Alongside our coverage of that, we think it’s worth having a quick look at where things stand with Pillar 1:

Recap: what is Pillar 1 trying to do?

While Pillar 2 addresses how much tax multinationals pay, Pillar 1 is an attempt to reform where that tax is paid. Current transfer pricing and permanent establishment rules attribute profits to locations where businesses have a physical presence. That poses challenges where businesses – most obviously digital service providers – are able to operate at “scale without mass”, i.e. generating large sales in and profits from a market without physically carrying out value-generating functions there.

Pillar 1 addresses market countries’ concerns about the adequacy of existing profit allocation rules by re-allocating taxing rights over a portion of some groups’ profits to the countries where their customers are located – essentially, a limited form of formulary apportionment. It is intended to replace the smorgasbord of digital services taxes (DSTs) that countries have introduced in an effort to ensure digital groups pay more tax in-market.

How does Pillar 1 work?

 The core Pillar 1 proposition seems relatively straightforward:

• The new rules will apply to groups with consolidated revenues of at least €20bn, reducing to €10bn after seven years
• That is subject to an exclusion for certain natural resources and financial services businesses
• Where those groups earn profits before tax in excess of a 10% return on sales, 25% of those “above normal” profits will be re-allocated
• The profits will be re-allocated to market countries, in proportion to the group’s revenues in each country

However, there are some difficult questions that the October 2021 agreement does not answer, and which countries are still grappling with.

The biggest question is where the profits will be re-allocated from. How will the surrendering entities be identified – will this rely on traditional transfer pricing ideas about where residual profits arise, or take a mechanical approach? And will the surrendering entities all give up a share of their profits, or will there be a priority order, for example based on connections to particular markets? There’s also a closely linked question about how the rules should deal with situations where residual profits are identified as arising in one country, but are subject to taxation at source – say through a royalty withholding tax – in another country or countries. A robust dispute resolution process will also be a critical feature of these proposals. 

Resolving all of these issues is more politically and technically challenging than working out which countries should benefit – unsurprisingly countries are more eager to accept increases in their slice of the taxing rights pie than they are reductions.

How will Pillar 1 impact on private equity?

We expect Pillar 1 to have a limited impact on both PE houses and portfolio businesses.

Firstly, the revenue and profitability thresholds will exclude the vast majority of houses and investee businesses. 

Secondly, houses should have an added layer of insultation from the financial services exclusion. The OECD hasn’t yet published a detailed model for the exclusion but the October 2021 agreement indicates that “regulated financial services” will be excluded, and we understand this is envisaged to include investment management.

PE businesses may therefore want to keep a watching brief on Pillar 1, but in our view the more immediate challenges come from Pillar 2.

What next?

The OECD’s last major announcement on Pillar 1 was the October agreement, which outlined the model described above and indicated that remaining questions would be addressed as part of a process leading towards publication of a draft multilateral convention (MLC) in “early 2022”. The MLC would then be opened for signature in mid-2022, so that the Pillar 1 rules could come into effect in 2023.

It’s unclear how much progress has been made behind the scenes since October, but even if the policy design is quickly finalised, 2023 implementation will be very challenging. Many countries would struggle to make the necessary legal changes on that timetable – not least the US, where it is still unclear whether the Biden administration will be able to sell the Pillar 1 deal to a sceptical and divided Congress.