A collection of the brief insights throughout February 2019 of the type provided on an ad hoc basis in our Latest digital tax byte update.
13 February 2019: OECD kicks off consultation to reshape the international tax system for the digitalised age
- On 13 February 2019, the OECD released a public consultation document on "Addressing the tax challenges of the digitalisation of the economy". The consultation will run until 1 March 2019, and a public meeting will then be held in Paris on 13 and 14 March 2019.
- While a recent policy note referred to two "pillars", this term is not used in the formal consultation document. Instead, two chapters are included covering "Revised profit allocation and nexus rules" and "Global anti-base erosion proposal" (Chapters 2 and 3 respectively).
- Each chapter sets forth an illustration of the challenges members have identified, then gives more detail on the proposals that the Inclusive Framework countries are examining on a "without prejudice" basis.
- Revised profit allocation and nexus rules
- Three proposals are under consideration, which "have the same over-arching objective... to recognise, from different perspectives, value created by a business’s activity or participation in user/market jurisdictions that is not recognised in the current framework for allocating profits".
- A significant question that separates the three proposals is whether "remote" participation is a feature only of highly digitalised businesses, or a broader range of international businesses.
- The proposals are said to have some commonalities, and accordingly, some design elements (such as a mechanism to allocate "residual" profits) are being considered in an aligned way.
- The paper also notes that nexus and profit allocation will be examined closely together, to avoid a repeat of the challenges that arose under BEPS Action 7, where a permanent establishment threshold was agreed before profit attribution guidance was finalised, and resulted in limited additional profits being allocated to the source jurisdictions where the functions undertaken in that jurisdiction took on limited risks.
- A) User participation proposal
- This proposal contemplates that the activities and participation of "users" (of online platforms) are a critical component of value creation, both in absolute and relative terms, for social media platforms, search engines, and online marketplaces, because either the content, the size of the network, or both, are determined by these users.
- These three business models are the same as those identified by the UK in its 2017 and 2018 discussion documents, ad subsequently targeted by the UK's Digital Services Tax (currently also under consultation).
- Recognising the challenges in capturing this value creation under existing transfer pricing principles, a four stage process is proposed to allocate profits to the jurisdiction of users of such platforms (with no changes for other businesses). Again, this is similar to the UK's previously announced view:
- Calculate the "residual" profits of a business (the remainder after all routine functions have been rewarded)
- Attribute a proportion of the residual to the user base (either a pre-agreed percentage or through analysis)
- Allocate between user jurisdictions based on agreed allocation metric (e.g. revenues)
- Give rights to jurisdictions to tax these profits, irrespective of whether existing activities result in a taxable presence there
- Several challenges are noted, including the calculations themselves and the trade-off between calculating the value generated, against the need for a more pragmatic approach (e.g. formula based). It is recognised that strong dispute resolution mechanisms would be needed.
- A challenge is made that users are third parties, and therefore their contributions do not constitute value created by the business (instead they are remunerated via free services). In addition, as digitalisation impacts more businesses it is questioned whether there is a difference in value creation for specific highly digitalised business models only.
- B) Marketing intangibles proposal
- This proposal contemplates a solution that applies to a much broader range of businesses, noting that remote (or limited) access to markets can allow development of user bases, customer bases and other marketing intangibles for all businesses. Customer data and relationships are said to contribute toward the development of brand and other marketing intangibles through this interaction.
- "Trade" intangibles are said to differ from "marketing" intangibles, as the former does not require an intrinsic link to the market jurisdiction (the example given is an efficient engine, which will perform in the same way regardless of where it is sold). Marketing intangibles are explicitly said not to include favourable demand conditions such as a stable population with financial means to purchase. Interestingly, the proposal makes explicit reference to splitting of losses as well as profits, unlike the other two proposals in this chapter.
- It is also acknowledged that digitalisation has allowed all businesses to operate in markets online without having a significant physical presence there, which justifies the need for a broader examination at this time.
- Crucially, the proposal suggests that taxing rights should be changed to allow market jurisdictions to tax "marketing intangible" profits regardless of physical presence or activities, thus "despite a different conceptual starting point it would get to a result similar to that which would be achieved using the user participation proposal."
- The gap between the user participation and marketing intangible proposals is clearest where there is a consumer business operating remotely or through a local presence with limited risk, regardless of whether the interaction with consumers is as digital "users" or as customers.
- Several options are suggested as mechanical ways to achieve an allocation to the market jurisdiction:
- Transfer pricing rules, based on updated assumptions that marketing intangibles (and risks) can be determined and thus are allocated under the current rules, and that they could be thus reallocated to market jurisdictions - relying on analysis of contribution to profit that they provide.
- A residual profit split following allocation to routine functions (with both the routine allocation and the profit split itself being either functional or formulaic).
- Allocation of these calculated profits to each "market" jurisdiction based on an agreed metric (e.g. revenues or users)
- Again, challenges around double taxation are cited, and the need for strong dispute resolution measures endorsed.
- A challenge is made that the intrinsic link cited is questionable, especially where activities are undertaken outside a jurisdiction, supplies are business-to-business (with limited customer data reliance), or where no localisation is performed.
- C) Significant economic presence (SEP) proposal
- This proposal notes that SEP was originally mooted in the BEPS Action 1 Report in 2015, and notes that while sustained revenues would be an important factor in determining whether a business had an SEP in a jurisdiction, revenues alone does not always equate to a purposeful and sustained interaction, and this would not alone be sufficient to establish nexus.
- Suggestions for secondary factors include:
- User base
- Volume of digital content derived
- Billing and collection in local currency (/local form of payment)
- Local language website
- Responsibility for delivery and/or support services
- Sustained marketing activities
- A fractional apportionment method such as that put forward in the BEPS Action 1 Report would require three successive steps, each of which has been furthered with brief methodological suggestions:
- Definition of the tax base to be divided (e.g. MNE global profit margin multiplied by local sales)
- Determination of the allocation keys to divide that tax base (e.g. sales, assets, employees, or where relevant, users), and
- Weighting of these allocation keys.
- In keeping with the suggestion that this method is intended to be simple to administer, other simplified methods such as deemed profit attribution (possibly by sector, degree of integration and type of product/service, although each adds further complexity) could also be applied, and it is being considered whether a withholding tax could be used as a collection mechanism.
- Commonalities between the proposals:
- All would require changes to nexus and profit allocation rules
- All apply a global approach for calculation of profit
- The user contribution and marketing intangibles proposals share a number of ideological and structural similarities, with differing scopes.
- Design considerations discussed focus on the trade-offs between certainty and precision in application (with a particular focus on the user contribution and marketing intangibles proposals):
- Scope and limitations
- Business line segmentation
- Profit determination
- Suggestion of a three step approach to identify total/combined profits, identify the residual contained, and then reallocate portions between a number of countries,
- Profit allocation
- Note that a proxy for profits or losses must be via an agreed allocation metric, with sales being the easiest to administer.
- Elimination of double taxation
- Nexus and treaty considerations
- Recognition that the individual entity approach may not suffice
- Administration
- Particular focus on legal/filing obligations, and dispute resolution procedures drawing on a range of existing programmes such as ICAP, multilateral APAs, and joint audit programmes
- Recognition that additional data points may be needed in Country By Country Reports
- Questions for public comment:
- What is your general view on those proposals? In answering this question please consider the objectives, policy rationale, and economic and behavioural implications.
- To what extent do you think that businesses are able, as a result of the digitalisation of the economy, to have an active presence or participation in that jurisdiction that is not recognised by the current profit allocation and nexus rules? In answering this question, please consider:
- To what types of businesses do you think this is applicable, and how might that assessment change over time?
- What are the merits of using a residual profit split method, a fractional apportionment method, or other method to allocate income in respect of such activities?
- What would be the most important design considerations in developing new profit allocation and nexus rules consistent with the proposals described above, including with respect to scope, thresholds, the treatment of losses, and the factors to be used in connection with profit allocation methods?
- What could be the best approaches to reduce complexity, ensure early tax certainty and to avoid or resolve multi-jurisdictional disputes?
- Global anti-base erosion proposal
- Focus on the need for stronger rules to address BEPS, as existing rules do not provide comprehensive solution to the risk of moving profits to low or no tax jurisdictions, particularly in relation to intangibles (which are prevalent in the digital economy, even though the digital economy should not be ring fenced).
- Two inter-related rules are proposed, an income inclusion rule (seeking to take income of a controlled entity or branch that is subject to low effective tax rate) and a tax on base eroding payments (denial of deduction or treaty relief where payment subject to low effective rate on receipt)
- Changes to treaties and domestic laws will need to be implemented to ensure the rules are comprehensive and do not result in double taxation
- Additional rules for thickly capitalised entities (those having lower gearing than a third party in similar economic circumstances) are also under consideration, but not detailed
- While the proposal is much more detailed than the three income allocation proposals, several broader questions remain under consideration while the proposal is being developed, including:
- What entities should be in scope
- Impact of behavioural changes
- The role of substance and desire not to impact business decisions
- Income inclusion rule:
- Applies for significant (e.g. 25%+) direct or indirect ownership interest for legal entities (through inclusion of income) and branches (through a switch-over rule to deny exemption) where tax is deemed insufficient.
- Intended to supplement rather than replace CFC rules, but build upon BEPS Action 3 report (and draw upon US GILTI proposals)
- Would require a Directive to implement within the EU.
- Technical issues under consideration include:
- Calculation of minimum rates
- Control tests and entities in scope
- Mechanism for assessing whether tax paid is below the minimum
- Decision whether to tax at minimum rate or shareholder domestic rate
- Safe harbours
- Thresholds
- Income attribution mechanisms
- Double taxation mechanisms
- EU law compatibility
- Tax on base eroding payments:
- Will require two elements, an "undertaxed payments rule" to deny deductions for related party payments, and a "subject to tax" rule to deny treaty benefits.
- Undertaxed payments rule
- Payments where (eg 25%) common ownership test similar to BEPS Action 2 proposals
- Would take withholding tax into account
- Include imported mismatches rule to deal with conduit arrangements
- May include some consideration of "substance" of recipient
- Requires additional design discussions around the scope, ownership threshold, mechanics, international obligations, and whether full or graduated denial is appropriate
- Subject to tax rule
- Would apply to treaty benefits otherwise granted under Articles 7 (business profits), 9 (associated enterprises), 10 (dividends), 11-13 (interest, royalties, and capital gains), and 21 (other income)
- Income or gains where (eg 25%) common ownership but broader scope could be explored for Articles 11-13.
- Requires additional design discussions around impact on tax exemptions (e.g. participation exemption), information available to taxpayers, and impact on different categories of taxpayers (e.g. individuals, funds, charities)
- Rule co-ordination
- Recognition that there may be overlap that would otherwise result in multiple taxation, and therefore a systematic approach may be required in application of the various rules.
- Questions for public comment:
- What is your general view on this proposal? In answering this question please consider the objectives, policy rationales, and economic and behavioural implications of the proposal.
- What would be the most important design considerations in developing an inclusion rule and a tax on base eroding payments? In your response please comment separately on the undertaxed payments and subject to tax proposals and also cover practical, administrative and compliance issues.
- What, if any, scope limitations should be considered in connection with the proposal set out above?
- How would you suggest that the rules should best be co-ordinated?
- What could be the best approaches to reduce complexity
For the most up-to-date information, see the Latest digital tax byte.
For more information please contact Dave Murray, Aamer Rafiq, Phil Greenfield, Giorgia Maffini or Rayna Taback.
