Despite its proliferation and wide acceptance, the Arm’s Length principle, cornerstone of the transfer pricing analysis for tax purposes, has had followers and opponents. Its application has been evolving in line with the evolution of the business models of multinational companies. There has been significant progress as a result of the BEPS (Base Erosion and Profit Shifting) action plan, in particular that transfer pricing results are aligned with value creation (actions 8-10) and documentation (Action 13). However, its interaction with income taxation in the digital economy has remained among the pending tasks.

In order to seek a definitive solution to the issue, the secretariat of the Organization for Economic Cooperation and Development (OECD), issued in early 2019, a policy note that, among other points, highlights that:

• Several proposals have been explored to assign more tax authority to the user’s market or jurisdiction;

• The inclusive framework (of the BEPS Action plan) agreed to explore proposals without prejudice, recognizing the implications for the fundamental pillars of the current international tax architecture (e.g. reconsideration of transfer pricing rules, routine and non-routine returns, going beyond the Arm’s Length principle);

• The proposals go beyond the limitation by physical presence of the tax authority;

• There is agreement among members of the Inclusive Framework on which aspects of benefit attribution and Nexus need to be developed simultaneously, with each participant playing a key role in the solution ultimately adopted;

• Different concepts of Nexus are explored (e. g. changes in permanent establishment threshold, such as significant economic presence or significant digital presence);

• There is a balance between accuracy and simplicity;

• The Inclusive Framework recognizes that not only small digital companies will be affected but also groups with international operations, with intangibles and limited risk distributors in market jurisdictions.

All this seemed to indicate that we were on the verge of a disruptive change in the international tax system despite the recent BEPS Action plan that was considered by many at the time the most important change in the international tax system in nearly a century.

Some of the solutions initially proposed were:

• Nexus considering the user’s contribution and allocation with a distribution-based approach, (distribution-based approach);
• Nexus considering marketing intangibles and allocation with a residual profit split; and
• Nexus considering significant economic presence and allocation with a fractional apportionment.

Some of these solutions were more aligned with the arm’s length principle (intangible), while others moved a little further (user’s contribution and significant economic presence).

After the public consultation process and faced with the difficulty of moving forward on the development of a solution, as part of its work programme, the OECD Secretariat presented an unified approach which sought to reconcile the solutions proposed above, which took a somewhat more procedural direction and considered simplification, leaving aspects relating to the modification of the current tax principles and foundations in the background.

This unified approach contemplates a so-called amount A, which considers the tax allocation to market jurisdiction for certain activities (digital and consumer-facing) through a formulistic approach. In addition, it provides for a B amount that considers a fixed remuneration for the baseline marketing and distribution functions, which were once referred to as activities subject to disputes between taxpayers and tax administrations, and this alternative is offered as a mechanism for simplification and relief of the administrative burden. Finally, it contemplates an amount C, which is an effective and binding dispute prevention and resolution mechanism, which in its origins seemed to include any additional benefit that in a country exceeded the functions referred to in amount B.

The implementation of the OECD work program has involved the hard work of the secretariat and the working parties involved, made up of representatives of the countries members of the Inclusive Framework (almost 70 days of virtual meetings during the pandemic, according to the OECD), which despite the difficulties, especially in the midst of a pandemic, were able to finalize in a timely manner the draft of the blueprint of the so-called Pillar 1 of Action 1 of the BEPS Action Plan, which was submitted for review and approval at the assembly of the inclusive framework on October 12, 2020. As stated in the cover statement issued by the inclusive framework, although no agreement has been reached, the blueprint provides a solid foundation for a future agreement that would adhere to the concept of net taxation of income, avoids double taxation and be as simple and administrable as possible.

According to the blueprint, broadly speaking, amount A of Pillar 1 is built by means of the following building blocks:

• Scope: identifies activities within scope for automated digital services (ADS) and consumer-facing business (CFB), the materiality threshold (to be defined) and excluded sectors (Natural Resources, Financial Services, Construction, and International Transportation);

• Nexus: defines different nexus rules (revenue amounts) for ADS and CFB. In the case of CFB, a “plus factor” consisting of physical presence through a subsidiary or fixed place of business is additionally applied, in which case it would not be necessary to reach the defined revenue level (physical presence test);

• Revenue sourcing: establishes rules, indicators and their respective hierarchies for the different activities considered ADS and CFB that identify revenue derived from a market jurisdiction;

• Tax base determination: sets the parameters for determining the tax base to be taken as a basis for later being partially assigned to the market jurisdictions;

• Profit allocation: includes 3 steps for profit allocation: i) identify residual and routine benefits, ii) apply the portion (assumed percentage to be defined by policy) of non-routine benefits to be distributed to market jurisdictions, and iii) apply allocation keys to allocate the portion established in the second step among all market jurisdictions;

• Elimination of double taxation: includes two components: (I) identification of paying companies (or companies that will provide tax relief) through four steps (activity test, profitability test, priority market connection test, pro-rata allocation) and (ii) methods for eliminating double taxation (exemption and credit).

Similarly, amount B is constructed by means of the following blocks:

• Scope: defines its application to companies that perform certain baseline marketing and distribution activities in a market jurisdiction and identifies the activities, risks and transactions considered;

• Amount: defines the indicator and fixed returns considering aspects such as region and industry.

Finally, it provides a tax certainty mechanism (originally part of what was considered amount C) and include the implementation and administration aspects.

As can be seen, the result of this solution seems to be the allocation of taxing rights to jurisdictions of market activities of amount A, through a formulistic approach, with little consideration to the principles and foundations of the international tax system (including the arm’s length principle), including a simplified mechanism, based in theory on the arm’s length principle, for certain activities of marketing and distribution, framed in the so-called amount B and amount C, that, more than an amount, is a mechanism of prevention and resolution of disputes. Everything indicates that what is not included in these amounts will continue to be governed by the principles and foundations of the current international tax system, including the arm’s length principle.

In short, this solution would imply the coexistence of a mechanism for the taxation of income of the digital economy (and with potential of digital transformation) with the application of the current tax system for the rest of the economy. This seems to indicate that, despite the invitation in the policy note to seek a solution without prejudice, the Arm’s Length principle will continue to be the guiding principle for transfer pricing for tax purposes.

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