Pillar 1: Amount A—Extractives Exclusion

In October 2021, 137 members of the OECD/G 20 Inclusive Framework on BEPS signed on to the Statement on a Two-Pillar Solution To Address the Tax Challenges Arising from the Digitalisation of the Economy. This constituted a political agreement on the key components of pillar 1 and pillar 2 of BEPS 2.0.

While the main targets of pillar 1 are the tech giants, amount A is not limited to these enterprises. That said, the OECD recognized that amount A could give rise to inappropriate results in the case of extractive companies (that is, mining companies and oil and gas companies) by shifting tax from the country where the resource is located to countries where the resource is consumed. Consequently, profits from extractive activities are intended to be excluded from amount A.

On April 14, 2022, the OECD released a public consultation document: Pillar 1—Amount A: Extractives Exclusion. The consultation document (the substantive part of which is schedule F to amount A) provides a description and explanation of the proposed rules. In light of the work-in-progress nature of other aspects of amount A, schedule F outlines the relevant principles in narrative format except for certain specific definitions delineating the scope of the extractives exclusion. The public was invited to provide comments by April 29, 2022.

This article is intended to provide a summary of schedule F. For a more detailed consideration of the proposals, readers are referred to the International Council on Mining and Metals’ recent submission to the OECD in response to the proposals.

Extractive Activities Exclusion

Profits from “extractive activities,” as defined, will be excluded from amount A. In very general terms, the intended result is to exclude revenue from the sale of “extractive products,” as defined, in respect of which the corporate group has carried out “exploration, development, or extraction,” as defined. The two-pronged aspect of the test draws a very deliberate line between integrated producers and pure trading and tolling operations. This means that revenue from commodity trading alone (without engagement in the relevant extractive activity), or revenue from performing extraction services alone (with no ownership of the extractive product), will not qualify for the exclusion (consultation document, at 5).

Schedule F outlines the process for determining whether the extractives exclusion excludes profits from amount A. This process has two key components: the redetermination of (1) in-scope revenue ex-extraction activities and (2) the extraction activities’ profit margin.

Revenue from Extractive Activities

Amount A in-scope revenue is the difference between consolidated corporate group revenue and third-party revenue (more on this below) from extractive activities. For this purpose, the definition of “extractive activities” has two tests that must be satisfied: (1) a product test (that is, the activity must involve the sale of an “extractive product,” as defined) and (2) an activities test (that is, the activity must involve “exploration,” “development,” or “extraction,” as defined).

While schedule F refers to “third-party revenue” in its general description of the principles, the definition of “extractive activities” and the definition of these activities’ key components (“extractive product” and “exploration, development, or extraction”) contemplate that in some circumstances, the revenue base for the extractives exclusion may be narrower than third-party sales of extractive product. In this regard, the definitions of “extractive product,” “exploration,” and “development” are self-explanatory and do not contain any surprises. However, the definition of “extraction” merits specific comment.

Extraction is defined to mean “the removal of an Extractive Product from its natural site or from mine tailings and includes the Qualifying Processing and Transportation of such Extractive Products.” “Transportation” is defined in a straightforward manner to mean the physical movement to the delivery location and incidental storage of an extractive product in fulfillment of delivery terms set out in a sales contract. Of more interest is the term “qualifying processing,” which is defined to mean

processing undertaken to concentrate, isolate, purify, refine or liberate an Extractive Product [as defined] from its natural state to produce a basic commodity.
a)  Qualifying Processing includes transformation and processing of hydrocarbons into a liquefied state, including liquefied natural gas (LNG) and liquefied petroleum gas (LPG); processing of bitumen from oil sands, oil shale and heavy oil to a stage that is not beyond the crude oil stage or its equivalent;
b)  Qualifying Processing for mining and metals includes activities which result in the production of minerals, mineraloids and metals including the casting of metals;
c)  Qualifying Processing does not include extrusion, fabrication or activities to produce alloys, steel, jewellery, petrol, gasoline, diesel, kerosene and similar refined hydrocarbons, lubricants, chemicals, plastics and plastic polymers;
d)  For all other cases, Qualifying Processing is deemed to include processing activities up to and including, but not beyond, the Delineation Point.

Paragraphs (a) to (c) are largely self-explanatory. Paragraph (d), however, is intended to provide a cutoff point (the “delineation point”) in the value chain, a point that may occur before extractive products are sold to third parties and may involve not a sale but, instead, the processing of extractive product to a point where there is a recognized market price for it.

To this end, the delineation point is defined as “the deemed end point of excluded Extractive Activities.” The definition goes on to state that the delineation point is the earliest of the following:

  1. The point where there is a sale of the extractive product to a third party (the revenue would be the sales price).
  2. The point where there is an intragroup transaction transferring extractive product from the country where extraction occurs to another country (the revenue would be the sales price).
  3. Where applicable, the point where the extractive product meets the specifications established by the “internationally recognised reference price,” as defined (for example, the pricing of Brent crude at the London Metal Exchange), that is used for pricing extractive product. (If this rule applies, the deemed revenue amount for the purposes of identifying the excluded revenue and for applying the profitability test is calculated as follows: revenue = internationally recognized reference price × quantity of extractive product.)

The definition also provides three interpretation rules. The first states that when none of the three delineation points is reached (that is, no sale or transfer occurs, and the extractive product is not refined sufficiently to meet the specification for an internationally recognized reference price), the deemed revenue amount for the purposes of identifying the excluded revenue and for applying the profitability test is calculated as market value (whatever that might be) of extractive product × quantity of extractive product.

The second interpretation rule provides that if there is a conflict between the tests set out under the definition, they are to be applied in the following order: (1) third-party sale, (2) intragroup transfer, and (3) internationally recognized reference price. The third interpretation rule simply provides that if there is an intragroup transfer of the extractive product from one state to another, it is deemed not to have taken place if further processing is done within [X] kilometres of the border of the first state.

It is noteworthy that intragroup transfers trigger a delineation point. This not only presumes that the transfer price for the sale is correct but also, potentially, subjects amounts in excess of this amount to amount A redistribution among countries where sales are made (for example, China and the United States) as opposed to countries where resources are extracted and processed. It is questionable whether this is a desirable result; why not shift back to the source state?

Another noteworthy point is that, in some circumstances, these rules could result in a delineation point that is earlier in the value chain than may have been intended. For example, it is not uncommon for some metals to be processed to a certain stage in a particular country, with the resulting product sold to a related company in another country for further processing and on-sale to either an intragroup marketing entity or a third party. In this scenario, the delineation point would be the first intragroup sale. Is it intended that the further value added by that processing be subject to amount A redistribution?

Profit Margin of Extractive Activities

If a corporate group meets the general scope provisions and also has more than €20 billion of in-scope revenues after redetermining the revenue to exclude revenue from extractive activities, the group must identify the profits from extractive activities in order to exclude them from amount A. This will also require the group to determine the remaining profits from in-scope activities in order to assess whether they exceed the 10 percent profitability threshold.

Schedule F notes that this exercise is expected to be “a more complex part of the Extractives Exclusion” because it may require identifying intragroup revenue and performing cost allocations. The objective of the exercise is to ensure that no residual profits from extractive activities are redistributed under amount A, and thus effectively to treat the in-scope part of the group as a stand-alone business on an equal footing with a similar downstream business (for example, manufacturing).

Schedule F describes two approaches for calculating the profit margin for in-scope revenue: the “disclosed operating segment” approach and the “entity-level” approach (the latter is relevant only if the disclosed-operating-segment approach is unavailable). The first approach applies if two conditions are met:

  1. The corporate group’s disclosed segments “predominantly” generate revenue that is excluded. To ascertain whether this condition is met, the “predominance test” is applied to determine whether any of the group’s segments made up at least 75 to 85 percent (precise amount to be determined) of excluded revenues (determined on the basis of the delineation point, discussed above). If this condition is satisfied and the in-scope revenues do not exceed a (€1 billion) cap, the entire segment qualifies for the extractives exclusion.
  2. Costs are appropriately and reliably allocated between the segments. Schedule F provides some additional commentary on how this is expected to be done in a number of circumstances. A brief reading over of even the broad principles outlined in the schedule suggests that this will likely be a very complex exercise.

If these conditions are met, the resulting profit computation is then tested against the 10 percent profitability threshold, with the excess subject to amount A redistribution.

Corporate groups that do not qualify for the disclosed-operating-segment approach must use the entity-level approach, which is essentially the disclosed-operating-segment approach applied on an entity level instead of a segment level. In other words, each entity in the corporate group applies the predominance test—that is, a percentage (75 to 85 percent) of excluded revenue and the (€1 billion) cap on in-scope revenue. If these conditions are met, the entity is excluded under the extractives exclusion. If the conditions are not met, the entity will be required to determine its in-scope revenue by subtracting the excluded revenue (determined by using the delineation point) from the total revenue of the entity.

Having determined its in-scope revenue for each particular entity, the corporate group would combine the in-scope entities into a “consolidated bespoke segment” for amount A purposes. The group would then need to apportion its expenses, including indirect and unallocated costs, using the segment-accounting or management-accounting principles that would have applied had the entity published the remaining in-scope portion of those entities as one combined disclosed operating segment. The result would then be tested against the 10 percent profitability threshold, with the excess subject to amount A.

At first sight, it appears that the extractives-exclusion analysis will be a very complex exercise for corporate groups that are subject to amount A. Whether the end result provides a better policy result than exempting resource companies from amount A altogether is questionable, particularly when one considers that income will be redistributed, in many cases, from countries where resources are located to wealthy, industrialized countries.

Michael Colborne
Thorsteinssons LLP, Toronto

International Tax Highlights

Volume 1, Number 1, May 2022

©2022, Canadian Tax Foundation and IFA Canada

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