BEPS 2.0 - Transfer Pricing at a Crossroads
July 31, 2021
Updated on July 31, 2021 to reflect ongoing developments.
By Henric Adey and Max Markel
After the Biden Administration’s first 100 days in office, one thing has become clear – there has been a tectonic shift in the direction of U.S. international tax policy from the days of the Trump Administration. With the Tax Cuts and Jobs Act of 2017 (“TCJA”) in the rearview mirror, Biden’s tax reform proposal aims to increase government tax revenue in order to pay for increased government spending aimed at investing in America’s infrastructure and a variety of social programs.
The Biden Effect
The Biden Administration is linking its international tax policy agenda with that of the Organization for Economic Cooperation and Development (“OECD”). U.S. negotiators led by Treasury Secretary Janet Yellen have been working in tandem with their counterparts from OECD member states around the clock to hammer out an agreement on BEPS 2.0. Furthermore, they have pushed for disincentives to member states who oppose or do not cooperate with their agenda regarding the adoption of such a framework to put in place a global minimum tax. This is a complete reversal of the Trump Administration’s position just mere months ago.
Understanding that U.S. multinational corporations risk being at a disadvantage with their global competitors due to a proposed increase in U.S. corporate tax rate to 28% among other potential changes to U.S. tax law, American officials have quickly reengaged with the OECD’s Inclusive Framework urging them to adopt this global minimum tax as outlined in Pillar II of BEPS 2.0. In their view, this would mitigate some of the negative consequences that would result from the Biden Administration’s proposed reforms on U.S. multinational enterprises (“MNEs”) and help them maintain a fair economic playing field with their non-U.S. based competitors.
A Case for the Global Minimum Tax
As broad consensus grows on the global minimum tax, it could help solve the tax haven problem that enables MNEs to shift profits out of high tax jurisdictions and into low tax countries by taking part in transactions such as sales of hard-to-value intangibles (“HTVI”). With the advent of the digital economy, governments have been struggling to claim their “fair share” of tax revenues for quite some time.
Tax authorities have begun implementing digital services taxes unilaterally in order to address this issue. Unfortunately it appears that this country-by-country approach does not provide a holistic solution to the problem of how best to tax an MNE’s tax base since a tax on digital activity would not truly capture its profits. Such a tax simply adds another excise tax on the consumption of goods and services in the country of the end user and could easily be akin to a value added tax (“VAT”) or a goods and services tax (“GST”).
An agreement on the global minimum tax may address the root cause of concern surrounding tax havens if it is adopted on a global scale. Such a tax would also provide clarity and offer governments a chance to collect their “fair share” of tax revenues, especially those who currently feel they are unfairly being left out on collecting taxes on services provided in the digital economy today.
One key proposal of the Biden Administration tax reform plan is the repeal of the Base Erosion and Anti-Abuse Tax (“BEAT”) that was enacted as part of TCJA under the Trump Administration. BEAT was originally enacted with the objective of preventing MNEs from shifting profits to lower tax jurisdictions out of the U.S. The Biden Administration hopes that with the addition of a global minimum tax within the OECD Framework, the U.S. reliance on BEAT will no longer be necessary.
By proposing to roll BEAT back, the U.S. is showing it is willing to compromise with OECD member states and work hand-in-hand with them on the implementation of a global minimum tax. This carrot-and-stick approach by U.S. officials shows they are serious in their negotiations and are willing to make concessions in order to achieve a fair and equitable result for all parties involved.
The Future of Transfer Pricing
What does the changing landscape described above mean for the future of transfer pricing? How should these recent developments guide MNEs’ transfer pricing policies as a whole? Will the adoption of BEPS 2.0 – specifically, Pillars I and II as currently proposed – mean that transfer pricing will cease to exist? These are all important questions to consider whether you are a stakeholder in an MNE or service them as a client.
Transfer pricing is alive and well. Action 13 of BEPS 1.0 which deals with transfer pricing documentation and country-by-country (“CbC”) reporting is the lay of the land. Companies must still maintain contemporaneous documentation amidst the uncertainty surrounding the COVID-19 pandemic and BEPS 2.0. MNEs still need to compute residual profits in accordance with the arm’s length principle (“ALP”) and document their positions as part of their current transfer pricing policy.
The ALP for pricing internal company transactions has been the modus operandi even as the digital economy continues to take shape. The ALP remains the gold standard when it comes to pricing transactions between related parties as if they were independent transactions on the open market. No one can argue there exists a unique complexity surrounding the pricing of certain transactions in the digital economy such as the sale of HTVI between related parties.
However, it is not easy to find an alternative to the ALP. The final form of Pillars I (profit reallocation) and II (global minimum tax) of BEPS 2.0 upon passage within the context of taxing the digital economy remains to be seen.
Pillar I was designed to address the reallocation of MNEs residual profits by giving taxing rights to local market jurisdictions by creating rules around the nexus of such profits. Pillar I’s objective is to provide an equitable solution to those countries that have fallen behind in their ability to collect tax revenues primarily due to the evolution of the global digital economy. In light of the delay around the negotiations and implementation of Pillar I, many OECD countries have taken it upon themselves to enact digital service tax regimes that would provide them some interim economic relief until a coordinated global agreement is reached. The question this has raised is how can these tax laws be unwound locally once an agreement is in place, given the complex political and bureaucratic difficulties that such a process may entail in each of these countries. The COVID-19 pandemic has also provided additional complexity as each country faces its own challenges on the path to economic recovery.
The aim of Pillar II is to provide a baseline global minimum tax for OECD member states in order to prevent low tax jurisdictions from gaining an unfair advantage over their peers. This Global Anti-Base Erosion (“GloBE”) proposal presents various levers that would enable countries to exercise their taxing rights to achieve this objective. Key among them is an income inclusion rule that would require MNEs to meet the minimum effective tax rate at the corporate shareholder level. Further, a switch-over rule may be introduced into tax treaties that would permit a residence jurisdiction to switch from an exemption to a credit method where the profits attributable to a permanent establishment or derived from immovable property are subject to an effective rate below the minimum rate.
Both Pillar I and II rely on specific definitions, and numerous exceptions and somewhat vague language around certain rules. One viewpoint is that this will lead MNEs to default back to the ALP in certain situations, especially if it helps them arrive at a reasonable and fair outcome. Others argue that the ALP’s difficulty in valuing HTVI assets is ineffective in stopping companies from shifting profits to lower tax jurisdictions artificially and will ultimately lead to its demise.
Conclusion (However, see below for update)
This is why an agreement on the global minimum tax is the big wildcard in play. The final act of BEPS 2.0 is yet to be written. Once we see what is behind the curtain, the global tax landscape will undoubtedly look different. A lot will depend on its successful implementation by OECD member states around the world. The pendulum may swing in either direction, but one thing remains clear – sound transfer pricing policy and tax optimization around global supply chains will continue to play an integral role in the success of MNEs.
OECD Pillar I&II - Latest Developments as of July 31, 2021
Recently, there have been some noteworthy developments as OECD member states inch towards an agreement on Pillars I and II.
With several important meetings taking place over the June and July timeframe, specifics of the draft language are starting to take shape. The G-7 finance ministers met in the UK in early June to iron out the next steps in their quest for a pact. After their July 9-10 meeting in Venice on the OECD’s Inclusive Framework, progress was made and the consensus amongst OECD countries on the status of Pillars I and II was nearly unanimous with 132 countries in support of an agreement. All of the G-20 nations endorsed it. However, several predictable holdouts remain, among them EU member states Ireland, Hungary and Estonia. This is significant as EU treaties dealing with changes in tax policy need to be approved unanimously by all EU countries.
What does an eventual agreement mean for U.S. tax policy domestically? As the Biden Administration rolls out its SHIELD agenda (Stopping Harmful Inversions and Ending Low-Tax Developments), more details are starting to emerge of what changes lie ahead for U.S. MNEs. First, the 15% global minimum tax as part of Pillar II is not going to replace the U.S. Global Intangible Low Taxed Income (“GILTI”) tax regime. In fact, the Biden Administration is considering doubling the GILTI tax rate to 21% by effectively removing the foreign derived intangible income (“FDII”) deduction.
One thing appears clear – the momentum is undeniable, but several obstacles and uncertainties remain.