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

After consolidation of the profits for purposes of the unitary business approach, it should be determined how the profits are to be allocated to the countries involved. Ignoring the legal form requires establishing an approach to divide income on a basis other than the current artificial division between related corporate entities.1 In literature unitary taxation and formulary apportionment are often mentioned as synonyms.2 However, in theory each profit allocation mechanism can be applied.3 The profit allocation method should minimize double taxation and not provide opportunities for tax avoidance. A profit allocation method should preferably be simple, balance the interests of residence and source countries, and minimize administrative costs.4

Allocating profits both to the supply side (firm inputs: the production jurisdiction) and to the demand side (firm outputs: the market jurisdictions), instead of solely to the supply side as is done under the current system, follows from the digitalisation of the economy. Taxation at the demand side is positive from an economic point of view. The demand side cannot be influenced easily by the supplier of a product or service. This reduces profit shifting opportunities.

As indicated earlier, the OECD is in the process of providing a multilateral solution for the issues surrounding the digitalisation of the economy: the Pillar One proposal.5 The consolidated financial accounts are used as the starting point. For multinationals that fall within the scope of the proposal, 25% of the residual profit (defined as profit in excess of 10% of revenue) will be allocated to the market jurisdiction where goods or services are used or consumed (the so-called Amount A). For this, a revenue-based allocation key will be used, with different revenue sourcing principles for different types of revenue.6 The implementation of this comprehensive change in profit allocation is something that cannot be solved bilaterally, but requires a multilateral approach.7 A multilateral convention that exists next to the current treaty framework will be required. Apart from that, the Pillar One proposal requires changes to national legislation, as national taxing rights should be created.8

The Pillar One proposal seems to be a step towards group taxation. However, it leads to a mixture between elements of a separate entity and a group approach as it only applies to a limited portion of the group profit.9 Additionally, the Pillar One proposal has some clear disadvantages. The scope will be limited to – briefly put – large multinational entities. Throughout the process, the scope has been reduced further and further, reducing the number of affected companies.10 Also, the size of the residual profit to be allocated has been reduced.11 Furthermore, the rules could lead to double counting or double taxation. For this a safe harbour has been proposed. The safe harbour will cap the residual profits allocated to the market jurisdictions through Amount A if the residual profits of an in-scope multinational are already taxed in the market jurisdiction.12 This means that, if there is already, e.g., a subsidiary in a country, the new allocation rules may not apply.13 Additionally, the Pillar One project contains legal challenges. As there is no international tax legislation in place, it relies on the domestic laws of the jurisdictions involved. Moreover, it relies on cooperation between the tax administrations of participating countries.14 All in all, the Pillar One proposal regarding Amount A is, in my view, not a feasible solution to comprehensively deal with the taxation of digital activities.

Furthermore, Pillar One includes rules on dispute prevention and resolution, as well as a simplified approach for the application of the arm’s length principle to in-country baseline marketing and distribution activities (the so-called Amount B). In short, under application of Amount B more value is placed on basic marketing and distribution activities by attaching a standard fee to them, thereby allowing more profits to be attributed to the jurisdictions where these activities take place (i.e., the market jurisdictions). The intention of Amount B is to simplify the administration of transfer pricing rules for tax administrations and to lower compliance costs for taxpayers. Moreover, the intention is to enhance tax certainty and reduce controversy between tax administrations and taxpayers.15 Amount B is mainly a solution for situations where there is a physical presence, but it is not possible to agree upon the profits that can be allocated to it.16 Therefore, in my view, Amount B is also not a real solution for the taxation of the digitalised economy. All in all, the ‘perfect’ profit allocation method requires further research.

Another question is how transactions that take place between members of the unitary business (i.e., entities that fall within the group definition based on economic parameters) and non-members that are associated with the unitary business (i.e., entities that are not within scope of the group definition but are related to the unitary business)17 would have to be accounted for.18 For transactions with associated entities, the arm’s length principle would remain applicable. This means the administrative issues with regard to the application of this principle will not disappear. However, for transactions with minority shareholders and other associated entities, the fundamental flaw of the arm’s length principle (i.e., that it cannot account for synergy benefits within corporate groups) seems less of an issue.