22 November, 2019
Pushing for a consensus solution
The OECD – in the form of a multijurisdictional task force involving 134 member countries – is working towards a long term, comprehensive, consensus-based solution to tax challenges arising from increased digitalisation of the economy, which it hopes to be in a position to deliver by the end of 2020.
Building on previous discussion documents, including a detailed programme of work, on 9 October 2019 the OECD Secretariat published for comment a proposed new approach (the "Secretariat Proposal") to the fundamental questions of where tax should be paid (the so-called "nexus" rules) and on what portion of profits they should be taxed ("profit allocation" rules). A similar consultation will take place in November and December 2019 in respect of a proposed global minimum tax, allowing jurisdictions to effectively charge a "top up" tax on group profits that would otherwise be subject to a low effective rate of tax.
These proposals are expressly designed to increase the tax actually paid by larger cross-border businesses as well as redistributing taxes paid to "market jurisdictions", that is the jurisdictions in which consumers of the goods or services in question are based. It is recognised that high-income economies would not benefit to the same degree as low and middle-income economies, while certain investment hubs would experience significant losses in their tax bases. There is a question, therefore, as to whether there is sufficient international political will to finalise and implement these proposals.
Nonetheless, the OECD has a positive record of obtaining political engagement under the BEPS Project, and the spectre of businesses having to cope with numerous uncoordinated and unilateral measures in the jurisdictions in which they earn revenues, coupled with an associated increase in tax disputes, may also be sufficient to persuade governments to engage with these proposals
If these OECD proposals are actually implemented by governments, they would represent the most seminal changes for many decades to the way in which larger cross-border businesses are taxed, dwarfing even the recent BEPS changes.
Two pillars emerge
The OECD has identified two "pillars" on which its proposed solution to taxation of the digital economy would rest.
- Pillar One focuses on profit allocation and nexus rules.
- Pillar Two focuses on the remaining BEPS issues and seeks to develop rules that would provide jurisdictions with the right to charge a "top up" tax where other jurisdictions have not exercised their primary taxing rights or the payment is otherwise subject to low levels of effective taxation.
1. Allocation of taxing rights
The OECD's programme of work, published in May 2019, contemplated a reform of profit allocation rules based around three alternative approaches: user participation, marketing intangibles and significant economic presence in the sense of a purposeful and sustained interaction with a jurisdiction.
Further work on the May 2019 proposals was not progressing as the OECD had hoped and, mindful of its commitment to deliver a solution in 2020, the OECD Secretariat published the Secretariat Proposal based on common elements in the proposals in an attempt to accelerate progress. This consultation does not therefore represent an emerging consensus amongst the OECD member countries but can nonetheless be viewed as an important step forward.
Nexus
The heart of the October 2019 Secretariat Proposal is a new nexus and profit allocation rule. That is needed to reflect the impact of the digital economy, with businesses often now able to avoid a physical presence through the use of existing and emerging technologies to enable remote participation. This has been particularly prevalent in the provision of search engines, and the online gaming, adtech, social media and digital marketplace sectors.
The OECD proposes introducing a nexus rule applicable wherever a business has a "sustained and significant involvement in the economy of a jurisdiction", such as through consumer interaction and engagement. It is suggested that a revenue threshold in the market (adapted appropriately to the size of the market) could be the primary indicator of such involvement. It would apply to all business models, whether making remote sales directly to consumers or selling in the market through a distributor.
It is anticipated that this new nexus rule would operate in conjunction with the existing permanent establishment rules.
Allocation methodology
A new nexus rule requires new profit allocation rules; it would be a nonsense to apply existing treaty provisions relating to location of functions, risks and assets in order to allocate profits to a jurisdiction where none of these attributes exist.
The OECD Secretariat suggests a three tier mechanism for taxing the market jurisdiction profits of in-scope businesses. Those tiers are named Amount A, B and C. It is Amount A which is the radical part of this proposal
| Amount A: that part of a group's deemed "residual profit" (i.e. that profit remaining after allocating what would be regarded as a deemed "routine" profit on activities to the countries where the activities are performed) which would be subject to the taxing right for market jurisdictions created under new nexus and profit allocation rules. |
In short, this has been designed to allocate the group’s deemed "residual profits" between the jurisdictions into which the group sells. Whilst that may be a useful response to the current perceived issues with the system, the practical question of how to calculate these "residual profits" is not addressed in much detail by the October 2019 OECD paper.
The details, such as they are, are in appendix 1 which provides a four step approach for determining the Amount A to be subject to the new taxing right.
- Identify the group profits, probably from the consolidated financial statements and potentially determined on a business line and/or regional/market basis to avoid distortive effects;
- Exclude remuneration for routine functions based on an agreed level of profitability. In the interests of certainty, this would be an approximation, possibly based on a fixed percentage which may vary depending on the industry or business line;
- Determine what proportion of non-routine profits are attributable to the market jurisdiction rather than other factors such as trade intangibles, capital and risk. Again this would be calculated using a simplifying convention such as an agreed percentage;
- Allocate the resulting Amount A among eligible market jurisdictions in accordance with a key based on variables such as sales.
| Amount B: baseline marketing and distribution functions that take place in the market jurisdiction could be taxed under existing transfer pricing rules, but the consultation appears to prefer the certainty of fixed remuneration for these activities, reflecting appropriate and negotiated fixed returns (potentially varying by industry or region). |
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Amount C: any additional profit where the marketing and distributions activities taking place in the market jurisdiction exceed the baseline activity compensated under Amount B. Such profits would need to be supported using the arm's length principle. |
Clearly a number of issues still require significant amounts of work and decisions on the best way forward. The need for further detail is particularly apparent in the four step process for determining Amount A and the way in which "deemed residual" profits will be calculated, but the interaction of Amounts A, B and C is also an area with the potential to cause numerous disputes if not delineated carefully.
The use of simplifying conventions or fixed percentages to approximate profit attribution should address a large number of concerns about the difficulties in valuing the relative contributions to profit of factors, particularly value created by users, but appropriate levels will still need to be agreed internationally.
Scope
It is suggested that businesses in scope would be widely defined, e.g. as businesses that generate revenue from supplying consumer products or providing digital services that have a consumer-facing element. Some sectors, for example extractive industries and commodities are expected to be carved out. Importantly, the Secretariat envisages further discussion on the possibility of the financial services sector also being carved out of scope.
A €750m revenue threshold is mooted as a size limitation, in common with the Country-by-country reporting requirements and, indeed, many of the unilateral digital services taxes or proposals, such as those in France, Spain and Italy.
Administration
The proposals indicate that determinations may need to be made at the business line level if the rules differentiate between particular types of business and if different percentages are used in the simplifying conventions. However, basing the new taxing right on business line figures could lead to disproportionate difficulties for the taxpayers in extracting the necessary data from entity information as well as being harder for tax authorities to police. Appropriate materiality thresholds and exclusions may be necessary in addition to the simplifying conventions if the rules are not to be unworkable or overly prone to disputes.
Compliance, collection and enforcement arrangements must all be designed and a withholding tax is still not ruled out provided it does not lead to double taxation. New reporting and exchange of information obligations will arise, although it is fair to say that the existing framework and technology used for the exchange of country-by-country reports should be adaptable for this purpose.
The introduction of these rules pushes up against the same issues encountered by the initial BEPS Project recommendations and minimum standards; it is acknowledged that these further measures are likely to need another multilateral instrument (MLI) to modify existing international agreements, as well as domestic implementing rules.
2. Global Anti-Base Erosion
The second pillar of the OECD's proposal is based on the concern that a risk of profit shifting to low tax jurisdictions remains, despite all the other BEPS Project initiatives, especially in the context of intangible property – on which digital businesses rely particularly heavily, such as the rich user data that can be derived from digital engagement.
The OECD proposal is broadly for a "top up" tax so that a minimum level of tax is paid, bolstered by provisions allowing the source jurisdiction to protect itself against base eroding payments. More specifically:
- The minimum tax would be imposed on a shareholder's proportionate share of an entity's income if it hadn't already been taxed at a minimum rate. Similar in concept to controlled foreign company (CFC) rules, this proposal is intended to supplement, rather than replace, such rules.
As with many CFC rules, the OECD suggests that only substantial shareholders should be affected, say, those holding over 25%. The tax base would broadly be determined by reference to the rules applicable in the shareholder jurisdiction, but the preference is to "top up" to a fixed percentage rather than a rate related to that in the shareholder jurisdiction. This has the advantage, it is said, of being both simpler and better for maintaining the desired level playing field between jurisdictions. - The proposal in relation to a tax on base eroding payments envisages:
- a denial of deductions or additional source-based tax (possibly including withholding tax) for related party payments where that payment was not subject to tax at a minimum rate (the "undertaxed payments rule"); and
- a "subject to tax" rule in treaties that would only grant certain treaty benefits, e.g. reduced or eliminated withholding taxes on dividends, interest or royalties, if the item of income was subject to tax at a minimum rate. This rule may apply only to related party payments but could be extended in some circumstances to payments between unconnected parties.
While various simplifications are being incorporated or at least investigated further (for example, the use of accountancy rules in determining the tax base to be subject to the "top up" tax), these new proposals inevitably introduce yet another layer of complexity into tax calculations. However, if international agreement cannot be reached on these multilateral measures, the alternative is likely to be a mishmash of domestic rules which would need to be considered concurrently and would likely result in a level of uncertainty and risk of double taxation. Our understanding is that the concept of the "top up" tax is gaining support amongst the OECD members.
Dispute resolution
Vital to the introduction of any new rules affecting cross-border taxation is the existence of a prompt and effective dispute resolution mechanism. This is particularly the case when allocating value to an activity or market jurisdiction, bearing in mind the lack of consensus of where or if value is created by users and/or consumers. However, it is also relevant to any part of the new rules which is not purely based on existing business data.
The OECD recognises this at various points in the public consultation document and working programme and has given responsibility for investigating this area to Working Party 1, which generally has responsibility for treaty developments. The fundamental question will be whether existing dispute resolution procedures are sufficiently effective; whether these need improvement or whether new dispute resolution measures need be developed.
Next steps
The Secretariat Proposal on Pillar One is open for comment until 12 November 2019, immediately after which there will be a public consultation meeting with a view to the OECD member countries reaching agreement on an outline approach at their meeting in January 2020.
Similarly, a public consultation document is expected to be released on Pillar Two issues in early November 2019. The OECD hopes that they will be
in a position to agree the main features of this at the January 2020 meeting, with political agreement on the remainder by the middle of the year.
Running in tandem with this work will be an economic analysis and impact assessment of the proposals. The OECD say that they recognise that it is important that any measures imposed are not disproportionate to the benefits gained, and the expected impact on investment, innovation and growth in different types of enterprise, sectors and economies will be monitored carefully; not least by businesses, which would be well advised to keep a keen eye on the direction of travel and its potential to stifle innovation and digital confidence. This is particularly the case when considering investing in emerging technologies which enable more remote activity, such as Internet of Things, AI and distributed ledger, within their digital operating models.
We note that the Secretariat Proposal does not represent a consensus reached by the OECD member countries, indeed it seems to have been borne from a lack of consensus. It will be interesting to see whether countries coalesce round this proposal in the coming months. It seems clear that, if agreement can be reached, any reforms proposed will be radical and substantially change how and where global multinationals are taxed.
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