In this dynamic era, the brick and mortar business models are turning digital and Multi-National Companies (MNCs) are effectively operating out of various jurisdictions without having a physical presence. From a taxation perspective, it is way more challenging when the value creation, income generation and the adjoining taxability cut across various countries.
The Organization for Economic Cooperation and Development (OECD) has been actively chalking out policies and proposals to monitor and harmonize the international tax framework. This includes introduction of a slew of action plans to counter Base Erosion and Profits Shifting (BEPS) strategies adopted by MNCs to reduce the group’s effective tax rate.
Introduced way back in 2013, the BEPS Action Plan 1 partially addressed the challenges posed by the digital economy. India was swift in implementing the recommendation of BEPS Action Plan 1 by introducing Equalization levy and Significant Economic Presence Rules (applicable from Assessment year 2022-23).
Pursuant to the success of Action Plan 1, in Feb 2019, the OECD issued a public consultation document consisting of a Two-Pillar Approach envisaging the challenges in a digital economy and spelling out the means to mitigate them.
- Pillar One, comprised of profit allocation rules between jurisdictions in case of cross border transactions and other nexus-based rules.
- Pillar Two, introduced the concept of Global Anti-Base Erosion (GloBE) ensuring minimum levels of taxation.
Further, in May 2019, the OECD released a Programme of Work, describing in more detail the proposals being considered under the Two-Pillar approach. The contents are summarized below:
Pillar One Proposal – Nexus and profit allocation
The OECD came up with a “Unified Approach” for Pillar One which intends to bring clarity on profit allocation and coherence rule. The ideas mooted in this approach include:
- Allocation of residual profits to market jurisdictions (Amount A) – These are intended for businesses operating in the automated digital industry and other consumer facing industries. Based on the ‘Profit Before Tax’ reported in the consolidated financial statements, non-routine profits would be computed. These non-routine profits would be subsequently allocated to eligible market jurisdictions based on agreed allocation keys. Further, measures would be taken to avoid double taxation of such non-routine profits. Revenue-thresholds would be prescribed to keep away small-scale corporates from the burden of compliance.
- A fixed remuneration based on the Arm’s Length Price (ALP) for distribution and marketing functions (Amount B) – This approach aims to put in place a standard mechanism to remunerate the enterprises that carry out baseline marketing and distribution activities. This remuneration would be based on ALP, but fixed amounts of return will be explored to minimize disputes. This mechanism would enhance tax certainty and substantially reduce tax litigations.
- Additional Return subject to tax when the jurisdiction can successfully establish the claim (Amount C) – In addition to adjustments mentioned above, a jurisdiction may bring under its tax gamut any profits attributable to the activities performed in its own jurisdiction. The scope of “Amount C” is still under discussion. Further, this approach also emphasizes on implementation of a robust dispute resolution mechanism. The necessity to eliminate double taxation and overlapping of any of the proposed adjustments have also been highlighted. Consideration of an alternative global safe harbor system has also been indicated in this proposal.
Pillar Two Proposal – GloBE
This proposal focuses on other BEPS issues and seeks to develop rules that provide jurisdictions, the right to tax transactions where the payment is subject to no tax or low levels of effective tax. The components of GloBE include:
- Income inclusion rule – This rule aims to tax foreign branches and controlled entities that are subject to tax at an effective rate that is below a minimum rate. This mechanism curbs conscious allocation of income to entities operating in low tax jurisdictions;
- Switch-over rule – This rule ensures that the income inclusion rule effectively applies to those foreign branches that take shelter under the double tax treaties and avail tax exemptions. This rule would permit a residence jurisdiction to switch from an exemption to a credit method where the profits attributable to a permanent establishment (PE) or derived from immovable property (which is not part of a PE) are subject to an effective rate below the minimum rate;
- Undertaxed payments rule – The said rule operates by denying a deduction or making an equivalent adjustment (withholding tax) in respect of intra-group payments that are under-taxed; and
- Subject to tax rule – This rule works by subjecting a payment to withholding or other taxes at source and denying treaty benefits on certain items of income where the payment is not subject to tax at a minimum rate.
All these proposals have been designed to limit complexity, compliance and administration costs and the risk of over-taxation.
The OECD has invited recommendation and opinions from various stakeholders on the proposals. Inputs on definition of key metrics such as tax base, tax rates, carve-outs and thresholds have also been sought. The devil lies in the details. As per the OECD’s timelines, a consensus on the proposals had to be reached by July 2020 and the technical implementation was slated to be completed by 2022, however, Covid-19 outbreak has stymied the progress.
In the current scenario, jurisdictions would be proactive in adopting these proposals once they are released by the OECD and so it is imperative for MNCs to carry out a preliminary analysis of their existing business structure.