Simplifying transfer pricing for baseline distribution activities

September 2024 | SPOTLIGHT | CORPORATE TAX

Financier Worldwide Magazine

September 2024 Issue

The Organisation for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) recently published its final guidance on Pillar One, specifically focusing on Amount B.

This framework aims to streamline and simplify the application of transfer pricing (TP) rules for baseline marketing and distribution activities, addressing the challenges faced by low-capacity jurisdictions. It is structured as an optional approach that can be applied by jurisdictions to in-scope distributors resident in their jurisdictions from fiscal years starting on or after 1 January 2025. Additionally, jurisdictions can decide to implement Amount B as either optional or mandatory for taxpayers.

In past years, several disputes have centred around determining the arm’s length remuneration of limited-risk distributors, particularly concerning the inclusion or exclusion of comparables and deciding the appropriate point within the range to apply. TP is not an exact science and this exercise can expose taxpayers to significant risks, including double taxation, high compliance costs and other negative consequences.

Therefore, the effort by the OECD to provide clearer boundaries for determining the remuneration of baseline marketing distributors is welcome. However, it should also be noted that, while Amount B aims to simplify the TP landscape, some application mechanics and the fact that not all jurisdictions within the Inclusive Framework have fully accepted it raise doubts about whether this initiative will lead to significant simplification.

This article provides an overview of the key aspects of this guidance, including its objectives, scope, methodology and expected impact.

Introducing a new framework

In a globalised economy, multinational enterprises operate across various countries, often leading to complex cross-border tax disputes. These disputes, particularly concerning baseline marketing and distribution activities, can be financially and administratively burdensome. Low-capacity jurisdictions, with limited resources and data, are particularly affected.

The OECD’s report on Pillar One Amount B aims to alleviate these challenges by providing a simplified approach to TP, reducing administrative burdens, compliance costs and enhancing tax certainty. To this end, the new guidance is integrated into the OECD’s ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022’ (OECD TPG). Jurisdictions can opt to apply this approach to eligible transactions, characterised by specific criteria.

Optionality of the regime

It is important to preliminarily mention that Amount B is designed as an optional regime that jurisdictions can decide to implement. Moreover, the Amount B can be designed as an optional regime for the taxpayers of that jurisdiction, or a mandatory regime should the transaction of a taxpayer fall in the scope of Amount B.

Scope and application

The simplified approach applies to qualifying transactions involving buy-sell marketing and distribution, and sales agency and commissionaire arrangements where the distributor or sales agent is the tested party. To qualify, transactions must meet specific criteria, including the absence of economically significant risks and non-distribution activities. Certain activities, such as the distribution of commodities or digital goods, are excluded from the scope. The first step is to perform an accurate delineation of the transactions. The second is to apply the scoping criteria outlined below.

Economic characteristics. The transaction must exhibit economically relevant characteristics that make it suitable for pricing using a one-sided method, with the distributor, sales agent or commissionaire being the tested party. This includes ensuring that the contributions of each party are not unique and valuable, the parties are not so integrated that their contributions cannot be evaluated separately, and the parties do not share economically significant risks that are closely interrelated (i.e., profit split is not applicable).

Operating expense threshold. The tested party’s annual operating expenses must fall within a specific range relative to its annual net revenues. Specifically, operating expenses must be no lower than 3 percent and no greater than an upper bound, which can vary between 20 and 30 percent of the tested party’s annual net revenues, depending on the implementing jurisdiction’s decision.

In principle, the first criteria, that is the qualitative criteria, should be substantially covered already by the outcome of the accurate delineation of the transactions. The second entails an additional compliance effort aimed at determining the required profit level indicators.

Pricing methodology

The transactional net margin method is chosen as the most appropriate method for in-scope transactions under the simplified approach, with the comparable uncontrolled price method being an exception if internal comparables are available.

The pricing framework involves a three-step process: (i) categorise the tested party’s products into one of three industry groupings; (ii) assess the tested party’s operating expense and asset intensity to classify it into one of five predefined categories; and (iii) use the pricing matrix to determine the return on sales based on the industry grouping and factor intensity classification.

As a result of the above steps, it will be possible to identify the pricing in the matrix provided in the report.

Operating expenses cross check

An operating expense cross-check mechanism acts as a guardrail, ensuring the return on sales is within a predefined range. If the calculated return falls outside this range, adjustments are made to align it with the operating expense cap and collar. That helps in avoiding situations where the application of the return on sales determines unrealistically high results in the tested party.

Documentation

Chapter 6 of the OECD report on Pillar One Amount B provides comprehensive guidance on the documentation requirements necessary for applying the simplified and streamlined approach to TP for baseline distribution activities. The goal of these documentation requirements is to ensure transparency, facilitate compliance and enhance tax certainty for both taxpayers and tax administrations.

The documentation requirements under the simplified and streamlined approach aim to ensure that taxpayers maintain adequate records to demonstrate that their TP practices align with the OECD guidelines and the newly introduced simplified approach. To this end, taxpayers must maintain detailed records of their transactions, including the accurate delineation of the transactions in scope. This involves documenting the functions performed, assets used and risks assumed by the parties involved in the transaction.

Documentation should include a thorough analysis of how the return on sales was determined, following the three-step process outlined above and in chapter 5 of the report. For distributors engaged in non-distribution activities, documentation must clearly separate and reliably price these activities. This includes allocation of revenues, costs and assets relevant to both distribution and non-distribution activities.

Taxpayers are required to periodically update their documentation to reflect any changes in the business operations or economic circumstances that may affect the application of the simplified approach. All relevant supporting evidence, including financial statements, internal reports and benchmarking studies, must be attached to substantiate the application of the simplified and streamlined approach.

Tax certainty

Chapter 8 of the OECD report on Pillar One Amount B addresses the crucial issues of tax certainty and the elimination of double taxation. The chapter emphasises that one of the primary objectives of the simplified and streamlined approach is to enhance tax certainty for both taxpayers and tax administrations. The approach aims to minimise disputes and ambiguities in TP practices.

The report outlines the traditional mechanisms to prevent and resolve double taxation, which may arise from the application of the simplified approach. Jurisdictions adopting this approach commit to respecting the outcomes determined by low-capacity jurisdictions, provided these jurisdictions apply the approach consistently. This includes taking reasonable steps to alleviate double taxation through mutual agreement procedures and other dispute resolution mechanisms as provided for in bilateral tax treaties.

The OECD encourages the development of competent authority agreements to facilitate the smooth implementation of these measures, ensuring that tax administrations work collaboratively to resolve any issues that may arise. By fostering cooperation and mutual understanding, the chapter aims to create a more efficient and effective international tax environment, reducing the administrative burden on all parties involved and promoting greater fairness and stability in global taxation.

Conclusion

Amount B introduces an optional regime aimed at simplifying the application of TP rules for transactions related to baseline marketing and distribution activities, ultimately reducing disputes in this field. Generally, TP efforts involve performing the accurate delineation of transactions, identifying the right pricing and preparing the necessary documentation.

Amount B, as currently designed, certainly alleviates the pricing work by providing a predetermined benchmarking exercise. However, compliance efforts regarding the other two areas seem to remain substantially unchanged: accurate delineation and documentation. For the first, an additional quantitative exercise is required to determine whether transactions fall within the scope. In terms of documentation, the requirements seem to be aligned with the requirements detailed in chapter 5 of the OECD TPG.

Additionally, there is no unanimous consensus on some key aspects, such as the need for an additional qualitative screening and the application of the operating expense cross-check. There can also be misalignment between jurisdictions that decide to implement Amount B and those that do not, potentially leading to inconsistencies and complications. While the report encourages tax administrations to resolve disputes in this area, no new dispute resolution mechanisms seem to be introduced.

The effectiveness of these simplification measures will then largely depend on the ability of different jurisdictions of applying judgement and to effectively use existing dispute resolution mechanisms, which have not always proven effective in the past. In conclusion, while the introduction of simplification measures is certainly welcome and admirable, their actual effectiveness will depend significantly on the capacity of jurisdictions to make good use of the existing mechanisms for resolving disputes.

Marco Orlandi is the transfer pricing lead upstream, projects & technology and group services at Shell. He can be contacted by email: marco.orlandi@shell.com.

Marco Orlandi

Shell