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The world of tax is constantly changing and often complex. What is BEPS, pillar two of the OECD, and the concept of substance in transfer pricing, and how do they all impact businesses crossing the border? BDO Tax Partner Harry Chana, alongside BDO Cross-Border Tax professionals Rita Trowbridge and Dan McGeown, unpack these concepts in part one of a two- part mini-series.
Harry Chana: Welcome to our first Cross-Border Tax Podcast episode. My name is Harry Chana and I'm the International Tax and Transactions Tax practice leader for BDO Canada. In this episode, we will discuss the impact of base erosion and profit shifting, commonly known as BEPS, and its impact on companies who have global operations.
BEPS is created out of the perceived abuse that Multi-National Enterprises undertook tax planning strategies that exploit gaps in mismatches and tax rules to artificially shift profits to low or no tax locations where there's little or no economic activity or to erode tax bases of governments through deductible payments, such as interest or royalties. BEPS encompasses a 15 action item plan to deal with this perceived abuse that would change the international tax system. The OECD member countries would adopt these action items so that the rules applied consistently and in a coordinated approach.
In today's podcast, we'll be focusing on Action 1 - Addressing the Tax Challenges of the Digital Economy – probably the most controversial and difficult measure to get consensus on among the OECD member countries. It impacts so many businesses given the digital world that we live in. For those who have been following the developments of Action 1, it started back in 2015 when the first report was released on how to tax highly digitalized businesses several versions later the OECD released the it’s Blueprint in October 2020 with a 2-pillar approach to address Action 1.
Joining me today to discuss this issue is Rita Trowbridge, a partner with our International Tax team and Dan McGowan, a director with our Transfer Pricing team.
BEPS Pillar Two
Rita, let's start with you. I know we've spoken at length about the OECD discussion draft, specifically on Pillar Two. Can you share with our audience what Pillar Two is and how it would affect businesses crossing the border?
So, essentially Pillar Two introduces a new global minimum tax, and it's been proposed to ensure all large and internationally operating businesses pay at least a minimum level of tax, regardless of where they're based. And to your earlier point, this minimum tax is being introduced to address the perceived abuse that exists around multinational enterprises shifting profit to low taxed entities and jurisdictions within a group. So, these rules will essentially ensure that a minimum effective tax rate is applied to the income earned in all jurisdictions by a multinational enterprise.
As of right now, the minimum tax rate hasn't been set within the Pillar Two blueprint, but the OECD has indicated that they are likely to settle on a 12.5% rate. So, we'll have to wait and see what that final tax rate ends up being. The rules within Pillar Two are very complex and as of right now they are anticipated to apply to multinational enterprises that have total consolidated group revenue above 750 million euro. Now, having said this, there are some excluded entities, such as certain investment funds, pension funds, and nonprofit organizations, just to name a few.
Thanks Rita, for that introduction. So, what would you say are some of the challenges of Pillar Two and implementing Pillar Two that multinational enterprises need to be aware of?
Well, aside from the extreme complexity of these proposals and additional work required to finalize them, it will be important to obtain a global consensus moving forward so that we can create a coordinated tax policy and limit the risk for international tax uncertainty.
So right now, as you know, tax authorities around the world are eager to increase their tax revenues. Now this was the case even before COVID-19 hit. And now there's an even more compelling case as a result of all the spending by governments on various programs to support businesses, workers, and the healthcare system. So, this may present challenges in arriving at a coordinated global tax policy. There are of course also technical and political challenges that need to be resolved to successfully implement Pillar Two. So for example, changes are required to domestic law as well as to Canada's bilateral tax treatises.
And the changes to Canada's domestic laws represents a significant policy shift in our international tax regime. So, we need to understand what impact this will ultimately have on multinational enterprises and what this may mean to future investment decisions and growth.
One thing to also mention is that the United States currently has the GILTIregime in place, and it may be exempt from Pillar Two and thus co-exist with the rules, given the similarity of its GILTI to the Pillar Two proposals. So, it will be important to monitor the interactions of US taxes and Pillar Two on US intermediaries as we move forward.
The concept of substance
Thanks, Rita. Dan, I want to bring you in on this discussion. Typically, in the tax world, in the transfer pricing world, we always talk about this concept of substance. So, I want you to just give the audience a brief description on what we mean when we talk about substance and I want to get your thoughts on whether these minimum tax rules would apply to low taxed income jurisdictions that pass the substance threshold.
Thanks Harry, and thanks for that question. Substance in the tax world really relates to where people are, where functions are performed, where risks are assumed. So, having a presence that is more than just a bare entity. So, people performing significant functions, an entity that bears risks, and assets to be used in the business.
So, that's what we think of when we think of substance in the tax world. Now, in terms of the blueprint, these minimum tax calculations will be applied to entities in low tax jurisdictions and to low tax jurisdictions where there is no permanent establishment or physical presence, but there is an act of business presence.
Thanks, Dan. So, clearly these rules are complex as you've indicated and there's still a lot of work that needs to be done both on the technical front and on the political level before we can get consensus among all the OECD countries.
I guess with this in mind, what should Canadian multinational businesses be considering right now? And is there anything that they can do right now to get prepared for these upcoming changes in rules?
Yes. You know, I think it's critical that multi-nationals review their current business structures from a risk benefit perspective and analyze the impact of the BEPS project on their business model and supply chain. So for example, consider how it will impact their overall effective tax rates. Are there any financing transactions or transfer pricing issues to consider? The focus should include identifying any cross border transactions that may be scrutinized.
I'd say an overall assessment of the risks associated with the tax arrangements is needed. Under Pillar Two, a multinational enterprise will be liable to incremental taxes if their global effective tax rate is less than the minimum tax rate. So, multinationals may find their focus shift from minimizing overall taxes to ensuring that business is conducted in the right location to mitigate the possible impact of any future audits. I think overall, the takeaway is that consideration should be given to developing strategies, to either restructure or unwind a structure and understand what the tax cost of doing so is and what the timelines involved are. These proposed changes are not simply limited to the digital economy and being prepared to pivot is going to be important.
Thank you for that, Rita. And thanks for walking through some of the impacts of Pillar Two.
BEPS Pillar One
Harry Chana: I want to just change focus and Dan, I want to bring you in and talk about Pillar One, because that also is a key action item within Action 1. Can you give us a background on what Pillar One is?
Sure, Harry. Thanks for asking about Pillar One. And if you think about the pre blueprint days in the absence of Pillar One, a multinational enterprise (MNE)'s grouped profits get taxed in those jurisdictions where that enterprise has a physical presence. So, permanent establishment (PE). And in that permanent establishment, linking back to what we said about substance, you would expect there to be a significant amount of substance in each PE.
But under Pillar One, the portion of the MNE group's consolidated profits that is not attributable to routine marketing and distribution activities, and that profit in transfer pricing terms is referred to as the residual profit, will get allocated to countries within which the MNE has an active business presence without a PE.
And then I guess with that point, Dan, should companies be rethinking their existing supply chains under these new taxing rates under Pillar One?
We would recommend that companies do rethink their supply chains at this point in time to determine whether it's better to establish permanent establishments in those countries where they just have a business presence, so that they can use traditional arms length transfer pricing mechanisms to determine exactly how much profit gets reported in each of the jurisdictions and thereby taking back control of this aspect of their overall business.
So, if you look at Pillar One's approach, it's somewhat similar in nature to a residual profits method model. Except that the entities in PE countries are first allocated routine return for routine marketing and distribution functions. And then the profit above that, the residual profit, then gets allocated to entities both in the PE countries, but also in the non PE countries where there is a business presence but no permanent establishment.
So, no effective substance from a traditional tax perspective. Under Pillar One, the profits that would have been taxed only in the permanent establishments are now taxed in those countries and the countries with no permanent establishments. The total profit subject to tax does not change, but the overall tax on those profits will change.
So, I guess just thinking about that, Dan, how does this tie into a group's overall multi-national existing transfer pricing model or policies and just the overall documentation that's required among these policies?
Right. And so Pillar One totally disrupts a group's existing transfer pricing model and the documentation that they put in place to support that model. So, as a result of all of that, if this MNE is required to allocate residual income to a number of non PE countries, they should really revisit their overall supply chain, their business model, their transfer pricing analysis, and how they're going to put that into their documentation to supply to the various tax authorities around the world.
Thanks for that, Dan. Definitely some food for thought to consider around Pillar One and the transfer pricing implications around that. I want to thank both Dan McGowan and Rita Trowbridge for walking us through Pillar One and Pillar Two. Both as you can see, have a lot of impacts it'll have to businesses as they operate globally.
As the world continues to evolve, tax rules are also changing and it's critical that businesses understand the changes in the tax landscape. They have to plan to address the exposure and to ensure that they are in compliant in this post-BEPS world. In our next episode, we continue our BEPS conversation and we'll discuss its impact on indirect tax, customs considerations, and global workforces with our Indirect Tax Practice Leader, Brian Morcombe, and our Expatriate Tax Practice Leader, Debra Moses. Tune into our next episode and don't forget to subscribe to our Cross-Border Tax Podcast series.
The information in this publication is current as of March 22, 2021.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.