The OECD’s Unified Pillar 1 Proposal: A Closer Look

David Stewart: 0:01

Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: pillar 1 proposal. The OECD has released a discussion draft outlining a partial solution to the taxation of the digital economy. A little later, we'll talk to EY global tax leader Barbara Angus to get her take on the direction the OECD is taking. But first, we'll turn to Tax Notes chief correspondent Stephanie Johnston to talk a bit about what we've learned. Stephanie, welcome back to the podcast.

S. Johnston: 0:31

Thanks for having me again.

David Stewart: 0:32

So what is this new draft?

S. Johnston: 0:34

So the OECD recently proposed a so-called unified approach under pillar 1 of their two-pillar work plan. But just to give everyone a little bit of background, if you'll recall, the OECD is working on building out action one of the Base Erosion and Profit Shifting project, which was about addressing the tech challenges of the digital economy. Now the OECD originally said that they would revisit the issue in 2020 after the BEPS project had been implemented, but there was political pressure in the meantime to act sooner, so that OECD has now picked up this line of work again. They issued a work plan in May, which outlined technical work to be done under two pillars. Pillar 1 was on profit allocation and nexus rules and pillar 2 was about global effective minimum taxation.

David Stewart: 1:17

How does this draft deal with pillar 1 issues?

S. Johnston: 1:20

So this draft basically consolidates three competing approaches under pillar 1 in the original work plan. Those three approaches all reflected different points of view that countries had at the time. One option was profit allocation based on user participation and this was favored mostly by France and the European countries. The second one was profit allocation based on marketing intangibles, which the U.S. was in favor of, and then the third one was about a new nexus, which countries like India favored. So this approach basically consolidates those three approaches. This unified approach is meant to draw from these three options so that everyone can agree on something. And the OECD secretariat thought this was necessary in order to get countries to move in their negotiations because they were sort of at a stalemate. So the hope was that this approach would reinvigorate discussions and negotiations in the hopes that the countries will agree on something by the end of 2020.

David Stewart: 2:16

All right, so how does this consolidation work?

S. Johnston: 2:19

The proposal has several features. The scope will apply to consumer-facing businesses broadly speaking, with potential carveouts for certain industries like extractives or financial services. And the work still needs to be done about on this particular issue. What's in scope? Who's going to be affected? Is it going to apply only to business-to-consumer companies? Or business-to-business companies that also have consumer-facing activities? It's unclear at this point what that is. The second part of this is the new nexus for taxpayers that fall within a scope. This will be largely based on sales, not on physical presence, and there may also be a large revenue threshold for the companies that are affected. So for example, the€750 million threshold that we see in the country-by-country standard. The unified approach also calls for a three tiered mechanism for profit allocation, which would tax multinationals that fall within the scope of the new nexus on three categories of group-wide profit in market jurisdictions and the discussion draft refers to these three categories as amounts A, B, and C. Amount A would consist of some portion of the groups' deemed residual profit, defined as the excess of group profit, over a routine return and internationally agreed fixed percentage of the total deemed residual profit would be allocated to all market jurisdictions. And that amount attributed to market jurisdictions would then be allocated among countries based on agreed variable like sales. Again, here the details are yet to be determined. Amount B, which is the return on routine distribution activities performed by a permanent establishment or subsidiary in the market country, would be some return on distribution activities that approximates an arms-length return. Amount B would be determined by fixed percentage instead of traditional transfer pricing methods. And Amount C would be any local group functions that go beyond the routine activities account of foreign Amount B and this amount would be determined under the arm's-length principle. Perhaps most importantly, the approach also calls for any disputes arising between market jurisdictions and taxpayers under this proposal to be subject to binding and effective dispute resolution, which is also yet to be determined.

David Stewart: 4:19

So there's a lot of stuff that is up in the air on this. When will we get more information on this proposal?

S. Johnston: 4:25

So the discussion draft is open for comments until November 12 and then the OECD is holding a public consultation November 21 and 22 in Paris.

David Stewart: 4:35

All right, and that leaves, I guess pillar 2 is still out there. When do we expect to see something on that?

S. Johnston: 4:40

The OECD will also release draft proposal for pillar 2 sometime in November with public consultation in December.

David Stewart: 4:48

All right, well we'll definitely have to follow up on this with you when we learn more. Stephanie, thank you for the update and thank you for being here.

S. Johnston: 4:53

Thanks so much.

David Stewart: 4:54

And now we'll go to my interview with Barbara Angus. Joining me in the studio is EY global tax policy leader Barbara Angus. Barbara, welcome to the podcast.

Barbara Angus: 5:03

Thank you. Pleasure to be here.

David Stewart: 5:05

So what are your first impressions of the new pillar 1 consultation draft?

Barbara Angus: 5:10

Well, a couple of things. One, the form in which it's been delivered is interesting. First, it's a secretariat draft, which means that it doesn't yet reflect the agreement of all the participating countries. So we're seeing it as the countries are still considering it. Also putting that secretariat draft out in the form of a consultation draft provides a welcome opportunity for stakeholders to provide feedback at this stage of the process. I think a couple of important things about the document: It makes clear that despite the name of the project, it's no longer limited to digital businesses or digital business models, but includes other consumer-facing businesses. The document makes clear that the arms-length principle isn't being abandoned, but will be replaced for some key computations. And the document also makes clear that the permanent establishment standard is not being abandoned but will be replaced in at least one area.

David Stewart: 6:02

Now you mentioned that this is a secretariat document. Is the approach that the OECD has outlined here something that is workable and can be agreed to by the member countries?

Barbara Angus: 6:11

Well, I do think it's important that it hasn't been agreed yet. There's a real tension, sort of a natural tension between the political urgency of this project and the need to have agreement on all of the technical details. In some ways, the project may well be unprecedented for the OECD because of the broad participation. 134 countries participating in this project from the very beginning. Also because it's a project that's being approached with the objective being consensus and commitment by countries to implement the agreed rules, that's quite different than most of what was done under the first BEPS project, which was in the form of recommendations. And the commitment they're looking for here really needs to be a commitment to the full technical details. Here the reason for requiring consensus is that you need all countries participating to be applying the same rules in the same way in order to avoid more than one country saying they have taxing jurisdiction over the same dollar of profits.

David Stewart: 7:10

Now do you see any parts of this that might present a problem for reaching that consensus?

Barbara Angus: 7:14

Well, I think there's significant political momentum behind the project and that's important because this is a project that will, it will lead to winners and losers with respect to countries in any given situation. If the aim of the new rules is, as they say, to provide additional taxing rights to allocate additional share of the profits to market countries, that means that there's another country that needs to give up or reduce its share of the profits. And so there will need to be political level commitment. There is, as I said, a lot of momentum behind the project and a view that this project in the OECD is the way to address these issues in a coordinated way to provide certainty to both taxpayers and tax administrations to avoid double tax. So I think there's a lot of incentive for countries to reach agreement, but there's an important road ahead to get to that agreement.

David Stewart: 8:04

So have you heard anything back from businesses that you advise or your colleagues with concerns about the draft from the business side?

Barbara Angus: 8:10

Well, I think tax professionals really are still parsing the document, both what is addressed in the document and the layers of details that are not yet addressed. So maybe one area of concern is the need for much more technical detail in order to ensure that an agreement that's reached is a fully informed and solid agreement that would be grounded in the ability to avoid double tax. That the unified approach that's laid out in the document has several elements where they're proposing formulaic rules, but they haven't filled in any numbers in those formulas. That obviously will be the subject of significant political debate, but clearly also is subject of great interest for businesses. Will this be a modest reallocation of profit or a more significant reallocation of profit? As I've said, certainty and avoidance of double tax are real priorities for businesses. Maybe another big priority for businesses that isn't addressed in detail yet in this document is the need for robust new dispute resolution mechanisms and really also the need for new tools to prevent disputes from arising in the first place. The document acknowledges the importance of that, but building that out and reaching agreement on those mechanisms is a step to come.

David Stewart: 9:22

Now given that there is a lot of uncertainty around how this draft will ultimately play out. How would you advise businesses to respond to be ready for what might come down the road?

Barbara Angus: 9:30

Well, you're right. There is a lot of work left to come, but I do think there's a lot that businesses can be doing now. Businesses can monitor the developments closely. They can work to understand the perspectives of the various countries that are part of their business's geographic footprint. They can do some work modeling the potential impact of the proposals. They could think about the implications of what are likely to be new reporting requirements going beyond, say the existing country-by-country reporting and also the potential for new compliance obligations in countries where they're not today a taxpayer. They can be thinking about communicating with both internal and external stakeholders about these concepts and the potential implications. And importantly they have an opportunity to be a part of the debate, to engage with the OECD and country officials to provide feedback and input and this document's a perfect example of that because it's put out for a public consultation.

David Stewart: 10:25

Now this is the second take at the BEPS project. We had the Base Erosion and Profit Shifting project. Then that finished out and we ended up with this digital economy project. How do you view this as the way to getting an ultimate answer on the taxation of digital economy? Or are we going to have the same problem a few years down the road where market jurisdictions don't feel like they're getting enough of the tax base and we'll be at this project again in the future with BEPS 3.0?

Barbara Angus: 10:52

That's really the$64,000 question and I think really all participants in the project are aiming to avoid that, to try to reach an agreement that will be lasting. The project is quite different than the BEPS project in that what's at stake are changes to fundamental elements of the international tax architecture and the potential for countries to be in any given situation to be a winner or loser, depending on whether they're gaining or losing taxing rights. It also is a project that while digital is in the name and part of the driver for the project, it isn't just about digital anymore because the document makes clear that they're bringing in the whole range of consumer-facing businesses. Whether an agreement can be reached and how lasting that agreement is, I think really is, it requires more of the detail work to be done and for the countries to start the discussions on things like the numbers. Will the additional jurisdiction that market countries are seeking, will what they want match up with what other countries are willing to give up? And will the process be able to develop formulaic approaches that can be described in enough detail that when there's agreement on them that those approaches can be implemented and applied in the same way by multiple countries so that there's not overlapping taxing jurisdiction so that there's not your disputes immediately created? It's fair to say that the project is focusing on some elements of the transfer pricing rules that have for a long time been a particular source of disputes between taxpayers and tax authorities and among tax authorities. And so if through these rules and a new more formulaic approach, if there can be solid and fully grounded agreement, there's a potential for greater certainty. And so there's a lot at stake here and potential benefits for all participants.

David Stewart: 12:41

Now, you mentioned earlier that there are these limited departures from the arm's-length standard and that there were also implementing a certain formulaic approaches. Could this be a first step toward a more formulary apportionment style of transfer pricing?

Barbara Angus: 12:55

I think the OECD is quite careful and quite explicit in the document to say that they're not abandoning the arms-length principle. I think that's really important because it feels like the most solid agreement among countries is an agreement that's grounded in principles. If everyone can agree on the principles, then it's just a matter of applying the principles. The move to more formulaic approaches in selected instances is a move away from that. It's a move away from the underlying economics and that is a cause for concern that that could create more disputes. If you're moving to a more, a more formulaic or numbers-based approach then and there's agreement on it, is that agreement solid? Or will some countries say down the road, well that number was good, but twice that number would be better? And so I thought was important the way this document makes clear that all of this is an overlay over the arm's-length standard, but they're retaining the arm's-length standard as the fundamental rules. The formulaic approach's intended to provide greater certainty and reduce some of the complexity, but there's tradeoffs there and really it remains to be seen how that will work.

David Stewart: 14:03

All right. Now as we're sitting here, we've seen the pillar 1 consultation draft and we're currently waiting on a pillar 2 consultation draft. Now, the minimum tax concept in pillar 2 as described seems somewhat similar to the international provisions of the Tax Cuts and Jobs Act. Now you served as chief tax counsel on the House Ways and Means Committee during the development of the TCJA. How do you view the pillar 2 solutions?

Barbara Angus: 14:26

Well, I think everyone is eagerly awaiting the consultation document with respect to pillar 2. There's been much less publicly discussed about that work, but there is a significant amount of technical work going on behind the scenes. And in the design of global minimum tax rules, I mean, that really is also breaking new ground for the OECD and it's also a part of the project that has both substantial political issues and complex technical questions. The rules that were included in the TCJA were developed in a very different context. In the TCJA, the new rules were part of a fundamental reworking of the U.S. International tax system and were aimed at protecting against base erosion and avoiding tax-driven location incentives in the setting of that new international tax system. I think the OECD documents and discussion have made clear that the pillar 2 work is really not about BEPS concerns. It's not about creating anti-abuse type rules. It's really about ending tax competition and that's a different objective. I think it's good that they're putting out a consultation document so there'll be an opportunity to get feedback from stakeholders. You made the comparison to the experience with the TCJA, and I will say based on my experience working on that bill, I find it hard to imagine crafting complex legislative language on something like minimum tax rules in a process that involves 133 of my closest friends.

David Stewart: 15:57

Well, do you have any predictions for us to leave on what you expect to see out of this OECD process?

Barbara Angus: 16:03

I would not be quick to bet against the OECD. I think in many ways you could say that failure is not an option for the OECD. That having started down this path, if this project were to be abandoned, you well could have some form of chaos: unilateral measures, more digital services, taxes, perhaps countries adopting concepts that were discussed as part of this process in a unilateral way. And so, it is I think important to continue the process and to get that benefit of coordinated set of rules. One area that perhaps may change is the timeline. This is a really complicated project, and from my perspective, it seems key that the consensus be full and formed consensus about all of the details of the rules and that feels like it will take time. And so, I think we could well see the process continuing as they make progress and can demonstrate that progress to the countries that are involved. I'm hopeful that they will take the time that's needed to make sure that the project's fully grounded.

David Stewart: 17:09

All right. Well, we'll see how this plays out. Thank you for being here.

Barbara Angus: 17:11

Thank you.

David Stewart: 17:12

Now for a new segment we're doing called Willis Weighs In, where Tax Notes contributing editor Ben Willis offers his thoughts on outbound planning.

Ben Willis: 17:21

Thanks, Dave and welcome to Willis Weighs In. Starting with this episode of Tax Notes Talk, I'll be using this time to answer questions from our readers about the articles from my Willis Weighs In column in Tax Notes. This episode I'll be talking about my September 16 article on smart tax planning under the 2017 tax law and responding to a recent letter to the editor from Professor David Roberts. Let's dive in. First question: Is President Trump a smart tax planner? I kicked off my smart tax planning article by citing Trump and explaining that he and I both agree that tax planning is smart. As for whether his specific planning efforts were smart or illegal, there's really no evidence either way. Without tax returns Trump has refused to give to Congress, we may never know whether he violated the law. I define smart tax planning simply as reducing unnecessary tax costs while achieving the intended goals of Congress. If Trump merely carried forward losses as many suspect, then that is exactly what Congress intended. That said, it is understandable that Congress has continued to question whether his returns show illegal behavior. Trump's been saying for years that he cannot disclose his tax returns because they're under audit. That makes no sense. Even the IRS has confirmed audits are no reason to prevent sharing tax returns, but Trump's returns could contain personal information he simply doesn't want to share and no one should feel guilty for simply planning to minimize taxes. Second question: Professor David Roberts asks, is sophisticated tax planning a moral? No. Listen. Almost all tax planning is sophisticated. Tax is complex and so is was determining how the rules work. To say that sophisticated tax planning amounts to abusive tax evasion makes no sense. It's like equating investing to insider trading. Have brokers and fund managers engaged in insider trading? Sure. But the vast majority of sophisticated investors and tax planners have never committed a crime. Professionals aid people all the time with complex business decisions. In fact, the more complex the tax returns, the more sophisticated assistance courts expect taxpayers to have in determining their taxes. As for unethical tax planning, I don't advocate for this. Why? Because there are countless provisions Congress intended taxpayers to benefit from that they and planners can look to without ever needing to question their conscience. Most taxpayers aren't hiring tax professionals to help them create questionable tax shelters. In fact, I'd argue the more sophisticated ones planning is the more confident that taxpayer can be and knowing they're not crossing the line. Taxpayers hire professionals because they want to protect their interests and minimize risk. Engaging in illegal activity would only increase that risk. Finally: Is using loopholes smart? Well, it depends on how you define a loophole. Take a look at the corporate tax rate. Many think 21 percent is too good to be true, but they don't wonder if it was a typo in the TCJA. Then again, that doesn't mean you don't need to worry about taking advantage of the 21 percent rate in light of the accumulated earnings and personal holding company penalty taxes. Some would argue even the effective dates in the TCJA present loopholes, but some of these effective dates retroactively hurt taxpayers. Take a look at the November 2, 2017 earnings determination for the section 965 mandatory repatriation tax when the law was passed nearly two months later on December 22. But the courts have confirmed we must follow the law as plainly written, including for effective dates. Ultimately, if a taxpayer can point to congressional intent behind an available tax benefit, the taxpayer can feel more confident that acting in line with that intent is smart and there is much that can be pointed to and planning under the TCJA. I want to thank those of you who reached out to me with questions. Please continue to do so. You can find me on Twitter at@ willisweighsin or email at ben.willis@taxanalysts.org. We'll discuss business purpose next time on Willis Weighs In.

David Stewart: 21:00

And now, coming attractions. Each week we preview commentary that'll be appearing in the Tax Notes magazines. I'm joined by Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?

Jasper Smith: 21:13

Thanks, Dave. In Tax Notes Federal, practitioners from McDermott consider how taxpayers can mitigate the effects of the TCJA's repeal of section 958(b)(4), which is particularly relevant to calculating tax liability on subpart F income and GILTI. Andrew Gradman argues that Treasury got it wrong and its Opportunity Zone regulations issued in April, which do not limit t axpayer g ain forgiveness when selling a qualified opportunity fund interest after 10 years. In Tax Notes State, Carolynn Kranz and Iris Kitamura argue that while some states have attempted to clarify the tax treatment of cloud services, the resulting measures have raised new questions and muddled the issue. Stephen Jasper, Mitchell Newmark, Carley Roberts, and Breen Schiller discuss some of the more significant locally imposed taxes that could cause unexpected issues for businesses entering a new jurisdiction. I n Tax Notes International, Jason Schwartz explores how direct lending funds can use the Ireland-U.S. income tax treaty to make loans in the United States without being subject to federal income tax. And Rhonda Rudick and Olivia Khazam discuss changes to Canada's tax laws and their effect on cross-border t rust and estate planning. Finally in the Opinions page, Roxanne Bland looks at how some jurisdictions are working to overcome the funding problem for their arts communities via taxes and J oe T horndike discusses the wealth tax.

David Stewart: 22:32

You can read all that and a lot more in the October 28 editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me online at@TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.