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Pillar One: Marketing and Distribution Profits Safe Harbour

Pillar One Amount A: Marketing and Distribution Profits Safe Harbour

Contents

The marketing and distribution profits safe harbour is included in Articles 6(3)-(6) of the Progress Report on Amount A of Pillar One. It is deducted from the initial amount of profits reallocated to a jurisdiction (but cannot reduce profits below zero). 

One of the purposes of the safe harbour is to prevent double taxation, where a multinational group has already established a taxing right in a jurisdiction due to physical presence.

Use our Marketing and Distribution Safe Harbour Calculator to simplify the calculation.

Summary

By way of a very high level summary, the marketing and distribution profits safe harbour is based on a measure of profits that the OECD terms ‘elimination profits’. This is the financial accounting profit subject to a number of adjustments. Many of the adjustments are also similar in certain respects to the adjustments that would be made for determining Pillar Two GloBE income.

The next step is to calculate the ‘elimination threshold return’. This is essentially the jurisdictional revenue x 10%/jurisdictional depreciation and payroll.

The elimination profits are then reduced by a deemed profit figure which is an amount so that the return on depreciation and payroll would equate to the higher of the elimination threshold or 40%.

The result of all this is then multiplied by an offset percentage.

The amount of the marketing and distribution profits safe harbour is the lower of the result of this calculation and the initial profits calculated for reallocation.

Whilst this is a formulaic approach to a carve out for allocated profits it is by no means straightforward.  However, the safe harbour can have a significant impact on the profits allocated. See the example calculation below. 

Elimination Profit

The first aspect of the marketing and distribution profits safe harbour is to calculate the elimination profit for the jurisdiction. This is the profit used to perform the calculation and is not the same as adjusted profits used in the main profit reallocation calculation. 

It is calculated by taking the financial accounting profit or loss of each group entity in a jurisdiction and subjecting it to a number of adjustments.

Tax Expense 

Just as for the adjusted profits calculation, the tax expense (including both current tax and deferred tax) is excluded (ie added back) for elimination profit purposes.

Excluded Non-Portfolio Dividends

Whilst adjusted profits had a general exclusion for dividends, for elimination profit purposes, only non-portfolio dividends are excluded. This uses a similar definition to the Pillar Two GloBE Rules and is defined as dividends  (or other distributions on shares) where the MNE group holds 10% or more of the ownership and had held full ownership for 12 months or more.

Excluded Non-Portfolio Equity Gain or Loss 

This is similar to the exclusion for calculating adjusted profits for the main profit reallocation calculation, however, only gains that relate to non-portfolio holdings (10%+ shareholding and held for 12 months or more) are excluded. 

Included Revaluation Method Gains or Losses 

Where an entity values assets under a revaluation method for accounting purposes, its value in the balance sheet is revalued to the current market value (less accumulated depreciation and impairment losses).

Revaluation gains are generally included in Other Comprehensive Income whereas revaluation losses are taken through the profit and loss account.

This would mean that revaluation gains (as they are reflected in Other Comprehensive Income and not the Profit and Loss account) would generally not be taken into account for the purposes of the Pillar One Amount A calculation.

As such, under Schedule I of the Progress Report on Amount A of Pillar One, all revaluation gains or losses that are included in Other Comprehensive Income and aren’t taken through the P&L are required to be included in elimination profits for Amount A. 

Policy Disallowed Expenses 

Just as for the calculation of adjusted profits for the main profit reallocation calculation, policy disallowed expenses are excluded (ie added back).

Prior Period Errors and Changes in Accounting Principles 

Again as for the main profit reallocation calculation, these are included in elimination profit.

Accrued Pension Expense 

This is the same adjustment as is made when calculating GloBE income for Pillar Two purposes. It looks to try and replicate the domestic law tax treatment in many jurisdictions.

Generally, pension contributions are tax-deductible when paid, as opposed to the amount accrued in the financial accounts.

The Progress Report on Amount A of Pillar One follows this treatment.

Therefore, if the amount paid is different from the amount accrued in the income or loss in the financial accounts, the difference is adjusted in the calculation of elimination profit for Amount A purposes.

Stock-Based Compensation Expense 

Just as for the Pillar Two GloBE income calculation, there is an adjustment for the amount of stock based compensation deducted for tax purposes, as opposed to what is including in the financial accounts. 

Given both Pillars rely on the financial accounts as the starting point of their respective calculations, the expense for stock-based compensation would be based on the accounting treatment.

As we explain in our analysis of Pillar Two GloBE Income Elections companies generally account for stock-based compensation based on the present value of the stock option at the time of issue, and amortize that amount over the vesting period. 

However, for tax purposes, companies generally deduct the value of stock-based compensation based on the ultimate market value of the stock. 

For Pillar Two purposes, an MNE group can elect to apply the treatment for tax purposes. For Pillar One there is no election – it is mandatory to replace the accounting treatment with the tax treatment. 

Hybrid Profit (or Loss)

This effectively replicates the same adjustment that is made for the purposes of calculating Pillar Two GloBE income. The elimination profit of a low-taxed entity does not include any expenses of an intra-group financing arrangement that can be expected to increase the expenses of a low-taxed entity without a corresponding increase in the taxable income of a high taxed entity.

Asset Gain (or Loss) Spreading Adjustments 

This is the same adjustment as required in calculating adjusted profits for the Amount A main profit reallocation amount.

Integration Asset Gains 

Gains on asset transfers within 18 months of a group entity joining the group are excluded from the calculation of elimination profit. 

Arms-Length Basis

Just as for the Pillar Two GloBE income calculation, Schedule I, Section 2(3) of the Progress Report on Amount A of Pillar One applies an arms-length requirement for transactions between constituent entities in different jurisdictions. This should generally apply in any case due to transfer pricing policies under domestic tax laws.

Although these transactions may be eliminated in the consolidated financial accounts, given the Pillar One Amount A income or loss is based on the entity’s financial accounts they would need to be considered.

If the financial accounts agree to an arms-length basis no adjustment would need to be made. However, if for tax purposes a different value is used to apply the arms-length basis an adjustment to Amount A income would then need to be made.

The arms-length basis doesn’t generally apply to transactions between group entities in the same jurisdiction, subject to one exception.

A transfer of an asset between group entities in the same jurisdiction that gives rise to a loss that is included in the Amount A income or loss. In this case the arms-length basis needs to be applied otherwise an MNE could artificially manufacture losses. 

Fair Value/Impairment Accounting

This is the same adjustment as is included in the calculation of adjusted profits for the main Amount A profit reallocation calculation.

Allocation of income or loss of a Permanent Establishment

Schedule I, Section 3 of the Progress Report on Amount A of Pillar One  includes provisions to allocate the income or loss of a main entity to a permanent establishment (PE). This is important as a permanent establishment will be in a different jurisdiction to the main entity. Therefore, rules are required to attribute the income or loss to the PE so that the elimination profit or loss can be calculated. 

In many ways, these are similar to the profit allocation requirements under the Pillar Two GloBE Rules.

The general rule is that if a PE produces separate financial accounts, then they form the basis of the amount allocated to the PE.

If no separate financial accounts are prepared, the amount of the profit or loss allocated to the PE is the amount that would have been reflected in separate financial accounts (based on the accounting standard used by the UPE in preparing the consolidated accounts).

The amount allocated to the PE can be adjusted under the terms of a double tax treaty or domestic law if there was a PE under the terms of a double tax treaty or as a result of the application of domestic law.

If there is no PE under a tax treaty or domestic law but there would have been one under the OECD Model Tax Convention, the amount attributed can be adjusted in accordance with the OECD Model Tax Convention.

The profit or loss attributed to the PE is deducted from the main entity’s profit or loss. However, just as for Pillar Two purposes, a loss (in this case an elimination loss) of a PE is treated as an expense of the main entity where the loss is deductible for the main entity for domestic corporate income tax purposes.

The corollary to this is that profit (elimination profit) of the PE is treated as elimination profit of the main entity up to the amount of the elimination loss that was treated as an expense of the main entity. 

Elimination Losses

Schedule I, Section 7 of the Progress Report on Amount A of Pillar One provides that elimination losses are carried forward and offset against future elimination profits.

This is computed on a jurisdictional basis. Therefore the profits and losses of all group entities in a jurisdiction are blended to determine whether there is an elimination loss. 

Elimination Threshold

The Elimination Threshold is a key component of the Marketing and Distribution Profits Safe Harbour. It is calculated as 10% of the group revenue divided by the groups depreciation and payroll in the jurisdiction. 

Depreciation

This is the amount of depreciation, amortisation or impairment in the consolidated financial accounts that relates to eligible assets.

Eligible assets include property, plant and equipment, natural resources and a government licence for the use of real property or exploitation of natural resources where that involves a significant investment in tangible assets.  Assets held for investment purposes or resale are excluded. 

Payroll Expenses

Payroll expenses include all payments for eligible employees including salary, health insurance, pension contributions and stock-based compensation. Payroll and employment taxes and employer social security contributions are excluded. 

Eligible employees includes full and part time employees and independent contractors.

Return on Depreciation and Payroll

The Marketing and Distribution Profits Safe Harbour calculation uses the ‘Return on Depreciation and Payroll’ to calculate the safe harbour amount.

The Return on Depreciation and Payroll is the Elimination Profit of the group in a Jurisdiction, divided by the total depreciation and payroll costs in that jurisdiction. 

The Marketing and Distribution Profits Safe Harbour Calculation

The Marketing and Distribution Profits Safe Harbour is calculated as the lower of:

  • The initial amount attributed to a jurisdiction using the standard profit reallocation calculation
  • The Elimination Profit less a portion of this that would result in a Return on Depreciation and Payroll of the group in the jurisdiction equal to the higher of the Elimination Threshold Return on Depreciation and Payroll or 40 per cent, multiplied by an offset percentage. 

There are therefore a number of aspects to the Marketing and Distribution Profits Safe Harbour Calculation. In particular it requires a calculation of:

1. Elimination profits/losses for the jurisdiction 

2. The Elimination Threshold for the jurisdiction

3. The Return on Depreciation and Payroll for the jurisdiction that equates to the higher of the Elimination Threshold or 40%

Example

An MNE Group had Elimination Profits of 100 Million Euros in jurisdiction A and revenue of 500 Million Euros.

Depreciation and Payroll Costs in jurisdiction A were 25 Million Euros in total.

Step 1

The first step is to calculate the key figures needed for the Marketing and Distribution Profits Safe Harbour.

Elimination Profits

In this case this is 100 Million Euros

Elimination Threshold

This is 10% of the group revenue divided by the groups depreciation and payroll in the jurisdiction.

10% * 500 Million/ 25 Million = 200%

Step 2

Take the higher of the Elimination Threshold Return and 40%. In this case the Elimination Threshold Return is 200%.

Step 3

Calculation the portion of Elimination Profit that results in a  Return on Depreciation and Payroll of Step 2 (in this case, 200%).

As the total depreciation and payroll costs in jurisdiction A is 25 Million Euros, Elimination Profit would need to be 50 Million Euros to equate to a 200% Return on Depreciation and Payroll.

Step 4

Calculate the Marketing and Distribution Profits Safe Harbour profits. This is the Elimination Profit less Step 3. Therefore

100 Million – 50 Million = 50 Million. 

Step 5

Apply the Offset Percentage. This is the final adjustment and is not defined in the Progress Report on Amount A of Pillar One

If we assume it is 20%, this would equate to a final safe harbour figure of 10 Million Euros. This is then compared to the amount allocated to jurisdiction A using the standard profit reallocation calculation, with the lower of the two amounts being the safe harbour amount.