Background
As part of the BEPS project, Action Point 1 “Challenges for Taxation of the Digital Economy”, a “Programme of Work” was adopted in May 2019 (and approved by G20 Finance Ministers and Heads of Government in June 2019), according to which the OECD is to develop a two-pillar model to address the BEPS aspects of digital business models. Pillar One of this model deals with the extension and redistribution of taxation rights between resident and market countries, while Pillar Two provides for a global minimum taxation.
On 9 October 2019, the OECD Secretariat published a consultation document which contains a proposal for the taxation of digital business models (Pillar One). With more than 300 comments submitted, and with the public hearing in Paris on 21/22 November 2019, the topic is becoming increasingly explosive.
The shift in power from the “traditional” to the digital economy is clearly illustrated by the following diagram and also justifies the public interest:
Source: Financial Times 2006,”Global 500”; PwC 2018,”Global Top 100 companies by market capitalisation”.
The main contents of the consultation document are the definition of a new nexus that no longer requires a physical presence, the distribution of taxation rights outside the arm’s length principle, and the consideration of the specifics of digital business models. It also examines questions such as how narrowly digital business models are defined or which profits (routine profits vs. residual profits) should be part of the redistribution of taxation rights.
To ensure legal certainty for taxpayers and tax administrations in the new system, the distribution of profits is to take place in a three-tier system:
- The so-called Amount A corresponds to the share of the residual profit that is distributed among the market states according to a formulaic breakdown.
- The so-called Amount B is intended to remunerate routine functions for marketing and sales in market countries.
- Amount C is intended to ensure that any activities in market states that go beyond routine functions are adequately remunerated by means of binding and effective dispute settlement mechanisms. The challenge here is that the profit to be distributed may also accrue in several companies in different states.
Detailed technical explanations and detailed questions on the determination of these amounts are contained in the consultation paper.
The Need for Full Segment Reporting
We would like to take this complex profit distribution system, which is currently the subject of heated debate, as an opportunity to address the associated need for segment reporting. The application and implementation of segment reporting is again brought into focus by the distribution of taxation rights discussed in Pillar One.
The segmentation of P&Ls has always been a painful issue for multinational corporations (MNEs), as the available reporting systems provide the best guidance for this segmentation - usually based on the management approach – but are far from sufficient for completely separate P&Ls. The trend within MNEs towards business segmentation (via management centres, business units or divisions) has also not yet been implemented in full.
Before the technical aspects of Amount A (as residual profit, allocation to market states) can be discussed, the crux of the matter will be the delimitation of consolidated profits and the numerous intra-group allocations that will be required. This concerns, for example, global infrastructure costs, central costs, or even more problematic costs such as research and development (as these costs do not correlate with existing revenues).
The following aspects should explain the scope of the problem in detail:
- In the absence of clear rules or frameworks, we will extend the uncertainty of complex national laws (arm’s length principle) to a globalised uncertainty related to the allocation of consolidated profits.
- The segmentations provided by listed MNEs are not yet all completely separate P&Ls. At best, they are fully allocated to revenue and cost of sales. These P&Ls can only provide a starting point, but a large amount of other costs are not fully allocated to the segments.
- It will be necessary to integrate the preparation of consolidated fully segmented P&Ls with the consolidation process itself, which is usually a very complex procedure.
- A centralised system for the transmission and validation of consolidated segmented data must be established, which, inter alia, automatically creates consistency asymmetry of data between the countries bearing the central costs compared to the markets.
An Opportunity – Automation for the Consolidation and Validation of Data
For MNEs, it might be important to think about the scope of P&L segmentation, starting from the interest in carrying out this segmentation by business unit, but also taking into account the processes for preparing country P&Ls in the context of consolidation and, moreover, in determining the tax rates of the respective countries along the value chain within the group.
The prerequisite for the application of segment reporting is a functioning internal financial reporting system from which all externally reportable segment information can be taken. Due to the direct reference to the internal planning, control and management system, the external reporting addressees are to be given an operational insight into the company or the group from the perspective of top management.
The following advantages for implementing segment reporting based on the management approach reinforce both the opportunity and the need for automation:
- Avoidance of additional costs by reclassifying data from internal financial reporting,
- Data harmonisation of internal and external reporting information,
- Greater familiarity of management with externally disclosed data,
- Higher decision relevance of the data, and
- Better verifiability of the data (or higher objectivity).
More than ever, companies should consider automation, at least to some extent, because of its use and traceability (and possibly the need to have these figures verified by third parties). Thus, audits are limited to checking the algorithm or the specifications of the software that performs the calculation based on pre-validated data (group report), rather than exposing themselves to cross-border audits involving huge amounts of data.
We at WTS advise many of our clients in the area of “Operational Transfer Pricing” on process optimisation and automation of the implementation of transfer pricing (focus on data availability, accuracy and reliability), in which segment reporting plays a key role. Inefficient processes cost companies considerable sums here. By professionally operationalising your transfer pricing system, you can achieve positive effects in terms of quality, efficiency, employees, cost savings and reduction of operational risk. Furthermore, by eliminating daily disruptive factors, employee satisfaction can increase and cooperation with other company departments can improve.
The trend is clear – the need for full segment reporting exists and should be automated to the highest possible degree.
