The Organisation for Economic Co-operation and Development’s (OECD) proposed Pillar One and Pillar Two initiatives continue to be very topical. The outline of this proposal has been under discussion internationally since 2019 and therefore there is a certain degree of topic fatigue – since delays in implementation and disagreement on policy details have pushed out the timelines several times. The latest targets are to try to achieve full agreementon Pillar One by mid-2023 and implementation of Pillar Two by 2024.
However, there are still significant hurdles to be cleared before there will be full global acceptance of both Pillars – most notably in the United States. So, the timing of these changes remains rather uncertain. It can be challenging to keep up with ongoing developments. For example, the OECD released an additional three-part implementation package for Pillar Two as recently as 20 December 2022.
As a brief reminder, Pillar One will mean that very large multinational enterprises (MNEs) may become subject to tax in countries where they sell their products or services (often referred to as market countries). Amount A of Pillar One would apply to MNEs with more than €20 billion in consolidated group revenues and an overall profit margin above 10%. It is envisaged that 25% of the profits above a 10% margin may be taxed in the market economies. This system is intended to supersede digital services taxes.
Pillar Two puts into place a global minimum tax system. The threshold for this system to apply is significantly lower than for Pillar One – namely consolidated group revenues of more than €750 million – aligned with the threshold for country-by-country (CbC) reporting. Broadly speaking, Pillar Two will apply to the extent that group companies are subject to tax at rates lower than 15% and would result in such under-taxed profits being subject to tax either in the country where the ultimate parent is located or, in the case of an MNE where the ultimate parent jurisdiction does not impose such tax, in the countries where other group companies are located.
Both Pillar One and Pillar Two effectively prescribe mechanical rules for determining the amounts subject to tax rather than doing so by reference to the arm’s length principle, the cornerstone of transfer pricing. So the question arises to what extent the traditional way of doing transfer pricing may be replaced, or at least eroded, by Pillar One and Pillar Two.
The precise nature and extent of the interaction between Pillar One and Pillar Two, and other tax rules (such as transfer pricing rules and controlled foreign company [CFC] rules), will probably only become clear over time. However, it seems clear that traditional transfer pricing will continue to be significant. A few points can be made in this regard.
Firstly, as regards Pillar One, the threshold for it to become effective is extremely high – particularly from a South African perspective. Consolidated group turnover of more than €20 billion means that only very large MNEs will potentially become subject to Pillar One. The further requirement is that such MNEs must also be very profitable – with overall profits above 10%.
It should be noted that it is intended to lower the threshold for Pillar One to €10 billion after an initial review period of seven years. This would significantly broaden the reach of this system. Nevertheless, as stated explicitly by the OECD, Pillar One will continue to only apply to the biggest and most profitable global MNEs.
Furthermore, certain types of business are excluded – namely extractive enterprises (mining and oil and gas companies) and regulated financial services.
Therefore, the vast majority of MNEs will fall outside the scope of Pillar One and will continue to be taxed according to traditional transfer pricing principles.
It seems clear that the impact of Pillar Two will be felt by far more MNEs since the threshold for applicability is much lower. The probable significance of Pillar Two, from a transfer pricing point of view, is to disincentivise affected MNEs from directing profits to very low tax jurisdictions via transfer pricing planning since such profits will probably end up in the corporate tax net in any event. Indeed, it seems likely that Pillar Two will be successful in deterring some of the most extreme forms of abusive transfer pricing.
However, for MNEs having a footprint which includes highly taxed countries like South Africa (SA), there will continue to be a significant incentive to transfer price profits away from such countries. As already noted, Pillar Two only applies to the extent that profits are taxed at rates below 15%. That rate is only 55.5% of the SA corporate tax rate of 27%. To the extent that MNEs with an SA presence actively do transfer pricing planning, it seems likely that they will continue to plan to shift profits away from SA as far as possible. SARS will therefore need to be remain vigilant about transfer pricing practices.
So arguably Pillar Two will, in the main, only have an effect on the most extreme forms of transfer pricing planning – such as transactions with very low tax jurisdictions including tax havens. This type of planning has probably already been quite significantly discouraged by the extent of the disclosure required to be made in terms of the CbC reporting system – which requires much greater transparency than before from taxpayers. So to what extent Pillar Two will result in MNEs restructuring their transfer pricing affairs is by no means clear.
There is considerable work to be done by SARS and all revenue authorities – and also by legislators – to prepare for the implementation of the new tax rules. Governments around the world are working on developing implementation plans. Some of the changes to be made will be embedded in intra-governmental agreements. As regards Pillar One, current double tax agreements (DTAs) do not give taxing rights of the type envisaged by Pillar One and therefore all the DTAs will need to be amended to give such rights to the market countries. Like the position with the CbC system, this is likely to be via an appropriate multilateral mechanism. One option that was considered was to amend the existing “Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI)” – which must be read together with existing tax treaties, and which modifies such treaties. However, the OECD has indicated that this is no longer considered the appropriate option and that this will be done via a standalone multilateral convention which co-exists with the existing global tax treaty network.
However, domestic tax laws will also need to be amended if necessary to actually put such taxing rights in place. For example, in SA, non-residents are only subject to SA tax on SA sourced income.
We therefore run the risk that we are given the right, in terms of the MLI, to tax a foreign MNE in respect of its income derived from SA customers, but that there is a gap in our domestic legislation which enable the MNE to avoid being taxed here.
Our existing source rules probably do not extend to the types of income to which Pillar One will apply. It will therefore be necessary for us either to codify and extend our source rules via appropriate legislation or to pass legislation which otherwise puts in place a suitable trigger to pull foreign MNEs into the SA tax net where SA is the market country.
The successful implementation of Pillar Two will rely heavily on the introduction and successful implementation of domestic enabling legislation. Countries will also have to consider to what extent such new laws overlap with existing legislation – particularly CFC legislation. It may also be necessary to consider to what extent existing tax incentives remain fit for purpose – since the tax benefits associated with such incentives may be forfeited or eroded by the new rules.
In summary, there is much to be done and the introduction of Pillars One and Two presents a significant challenge for taxpayers, revenue authorities and legislators. However, it also seems clear that, while these rules will impact on transfer pricing planning and compliance, transfer pricing will be no less important and prevalent once the new rules are in place. This applies particularly in high tax countries like South Africa.