The Organisation for Economic Co-Operation and Development (“OECD”) announced last Friday that after years of negotiations and efforts, 136 world economies have agreed to a Global Minimum Tax (“GMT”) of 15%. This includes the US, the G-20, all other major world economies, and even the three hold-out countries of Ireland, Hungary, and Estonia, that currently provide low-tax incentives for the world’s multinational enterprises (“MNEs”). Only four OECD member countries have not yet signed on to this united approach to global taxation: Kenya, Nigeria, Pakistan, and Sri Lanka.
The agreement also includes a new nexus rule that will greatly impact the way companies have approached Transfer Pricing historically.
While an agreement has been reached, we have ways to go, with individual countries working to pass into law, plus agreements for resolving future disputes, but the target effective start is 2023 for MNEs with global revenue of EUR750 million or higher.
This is the most significant change and united approach to global taxation in a decade, where the world’s largest multinationals – trying to minimize their world-wide effective tax rates – have created a “race to the bottom” approach to shift part of their operations to low-tax jurisdictions, thus realizing more profit in a lower tax geographic market.
Revisiting Transfer Pricing Strategies to Align with the 15% Global Minimum Tax and Digital Economy Tax
It’s All About the Substance
The key distinction between tax minimization and tax manipulation is economic substance. Transfer pricing between affiliated companies must be at arm’s length – or market rates – to respect tax law and regulations in the respective geographic markets and build economic substance in the new lower-tax locations. This supports the commercial aspects of the new organization and ensures that profits flow to each affiliated company/tax jurisdiction based on the functions, assets (intangibles especially), and risks of one entity relative to the others. Determination of arm’s length pricing involves transfer pricing professionals and economic analyses to benchmark independent transactions/profitability of comparable firms in the industry. Tax authorities do not respect negotiations between directors of affiliated firms as resulting in market rate, or arm’s length, pricing without having it independently verified and tied to the marketplace.
Taxing the Digital Economy
Agreement was also reached on taxing the digital economy (AKA aligning international tax and transfer pricing laws) with the modern era of fewer brick and mortar and people-intensive businesses and more e-commerce and Artificial Intelligence (“AI”) driven businesses. These new rules for the digital economy have been debated and brewing for years, and it seemed like we would never see 90% of the world markets aligning on this issue. But here we are. There are a lot of details around this, but keeping things interesting and not overly technical here, the bottom line is that we will need to redefine how we practice transfer pricing, re-learn everything we have practiced around people and “boots on the ground” being essential to achieve substance in markets in which MNEs operate.
Entertainment streaming service companies are the perfect example of the digital era. These companies can stream millions of dollars in movie and TV content to customers in France (or anywhere) where they have no substance, no registered corporate entity, no physical building, no sales team, and thus, no tax bill. The French tax authority currently has no way to tax these MNEs, since the traditional transfer pricing concept of functions, assets, and risks is more people-driven and would not attribute taxable profits in France. The IP is developed and owned in the US, copyrights to the content held in the US, the business origination/e-commerce site is in the US, the sales are on the US books… so customers just happen to be in France, with no actual (traditional) efforts to gain these customers and market-share in France. With the new digital economy focus, tax authorities will have the right to tax at the consumer level, where goods (via e-commerce sales) and services (SaaS and streaming services) are sold, even if the MNE has no physical presence there.
It needs to be said that US MNEs will be highly impacted by this new digital tax concept since it primarily effects technology-driven companies, and the US seems to have a disproportionate share of them. At one point there was discussion around taxing all highly recognizable, branded products, in all world markets to level that playing field, but that seemed to lose momentum somewhere along the way.
What is the Future of Transfer Pricing?
The whispers, started with the 2017 new US tax laws and now with the GMT, were that somehow all these changes will kill the importance and need for transfer pricing. Spoiler Alert: Transfer Pricing is alive and well and – while it has always been a hot topic – it is now on fire. There will always be a need for transfer pricing, and these changes make the subject even more relevant.
There will be differences in how companies approach tax planning — there may be less incentive to chase lower tax rates by offshoring operations and IP with the same enthusiasm as in the past. Though let’s not forget that there are state tax, local tax, provincial tax, GST, VAT, and withholding tax implications and differentials that the 15% GMT at the federal level does not speak to. Domestic transfer pricing is very much a topic of conversation, as state tax audits are increasing, especially in separate filing states. Getting costs allocated to match income at both the domestic as well as global level is critical to ensure tax authorities are viewing the stand-alone business in its state or country and assessing the true tax due there.
Tax authorities will always care about transfer pricing and the need to have arm’s length pricing between affiliates, regardless of the more level playing field in tax rates, because tax authorities will always want to quantify and justify a higher amount of taxable income to its respective market. We still need to divide the global profit of the MNE between the countries in which it operates, and transfer pricing analyses based on relative functions, assets, and risks are more critical than ever. Determining these arm’s length profit rates for digital era businesses is infinitely more complicated than in the people-driven, physical presence-driven businesses.
Every indication leads us to believe that transfer pricing scrutiny will continue to rise in all markets, as tax authorities will fight even harder to increase taxable income in their respective markets with the new digital tax. Countries will need to scrutinize their transfer pricing margins even more in the new economy. MNEs should be sure they have a strong foothold in their economic position supported by robust transfer pricing planning strategies, as well as documentation studies, prepared annually at the time of their tax return filing. Transfer pricing continues to be the biggest tax uncertainty for all MNEs, with different compliance requirements in every country, and different audit and litigation risks as well. MNEs need to work together with their transfer pricing advisers to understand and help secure their economic positions and compliance around the world.
Details of this groundbreaking agreement can be found here.
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