdictions where MNEs earn revenues by selling their goods
/ services either physically or remotely. In this regard, new profit
allocation rules are proposed wherein a portion of the MNEs’ book
profits would be allocated to market jurisdictions on formulary basis.
The intent is to necessarily allocate a certain portion of MNE profits
to a market jurisdiction even if sales are completed remotely. Such
portion of MNE profit recommended by Pillar One to be allocated to
market jurisdictions is termed as ‘Amount A’.

(b) Amount B – Safe harbour for routine marketing and distribution activities:
Arm’s length pricing (ALP) of distribution arrangements has been a key
area of concern in transfer pricing (TP) amongst tax authorities as well
as taxpayers. In order to enhance tax certainty, reduce controversy,
simplify administration under TP laws and reduce compliance costs, the
framework of Amount B is proposed. ‘Amount B’ is a fixed return for
related party distributors that perform routine marketing and
distribution activities. Unlike Amount A which can allocate profits even
if sales are carried out remotely, Amount B is applicable only when an
MNE group has some form of physical presence carrying out marketing and
distribution functions in the market jurisdiction. Currently, the report
suggests that Amount B would work independent of Amount A and there is
no discussion on the inter-play of the two amounts in the report.
Besides, even if Amount A is inapplicable to an MNE group (for reasons
discussed below), the MNE group may still need to comply with Amount B.

(c) Dispute prevention and resolution mechanism:
The report recognises that it would be impractical if tax
administrations of all affected market jurisdictions assess and audit an
MNE’s calculation and allocation of Amount A. It is also unlikely that
all disputes concerning Amount A rules could be resolved by existing
bilateral dispute resolution tools such as Mutual Agreement Procedure
(MAP) and Advanced Pricing Agreement (APA). To remove uncertainty, a
clear and administrable mandatory binding dispute prevention process is
proposed in the report to prevent and resolve disputes specifically
related to Amount A. Under this process, a detailed consultation would
take place amongst taxpayers and tax authorities of market jurisdictions
before tax adjustments are made to the MNE’s assessment.

Considering
that Amount A is the heart of the Pillar One report, this article
focuses on the concept, computation and taxation of Amount A.

2              BEPS
IF was formed by OECD in January, 2016 wherein more than 135 countries
participate on equal footing in developing standards on BEPS-related issues and
reviewing and monitoring its consistent implementation

To
recollect, Amount A represents the amount recommended by the Pillar One
report to be allocated, for the purpose of taxability, to market
jurisdictions even if, as per existing taxation rules, no amount may be
allocable to the market jurisdiction. Some fundamental conditions are
proposed on the applicability of Amount A and subject to these
conditions alone Pillar One recommends allocation of MNE profits of a
group to market jurisdictions.

Each of the following conditions
needs to be satisfied by the MNE group for triggering of Amount A
allocation. Non-compliance with any of the conditions may result in
complete non-trigger of allocation:
a) MNEs having consolidated
global revenues (from all businesses) exceeding €750mn as per
consolidated financial statement (CFS) prepared at the parent entity
level under the applicable accounting standards;
b) MNEs engaged in ‘Automated digital service’ (ADS) and ‘Consumer-facing business’ (CFB);
c)
MNEs earning revenues of more than €250mn from ADS and CFB activities
carried out outside their home jurisdiction. The definition of an MNE’s
home jurisdiction is still being developed. For instance, one option
being explored is where the group is headquartered or where the ultimate
parent entity is a tax resident; and
d) MNEs earning more than routine profits.

Some further comments / elaborations of the conditions enumerated above are as under:

Pre-condition for allocation of Amount A to market jurisdictions	Comments / observations
a. MNEs having consolidated global revenues (from all businesses) exceeding €750mn as per consolidated financial statement (CFS) prepared at the parent entity level under the applicable accounting standards; and	This addresses the factor of materiality – small and medium-sized MNEs are proposed to be excluded from the Amount A regime in order to ensure the compliance and administrative burden is proportionate to the expected tax benefits
b.  MNEs engaged in ‘Automated digital service’ (ADS) and ‘Consumer-facing business’ (CFB); and	•   Given globalisation and the digitalisation of the economy, these businesses can, with or without the benefit of local physical operations, participate in an active and sustained manner in the economic life of a market jurisdiction •   ADS is defined to mean services which require minimal human intervention on part of service provider through a system (i.e., automated) and such services are provided over internet or an electronic network (i.e., digital). To illustrate, ADS cover online advertising services, digital     content services, online gaming
	services, cloud computing services, etc. •   CFB is defined as businesses that supply goods or services, directly or indirectly, that are of a type commonly sold to consumers, and / or license or otherwise exploits intellectual property that is connected to the supply of such goods or services. It primarily covers business of sale of goods and services which are not regarded as ADS. It also extends to cover licensing and franchising businesses •   Specific exclusion from Amount A is provided to certain sectors such as natural resources; banking and financial services; construction, sale and leasing of residential property; and international airline and shipping businesses
c.  MNEs earning revenues of more than €250mn from ADS and CFB activities carried out outside the MNE group’s home jurisdiction. Definition of MNE’s home jurisdiction is still being developed. For instance, one option being explored is where the group is headquartered or where the ultimate parent entity is tax resident; and	Where MNEs primarily earn revenue from ADS and / or CFB businesses carried out in the home jurisdiction itself and the business in market countries is only meagre, applying Amount A is likely to have a limited tax impact because the Amount A formula may allocate profits to the same jurisdiction that already has taxing rights under existing tax rules
d. MNEs earning more than routine profits. While the discussions are still ongoing, a profitability ratio (i.e., ratio of profit to sales) of 10% is being considered as routine profit and hence, MNEs which carry on in-scope business but have losses3 or have profitability margin of less than 10% as per books need not compute Amount A	MNEs that earn only routine profits are outside the scope of Pillar One. Routine profit is a reward for undertaking usual business taking risks. Usually, if there is physical presence of an MNE group in any market jurisdiction for the purpose of effecting sales in the market, under transfer pricing rules, routine profits are usually allocated to such market jurisdictions However, Pillar One is built on the basis that where an MNE group earns bumper profits, market jurisdiction contributes to accrual of more than routine profit to the MNE group (irrespective of whether or not the MNE group has any physical presence in such market jurisdiction) and hence,
	market jurisdictions deserve a share in such bumper profit. But if the MNE group does not earn super profits, the issue of allocation of additional profits to market countries does not arise

 

3   If an MNE has losses,
such MNE need not compute Amount A but instead the losses may be allowed to be
carried forward. In this regard, a special loss carry-forward regime for Amount
A will be developed by OECD which is currently under discussion

MNEs who do not fulfil any of the above conditionswill be
outside the Amount A profit allocation rules. However, where the above
conditions are fulfilled, the MNE would need to determine Amount A as
per the proposed new profit allocation rules (which would be determined
on formulary basis at the MNE level, refer Para 7) and allocate Amount A
to eligible market jurisdictions as discussed in Para 6.

The above conditions on applicability of Amount A to MNE groups can be understood by the following examples:

Particulars	Scenario 1	Scenario 2	Scenario 3
Facts
Name of MNE group	ABC group	PQR group	MNO group
Nature of business	ADS	CFB	ADS
Home jurisdiction of group	France	Germany	Spain
Consolidated global revenue of the group	500 mn	1000 mn	1000 mn
Revenue earned by the group from outside home jurisdiction	100 mn	200 mn	500 mn
Profitability ratio of the group	8%	15%	-5%
Analysis of satisfaction of conditions
Global revenue test (€750mn) as per books	Q	R	R
Foreign revenues from ADS and CFB test (€250mn)	Q	Q	R
Routine profitability test (whether profit as per books exceeds 10%)	Q	R	Q
Impact	Amount A not applicable to ABC group	Amount A not applicable to PQR group since revenue from outside home jurisdiction is not more than €250mn	Amount A not applicable to MNO group since group is incurring losses

6. AMOUNT A ALLOCABLE ONLY TO ELIGIBLE MARKET JURISDICTIONS

MNE
groups that pass all the tests mentioned in Para 5 will need to
determine Amount A and allocate the same to market jurisdictions.

(i) Sales, marketing and distribution activities pre-requisite to qualify as market jurisdiction:
At the outset it should be noted that Amount A is a specific regime for
allocation of super profits to market jurisdictions. Market
jurisdiction is defined as jurisdictions where an MNE group sells its
products or services, or in the case of highly digitalised businesses,
jurisdictions where the MNE provides services to users or solicits and
collects data or content contributions from users. Thus, if an MNE is
carrying out manufacturing function or research and development which
are completely unrelated to sales, marketing and distribution functions
in a jurisdiction and there is no sales function carried out there, such
jurisdictions would not qualify as a ‘market jurisdiction’ and, hence,
not eligible for Amount A.

(ii) Not all market jurisdictions will be eligible for Amount A allocation:
As aforesaid, Amount A is applicable only to the MNEs engaged in ADS
and CFB activities. Amount A will be allocable to a market jurisdiction
only where an MNE group has a reasonable level of ADS and CFB activity
in that market jurisdiction and such markets are termed as ‘eligible
market jurisdictions’. In order to determine a reasonable level of
activity, certain tests are proposed as discussed below.

6.1 Likelihood of threshold for ADS business per market jurisdiction

a.
To recollect, ADS business means services provided with minimal or no
human involvement over Internet or an electronic network. These
businesses may include online advertising services, online search
engines, social media platform, digital content service, etc.
b. The
very nature of ADS is such that these businesses will always have a
significant and sustained engagement with market jurisdictions remotely,
i.e., without physical presence. Hence, for ADS businesses a simple
revenue threshold test is being proposed to determine whether the MNE
has a nexus with that market jurisdiction. The revenue threshold that
can be prescribed is still being negotiated.
c. For example, assume
that per market nexus revenue threshold for ADS business is proposed to
be €50mn. In such a case, even where the MNE group turnover from the ADS
business may be €1000mn but revenue in India from ADS only €10mn, India
being a relatively insignificant market contributing revenue cannot be
considered as an eligible market jurisdiction to which Amount A is
allocable as chargeable profit.
d. Alternatively, if revenue in India
from ADS is €100mn (and the MNE fulfilled other conditions as stated in
Para 5), India qualifies as eligible market jurisdiction entitled to
tax a proportion of Amount A – regardless of the fact that there is no
physical presence in India, or regardless of the fact that the
traditional taxation rules would have failed to capture such taxability.

6.2 Likelihood of threshold for CFB business per market jurisdiction

a.
Unlike ADS, the ability of an MNE to participate remotely in a market
jurisdiction is less pronounced in the CFB model. MNEs usually have some
form of presence in market jurisdictions (for example, in the form of
distribution entities) to carry out consumer-facing businesses.
b.
Hence, countries participating in the discussions believe that a mere
revenue threshold test may not denote the active and sustained
engagement with the market jurisdiction and the presence of certain
additional indicators (‘plus factors’) may be necessary. These plus
factors which can be used to establish a nexus are still being debated
and developed at the OECD level.

Market jurisdictions that meet
the nexus test will qualify as ‘eligible market jurisdictions’ for the
MNE group and will be eligible for a share of Amount A of such MNE group
to be taxed in the market jurisdiction. Such allocation of Amount A
will yield tax revenue for that market jurisdiction irrespective of
whether the MNE group has an entity or PE in that market country, or
whether any profits are offered to tax in that market country under
existing tax laws.

7. DETERMINATION OF AMOUNT A OF MNE GROUP THAT WILL BE ALLOCABLE TO MARKET JURISDICTIONS

a.
The norms of profit allocation suggested in the Blueprint are very
different from the taxability norms which are known to taxpayers as of
now. Hence, the exercise suggested in the report should be studied on an
independent basis without attempting to rationalise or compare it with
the conclusion to which one would have arrived as per traditional norms
of taxation.

b. The philosophy behind the report is that no MNE
group can make sizeable or abnormal or bumper profit without the
patronage and support that it gets from the market jurisdiction. There
is bound to be some contribution made by the market jurisdictions to the
ability of the MNE group to earn more than routine4 (abnormal) profit.
Hence, in relation to MNE groups which have been successful enough to
secure more than 10% routine (i.e., abnormal / bumper profits), some
part of such bumper profits should be offered to tax in every market
jurisdiction which has contributed to the ability to earn profit at the
group level. Consequently, if the MNE group’s profits are up to routine
or reasonable, or if the MNE is in losses, the report does not seek to
consider any allocation of profits to the market jurisdiction.

c.
As to how much profit of an MNE group qualifies as normal or reasonable
or routine profit and how much qualifies as abnormal or bumper or
non-routine profit is yet to be decided multilaterally amongst all
countries participating in the Pillar One discussions. Currently, (but,
provisionally) the report suggests that countries are in favour of
considering a profit margin of 10% of book revenue as normal profits,
i.e., 10% profit margin will be considered as ‘routine profits’
warranting no allocation, and any profit earned by the MNE group above
10% alone will be considered as ‘non-routine profits’ warranting
allocation to the market jurisdiction.

d. For example, if the
consolidated turnover of an MNE group as per CFS is €1000mn on which it
has earned book profits5 of €50mn as per CFS, its profit margin is only
5%. Since the profit earned by the MNE group is only 5% (i.e., within
the routine profit margin of 10%), the MNE group is considered to have
earned profits due to normal / routine entrepreneurial risk and efforts
of the MNE group and nothing may be considered as serious or abnormal
enough to permit market jurisdictions to complain that, notwithstanding
traditional taxation rules, some income should be offered to tax in the
market jurisdiction.

4   The report uses the
expression ‘residual profits’ to convey what we call here abnormal or
non-routine or super profit

5   The report also proposed
adjustments to the book profits by adding back of income tax expenses, expenses
incurred against public policy like bribes, penalty, reducing dividend and
gains on transfer of asset, etc., to arrive at a standardised base of profits

e.
Alternatively, if the consolidated turnover of the MNE group as per CFS
is €1000mn on which it has earned book profit of €400mn as per CFS, its
profit margin as per the books is 40%. In such a case, the profits
earned by the group beyond 10% (i.e., 40%-10%=30%) will be considered as
non-routine profits. Some part of such non-routine profits will be
considered as having been contributed by market jurisdictions and need
to be allocated to the eligible market jurisdiction as discussed in the
Para below6.

f. Once it is determined that the MNE group has
received non-routine profit in excess of 10% (in our example, excess
profit is 30% of turnover), the report is intended to carry out an
exercise where a portion of the excess profit is to be allocated to the
market factor of a market jurisdiction.

g. It is the philosophy
that the consumers of the country, by purchasing the goods or enjoying
the services, contribute to the overall MNE profit and but for such
market and consumers, it would not have been possible to effect the
sales. However, at the same time it is not as if the entirety of the
non-routine or super profit is being earned because of the presence of
the market. There are many other factors such as trade intangibles,
capital, research, technology, etc., which may have built up the overall
success of the MNE group.

h. As per present estimates and
thinking discussed in the report, about 80% of the excess profit or
super profit (in our example, 80% of super profit of 30%) may be
recognised as pertaining to many different strengths of the MNE group
other than the market factor. It is the residual 20% of the super profit
component which is recognised as being solely contributed by the
strength of the market factor. Hence, the present report on Pillar One
discusses how best to allocate 20% of the super profit (in our example,
20% of 30%) to market jurisdictions. The report is not concerned with
allocation or treatment of the 80% component of the super profit which
is, as per the present text of Pillar One, pertaining to factors other
than market forces.

6   Throughout the article,
this is assumed to be the applicable fact pattern of excess or more than
routine profit

i. A tabulated version of the illustrative fact pattern and proposed allocation rules of Amount A is as under:

Particulars	Amount
Consolidated turnover of MNE group	1000 mn
Consolidated book profit	400 mn
% of book profit to turnover	40%
Less: Allowance for routine profit	(10%)
Excess profit over routine profit, also loosely for abnormal or super profit	30%
Of this, 80% of super profit of 30% is considered as pertaining to the strength of non-market factors and having no nexus with contribution of the market jurisdiction (and hence out of Pillar One proposal)	24% of 1000 mn
20% of super profit of 30% being considered as fair allocation having nexus with contribution of market jurisdictions – known also as Amount A recommended by the report – to be allocated to different market jurisdictions	6% of 1000 mn

j. Some countries participating in the discussion are of the
view that allocation of 20% of non-routine profits to market countries
is minuscule and a higher margin should be allocated since the overall
success of the MNE group can be accomplished only as a result of
consumption in the markets. This article goes by the ball-park
recommendations of 20% discussed in the report for the purpose of
understanding the concept – though it may be noted that the
multilaterally agreed allocation percentage may be different.

k.
Even if under existing tax norms no profits are taxable in a market
jurisdiction (say due to no physical presence), Amount A will ensure
market countries get right to tax over 20% of non-routine profits of the
MNE group and that the market jurisdictions should not be left high and
dry without right to tax income.

8. CORRELATION OF INTERIM MEASURE ALREADY IMPLEMENTED BY INDIA, PENDING FINAL OUTCOME OF PILLAR ONE REPORT AND / OR BEPS ACTIONS

As
we are aware, even without waiting for the final outcome of the Pillar
One recommendations, India has already introduced in its domestic law
the equalisation levy which seeks to tax 2% of the digital or remote
sales as taxable profit of a non-resident and 6% of advertisement
services rendered by a non-resident.

It may be noted that all
countries participating in Pillar One discussions have agreed to
withdraw relevant unilateral actions introduced by them in their
domestic laws once Pillar One recommendations are successfully
implemented. Hence, India will hopefully withdraw the equalisation levy
once a Pillar One consensus-based solution is reached.

It is,
therefore, submitted that the Pillar One discussions may be studied as
an independent exercise rather than trying to compare them with the
interim measures. No attempt has, therefore, been made in this article
to explain or review the provisions of the equalisation levy. The
article concentrates on Pillar One proposals which are likely to
substitute the present levy.

9. FACTORS WHICH INFLUENCE QUANTUM OF ALLOCATION TO MARKET JURISDICTIONS
Broadly,
and with respect to marketing and sales activity, an MNE can carry out
operations in a market jurisdiction in the following manner:
(a)    Sales through remote presence
(b)    Presence in form of Limited risk distributor (LRD)
(c)    Presence in form of Full risk distributor (FRD)
(d)    Presence in dependent agent permanent establishment (DAPE).

Assuming
that there is no physical presence of the MNE group in a market
jurisdiction, say, India, Amount A of the MNE group determined as per
Para 7 above would be allocated to market jurisdictions on the basis of
revenue generated from each market jurisdiction. If, for example,
turnover from India is €100mn, 6% of India turnover, which equals to
€6mn, will be allocated for taxability to India.

However, if the
MNE group has a physical presence in India as well (say in the form of
LRD or FRD or DAPE), there may be a trigger for taxability in India even
as per existing taxation rules. In any such case, there could be some
variation in the rules relating to the allocation of Amount A to India.
Taxation of Amount A under each form of business presence is explained
below.

Sales is only through remote presence:
a.
Consider an example where an MNE group engaged in providing standard
online teaching services earns subscription revenue from users across
the world. In India, the group does not have any form of physical
presence and all the functions and IPs related to the Indian market are
performed and owned by a Swiss company (Swiss Co).

b. The financials of the MNE group suggest as under:

Facts:
MNE group turnover as per CFS	€1000 mn
Profit before tax (PBT) as per CFS	€400 mn
Group profit margin as per CFS	40% of group turnover
India turnover	€100 mn

c. Under existing tax rules, Swiss Co’s income is outside
the tax net [since the service is not in the nature of fees for
technical services (FTS) and Swiss Co does not have a permanent
establishment (PE) in India], thus all profits earned from the India
market (routine as well as non-routine) are taxed only in Switzerland in
the hands of Swiss Co.
d. Though India does not have taxing rights
under the existing tax rules (due to no physical presence), the
Blueprint would ensure that Amount A be allocated to India. As explained
in Para 7, Amount A recommended by the report to be allocated to
different market jurisdictions would come to 6% of the turnover. Since
turnover from India is €100mn, 6% of India turnover, equal to €6mn, will
be allocated for taxability to India.
e. However, an issue arises as
to which entity will pay taxes on Amount A in India. In this regard,
the report recognises that Amount A will co-exist with the existing tax
rules and such overlay of Amount A on existing tax rules may result in
double taxation since Amount A does not add any additional profit to the
MNE group but instead reallocates a portion of the existing non-routine
profits to market jurisdictions.
f. In the given example, all
profits (routine as well as non-routine) from the India business are
taxed in the hands of the Swiss Co under the existing tax rules. In
other words, the €6m allocated to India under Amount A is already being
taxed in Switzerland in the hands of Swiss Co due to the existing
transfer pricing norms. Hence, Swiss Co may be identified as the ‘paying
entity’ in India and be obligated to pay tax on Amount A in India.
Subsequently, Swiss Co can claim credit of taxes paid in India in its
residence jurisdiction (i.e., Switzerland).

9.2 Presence in form of limited risk distributor (LRD)
a.
There are a number of cases where an MNE group may not have full-scale
presence in the market jurisdiction but may have an LRD who is assisting
in the conclusion of sales. In a way, the LRD’s presence is
contributing to routine sales functions on a physical basis in such a
market jurisdiction. It is not a category of work which contributes to
any super profit but is taking care of logistics and routine for which
no more than routine profits can be attributed.
b. Consider an
example; a Finland-based MNE group is engaged in the sale of mobile
phones across the world. The headquarter company (FinCo) is the
intellectual property (IP) owner and principal distributor. The group
has an LRD in India (ICo) which performs routine sales functions under
the purview of the overall policy developed by FinCo. The financials of
the MNE group suggest as under:

Facts:
Group turnover as per CFS	€1000 mn
PBT as per CFS	€400 mn
Group profit margin as per CFS	40% of group turnover
India turnover	€100 mn

c. Under existing TP principles, assume that ICo is
remunerated @ 2% of India revenue for its routine functions and the
balance is retained by FinCo which is not taxed in India. In other
words, all profits attributable to non-routine functions are attributed
to FinCo and hence not taxable in India.
d. As explained in Para 7,
Amount A recommended by the report to be allocated to different market
jurisdictions would come to 6% of the turnover. Since the turnover from
India is €100mn, 6% of Indian turnover equal to €6mn will be allocated
for taxability in India.
e. India also has taxability right with
regard to the LRD function @ 2% of India turnover. This right is shared
by India so as to compensate for the routine functions carried out in
India. No part of the super profit element is contained therein, whereas
Amount A contemplates allocation of a part of the super profit.
Considering this, there is no concession or reduction in the allocation
of Amount A merely because there is taxability @ 2% of turnover for
routine efforts in the form of an LRD. The overall taxability right of
India will comprise of compensation towards LRD function as increased by
allocation of super profits in the form of Amount A.
f. Besides,
even if Indian tax authorities, during ICo’s TP assessment, allege that
ICo’s remuneration should be increased from 2% to 5% of India turnover,
there would still not be any implication on Amount A allocable to India
since ICo’s increase in remuneration for performing more routine
functions and no element of super profit forms part of such
remuneration.
g. While tax on compensation towards LRD function will
be payable by ICo, an issue arises as to which entity should pay tax on
Amount A allocable to India. Since FinCo is the IP owner and principal
distributor, existing TP rules would allocate all super profits
pertaining to the India market to FinCo. Thus, the super profits of €6mn
allocated to India under Amount A are already being taxed in Finland in
the hands of FinCo on the basis of the existing TP norms. Hence, the
Blueprint suggests that FinCo should be obligated to pay tax on Amount A
in India and then FinCo can claim credit of taxes paid in India in its
residence jurisdiction (i.e., Finland) against income taxable under
existing tax laws. Accordingly, ICo would pay tax in India on LRD
functions (i.e., routine functions) whereas FinCo would pay tax on super
profits allocated to India in the form of Amount A.

9.3 Presence in form of Full risk distributor (FRD)
a.
As a variation to the above, an MNE group may appoint an FRD in a
market jurisdiction. An FRD performs important functions such as market
strategy, pricing, product placement and also undertakes high risk qua
the market jurisdiction. In essence, the FRD performs the marketing and
distribution function in entirety. Hence, unlike an LRD, an FRD is
remunerated not only with routine returns but also certain non-routine
returns.
b. Consider an example where a French headquartered MNE
group engaged in the business of fashion apparels carries out business
in India through an FRD model. All key marketing and distribution
functions related to the Indian market are undertaken by the FRD in
India (ICo). Applying TP principles, ICo is remunerated at 10% of India
sales.
c. The financials of the MNE group are as under:

Facts:
Group turnover as per CFS	€1000 mn
PBT as per CFS	€400 mn
Group profit margin as per CFS	40% of group turnover
India turnover	€100 mn

d. To recollect, Amount A contemplates allocation of a part of
an MNE’s super profits to market jurisdictions, India being one of them.
Had there been no physical presence in India, as per calculations
indicated at Para 9.1, part of the super profits allocable to India as
Amount A would come to 6% of the India turnover (i.e., €6mn).
e. Now,
ICo as an FRD is already being taxed in India. This represents
taxability in India as per traditional rules for performing certain
marketing functions within India which contribute to routine as also
super profits functions in India. This is, therefore, a case where, in
the hands of ICo, as per traditional rules, part of the super profit
element of the MNE is separately getting taxed in the hands of ICo.
f.
In such a case, the report assumes that while up to 2% of India
turnover the taxability can be attributed towards routine functions of
ICo (instead of towards super profit functions), the taxability in
addition to 2% of India turnover in the hands of ICo is attributable to
marketing functions which contribute to super profit.
g. Since India
is already taxing some portion of the super profits in the hands of ICo
under existing tax rules, allocation of Amount A to India (which is a
portion of super profits) creates the risk of double counting. In order
to ensure there is no double counting of super profits in India under
Amount A regime and the existing TP rules, the Blueprint recognises that
Amount A allocated to India (i.e., 6%) should be adjusted to the extent
super profits are already taxed in the market jurisdiction. In order to
eliminate double counting, the following steps are suggested7:
(i)
Find out the amount as would have been allocable to market jurisdiction
as per Amount A (in our illustration, 6% of India turnover of €100mn).
(ii)
Fixed routine profit which may be expected to be earned within India
for routine operations in India. While this profit margin needs to be
multilaterally agreed upon, for this example we assume that additional
profit of 2% of India turnover will be expected to be earned in India on
account of physical operations in India. Additional 2% of India
turnover can be considered allocable to India in lieu of routine sales
and marketing functions in India – being the allocation which does not
interfere with the super profit element.
(iii) The desired minimum
allocation to market jurisdiction of India for routine and non-routine
activities can be expected to be 8% of the India turnover, on an
aggregate of (i) and (ii) above.
(iv) This desired minimum return at
step (iii) needs to be compared with the allocation which has been made
in favour of India as per TP analysis.

?    If the amount
allocated to FRD in India is already more than 8% of turnover, no
further amount will be allocable under the umbrella of Amount A.
?  
 On the other hand, if the remuneration taxed under TP analysis is <
8%, Amount A taxable will be reduced to the difference of TP return and
amount calculated at (iii).

?    However, if the return under TP
analysis is < 2%, then it is assumed that FRD is, at the highest,
taxed as if it is performing routine functions and has not been
allocated any super profit under TP laws. The allocation may have been
considered towards super profit only if it exceeded 2% of India
turnover. And hence, in such case, allocation of Amount A will continue
to be 6% of India turnover towards super profit elements. There can be
no reduction therefrom on the premise that TP analysis has already been
carried out in India. It may also be noted that since Amount A
determined as per step (i) above is 6% of India turnover, an allocation
in excess of this amount cannot be made under Amount A.

7   Referred to as marketing
and distribution safe harbour regime in the report

h. Once the adjusted Amount A is determined as per the steps above, one would need to determine
which entity would pay tax on such Amount A in India. In this case, since France Co and ICo both perform function
asset
risk (FAR) activities that result in revenue from the India market, the
Blueprint recognises that choosing the paying entity (i.e., entity
obligated to pay tax on Amount A in India) will require further
discussions / deliberations. Further, the report also recognises that
taxes may have been paid in the market country on royalty income.
However, whether and how such taxes paid can be adjusted against tax on
Amount A is currently being deliberated at the OECD level.

i. In the fact pattern below, ABC group, engaged in CFB business, carries out sale in India under the FRD model.

Facts:
Group turnover as per CFS	€1000 mn
PBT as per CFS	€400 mn
Group profit margin	40%
India turnover	€100 mn
TP remuneration to FRD in India •     Scenario 1 •     Scenario 2 •     Scenario 3	10% of India turnover 5% of India turnover 1% of India turnover
Amount A allocable to India (6% of 100 mn)	6 mn

Elimination of double counting of non-routine profits in India under different scenarios:

 

	Particulars	Scenario 1	Scenario 2	Scenario 3
a.	Amount A allocable to India (as determined above)	6%	6%	6%
b.	Return towards routine functions (which OECD considers tolerable additional allocation in view of presence in India)	2%	2%	2%
c.	Sum of a + b (This is the sum of the routine and non-routine profits that the OECD expects Indian FRD to earn)	8%	8%	8%
d.	TP remuneration to FRD in India	10%	5%	1%
e.	Final Amount A to be allocated to India	No Amount A allocable since FRD in India is already remunerated above OECD’s expectation of 8%	3%, OECD expects Indian FRD to earn 8% but it is remunerated at 5%. Hence, only 3% to be allocated as Amount A [instead of 6% as determined at (a)]	6%, No reduction in Amount A since OECD intends only to eliminate double counting of non-routine profits and where existing TP returns is less than fixed return towards routine functions, it is clear that no non-routine profit is allocated to India under existing tax laws

9.4 Presence in form of DAPE

a.
The report recognises that the MNE groups may have a presence in a
market jurisdiction in the form of PE as well. A DAPE usually is an
agent in the market jurisdiction who undertakes sales or secures orders
for its non-resident principal.
b. The manner in which Amount A would
be taxed in a market jurisdiction where an MNE group operates through a
DAPE model would depend on the functional profile of the DAPE. If the
DAPE only performs minimum risk-oriented routine functions, the
taxability of Amount A may be similar to the LRD scenario discussed at
Para 9.2. On the other hand, where the DAPE performs high-risk
functions, the taxability of Amount A would be similar to the FRD
scenario discussed at Para 9.3.

10. COMPREHENSIVE CASE STUDY ON WORKING AND ALLOCATION OF AMOUNT A
FACTS
?    ABC group is a German headquartered group engaged in the sale of mobile phones which qualifies as CFB activity.
?  
 The ultimate parent entity is German Co (GCo) which owns and performs
development, enhancement, maintenance, protection and exploitation
(DEMPE) functions related to the MNE group’s IP.
?    ABC group makes sales across the world. As per ABC group’s CFS,
o    Global consolidated group revenue is €1000mn
o    Group PBT is €400mn
o    Group PBT margin is 40%
?    ABC group follows a different sale model in the different countries in which it operates:

Particulars	France	UK	India	Brazil
Sales model	Remote presence	LRD	FRD	DAPE performing all key functions and risk-related Brazil market
Sales	100	200	400	300
TP remuneration	NA	2%	10%	5%

? All countries (France, UK, India, Brazil) qualify as eligible market jurisdictions

Computation of Amount A at MNE level:

Particulars		Profit margin	Amounts
PBT of the group	(A)	40%	400
Less: Routine profits (10% of €1000Mn)	(B)	10%	100
Non-routine profits	C = A-B	30%	300
Profits attributable to non-market jurisdiction	D = 80% of C	24%	240
Profits attributable to market jurisdictions (Amount A)	E = C-D	6%	60

Allocation of Amount A to respective market jurisdictions:
   

	Particulars	France	UK	India	Brazil
	Sales model	Remote presence	LRD	FRD	DAPE
a.	Amount A allocable (as determined above)	6%	6%	6%	6%
b.	Fixed return towards routine functions (as calibrated by OECD)	Marketing and distribution safe harbour regime – NA since MNE has no presence or limited risk presence		2%	2%
c.	Sum of a + b			8%	8%
d.	TP remuneration to FRD in India			10%	5%
e.	Final Amount A to be allocated	6%	6%	NIL since FRD in India is already remunerated above OECD’s expectation of 8%	3% OECD expects DAPE to earn 8% but it is remunerated at 5%. Hence, only 3% to be allocated as Amount A
f.	Entity obligated to pay Amount A	GCo (FAR analysis would indicate that GCo performs all key functions and assumes risk related to France and UK market which helps to earn non-routine profits from these markets)		NA, since there is no Amount A allocated to India	Depending on FAR analysis, Amount A may be payable by GCo or DAPE or both on pro rata basis

11. UNITED NATION’S EFFORTS TOWARDS TAXATION OF DIGITAL ECONOMY
While
OECD is working with BEPS IF members to develop a solution to
effectively tax the digital economy, some members of the United Nations
(UN) digital taxation sub-committee have raised concerns on OECD’s
proposed solution. For example, concerns are raised that Pillar One will
introduce a great deal of complexity. Besides, the expected modest
revenue impact of Pillar One does not justify the large-scale changes in
the system of taxing MNEs8.

As an alternate solution, UN has
proposed to introduce a new Article in the United Nations Model
Convention which would apply to income from ADS (automated digital
services, i.e., services provided with minimal or no human involvement
over Internet or an electronic network). A specific inclusion of the ADS
article would ensure that such highly-digitalised services do not fall
under the general business profits article (i.e., Article 7) and hence
the source countries may be able to tax such income even in the absence
of a PE.

The ADS Article proposed by the UN is designed along the
lines of royalty, dividend, FTS articles, i.e., taxing rights to source
state, gross basis taxation, concept of beneficial owner, payer and PE
source rule, ALP adjustment, etc. Additionally, an optional net basis
taxation is proposed where the beneficial owner of the ADS income will
be taxed on a net basis instead of on gross income. Under the net basis,
the taxable amount will be determined on the basis of a normative
formula which is currently being discussed at the UN level.

A comparison of UN’s proposal for digital taxation and OECD’s Amount A proposal indicates as under:

Particulars	ADS Article proposed by UN	OECD’s proposed Amount A
Level of taxability	Entity level	MNE group level
Taxes remote presence beyond conventional PE	Yes	Yes
Activities covered9	ADS	ADS and CFB
Monetary threshold for applicability	No threshold (countries may adopt local thresholds if required)	Global revenue threshold and in-scope foreign de minimis threshold
Gross vs. Net	Provides option to taxpayer to choose between tax on gross consideration and taxation on net basis	Net basis (Amount A is a share of MNE profits)
Taxable amount	Gross basis: Gross consideration Net basis: Taxable amount to be determined on formulary basis	Taxable amount to be determined on formulary basis
Rate of tax	Gross basis: 3-4% of transaction value Net basis: Domestic tax rate	Domestic tax rate of market jurisdiction
Taxing right allocated to	Source country	Eligible market jurisdictions
Source rule	Payer or PE-based source rule	Market jurisdictions that meet tests as discussed in Para 6
Tax-bearing entity	Recipient or beneficial owner of ADS income	MNE group entity identified as paying entity
Treatment of losses	Gross basis: Not considered Net basis: No tax in case of losses (No clarity on treatment of past losses)	No Amount A allocation when MNE is in losses, losses would be carried forward and past losses can be considered
Implementation	New MLI approach or bilateral	New MLI to be drawn to implement Amount A
Dispute resolution	Existing MAP or domestic route	Customised tax certainty or dispute resolution process being formalised
Inter-play with existing business profits rule	Where Article 12B would apply, income would fall outside PE taxation	Amount A to work alongside existing tax rules

12. CONCLUDING THOUGHTS
The reports published by OECD
and UN as proposals to effectively tax the digital economy indicate that
international taxation norms are at the cusp of a revolution. MNEs will
have a daunting task of understanding the nuances of the proposals and
their impact on their businesses, though on a positive note there may be
relief from unilateral measures taken by countries to tax the digital
economy once the OECD / UN proposals are implemented.

While tax
authorities will be eager to have another sword in their armoury, it may
be noted that the OECD / UN proposals are still far from the finishing
line. Though the Blueprint released by OECD is more than 200 pages, the
report mainly provides the broad contours of the structure and working
of Amount A. Most of the aspects of Amount A are still under discussion
and debate. With 135countries participating in the OECD discussions, the
biggest challenge will be to achieve multilateral
consensus. While
countries have committed to arrive at a consensus-based solution by
mid-2021, it will be interesting to see how it is accomplished within
such a short span of time.

7   Referred to as marketing
and distribution safe harbour regime in the report

8   Note submitted by
Committee member Rajat Bansal as published in UN Doc E/C.18/2020/CRP.25 dated
30^th May, 2020

9   Definition of ADS is the
same in the UN as well as in the OECD proposal