An Imprecation or A Benediction | The Two Pillars & Its Relationship with Tax Ecosystem

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  • Last Updated on 2 June, 2022

Tax Ecosystem

Assem Chawla – [2022] 138 taxmann.com 550 (Article)

Introduction

The world is ever-changing, and one of the chief catalysts is digital transformation. Digitalization and globalization have had an unprecedented impact on the existing “TAX PRINCIPLES” in vogue and accompanying them are new challenges.

With the emergence of integrated global trade and borderless virtual markets, the conventional concept of physical trade has been supplanted by the ‘Digital Economy’, a resultof tremendous advancement in electronic communication. The traditional concept of physical trade with conventional residence-based and source-based tax rules are not sufficient enough to envision taxable presence of a digital economy owing to its nebulous nature.

The concept of digital economy has been more often than not viewed in a circumspect manner by tax authorities and thus, in their zeal to tax such transactions, the Revenue has not hesitated making unreasonable assumptions not normally not found in their edicts of taxation rules.

Two-Pillar Approach

Pillar One

Pillar One is a set of proposals to reconsider tax allocation rules in a changing economy which aims to distribute profits and taxation rights more equitably among countries with respect to the largest MNEs which are beneficiaries of globalization. it allows the market jurisdictions to tax global companies even if they don’t have a physical presence in that jurisdiction.

The agreement to re-allocate profit under pillar one includes removal and standstill of Digital Services Tax (DST) and other relevant or similar measures, bringing an end to trade tensions resulting from the instability of the international tax system. It is expected to provide a simplified approach to the application of the arm’s length principle in specific circumstances, with particular focus on the needs of low-capacity countries.

The essential elements of this pillar can be grouped into following elements:

    • Envisioning a new taxing right for market jurisdictions over a share of residual profit calculated at an MNE group which referred to as Amount A.
    • Fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction which referred to as Amount B.
    • Process of improving tax certainty through effective conflict prevention and resolution mechanisms.
    • Entailing the removal and standstill of DST and similar measures to prevent unsafe trade disputes.

Description of Amount A

Amount A is a new taxing right which refers to a share of residual profit allocated to market jurisdictions using a formulaic approach to every business which falls under its ambit.

It is an overlap to the present nexus and profit allocation rules and will be applied to small number of MNEs in specific industries. Though, given its innovative features, the inclusive framework members are cognizant of the need to keep the number of MNEs affected at an administrable level and have agreed to consider thresholds and other characteristics that help keeps the approach expected while minimizing compliance costs, and to address tax administrations capacity considerations.

Key highlights of the abovementioned taxing rule are:

    • A revenue threshold based on annual consolidated group revenue coupled with a de minimis Foreign “in-scope” revenue carve-out. Such thresholds aim to reduce the compliance costs while keeping the administration of the new rules adaptable for tax administrations.
      These thresholds could be implemented on phased approach so that the tax administrations are not encumbered with the initial operation of the new taxing right
    • Scoping Rules covering Automated Digital Services (ADS) and more broadly Consumer Facing Business (CFB). This includes companies that can have considerable and long-term interactions with customers and users in a market jurisdiction.
    • A new nexus rule is being employed to identify market jurisdictions eligible to receive Amount A. The new nexus rules aim in striking a balance between the interests of smaller jurisdictions, particularly developing economies, benefiting from the new taxing right with the need for low and proportionate compliance costs, maintaining the overall balance while avoiding spill-over effects in other tax and non-tax areas.
    • A loss carry-forward regime to ensure that there is no Amount A allocation where the relevant business is not profitable over time.
      To ensure Amount A applies only to economic profits, consideration be given to MNEs in scope being allowed to bring existing losses incurred prior to the introduction of Amount A into this loss carry-forward regime relying on an earnout mechanism to enable offsetting past losses against future profit.
      Amount A losses will be maintained and carried forward in a single account at the level of the group (or segment level where relevant), and not allocated to individual market jurisdictions.
    • Where an MNE is subject to the new taxing right, a streamlined administrative process would be developed to minimise the Intricacies viz; (the complexity, burden and cost of filing and payment) aiming at benefitting the tax administrants and taxpayers similarly.
    • Amount A taxing right would be implemented through changes to domestic law and by way of public international law instruments requiring a multilateral convention. Domestic law and multilateral convention will be complimented by the guidance and other instruments where deems necessary.

Scope and Nexus Rules of Pillar One

Companies which fall under the scope of the rule are those MNEs having global turnover of €20 billion and profitability beyond 10% of profit before tax with the turnover threshold to be reduced to €10 billion, contingent on the successful implementation including of tax certainty of Amount A with the relevant review beginning 7 years after the agreement comes into force, and the review being completed in no more than one year excluding Extractives and Regulated Financial Services.

Amount A endeavours allocating 25% of the residual profits defined as profit before tax in excess to 10% of revenue to a market jurisdiction with nexus using a revenue-based allocation key.

A new special purpose association rule allows Amount A to be allocated to a market jurisdiction when the MNE entity has generated at least €1 million in revenue from that jurisdiction.

For smaller jurisdictions having GDP lower than €40 billion, the nexus threshold will be set at €250,000. The nexus rule applies solely to determine whether a jurisdiction is qualified for the Amount A’s allocation, limiting compliance costs to minimum.

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