Value chain analysis for digitally integrated business
In 1985, for the first time Michael Porter theorised the concept of “value chain”, defining it as the process to describe the activities of a company’s production cycle, enabling the company to increase the value of the product or service at each stage (e.g. from the input logistics activity to the after-sales service offered to the end consumer).
With a proper value chain analysis (VCA) each multinational enterprises (MNE) can identify key functions and drivers to obtain higher profitabilities than their competitors. Furthermore, VCA outputs can be used even to make a strategic decision on the current business models.
From a tax and transfer pricing perspective, these aspects are considered by both MNEs and tax administrations to assess the consistency between their actual value chain and the allocation of taxable profits within the group. In particular, a VCA currently requires MNE and tax authorities to investigate into the functions, risks and assets of the controlled group as a whole and give an evaluation of how they integrate with the group’s key value drivers. The conclusions of these analyses are therefore used to attribute the MNE profits within the group entities in relation to their key functions, risks, assets and business value drivers.
The impact of digitalisation on the value chain and the related aspects
The past decade has been characterised by a deep transformation of a companies’ value chain, increasingly influenced by widespread digitalisation and by the consequent implementation of digital tools and technologies that can make business processes flow more rapid and efficient. Indeed, the advent of digital transaction and technological changes has affected the companies’ organisational structure, which have adopted business models consistent with the latest scenarios.
From these substantial changes in business processes, together with the organisational reorganisation of companies, different issues arise, particularly with regard to the identification of MNEs key functions and profit allocation in the context of transfer pricing.
Specifically, the increased digitalisation of processes has led to the creation of new intellectual properties (IPs), such as implementation of artificial intelligence (AI) systems at different logistic stages and digitalised marketing functions. In this respect, according to Chapter VI of the OECD Transfer Pricing Guidelines, the allocation of profits from the exploitation and use of intangible assets should be based on the functions performed, the assets used and the risks assumed by the different companies involved in the transactions. In particular, if several MNEs entities assume or control significant risks in relation to the development, enhancement, maintenance, protection and exploitation (so-called “DEMPE” functions) on these digital intangibles, then the profit arising from such IPs used should be allocated among such entities in relation to the contribution made and the risks assumed on the DEMPE functions performed. A DEMPE analysis is therefore crucial in order to determine an arm's length remuneration for the entity in the MNEs value chain.
The identification of the functions performed, and the risks assumed by the MNEs entities controlling the economically significant risks in the IPs is normally challenging in traditional business models. This analysis will become even more difficult in the context of digitalised business model.
For example, logistics is one of the most affected functions by the change in the value chain as a result of digital transformation. This represents a key function at a time when the use of digital IPs enables significant cost reductions in order to guarantee margins higher than the competitors. Even at the level of the typical sales functions, it is possible to observe substantial change in business processes. Through innovative, digital systems, it is possible to reach end consumer without using local agents or distribution companies.
Current VCAs tend to increase the functional profile of the MNEs entity resulting as economic owners of digital IPs. As consequence, the local entities (e.g. distribution subsidiaries) are being stripped from some of their core activities (e.g. logistic management, implementation of marketing campaign) that are now executed and controlled remotely by other entities through the use of the aforementioned digital IPs.
Based on the facts and circumstances, such digital transitions may significantly revise the MNEs value chain, leading to the need of reorganising the entire business model and the profit allocation between group entities. For instance, local subsidiaries with reduced functions and risks may have seen reduction even at the level of their profitability.
In this regard, focus should be made on the several tax and transfer pricing aspects that may arise in the context of business reorganisation in order to mitigate potential challenges from local tax authorities. A globally accepted guide is included in the Chapter IX of the OECD Transfer Pricing Guidelines, which provides instructions on how analysed and implement business restructurings in the context of MNEs, including compensation mechanisms and post-restructuring remunerations.
OECD Proposed Solution - Pillar One
As a result of the change in the value chains due to digitalisation, leading to the creation of new intellectual properties and to business reorganisations, the OECD decided to act in order to mitigate opportunistic aggressive tax planning behaviours by MNEs in the context of new digitalised business models.
With the aim of addressing the tax challenges raised by digitalisation, in October 2021 the OECD released the so-called Two-Pillar Solution, proposing a reform in the international tax systems to ensure that multinational enterprises pay a fair share of tax wherever they operate.
From a transfer pricing perspective, it is worth mentioning Pillar One, a proposed approach to re-allocate taxing rights among countries with respect to the largest MNEs, from their home countries to the markets where they have business activities and earn profits, regardless of whether firms there have a physical presence there. As mentioned in its section 1.2., Pillar One “seeks to adapt the international income tax system to new business models through changes to the profit allocation and nexus rules applicable to business profits. It also aims to significantly improve tax certainty by introducing innovative dispute prevention and resolution mechanisms”.
In a nutshell, the main drivers of Pillar One can be grouped into three parts:
A new taxing right for market jurisdictions on a share of the residual profit calculated at the MNE level (so-called “Amount A”);
A fixed return for specified basic marketing and distribution activities taking place physically in a market jurisdiction, in line with the arm’s length principle (so-called “Amount B”); and
Processes to improve tax certainty through effective dispute prevention and resolution mechanism.
However, the OECD Pillar One is not yet definitive and there are still several works in progress with the aim of identifying objective criteria and determining which companies will be subject to the global tax (i.e. Amount A). In this context, on July 11, 2022, the OECD published the “Progress Report on Amount A of Pillar One”. The content of the document aims to define the criteria for identifying MNEs subject to the measures and the rules for determining the jurisdiction in which the revenues are to be generated. In particular, MNEs with revenues on a consolidated basis more than 20 billion euros (so-called “Global revenue test”) and with a marginality of income before tax in relation to total revenues more than 10% (so-called “Profitability test”) would generally fall within the Pillar One scope.
The emergence of digitalisation and the spread of advanced technologies have significantly affected the world of MNEs. New digitalised business models have led to the creation of new IPs, such as artificial intelligence systems in various stages of the value chain. Consequently, several aspects emerge from these substantial changes in business processes, particularly with regard to the identification of the MNEs key functions and to the allocation of profits in presence of new digital IPs, which may imply the need for business restructuring.
In this context, it is strongly suggested to proper analyse and document any changes in the value chain and in the functional and risk profile of the entities within the MNEs, in order to defend taxpayer positions in front of local tax authorities and, therefore, mitigate the risk of tax challenges.
Meanwhile, focus should be made also on the Pillar One evolution that can significantly reshape the international tax principles and, as consequence, the allocation of taxable profits. MNEs should therefore be in line with the Pillar One evolutions, defining the business models also in light of the potential implementation of this OECD proposed approach in the local jurisdictions.