OECD consults on digital services taxes

The OECD has launched a public consultation on reforming the global tax rules for the digital and wider international economy. The consultation document, “Addressing the Tax Challenges of the Digitalisation of the Economy”, puts forward four proposals that are being considered by the OECD covering both the place where a supplier of international services should be taxed and also the suggestion of a global minimum tax.

The proposals are far reaching and have the potential to significantly change the future international tax landscape, not only in relation to digital services. Responses will be used to inform the OECD report to be presented to the G20 in 2020.

Background

In its final Report on BEPS Action 1, the OECD concluded that it would not be feasible to ring-fence the digital economy for tax purposes and treat it differently to other parts of the economy. However, since then the focus has shifted back to the tax treatment of the digital economy as a number of jurisdictions have concluded that more was needed to ensure fair taxation of businesses. As a result, the G20 mandated the OECD to bring forward delivery of an Interim Report.

In March 2018, the OECD delivered its interim report, entitled “Tax Challenges Arising from Digitalisation” recognising that there was no general consensus among participating jurisdictions as to whether, and if so what, further measures to tackle taxation of digital services were needed. Since then, the EU Commission has put forward proposals to address the tax treatment of companies operating in the digital economy, seeking to influence developments in relation to the taxation of the digital economy and ensure that the EU acts in a co-ordinated manner. In addition, several jurisdictions have commenced implementation of unilateral, domestic measures, such as the UK’s proposed Digital Services Tax.

These developments appear to have spurred the OECD and participating States into intensifying their work in this area and led to the publication of a Policy Note in January 2019.

OECD Public Consultation

The public consultation document sets out a number of proposals for reform which have been discussed by the OECD working party at a high level and seeks feedback on them. These proposals do not (yet at least) represent a consensus view and are intended to provoke comment and analysis more widely with a view to informing the final report due to be delivered to the G20 in 2020.

Revised profit allocation and nexus rules

The first area addressed by the consultation covers proposals in relation to the allocation of taxing rights. The aim is to recognise value created by a business’s activities or participation in user/market jurisdictions which is not currently recognised by global tax rules. The interim report in 2017 noted three characteristics typical of scenarios where digitalised businesses are able to create value by activities closely related to a jurisdiction without any physical presence: scale without mass; heavy reliance on intangibles; and the role of data and user participation.

The consultation sets out three proposals which the OECD is currently examining.

User participation

This proposal focuses on the value created by certain highly digitalised businesses through developing an active and engaged user base and soliciting data and content contributions from them. The activities of the user base contribute to the creation of the brand, generation of valuable data and the market power of the business. Typically these businesses would include social media platforms (such as Facebook), search engines (such as Google) and online marketplaces (such as Ebay).

Current international tax rules focus on the physical activities of a business in a jurisdiction and fail to capture the value created by user participation. The proposal, therefore, is to amend the current nexus rules (based on the existence of a permanent establishment) and also revise the profit allocation rules to accommodate such activities. The proposal also recognises that the arm’s length principle is an inadequate method in this case to allocate profit and that an alternative form of profit allocation for such “non-routine” profit would be needed.

Marketing intangibles

The second proposal covers the use of intangibles (such as brand and trade names and customer lists and relationships) that aid the commercial exploitation of a product or service. The proposal recognises a significant link between such “marketing intangibles” and the customer base in a jurisdiction. In a sense, the strength of the brand, for example, can be seen to have been created in the market jurisdiction. The consultation recognises that developments in the digital economy have made it increasingly easy for businesses to capture “marketing intangible” profits in low tax jurisdictions. For example, with consumers increasingly shopping online, sales and marketing can be increasingly handled online which has reduced the need for businesses to have a physical presence or changes the nature of the physical presence that is required in a jurisdiction.

This proposal would seek to modify the application of existing transfer pricing and treaty rules to require marketing intangible profits to be allocated to the market jurisdiction. Whilst the proposal would overlap with the “user participation” proposal (since marketing intangibles are of high importance to highly digitalised businesses), it would operate much more widely and would not be limited to such businesses. For example, this proposal could apply to an online retailer with little or no physical presence in a jurisdiction which develops a large customer base in that jurisdiction (such as Amazon).

The consultation sets out proposals for determining the amount of profits to be attributed to marketing intangibles and suggests that that those profits could be split amongst market jurisdictions based on an agreed metric, such as sales or revenues.

Significant economic presence

The third proposal dealing with profit allocation and nexus is one which seeks to recognise that the modern economy, which enables a business to be heavily involved in a jurisdiction with little physical presence, has rendered the current approach to nexus ineffective. Instead, the proposal is to recognise a taxable presence in a jurisdiction where a business has a significant economic presence based on a number of factors “that evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means”. Such factors could include:

• the existence of a user base and the associated data input
• the volume of digital content derived from the jurisdiction
• the maintenance of a website in a local language and billing and collection in local currency or with a local form of payment
• responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance, or
• sustained marketing and sales promotion activities, either online or otherwise, to attract customers.

Allocation of profits might be based on a “fractional apportionment” method, using the global profit rate of the MNE to the revenue sales in a jurisdiction as a starting point.

Global anti-base erosion proposal

The final proposal being considered is one that is aimed generally at structures that seek to shift profits to low tax jurisdictions, particularly in relation to intangibles but also in areas such as group financing. The proposal is to introduce a minimum level of tax for businesses operating internationally and would not be limited to highly digitalised businesses.

The rationale is that the ability of MNEs to utilise low tax jurisdictions encourages a “race to the bottom”, which risks shifting tax onto less mobile bases such as labour and consumption. The proposal is aimed at advancing a multilateral framework to achieve an outcome that makes business location decisions less sensitive to tax considerations.

The proposal has two limbs:

• an income inclusion rule that would tax the income of a foreign branch or a controlled entity if that income was subject to a low effective tax rate in the jurisdiction of establishment or residence; and
• a tax on base eroding payments that would deny a deduction or treaty relief for certain payments unless that payment was subject to an effective tax rate at or above a minimum rate.

The income inclusion rule would operate as a minimum tax by requiring any shareholder in a company with a significant participation (eg 25%) to bring into account a proportionate share of the income of that company if it was not subject to tax at the minimum rate.

The tax on base eroding payments aspect would deny deductions for payments to a related party if that payment was not subject to tax at a minimum rate as well as denying certain tax treaty benefits (such as allowing a contracting state to tax the business profits of a non-resident business regardless of its obligation under Article 7 of the OECD Model where those profits are not subject to a minimum level of tax in the state of the permanent establishment).

Comment

These proposals are potentially far reaching and raise many questions of detail on the individual proposals as well as the administrative aspects of such changes. The consultation asks open-ended questions on both the policy and design features of each of the proposals, as well as requesting feedback on how issues of complexity, certainty and administration might be handled.

The consultation is open for comment until 01 March 2019 and comments should be sent to: TFDE@oecd.org

For Simmons & Simmons response to the public consultation, see "OECD Discussion Draft on addressing the tax challenges of the digitalisation of the economy: Simmons & Simmons response".