Taxation has developed over hundreds of years, with some general principles coming to the fore. Tax has generally been levied on the basis of income, expenditure, or wealth and the taxation of income is typically based on the residency of the “subject” to tax as well as the location of the source or “object” of the tax.
Nations normally seek to exert sovereignty over their tax policy. However, it is frequently in the mutual interest of countries to collaborate to the extent of respecting the concept of proportionality and have harmonisation across certain tax regulations. These two drivers work to decrease the level of double taxation and restrict tax leakage due to non-taxation.
In September 2023, the European Commission (“EC”) put forward a proposal for council directives on
- “Business in Europe: Framework for Income Taxation” (“BEFIT”); and
- Transfer Pricing (“TP”).
Currently, the European Union (“EU”) is comprised of 27 countries and operates as a single market enabling the free movement of capital, people, goods, and services. The BEFIT proposal is aimed at developing an EU corporate tax framework to compute taxable income under a common set of rules. The BEFIT proposal follows earlier attempts to achieve similar aims in 2011 and 2016 in respect of the common consolidated corporate tax base (“CCCTB”).
The final proposal for TP directives sets out an approach whereby the OECD arm’s length principle and TP Guidelines will be incorporated into EU law alongside the development of common approaches to the practical application of TP rules.
Who will be affected by BEFIT?
The BEFIT directive rules will apply to EU multinational groups (“MNE Groups”) which meet the BEPS Pillar 2 thresholds. This will normally mean Groups with an annual combined turnover of €750 million in 2 of the last 4 years. However, such MNE Groups must have 75% ownership of their entities located in the EU.
If a MNE Group is headquartered in a country outside the EU then at least €50 million of annual combined turnover in the last 2 out of the 4 years should come from the EU entities in the group. However, the EU combined turnover should represent at least 5% of the global turnover of the Group.
There is an option for small and medium-sized enterprises to adopt the common tax base rules, however, international shipping and extractive activities are specifically excluded. The EC aims to have the BEFIT rules in force from 1 January 2028.
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How will it be applied?
When an MNE Group meets the BEFIT threshold, the regulations will apply to the computation of income for all subsidiary companies and permanent establishments (branches) in the EU (collectively the “BEFIT group”). The results for all BEFIT group members will be aggregated to form a single tax base or pool. This pooling will effectively result in cross-border set-off of losses.
The next step will be the allocation of the aggregated tax base to the members of the BEFIT group based on transitional allocation rules. The current proposal recommends that this allocation be based on each BEFIT member’s percentage of an aggregated tax base calculated as the average of taxable results in the previous three years.
The proposal says that this transitional allocation could help develop a permanent allocation method based on a formulary apportionment. However, this area needs further evaluation as multiple economic factors including changing supply chains and value contributions by different players may affect these so-called three-year averages in the transitional period and thereafter.
The regulations indicate that the pricing of transactions between members of a BEFIT group could affect the allocation of the tax base between group members. This pricing, therefore, needs to be based on the arm's length principle.
During the transition period of seven years, the pricing will not be challenged if there is a less than 10% variation in comparison to the average of the last three years. This is similar to the provisions of standard deviation in the TP regulations of some jurisdictions in the developing market.
This is a welcome provision that will reduce the burden of benchmarking transactions where there is no change in the functionality or underlying economic circumstances. Where an item of income or expenditure arising out of transactions between BEFIT members, increases by more than 10 percent from the average of the last three years, the excess over 10 percent will be ignored for baseline allocation unless it is proven to be at arm's length.
Transfer Pricing traffic light system
One of the more interesting features of BEFIT is a risk assessment framework for transfer pricing. This framework will be used to select cases for assessing the arm's length nature of transactions between a BEFIT group member and its non-EU associated enterprises. This risk-based framework will apply to limited risk distributors (LRD) and contract manufacturers located in the EU.
Whilst BEFIT will cover LRDs, low-risk captive service providers (including procurement service providers) are not covered. Similarly, the definition of contract manufacturers needs further deliberation regarding entities acting as toll manufacturers. The regulations mention that to qualify as an LRD or contract manufacturer, one should not hold any legal or economic interest in intellectual property relating to the products or services.
As businesses become more and more complex, the appropriate characterisation of LRDs and contract manufacturers must be clearly demonstrated by the MNE Groups particularly where the reality is that such players often contribute to one or more of the elements of a DEMPE analysis to determine the ownership of IP.
The proposal suggests low, medium, and high risk zones based on interquartile ranges from public benchmark studies of LRDs and contract manufacturers which will be published every year. A BEFIT group member earning above the 60th percentile of the public benchmark will be in the low-risk zone, the medium risk zone will be between the 40th percentile and 60th percentile and the high-risk zone will be below the 40th percentile.
BEFIT Transfer Pricing risk assessment
The proposal does not unfortunately, include the possibility of having multiple public benchmarks based on different Industries or levels of activities. Similarly, there could be challenges of comparability with these public benchmarks where a distributor is dealing with high-value goods with minimal effort and limited costs.
Such cases might expect to apply the berry ratio to demonstrate the application of the arm's length principle. It is possible that the risk assessment framework based on interquartile ranges indicates the commission’s limited intention to move towards a European safe harbour for routine players.
The risk assessment framework recommends EBIT/ sales and EBIT/ total cost as the profit level indicators for LRDs and contract manufacturers, respectively. However, it does not consider the effect on cases where the comparable uncontrolled price method is actually the most appropriate method.
Proposal for Transfer Pricing directives
Although most of the TP regulations in member states’ domestic tax laws already recognise the OECD TP guidelines (which is a nonbinding instrument) as a baseline framework, there are some differences between these regulations. Further, each jurisdiction’s revenue guidance explains and elaborates the provisions from its own perspective which can create interpretational issues.
Such divergence can work against the harmonization of approaches for determining arm’s length prices. In the light of BEFIT and a framework for one computation of taxable income with minor post-allocation adjustments by the member states, it makes sense to also have common TP rules across the union. The divergence of TP rules creates an uneven playing field and increases the risk of non-taxation or double taxation leading to high compliance burden/ costs and more audit challenges.
In its explanatory memorandum, the EC explains this by drawing attention to the basic concept of “control” itself having inconsistent treatment between member states’ TP regulations. Some member states apply a threshold of 25% whereas some apply 50%. There can also be considerable variances between TP documentation thresholds, comparability preferences, filing requirements including deadlines, and penalty provisions within member countries.
The proposal defines and elaborates on key concepts including associated enterprises, arm’s length principle, arm’s length result and range, corresponding and compensating adjustments, and TP methods. There is also discussion on topics such as identifying commercial and financial relations, the concept of the most appropriate method, and comparability analysis. Through its articles, the proposal provides insight into how to determine the arm’s length range, how to apply the arm’s length principle, and what TP documentation is to be maintained.
Issuing a TP directive with the aim of moving towards a single set of TP regulations for all member states is a big step and may not be equally welcome in all 27 states. In October 2023, Sweden has indicated that it thinks that EU is overestimating the interpretational challenges for TP. In its view, TP directives may have some limitations on implementation (accuracy) and also from the perspective of “concept of proportionality” under EU law.
However, given the generally positive impact globally from the work done by the OECD on TP so far, it seems sensible to have the OECD guidelines at least form part of an umbrella over all EU national regulations.
Closer harmonisation should make TP regulations more robust and reduce the amount of litigation arising from their interpretation if they are based on the wider OECD framework. TP is a constantly developing area of tax, as it is closely linked to the ever-changing and advancing commercial world; subject to supply chain transformations, wider state regulation (e.g. future focus on ESG), and global geopolitical economic effects caused by demographic shifts/ pandemics/ wars. All of these factors (and more) will continue to affect the entire notion of an arm’s length price.
Given this backdrop, some specialists might counsel a more cautious approach, avoiding binding TP to too many formulae or prescriptive regulations, as they may not reflect the future economic reality.
In addition, as the Irish Tax Institute has pointed out in its response to the proposal, the Directive is likely to result in a divergence between the TP rules applying to transactions within the Single Market and the rules which apply to transactions with third countries. Consequently, while the Directive may result in fewer TP disputes arising between EU Member States, it may lead to an increase in such disputes with third countries.
Whilst the EU aims to implement the TP directive with effect from 1 January 2026 that will still be two years before the expected date of implementation of the BEFIT directive. It may be advisable to coordinate their introduction more closely, to enable a smoother introduction of a combined platform for computing a common tax base and for allocating it across member states.
Conclusion and next steps
Overall, both the proposals are ambitious and have the stated objectives of facilitating business, creating a level playing field, harmonisation, fair taxation and reducing the compliance burden in the EU. However, an important point to remember is how all of these objectives align with wider global developments and other EU initiatives.
EU tax policy cannot operate in a vacuum and will always indirectly affect tax policies of other economies and economic groupings. Ensuring alignment with those could present a significant challenge for many MNEs.
Each EU MNE Groups has to ensure that profits returned in territories; not just in the EU, but wherever they trade globally, are in line with the functions performed, the value created by each link in the value chain, the risks assumed and controlled and the assets employed. That is a lot to keep in balance without adding in a need to abide by European margins and a formulary apportionment.
As a next step, the EC will consider the comments received from the public consultation. Once unanimous approval has been achieved in the council, the European Parliament and related committees’ opinions will be considered. Looking at some of the wider issues on the table it will be interesting to see the views of various stakeholders over the coming months.
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