The upcoming International Tax rules for digitalized business - End of arms length’ principle?

In a digital age, the allocation of taxing rights and taxable profits can no longer be exclusively circumscribed by reference to physical presence. Due to globalisation and the digitalisation of the economy, there are businesses that can develop an active and sustained engagement in a market jurisdiction, beyond the mere conclusion of sales, without necessarily investing in local infrastructure and operations. This means that the profits attributable to the physical operations that a business undertakes in a jurisdiction, may no longer be reflective of its sustained and significant engagement in the market.

These tax challenges related to digitalisation of the economy have been one of the main focus areas of the Base Erosion and Profit Shifting (BEPS) Action Plan and were initially reflected in the 2015 BEPS Action 1 Report.  Allocation of the taxing rights on income generated from MNE’s digital business activities among jurisdictions was identified as a key issue for the international agenda, so that the Action 1 Report called for continued work to reach an ultimate agreement in this area with a further report to be delivered by 2020.

Advancing to the next level, on 31 January 2020, the Organisation for Economic Co-operation and Development (OECD) released a Statement by the Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalization of the Economy (the Statement). The Statement reflects the outcome of the plenary meeting of the Inclusive Framework, where 137 participating jurisdictions affirmed their commitment to reach an agreement on the key policy features reflecting the new international tax rules for digitalized business and endorsed an outline of the architecture of the unified approach under Pillar One covering the allocation of taxing rights through modifications to the rules on nexus and profit allocation (“Unified Approach”) .1

The key points addressed in the Statement in relation to the Unified Approach under Pillar One are further discussed below in greater detail.

Pillar One Overview

The Unified Approach encompasses three types of taxable profit that may be allocated to a market jurisdiction; these are described as Amount A, Amount B and Amount C. Unlike Amount A, Amounts B and C do not create any new taxing rights. The taxable profits potentially allocable to market jurisdictions under Amounts B and C are based on the existing profit allocation rules (including the reliance on physical presence). The formula-based approach (with no connection to the arm’s length principle!) is therefore applied only in the case of Amount A.

The new taxing right under Amount A

Amount A is a share of residual profit to be allocated to market jurisdictions using a formulaic approach applied at an MNE group (or business line) level, irrespective of the existence of physical presence. It primarily reflects profits from the active and substantial participation of MNE in the economy of a market jurisdiction, through activities in, or remotely directed at that jurisdiction.

  • Business in scope: There are two categories of business that fall within the scope of the new taxing right under Amount A: (i) automated digital services, including, but not limited to online search engines, social media platforms, online intermediation platforms etc. and (ii) consumer-facing businesses, covering activities generating revenue from the sale of goods and services of a type commonly sold to consumers. Extractive industries and other producers and sellers of raw materials and commodities are carved out from the consumer-facing business definition. Moreover, since most of the activities of the financial services sector (including insurance activities) take place with commercial customers, they are out of scope as well. Nevertheless, consideration might be given to whether there are any unregulated elements of the financial services sector, such as digital peer-to-peer lending platforms.
  • Threshold: To ensure that the compliance and administrative burdens are proportionate with the intended benefits, the new taxing right will operate with a number of thresholds. In particular, its application will be limited to MNE groups that meet a specified gross revenue threshold – such as, for example, the Country-by- Country reporting threshold of EUR 750 million. A further carve-out will be considered where the total aggregated in-scope revenue is less than a certain threshold and for situations where the total profit to be allocated under the new taxing right would not meet a specified de minimis amount.
  • Nexus: The new nexus standard will be created based on indicators of significant and sustained engagement with market jurisdictions. To this end, the revenue threshold would be commensurate with the size of a market, with an absolute minimum amount to be determined.
  • The tax base and allocation key: In contrast to the traditional transfer pricing “separate entity” approach, the calculation of Amount A will be based on a measure of profit derived from the consolidated group financial accounts, whereby a profit before tax is the preferred profit measure to compute Amount A and will be applied consistently from year to year. The rules will apply to both profits and losses and will include loss carry-forward regulation. The Pillar One specifies that after determining the quantum of Amount A, it will be necessary to distribute Amount A among the eligible market jurisdictions based on an agreed allocation key. This allocation key would be based on sales of a type that generate nexus.

Scope and nexus for Amount B

Amount B represents a fixed remuneration based on the arm’s length principle for defined baseline distribution and marketing functions that take place in the market jurisdiction, which implies that Amount B would not be optional nor a safe-harbour.  Amount B will likely include distribution arrangements with routine levels of functionality, no ownership of intangibles and no or limited risks. The Statement indicates that defining what entities and activities would qualify under Amount B could be achieved by a positive definition, together with a list of activities and entities that would be out of scope.

The expectation is that treaty changes will not be required to implement the Amount B regime, which should simplify its implementation.

Scope and nexus for Amount C

Amount C covers any additional profit where in-country functions exceed the baseline activity compensated under Amount B.  However, the scope of Amount C is still being discussed and considered as a critical element in reaching and overall agreement on Pillar One.


The new rules primarily cover the principles relating to the allocation of taxing rights by taking into account new digitalized businesses models and thereby expanding the taxing rights of market jurisdictions, which, for some business models, may include jurisdiction where the user is located, irrespective of physical presence of MNE within the given jurisdiction. Moreover, the new profit allocation rules under Pillar One deviate from the traditional transfer pricing separate-entity approach by establishing a new principle for allocation of a portion of the residual profit to market jurisdiction based on a formula-based approach and certain quantitate indicators. Thus, the new standard for nexus proposes fundamental changes in international taxation landscape for MNEs and could result in a significant impact on their overall tax liabilities, and at the same time in a revised allocation of the taxable base between multiple countries.

Securing tax certainty is defined as an essential element of the unified approach and is a fundamental part of the design of Pillar One. While the challenges faced by the Inclusive Framework in arriving at a consensus solution by the end of 2020 are considerable, it is critically important to prevent potentially aggressive unilateral measures regarding implementation of the new nexus rules. The introduction of a revised nexus and allocation rules may result in double taxation of taxpayers in multiple jurisdictions; therefore, given the potential number of jurisdictions involved in the new digital taxation system, implementing the new approach may require changes to domestic legislation and tax treaties to remove existing treaty barriers and to adopt effective dispute prevention and resolution mechanism; this might be achieved  within the framework of a new mandatory multilateral instrument (MLI) to ensure that all jurisdictions can implement the Unified Approach consistently and at substantially the same time.


Gertrud Bergmann

Bettina Grothe

Elisabeth Tzumburidze


1OECD/G20 Base Erosion and Profit Shifting Project, Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy, OECD, Paris 2020