After years of intense work and negotiations, 136 of the 140 members of the OECD’s Inclusive Framework (“IF”) agreed to the two-pillar plan to reform international taxation rules on October 8, 2021. The plans for Pillar 1 and Pillar 2 are radical, and it is expected that they will become game changers for international taxation once they are implemented in 2023. There are still some hurdles between this deal and the actual implementation, but the course has been set.

The following timeline has been set out:

Please find below a short overview of the highlights prepared by Dentons’ Amsterdam tax team, comprising text excerpts from the agreed framework, which allow you to quickly understand and get an idea of what is to come without having to dive into the documents themselves. Read more in our August 2020 tax alert relating to the original draft blueprints.

The Netherlands government announced that it fully supports the tax reforms and it aims to implement

the necessary legislation and conventions in line with the ambitious timeline of the OECD.

Pillar 1—Automated digital services and consumer-facing businesses

Pillar 1 seeks to adapt the international income tax system to new business models through changes to the profit allocation and nexus rules applicable to business profits. Within this context, it expands the taxing rights of market jurisdictions (which for some business models are the jurisdictions where the users are located) where a business has active and sustained participation in the economy of that jurisdiction through activities in (or remotely directed at) that jurisdiction. It also aims to significantly improve tax certainty by introducing innovative dispute prevention and resolution mechanisms. Pillar 1 seeks to balance the different objectives of IF members, resulting amongst others in the removal of relevant unilateral measures aimed at taxing highly digitalized businesses (e.g. digital service taxes).

The key elements of Pillar 1 can be grouped into three components:

• A new taxing right for market jurisdictions over a share of residual profit calculated at a multinational enterprise (“MNE”) group (or segment) level (Amount A)
• A fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction, in line with the ALP (Amount B)
• Processes to improve tax certainty through effective dispute prevention and resolution mechanisms in case of disagreements on the amounts of profit allocated to market jurisdictions.

Furthermore, the IF members also agreed on a standstill and rollback of all digital services taxes and similar measures. “Similar measures,” however, remains undefined at this stage.

Amount A

The new taxing right (Amount A) applies broadly and is not limited to a small number of MNEs in a particular industry. However, the need to keep the number of MNEs affected at an administrable level is recognized, and thresholds and a phased implementation are a possibility. Key design features of the new taxing right include the following:

1. In-scope companies are multinational enterprises whose global turnover is more than €20 billion with profitability above 10 percent, with the turnover threshold to be reduced to €10 billion, contingent on successful implementation, including implementation of tax certainty on Amount A. Review of these numbers begins seven years after the agreement comes into force and the review being completed in no more than one year.
2. A new nexus rule permits allocation of Amount A to a market jurisdiction when the in-scope MNE derives at least €1 million in revenue from that jurisdiction. For smaller jurisdictions with GDP lower than €40 billion, the nexus will be set at €250,000. The nexus rules balance the interests of smaller jurisdictions, in particular developing economies, in benefiting from the new taxing right with the need for low and proportionate compliance costs, while avoiding spill-over effects in other tax and nontax areas.
3. The nexus rules are supported by detailed sourcing rules that reflect the particularities of digital services and balance the need for accuracy with the ability of in-scope MNEs to comply. This is achieved through due diligence rules subject to a clearly defined hierarchy, likely to be of particular importance in connection with third-party distribution.
4. A loss-reallocating residual profit. Eligible market jurisdictions will receive a portion of 25 percent of residual profit (income exceeding an agreed level of profitability of (10 percent) using a formula. To strike a balance between simplicity and accuracy, the calculation of the relevant measure of profit will rely as much as possible on published consolidated financial accounts.
5. A marketing and distribution profits safe harbor will cap the allocation of Amount A to market jurisdictions where an MNE already leaves residual profits under the existing ALP-based profit allocation rules. Conceptually, it considers the income taxes payable in the market jurisdiction under existing taxing rights and Amount A together and adjusts the quantum of Amount A taxable in a market jurisdiction, limiting it where the residual profit of the MNE is already taxed in that jurisdiction as a result of existing profit allocation rules. Under the safe harbor, groups that already allocate profits to a market jurisdiction in excess of the safe harbor return would not pay Amount A or would apply the mechanism to eliminate double taxation and thus would remain subject to the current rules.
6. Double taxation of profit allocated to market jurisdictions will be relieved using either the exemption or credit method.
7. Where an MNE is subject to the new taxing right, a simplified administrative process is in place to minimize the complexity, burden and cost of filing and payment, which will benefit tax administrations and taxpayers alike. Tax compliance will be streamlined (including filing obligations) and will allow MNEs to manage the process through a single entity.
8. The new Amount A taxing right will be implemented through a new multilateral convention. The multilateral instrument through which Amount A is implemented will be developed and opened for signature by mid-2022, with Amount A coming into effect in 2023.

Amount B

The purpose of Amount B is twofold. First, it is intended to simplify the administration of transfer pricing rules for tax administrations and lower compliance costs for taxpayers. Second, Amount B is intended to enhance tax certainty and reduce controversy between tax administrations and taxpayers.

Amount B will standardize the remuneration of related party distributors that perform “baseline marketing and distribution activities.” The definition of baseline marketing and distribution activities covers distributors that (i) buy from related parties and resell to unrelated parties, and (ii) have a routine distributor functionality profile.

In addition, in-scope activities are first defined by a “positive list” of typical functions performed, assets owned and risks assumed at arm’s length by routine distributors (based on a narrow scope, akin to limited-risk distributors). A “negative list” of typical functions that should not be performed, assets not owned and risks not assumed at arm’s length by routine distributors are also used to qualitatively measure the additional factors that would deem a distributor as being outside the scope of Amount B. Certain quantitative indicators are then used to further support the identification of in-scope activities.

Amount B will be determined in accordance with the arm’s length principle (ALP), therefore based on comparable company benchmarking analyses under the Transactional Net Margin Method (TNMM), with the quantum varying by industry, as well as region, provided any such variation is supported by the relevant benchmarking analysis. As a result Amount B will have a number of fixed points.

It is estimated that work on Amount B will be completed by the end of 2022.

Pillar 2—the GloBE and substance to tax rules

The GloBE rules

The income inclusion and undertaxed payments rules (together, the GloBE rules) provide a systematic solution that is designed to ensure that internationally operating businesses pay a minimum level of tax regardless of where they are headquartered or the jurisdictions they operate in. The GloBE rules have the status of a common approach; countries will not be required to adopt them, but if they choose to, implementation must be in a manner consistent with the model rules and IF guidance.

As for Country by Country Reporting (CbCR), application of the GloBE Rules is confined to MNE groups that have total consolidated group revenue above €750 million or equivalent in the immediately preceding fiscal year of the group. Investment funds, pension funds, government bodies, international organizations, and non-profit organizations are outside the scope of these rules. It is also determined that international shipping income will be outside the scope, using the definition of such international income under the OECD Model Tax Convention.

To determine an MNE’s effective tax rate (ETR) under the GloBE rules, the MNE first determines its income for GloBE purposes and the covered taxes on that income. In the event that an MNE’s ETR for a given jurisdiction in which it operates is below the agreed minimum rate of 15 percent, the MNE will be liable for an incremental amount of GloBE tax that is sufficient to bring the total amount of tax on that income up to the minimum rate. To ensure transparency and a level playing field, the GloBE tax base is uniform across jurisdictions and will start with the financial accounts as prepared by the MNE in the jurisdiction of its headquarters.

The GloBE rules will provide for a formulaic substance carve-out that will exclude income that is 5 percent of the tangible assets and payroll. In a 10-year transition, the amount of income will be 8 percent of the carrying value of tangible assets and 10 percent of payroll, declining annually by 0.2 percent for the first five years, and by 0.4 percent for tangible assets and by 0.8 percent for payroll for the last five years.

The difference between an MNE’s actual ETR in a low-tax jurisdiction and the agreed minimum rate of 15 percent is referred to as the “top-up tax percentage,” while the constituent entities located in the low-tax jurisdiction are referred to as “low-tax constituent entities.” Once the low-tax jurisdictions have been identified and the low-tax income and top-up tax percentage have been determined for each of those jurisdictions, the Income Inclusion Rule (IIR) and the Undertaxed Payments Rule (UTPR) operate to attribute that low-tax income and corresponding top-up tax to another constituent entity under the IIR or to determine the amount of adjustment to be made in respect of a taxpayer applying the UTPR.

1. The IIR applies at the level of the parent jurisdiction (If this jurisdiction does not apply the GloBE rules, then the IIR applies at a lower level in the group) and levies top-up tax on the low-tax income of those foreign constituent entities that are directly or indirectly controlled by the parent entity, operating effectively as a CFC rule.
2. The UTPR, planned to come into effect in 2024, operates as a backstop to the IIR while also providing jurisdictions with a tool to protect themselves from the effect of base-eroding transactions. This rule operates by way of a limitation on the deduction of intra-group payments or through an equivalent incremental adjustment. The GloBE rules will provide for an exclusion from the UTPR for MNEs in the initial phase of their international activity, defined as those MNEs that have a maximum of €50 million in tangible assets abroad and that operate in no more than five other jurisdiction. The exclusion is limited to a period of five years after the MNE falls under the scope of the GloBE rules. For MNEs that fall under the scope of the GloBE rules when they come into effect, the five-year period will start at once the UTPR rules come into effect.
3. The amount of the adjustment under the UTPR is calculated by reference to remaining pools of low-tax income that arise within the MNE group and are not subject to tax under the IIR. This low-tax income could include, for instance, profits made by those constituent entities that are located in the parent jurisdiction if the MNE’s jurisdictional ETR in the parent jurisdiction is below the minimum rate. To ensure that the UTPR does not result in over taxation the UTPR is coordinated with other applicable UTPRs in other jurisdictions. Such coordination is achieved by way of allocating top-up tax to UTPR taxpayers on the basis of their intra-group payments.

Rules are proposed to scope out special situations such as joint ventures.

The subject-to-tax rules

The GloBE rules are designed to ensure large MNEs pay a minimum level of tax on their income globally. The subject-to-tax rule complements these rules, but focuses on the bilateral context of tax treaties and the ability of source jurisdictions to protect themselves from the risks posed by BEPS structures, which take advantage of low-tax outcomes in the other contracting jurisdiction. The minimum rate for the subject-to-tax rule will be 9 percent. The subject-to-tax rule will incorporate the following design components:

1. Applied to payments. The subject-to-tax rule is a standalone treaty rule and, consistent with the way bilateral tax treaties operate, will apply to payments between residents of two contracting states. This payments-based approach means that the rule will not apply jurisdictional or entity blending, but will instead operate by reference to the tax applicable to an item of income. Consistent with the scope of application of the GloBE proposal, however, it will not apply to payments made to or by individuals.
2. Applied between connected persons. The rule will apply to payments between connected persons. The definition of connected persons is based on the definition of “closely related” persons in Article 5(8) and 5(9) respectively of the OECD and UN model tax conventions. Under this test, two persons are treated as “connected” if one has control of the other or both are under the control of the same person or persons. While the test is based on a de facto control relationship, these control requirements are automatically met where one person possesses directly or indirectly more than 50 percent of the beneficial interests in the other or if a third person possesses directly or indirectly more than 50 percent of the beneficial interests in both.
3. Covered payments. The rule will apply to a defined set of payments giving rise to base erosion concerns, which include at least interest and royalty payments and a “defined set of other payments”, which is currently not yet clear.
4. Excluded entities. Consistent with the scope of application of the GloBE, the subject-to-tax rule will not apply to certain entities that are outside the scope of the income inclusion and undertaxed payments rules (where certain conditions are met). Entities currently envisaged as being excluded from those rules are investment funds, pension funds, government bodies, international organizations, and non-profit organizations.
5. Materiality threshold. In order to ensure that the subject-to-tax rule is focused on those structures that pose the most material profit-shifting risks, it will be subject to a materiality threshold.
6. Adjusted nominal rate trigger. The rule will be triggered when a payment is subject to a nominal tax rate in the payee jurisdiction that is below the minimum rate of 9 percent, after adjusting for certain permanent changes in the tax base that are directly linked to the payment or the entity receiving it. This approach is consistent with the design of a payments-based rule; applying an effective tax rate test to each payment would be prohibitively complex to administer and comply with.
7. Using a top-up approach. The effect of the rule will be to allow the payer jurisdiction to apply a top-up tax to bring the tax on the payment up to an agreed minimum rate and one that interacts in a coordinated manner with any existing withholding rate in the treaty. Because the rule applies to the gross amount of the payment, the top-up tax will be limited to avoid excessive taxation.

An implementation framework will be developed for Pillar 2 and will contain agreements on the administrative procedures (such as the tax return procedure) and the creation of certain safe harbors to simplify the application of Pillar 2 by taxpayers and tax authorities.