On February 13, 2019, the OECD released a consultation document that describes and requests comment on various options for implementing a two-pillared approach to addressing the tax challenges of digitalization and "remaining BEPS issues." The document includes options covering: (1) changes to the profit allocation and nexus rules and expanding the taxing rights of user and market jurisdictions; and (2) a global anti-base erosion proposal consisting of an income inclusion rule, or minimum tax, and a fallback proposal aimed at certain related-party, base-eroding payments.

While characterized by the OECD as addressing the tax challenges of the digital economy, the options covered by the consultation document could apply broadly to many industries and companies that don't view themselves as "digital companies." Moreover, the proposals in pillar 2 will absolutely have broad application to most multinational businesses.

Interested parties are invited to provide comments by March 1 to the OECD and a public consultation on the consultation document will be held on March 13-14, 2019, at the OECD Conference Centre in Paris, France. Following the consultation, an update is expected to be presented to the G20 finance ministers meeting in Japan in June, and the OECD is aiming for "a consensus-based, long-term solution" to be reached in 2020.

Revised profit allocation and nexus rules

The consultation document said the discussion over revising the profit allocation and nexus rules has focused primarily on two proposals: user participation and marketing intangibles.

User participation

The user participation proposal focuses more specifically on digital business and on the value created by digitalized businesses through "developing an active and engaged user base, and soliciting data and content contributions from them," and envisions that the value is most significant from business models like social media, search engines and online marketplaces. The proposal seeks to revise profit allocation rules to accommodate such value-creating activities, and to revise nexus rules so that user jurisdictions would have the right to tax the additional profit allocable to them.

It is proposed that the profit allocated to a user jurisdiction regarding activities and participation of users could be calculated through a non-routine or residual profit split approach involving:

1. Calculating the residual or non-routine profit of a business, i.e. the profits that remain after routine activities have been allocated an arm's length return

2. Attributing a proportion of those profits to the value created by the activities of users, which could be determined through quantitative/qualitative information, or through a simple pre-agreed percentage

3. Allocating those profits between the jurisdictions in which the business has users, based on an agreed allocation metric (e.g. revenues); and

4. Giving those jurisdictions a right to tax that profit, irrespective of whether the business has a taxable presence in their jurisdictions that meets the current nexus threshold

The profit attributed to the routine activities of a multinational enterprise group would continue to be determined in accordance with current rules

Marketing intangibles

A marketing intangibles approach would change the profit allocation and nexus rules for a broader set of businesses (beyond digital) that enter a jurisdiction to develop a user/customer base and other marketing intangibles. The document acknowledges "an intrinsic functional link between marketing intangibles and the market jurisdiction." The discussion document defines marketing intangibles as having the same meaning as set forth in the OECD Transfer Pricing Guidelines:

"an intangible … that relates to marketing activities, aids in the commercial exploitation of a product or service and/or has an important promotional value for the product concerned. Depending on the context, marketing intangibles may include, for example, trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers."

Current transfer pricing and tax treaty rules would be modified, under the proposal, to require marketing intangibles and risks associated with such intangibles to be allocated to the market jurisdiction, which would be entitled to tax some or all of the associated income. All other income, such as income attributable to technology-related intangibles generated by research and development and income attributable to routine functions, including routine marketing and distribution functions, would continue to be allocated based on existing profit allocation principles.

The document stated that different methods could be used to allocate income between marketing intangibles and other income-producing factors, including: (1) applying normal transfer pricing principles and having marketing intangibles determined along with their contribution to profit; or (2) applying a revised residual profit split analysis that calculates profit attributable to marketing intangibles through an as-yet-undetermined method, then allocates that profit to each market jurisdiction based on a metric such as sales or revenues.

The document stated that there has been some exploration of a "significant economic presence" principle. It also includes a discussion comparing the user participation and marketing intangibles approaches as well as some design considerations.

Global anti-base erosion proposal

The consultation paper continues to address remaining BEPS challenges of risk and profit shifting to entities subject to no or very low taxation through two interlocking rules: (1) an income inclusion or minimum tax; and (2) a tax on base eroding payments.

Income inclusion rule

The income inclusion rule would operate as a minimum tax by requiring a shareholder in a foreign branch or controlled entity to bring into account a proportionate share of income if that income was subject to a low effective tax rate in the jurisdiction. The rule would apply to shareholders with significant (e.g. 25%) direct or indirect ownership in the foreign branch or entity. The consultation document states that the rule would be applied on a per jurisdiction basis. The amount of income subject to the rule would be calculated under domestic law rules and shareholders would be entitled to claim a tax credit for the minimum tax calculated on a jurisdiction-by-jurisdiction basis. The application of the rule on a jurisdictional basis is clearly a design feature that could be controversial. The consultation document notes that in some ways the minimum tax is modeled on the US global intangibles low-taxed income (GILTI) regime, which is calculated on a global basis.

Several design issues are mentioned including:

1. How the minimum rate itself should be determined and applied
2. The types of entities covered and definition of minimum level of ownership or control
3. The mechanism for determining whether a corporation has been subject to the minimum rate (i.e. the design of the effective tax rate test)
4. The design of any thresholds or safe harbors to facilitate administration and compliance
5. Rules for attribution of income to shareholders based on control or economic ownership, including rules to prevent structuring around the rules

Tax on base eroding payments

The second element of the proposal is a tax on base eroding payments that complements the income inclusion rule. The proposal would include both an undertaxed payments rule that would deny a deduction for a payment to a related party if the payment was not subject to a tax of a minimum rate and a subject to tax rule to deny treaty benefits if the item of income is insufficiently taxed in the other jurisdiction.

The undertaxed payments rule would deny a deduction for certain defined categories of payments made to a related party unless those payments were subject to a minimum effective tax rate, taking into account withholding taxes. Related parties could be based on a 25% common control test and the rule is intended to consider a broad range of payments including "conduit" or "imported" arrangements where the effect of the undertaxed payment is "imported" into the payer jurisdiction through a payment that is otherwise outside the scope of the rule.

Other design considerations mentioned by the consultation paper include:

1. Scope of payments covered by the rule
2. Threshold for related party status and degree of common control
3. The mechanics of the effective rate test, including whether it should be applied on an entity-by-entity or a transaction-by-transaction basis
4. The compatibility of the undertaxed payments rule with international obligations
5. Whether the rule should deny deductions in full or only on a graduated basis reflecting the level of taxation in the jurisdiction of the recipient

The subject to tax rule complements the undertaxed payments rule by denying certain double-taxation tax treaty relief provisions for "undertaxed" payments. The consultation paper mentions denying tax treaty benefits under several articles of the OECD Model Convention, including business profits (Article 7); associated enterprises (Article 9); dividends (Article 10); interest, royalties and capital gains (Articles 11-13); and other income (Article 21). In addition to technical issues, the paper mentions design issues ranging from the impact on tax exemptions accorded to dividend distributions to the impact on certain categories of taxpayers, including individuals, pension funds and charitable organizations.

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