Profit Allocation within MNEs in Light of the Ongoing Digital Debate on Pillar I – A “2020 Compromise”?

Article by: Vikram Chand, Alessandro Turina and Louis Ballivet

First published in the World Tax Journal

There are two broad approaches that could be used to allocate profits to separate legal entities or separate establishments (suchas permanent establishments, PEs) that exist within a multinational enterprise (MNE). At one end of the spectrum, countries canresort to using the ALP. This principle relies on the “separate-entity” approach, which implies that profit allocation to the separatelegal entity or establishment depends on the value created or generated by such taxpayer. At the other end of the spectrum,countries can resort to the “enterprise doctrine”, as opposed to the separate-entity approach, which considers an MNE as asingle economic unit for tax purposes. The group’s aggregated profit constitutes its tax base. This is then divided between variousestablishments by predetermined allocation keys that could be based on payroll, tangible assets or turnover or a combination ofsuch factors. This approach is better known as MNE group-wide formulary apportionment.

The current international corporate tax system uses the ALP to allocate profits in the vast majority of cases. The history of thisframework can be traced back to the work done by Mitchell B. Caroll. In the 1933 Report, he took the position that the separateentityapproach should be the basis of profit (loss) allocation. This was mainly due to the fact that several countries alreadyapplied this principle with respect to transactions between related entities or head office and PEs.[2]Such a framework, developedin the 1930s, was built upon a more fundamental international consensus on the division of the international tax base betweenresidence and source countries that in scholarship is frequently referred to as the “1920s compromise”. As can be appreciated,profit allocation based on the separate-entity philosophy in the 1920s compromise was an offshoot (although not a necessarylogical implication) of a fundamental agreement between source and residence countries. If it is to be speculated on whethera “2020 compromise” shall be reached, one of its main features will be that it will directly address the issue of profit allocationfrom which a new landscape in terms of a “balance” between source and residence will be established. To the authors, thiscircumstance appears as one of the key and unprecedented characteristics of the current debate, and it is for this reason thatthis contribution will primarily focus on the possible new mechanics of profit allocation rather than on a policy reconsideration ofthe existing and proposed nexus-related thresholds.

Besides being “rooted in history” and an expression of the fundamental compromise (or at least, as outlined above, an offshootthereof), there are also normative reasons that would seem to corroborate the ALP’s standing.[3]In this regard, the first chapterof the OECD Transfer Pricing Guidelines (TPG) states that the ALP should prevail for the following reasons: First, the ALP iswidely considered to be a fair system. It is reputed to offer parity of tax treatment for members or establishments of MNE groupsand independent enterprises. Second, the ALP works effectively in the majority of cases. Third, the ALP is a functional profitallocation mechanism. It allocates appropriate levels of income between members of MNE groups and the countries in whichthey operate. Lastly, as it takes into account the facts and circumstances of each case, it provides a good reflection of economicreality….

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