7.2.5 Profit allocation mechanism (‘where to tax – part 2’)

The profits that are consolidated at the level of the ultimate parent company should be allocated to the relevant countries. The chosen profit allocation method should minimize double taxation and should not provide opportunities for tax avoidance, while taking the digitalisation of the economy into account. It should be kept in mind that a profit allocation system that uses the arm’s length principle does not take into account that a group can be a single integrated enterprise.

A system that does not operate on a global level would likely lead to double taxation and would provide opportunities for tax avoidance. Therefore, harmonization is key. Furthermore, a profit allocation mechanism should be simple, balance the interests of residence and source countries, and be efficient. Profits should be allocated both to the supply side and to the demand side. If a formulary apportionment method is chosen, factor shifting possibilities should be minimized. Additionally, the chosen factors should take into account the digitalisation of the economy. Under a formulary apportionment system, the arm’s length principle would remain of relevance for transactions with associated entities that are not part of the unitary business.

From a tax treaty perspective, art. 7 and 9 OECD MTC should be amended to reflect the unitary business approach, including the chosen profit allocation method. Art. 7 OECD MTC should be rewritten to determine that the profits are in principle solely allocable to the country of the ultimate parent company of the unitary business, except if there is a sufficient economic nexus in another state or in multiple other states. For intra-unitary business transactions art. 9 OECD MTC would no longer be of relevance, as those transactions would no longer be visible. However, transactions between the unitary business and associated non-unitary business entities would still be in scope of the article.

The articles on passive income (art. 10, 11 and 12 OECD MTC) would no longer play a role in an intra-unitary business context, as there would be no intra-group dividends, interest and royalties. This would make sure that arbitrage opportunities in this respect would no longer exist. Furthermore, it would fully abolish any potential juridical double taxation on intra-group passive income flows.

Specific rules should be introduced for passive income flows between the unitary business and non-unitary business entities. Any dividends paid by the unitary business to a shareholder that is not part of the unitary business should be subject to dividend taxes if it is an investment structure. For dividends received by the unitary business, a participation exemption should be introduced. Interest and royalty payments received by the unitary business from a third party, or an associated non-unitary business entity, would be taxable at the level of the unitary business. The tax credit for inbound interest payments would have to be shared amongst the unitary business members. Any withholding taxes on outbound interest and royalty payments would likewise be shared by the group members.

The tax treaty article on capital gains (art. 13 OECD MTC) would no longer be of relevance for intra-unitary business transactions and reorganizations. Those transactions and reorganizations would no longer be visible, which is logical from an economic perspective.

The country of the ultimate parent company of the unitary business would include all the profits of the unitary business in its domestic tax base. After allocation of the profits, the country of the ultimate parent company should apply a method to eliminate double taxation. This could either be the exemption method or the credit method, depending on its tax policy goals.