Pillar I, Amount B updates: Light at the end of the tunnel?

On 17 June 2024, the OECD released supplementary materials relating to the report on Pillar I, Amount B. The updates address concerns raised by members such as India regarding the definition of terms such as:

• “Qualifying jurisdictions” within the mechanism of the operating expense cross-check and the data availability mechanism, and
• “Covered jurisdiction” for the political commitment in the Amount B report.

Previously, on 19 February 2024, the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (Inclusive Framework, or “IF”) approved and published the report on Amount B (the “Amount B report”), which provided a simplified and streamlined approach for baseline marketing and distribution activities. It was incorporated as an Annex to Chapter IV: Administrative approaches to avoiding and resolving transfer pricing disputes of the 2022 OECD Transfer Pricing Guidelines. A summary of the main characteristics of Amount B was published in this blog earlier this year.

The Amount B report provides a standardized pricing matrix to apply a simplified and streamlined approach to the wholesale distribution of tangible goods. This includes the activities of sales agents and commissionaires.

The matrix outlines a range of return on sales that would be considered to be at arm’s length by measuring two factors:

• Net operating asset intensity (“OAS”) (the ratio of net operating assets to net revenue); and
• Operating expense intensity (“OES”) (the ratio of operating expenses to net revenue) of the tested party.

Depending on the results, a “factor intensity classification” is calculated. This, coupled with the tested party’s industry group, determines the range of return on sales within the pricing matrix.

These June updates eliminated the gaps in the original Amount B report and allowed jurisdictions to begin with the (optional) implementation of the streamlined approach. Ideally, the OECD intends for countries to implement Amount B as of 1 January 2025.

1. What are the updates on qualifying jurisdictions?

To reach an arm’s length result, the pricing mechanism under Amount B includes:

• The pricing matrix that sets standard returns based on the relevant party’ industry;
• An operating expense cross-check which can adjust the pricing matrix result, based on the return on operating expenses achieved; and
• A data availability mechanism for “qualifying jurisdictions”, increasing the returns in jurisdictions with limited data in the global dataset and/or a low sovereign credit rating.

Operating expense cross-check

In the Amount B report, India expressed its disagreement with the lack of a suitable definition for the term ‘qualifying jurisdictions’ relevant for the application of the operating expense cross-check and the data availability mechanism.

First, the operating expense cross-check is applied as a guardrail within which the primary return on sales net for the purposes of the simplified and streamlined approach. Such a cross-check will be triggered if the computation of the equivalent return on operating expense derived from the return on sales determined under the pricing matrix yields a result outside of the pre-defined operating expense “cap-and-collar range" specified in the report. The equivalent return on operating expense refers to the return on sales of a tested party calculated in accordance with the pricing matrix and converted into a corresponding ratio of EBIT to operating expenses for the purpose of applying the operating expense cross-check.

If the cross-check is triggered, the profitability of the tested party will consequently be adjusted downwards or upwards, depending on whether the equivalent return on operating expense of the tested party falls above or below the operating expense cap-and-collar range. The range is limited at the top by the operating expense cap which refers to the maximum equivalent return on operating expense that the simplified and streamlined approach will produce for a given tested party, and at the bottom by the operating expense collar which refers to the minimum equivalent return on operating expense that Amount B will produce for a given tested party.

The applicable operating expense cap-and-collar range will depend on the factor intensity classification of the tested party. In addition, the operating expense cap-and-collar range is different for qualifying jurisdictions since alternative cap rates are specifically designed for these jurisdictions. Therefore, they have a less restrictive cap and are allocated a higher return when the operating expense cross-check applies. The table below shows the default cap-and-collar rates and the alternative cap rates applicable for qualifying jurisdictions.

The IF reached a consensus, although divergent opinions arose, on the following definition: “Qualifying jurisdiction(s)” within the meaning of Section 5.2 refers to jurisdictions that are classified by the World Bank Group as low income, lower-middle income, and upper-middle income based on the latest available ‘World Bank Group country classifications by income level’.

Data availability mechanism

Second, the data availability mechanism is intended to account for cases where there is no or insufficient data in the global dataset for a particular tested party jurisdiction and that jurisdiction is a qualifying jurisdiction. In this event, an adjustment will be made to the return on sales initially determined based on the pricing matrix and the operating expense cross-check, if applicable.

The mechanism also considers whether the jurisdiction could be reasonably considered a ‘higher risk’ jurisdiction by calculating the net risk adjustment percentage of the qualifying jurisdiction. To that end, sovereign credit ratings are used as a proxy to determine ‘higher risk’ jurisdictions and to quantify the applicable adjustment under the mechanism.

Finally, the formula for calculating the adjusted return on sales is composed of the net operating asset intensity percentage of the tested party.

The adjusted return on sales thus equals the sum of the return on sales percentage of the tested party calculated in accordance with the pricing matrix and the operating expense cross-check and the product of the net risk adjustment percentage of the qualifying jurisdiction and the OAS of the tested party.

The IF also reached a consensus and defined that a jurisdiction is a “qualifying jurisdiction” within the meaning of the data availability mechanism if it meets the following two cumulative conditions:

• The jurisdiction has a publicly available long-term sovereign credit rating of BBB+ (or equivalent) or lower from a recognized independent credit rating agency, and
• It has less than 5 comparables in the global dataset.

The definitions of qualifying jurisdiction(s) within the meaning of the operating expense cross-check and the data availability mechanism differ, although they significantly overlap. Consequently, when pricing in-scope transactions under Amount B either the operating expense cross-check or the data availability mechanism, or both may be triggered.

2. What are the updates on covered jurisdictions?

The second update addresses a concern made by India during the work on Amount B. India expressed its inability to make a political commitment as long as the report does not define the term ‘low-capacity jurisdiction’. This term is essential in the implementation of Amount B. As Amount B is optional, the fact that one jurisdiction chooses to apply it does not require the counterparty jurisdiction to accept the outcome of Amount B’s application in the first jurisdiction. However, the OECD provides one exception: if the jurisdiction applying Amount B is a ‘low-capacity jurisdiction’, the counterparty jurisdiction commits to respect the outcome determined under the simplified and streamlined approach, subject to the counterparty jurisdiction’s domestic laws and administrative practices.

Such a commitment is referred to as the political commitment which implies two main aspects for jurisdictions:

• Respecting the outcome determined under the simplified and streamlined approach to in-scope transactions where such approach is applied by a covered jurisdiction. In other words, if a jurisdiction applies the Amount B approach, other IF members agree to respect the results of this application.
• Taking all reasonable steps to relieve potential double taxation that may arise from the application of the simplified and streamlined approach by a covered jurisdiction where there is a bilateral tax treaty in effect between the relevant jurisdictions. This means that IF members commit to preventing situations where a company or individual is taxed twice on the same income by two jurisdictions.

The OECD preferred to use the term ‘covered jurisdiction’ instead of ‘low-capacity jurisdiction’ because it is neutral, and it avoids suggesting that the jurisdictions covered by the commitment are necessarily low-capacity jurisdictions. The definition of covered jurisdiction is not limited to low-capacity jurisdictions, but includes any jurisdiction that meets certain criteria. Covered jurisdictions are:

• Low- and middle-income IF jurisdictions using the World Bank Group country classifications by income level, excluding EU, OECD or G20 member countries.
• Low- and middle-income IF jurisdictions that are OECD and G20 member countries that otherwise satisfy the first criterion and that expressed to the Inclusive Framework a willingness to apply Amount B by March 2024. It must be highlighted that Argentina, Brazil, Costa Rica, Mexico and South Africa expressed their willingness to apply Amount B.
• Any non-IF member that meets the first criterion and expresses to the IF a willingness to apply Amount B will be added to the list of covered jurisdictions.

The OECD provides an exhaustive list of covered jurisdictions (as of June 2024: over 60 countries) to be updated every 5 years.

3.?What can taxpayers do?

As the end of the road appears to be near for Amount B, and with some countries anticipated to apply it from 1 January 2025, there is limited time for companies to assess the impact of Amount B and adjust their transfer pricing policies.

This can be done by:

Assessing which jurisdictions may be impacted based on the operating asset cross-check and current margins;

• Performing a preliminary modelling of the impact for the different jurisdictions;
• Reviewing the current transfer pricing policy for marketing and distribution activities against the Amount B pricing matrix;
• Evaluating the current segmentation approach and potentially revising it to effectively separate in-scope and out-of-scope activities; and
• Reviewing the existing transfer pricing documentation to demonstrate that a unilateral method can be applied and all the information required for the qualifying transactions can be provided.

Given the potential impact, companies are well advised to begin the process as soon as possible.