The OECD and the evolution of international taxation: state of the art and operational reflections in the light of the work on Pillar One and Pillar Two.

Pillar One focuses on profit allocation and the nexus concept. It moves away from the more traditional approach to taxation based on the "physical presence", by transferring taxation rights into the so-called market jurisdictions, namely in those jurisdictions where commercial activities arise (i.e., marketplaces and users location) and the consequent profits originate.

The first concrete examples of this new approach are represented by the introduction of taxes on digital services at domestic levels as happened, for example, in the United Kingdom, Italy, India and other countries where we have witnessed the implementation of similar unilateral measures. However, it is already envisaged that these unilateral measures will be repealed once agreement is reached on the functioning mechanisms of Pillar One (so-called, sunset clause).

From an operational point of view, the provisions contained in Pillar One apply only to the largest multinationals, i.e. those with global revenues in excess of €20 billion and a pre-tax profit margin above 10%.

The proposed approach for the functioning of Pillar One is technically complex: in brief, it will lead to the creation of new taxation rights in favor of market jurisdictions, essentially based on a simplified approach, rather than on the use of the arm’s length principle. This will allow the taxation of residual profits in jurisdictions to which at least €1 million of revenue is allocated (€250,000 for jurisdictions with a GDP of less than €40 billion). These provisions are contained in the calculation rules of the so-called Amount A.

A second aspect (i.e., Amount B) of Pillar One is the allocation of a minimum profit for routine functions related to marketing and distribution activities. 

Although the original proposals regarding the concepts and operating mechanisms of Pillar One were aimed at highly digitized business models, the subsequent ones have taken on a much broader scope, although exclusion from this discipline is envisaged for some specific sectors, like - for example - regulated financial services.

The crucial point of Pillar Two is the introduction of a global minimum tax rate of 15%.

The aim is to reduce the incentive for multinational companies to operate in low or no tax jurisdictions, limit tax competition between states and promote the sustainability of corporate income tax as the main source of public revenue.

The Pillar Two provisions will only apply to those multinational groups with a total consolidated turnover of at least €750 million. The working mechanisms of Pillar 2, which is at a more advanced stage than Pillar One, focus on a two-step approach in order to grant jurisdictions additional taxing rights.

More precisely, on the one hand there is a set of provisions to be implemented at the level of national regulations, commonly referred to as GloBE (Global Anti-Base Erosion Model Rules): in particular, they provide for a coordinated taxation system which imposes an additional tax (top-up tax) on profits made in a jurisdiction whenever the effective tax rate, determined on a jurisdictional basis, is lower than the minimum rate. Hence, the "Income Inclusion Rule” (IIR) imposes an additional tax on the parent company when it holds shareholdings in subsidiaries located in jurisdictions where the effective tax rate (ETR) is less than 15%.
It is accompanied by the so called Undertaxed Payment Rule (UTPR) which is intended to deny deductions or prevent adjustments on profits that are not subject to the minimum level of taxation under the "Income Inclusion Rule” (IIR).

The GloBE provisions are then accompanied by a safeguard mechanism (Subject To Tax Rule – STTR) which allows source jurisdictions to impose a limited withholding tax on certain intercompany payments subject to a tax lower than a minimum rate.

In this regard, it is worth recalling that IF members recognize that the STTR is an integral part of reaching a consensus on Pillar Two for developing countries. In the Two-Pillar Solution statement published by the OECD on 8 October 2021, it is stated that IF members who apply nominal corporate income tax rates below the STTR minimum rate to interest, royalties and a defined variety of other payments, will implement the STTR in their bilateral treaties with developing IF members when required. The right to tax will be limited to the difference between the minimum rate and the tax rate on the payment. The minimum rate for the STTR will be 9%.

Even with Pillar Two, it is expected that there will be some industry-based scope exclusions.
A substance test will also apply, so that the additional tax will not be assessed on the income of a low-taxed subsidiary, to the extent that its return does not exceed 5% of personnel costs and tangible fixed assets. The rules are therefore clearly targeted at firms that earn excessive returns on intangibles.

As part of the work of the OECD/G20 Inclusive Framework on BEPS aimed at implementing a two-pillar solution aimed at addressing the tax challenges arising from the digitalization of the economy, in December 2022 the OECD placed the following documents for public consultation:

• Pillar One – Amount A: Draft Multilateral Convention Provisions on Digital Services Taxes and Other Relevant Similar Measures. [opening of consultation 20 December 2022 – deadline for sending comments: 20 January 2023].
  The Inclusive Framework has mandated a dedicated Task Force on the Digital Economy (TFDE) to carry out the work necessary for the design and implementation of Amount A. In particular, the TFDE has been asked to develop a so-called Multilateral Convention (MLC) and its specific commentary as well as to provide indications so that individual States can proceed with the implementation in national legislation. The draft MLC-related provisions under discussion in the document (which do not yet reflect a consensus on the substance of the document itself) reflect the commitment to eliminate all existing Digital Service Taxes (DSTs) and other relevant similar measures and for the suspension of such measures in the future. This commitment is an essential part of achieving the Pillar One goal of stabilizing the international tax architecture.

• Pillar One – Amount B relating to the simplification of transfer pricing rules. [opening of consultation 8 December 2022 – deadline for sending comments: 25 January 2023]On 14 October 2020, the Inclusive Framework published the report “Tax Challenges Derive from Digitalization-Report on Pillar One Blueprint”. The document stated that Amount B was intended to simplify the pricing process of core marketing and distribution assets in accordance with the arm's length principle, thereby aiming at enhancing tax certainty and reduce high-intensity litigations between taxpayers and tax administrations. Starting from this assumption, through this new document submitted to public consultation, the IF takes steps forward in the declination of the following aspects:
• the definitive criteria for identifying the taxpayers destined to fall within the scope for the purposes of Amount B in order for the carefully delineated controlled transactions to be classified as material transactions, duly taking into account where qualitatively the analysis of specific facts or circumstances and where quantitative simplifications are appropriate to measure the performance of specific activities;
• the pricing methodology for Amount B purposes and whether any exemptions should apply;
• what are the tools and ways forward to streamline the comparability analysis for Amount B pricing purposes so that it remains aligned with both the OECD Transfer Pricing Guidelines and the objectives background of the Amount B.
• Pillar Two – Globe Information Return. [opening of the consultation 20 December 2022 – deadline for sending comments: 3 February 2023]
  The Inclusive Framework on BEPS has initiated work to develop a standardized GloBE Information Return - GIR (i.e., a statement of information relevant to GloBE purposes) that will facilitate compliance with and administration of GloBE rules. To date, the work of the Inclusive Framework, through the document at stake, has mainly focused on the identification of a complete set of punctual data for the calculation of the GloBE tax burden of a multinational company.

Although the opinions and proposals included in the document for public consultation do not represent positions on which consensus has already been found between the Inclusive Framework, the Committee for Fiscal Affairs (CFA) or their subsidiary bodies, they - nevertheless - intend provide interested parties with substantial information and proposals to carry out the necessary analyses and submit comments.

The data indicated in Annex A of the document under consultation are those considered sufficient to calculate the GloBE tax burden of the multinational group and are sorted into the following four sections:

• General information, which includes general information on the multinational group and on the constituent entity in charge of submitting the GloBE return;
• Corporate structure, which includes information on the corporate structure of the multinational group, in particular the ownership structure of each constituent entity, whether it is required to apply the IIR and whether the UTPR might apply in relation to that entity, as well as information on changes to the ownership structure that occurred during the year;
• ETR calculation and Top-up tax calculation, which includes information on the effective tax rate and additional tax calculations for those jurisdictions where constituent entities or members of JV-related groups are located, as well as any choices made in compliance with the GloBE Rules. This section will also include simplified compliance procedures connected to the safe harbors that will be identified;
• Top-up tax allocation and attribution, which includes information on the allocation of this additional tax as well as the tax jurisdictions that will implement this top-up tax in accordance with the GloBe Rules. The section also provides more details on the calculation of the top-up tax quota to be attributed to each parent company to apply the IIR and on the calculation of any amount of this top-up tax in relation to the UTPR.

• Pillar Two – Tax Certainty for the Globe Rules. [opening of the consultation 20 December 2022 – deadline for sending comments: 3 February 2023]
  The document in public consultation concerns the aspects related to fiscal certainty as regards the GloBE rules: more concretely, it outlines various mechanisms, including those aimed at prevention (dispute prevention mechanisms) and dispute resolution mechanisms (dispute resolution mechanisms). The document outlines the next steps envisaged in relation to the development of such mechanisms and identifies a number of areas where input from all stakeholders would be valuable. Indeed, the comments that will be submitted will help Inclusive Framework members complete the work related to the compliance and coordination aspects of the GloBE rules under Pillar Two in an effort to ensure consistent and coordinated outcomes for multinational enterprises, while minimizing compliance charges and avoiding the risk of double taxation.
  In fact, the agreed approach under Pillar Two requires jurisdictions wishing to introduce the GloBE Rules to implement and apply their domestic law provisions in a coherent and coordinated manner. Despite this, there is the concrete possibility that differences may arise in the interpretation or application of these rules between jurisdictions, which could thus give rise to divergent results in the face of the application of the same set of GloBE rules. Therefore, the Inclusive Framework has started work dedicated to exploring mechanisms to provide further tax certainty regarding the GloBE rules.

As anticipated above, in December 2022, the OECD published - for public consultation - a document on Pillar One Amount B. It allows the following considerations: first, Amount B is basically a safe harbor for distribution activities. In fact, if within the multinational group there are entities characterized as limited risk distributors (i.e., Limited Risk Distributors - LRD), commission agents or sales agents who are paid on the basis of the TNMM method (Transactional Net Margin Method), then the Amount B will have to be the focus of careful analyses and assessments also in consideration of the entire supply chain in which this entity with a routine operational and risk profile finds itself acting. Since this is a simplification measure, one can essentially think of the Amount B as a fixed margin to be recognized to the distributing entity, for example as profit on sales (Return on Sales - ROS) in the case of LRD.

Further aspects connected to the transfer pricing simplification mechanisms thus emerge:

- Amount B will only apply to tangible assets. Performance of services and IPs will therefore not be affected. The OECD is also considering excluding transactions involving the sale of raw materials, where the CUP typically proves to be the most appropriate method. However, further considerations on the point are awaited;
- the written contract should become the rule: in this way it would be possible to clearly and precisely outline all the conditions of the transaction which qualify the entity as subject to routine functions and limited risk;
- the entity will be required to carry out its distribution activities mainly in the market of its residence (cross-border distribution must not exceed a certain threshold). Also in this case, the aspects to be taken into consideration are innumerable and the debate is far from being concluded;
- a routine functional profile that allows the adoption of a simplified approach essentially means that the entity does not carry out activities unrelated to the strictly commercial one, such as - for example - R&D activities, procurement, financing;
- the entity must not perform any "risk control function", which involves the assumption of economically significant risks associated with the DEMPE functions (Development, Enhancement, Maintenance, Protection and Exploitation);
- the entity must not perform strategic activities that would lead to the creation of unique intangible assets;
- Amount B does not apply if the distribution relationship in question is already covered by a bilateral/multilateral APA.

These considerations immediately give rise to other comments, connected - for example - to situations in which the entity that carries out limited-risk distribution activities also carries out other activities in parallel, such as - just to name a few - production on behalf of third parties for other affiliates (and, therefore, always with a "lean" functional and risk profile), the provision of R&D services on behalf of other group entities (so-called, contract R&D service providers) as well as retail trade to such a significant extent that may assume the performance of DEMPE functions and even the creation of (commercial) IPs.

Therefore, we must wait for the developments of this design phase of the relevant provisions for determining the Amount B to continue monitoring not only the practical implications on the current business models of multinational groups but also the possible future evolutions of convergence international on other cases such as those just mentioned above. 

It must also be added that, as an activity necessary for implementation, the OECD is carrying out an important benchmarking exercise through specific databases (Moody's BvD Orbis) and considering two approaches to determine the safe harbor margins:

- Pricing matrix approach: the output from using common search criteria for benchmarking can be presented in the form of an arm's length pricing results matrix where comparable marketing and distribution entities would be grouped into subsets based on their relevant economic characteristics;
- Mechanical pricing tool approach: The IF continues to identify and test profit drivers with econometric models. If the work to identify statistically significant relationships between some distributor characteristics and profitability proceeds, the construction of an alternative "mechanical" type of price setting method could be possible. This approach would allow for a "translation" of underlying data derived under common benchmarking research criteria into mechanical pricing tools such as a formula or set of quantitative adjustments, to reliably derive arm's length profitability rates, adapted to the economically relevant characteristics of the company being analyzed (tested party).

The profit indicators (Profit Level Indicator – PLI) examined are:

- Berry Ratio;
- Return on Sales (with Berry Ratio as corroborative);
- Return on Assets (ROA);
- Combinations of the above.

Finally, it will also be important to see what considerations will be made regarding the range of values, which could ultimately turn out to be narrower than the interquartile range. 

According to new OECD analysis published on 18 January 2023, revenues from the implementation of the international tax reform agreement will be higher than previously expected.

The two-pillar solution to address the tax challenges deriving from the digitization and globalization of the economy will lead to additional taxing rights for the jurisdictions where the products are marketed or where the users are located (the so-called, market jurisdictions) and will limit tax competition through the creation of a global minimum effective rate of 15% for corporate income tax.

The proposed global minimum tax is now expected to increase annual global revenues by approximately $220 billion, or 9% of global corporate income tax revenues. This is a significant increase from the OECD's previous estimate of $150 billion in additional annual tax revenue attributed to the second pillar minimum tax component.

Pillar One, designed to ensure a more equitable distribution of taxing rights among jurisdictions on the largest and most profitable multinational corporation (MNE), is now expected to allocate taxing rights on approximately $200 billion of profits to market jurisdictions annually. This is expected to lead to annual increases in global tax revenues of between $13 billion and $36 billion, based on 2021 data.

The new estimates reflect a significant increase from the $125 billion in earnings in the previous estimates. The analysis finds that low- and middle-income countries are expected to earn more as a share of existing corporate income tax revenues.

"The international community has made significant progress towards implementing these reforms, which are designed to make our international tax arrangements fairer and work better in a digitalized and globalized world economy," said OECD Secretary-General Mathias Cormann. “This new economic impact analysis once again underscores the importance of rapid, efficient and widespread implementation of these reforms to ensure these potential significant revenue gains can be realized. Widespread implementation will also help stabilize the international tax system, enhance tax certainty, and avoid the proliferation of unilateral digital services taxes and related tax and trade disputes, which would be detrimental to the global economy and economies around the world".

The new estimates of the economic impact of the two-pillar solution are based on updated data and incorporate most of the recently agreed upon design features included in the Amount A Progress Report and the GloBE Model Rules, many of which were not considered in other studies.

The OECD's update of previous assessments, including its detailed economic impact assessment published in October 2020, shows that projected revenues under the first pillar have increased and are continuing to increase over time, due to both revisions of the structure of the tax reform and of the increased profitability of the multinational enterprises falling within the scope. It also shows an increase in forecasted Pillar 2 revenues, reflecting some increases in global low-tax profit, including as a result of better data coverage.

Although the rules are complex and apply only to the largest multinational companies, the agreement reached on the implementation of Pillar Two by the Inclusive Framework represents a huge step forward and has also served as an impetus for the acceleration of the work of the Pillar One.
The increased focus on global cooperation between tax authorities to address BEPS issues is a clear and irreversible trend and companies should be increasingly careful to ensure that taxation is aligned with the substance of their operations.

In parallel to the work carried out within the OECD, the effort carried out by the European Union is certainly to be highlighted: in fact, on 14 December 2022, the EU Council approved the text of the Directive on the Minimum Tax (Dir. 2022/2523/EU) which is essentially aligned with that of the GloBE Model Rules of Pillar Two (albeit with some differentiations due to the principles of European Union legislation). The Directive will apply to all large groups, both domestic and international, with parent or controlled entities in the EU.

As for timing, the Directive was published in the Journal of the European Union on 22 December 2022 and therefore entered into force the day after its publication (i.e., 23 December 2022) and must be implemented by the Member States by 31 December 2023, through specific legislative provisions that must be communicated to the EU Commission (art. 56). 

The operating mechanisms that it envisages for the implementation of the provisions (the Income Inclusion Rule - IIR and the Undertaxed Profit Rule - UTPR) will gradually apply in two different moments, the IIR from the fiscal years starting from 31 December 2023 and the UTPR from those starting from 31 December 2024. Further details are provided in art. 49 of the Directive.

Moreover, one should also consider the provision (art. 50) that the Member States in which no more than twelve parent entities of groups that fall within the scope of application of the Directive are located may choose not to apply the IIR and the UTPR for six consecutive financial years starting on 31 December 2023. Member States making this choice shall inform the Commission by 31 December 2023.

Therefore, potential criticalities connected to the differences in some provisions between the two architectures may arise (i.e., the OECD and the EU), as well as the different implementation times of the disciplines: supranational institutions, individual states, financial administrations and multinational groups will therefore be called upon - each on the basis of their own "role" in this complex scenario - to make a constructive and collaborative contribution to allow for a transition from the old to the new framework of the founding principles of international taxation.

The scenario, then, becomes even more complicated when, to this complex interweaving of rules, we add the actions - which in part have already been taken and which will be adopted in the near future - by those countries that have a crucial role in world economic-financial flows, such as for example the United States of America, India and China.

Therefore, it is strategic to start from the fundamental tools: having adequate transfer pricing policies and transfer pricing documentation has never been so important, especially in the light of the increased risk of dispute by the tax authorities following the loss of revenue due to the pandemic on the one hand and possible recession scenarios on the other.

Ten years after the launch of the BEPS Project, it is possible to recognize - in a unified vision that connects past works and future evolutions - a common thread that links the TP documentation, the Country By Country Reporting and the Two-Pillar Solution, linking fiscal aspects and operational dynamics: therefore, the harmonization of international best practices and the sharing of the founding principles of international taxation definitively impose on the management bodies of multinational groups the need for an overall vision of the supply chain capable to combine the "macro" level of the group with the domestic instances of the individual countries. These must necessarily be accompanied by proactive management of the dynamics of business development and ever greater transparency and collaboration in relations with the individual financial administrations.

The maturation of such a managerial culture is essential not only in large multinational companies“(i.e.” consolidated turnover exceeding EUR 750 million), but also in those groups that are preparing to experience an important dimensional development and that in the next 3-4 years expect to go beyond – for example – the threshold of Pillar Two: the latter will have to start dedicating resources to the design and implementation of internal structures (tax control framework and risk management procedures) capable of meeting the commitments the predictions of Pillar Two (and possibly Pillar One in the future) will dictate to them.