A new tax nexus: the OECD's proposed unified approach

UPDATE: For the OECD’s public consultation on Pillar Two proposals, see OECD Public Consultation on Pillar Two: a global anti-base erosion proposal.

The OECD Secretariat has published a Public Consultation document to assist the Inclusive Framework Member States with reaching international consensus on the scope of taxation of the digital economy and methods to determine what digital income would be subject to tax. The document, “Secretariat Proposal for a “Unified Approach” under Pillar One”, puts forward a Secretariat proposal to define scope, tax nexus and a new profit allocation rule for public comment.

The Unified Approach suggests a broadening of the recognition of a market jurisdiction’s taxing rights when there are significant consumer-facing activities in that jurisdiction irrespective of any physical presence. The proposal is not necessarily limited to digital businesses, but would apply to any (large) consumer facing businesses which exceed certain revenue thresholds in the market jurisdiction (mention was made of possibly a 750 million USD threshold). To deal with this wider concept of tax nexus, new profit allocation rules are put forward which will need to go beyond the existing arm’s length principle and apply a formulaic approach to profit recognition in some cases, yet will exist adjacent to the existing transfer pricing rules and arm’s length standard.

The OECD is still working towards a 2020 implementation deadline, but recognises that significant progress needs to be made quickly if this timeframe is to remain realistic. On that point, much will depend on the reaction of the international community to the Secretariat proposal which is broad, extensive and, in many ways novel.

There will be reservations and concerns over the scope and detail of these proposals and the administrative burden that new rules will create.
However, against that must be set the alternative prospect of a plethora of individual and jurisdiction-specific rules targeted at the digital economy which are starting to be introduced and becoming effective in a significant number of countries.

Background

Despite determining in its final Report on BEPS Action 1 that it would not be feasible to ring-fence the digital economy for tax purposes, international pressure has continued to mount over the tax treatment of the digital economy as a number of jurisdictions have concluded that more is needed to ensure fair taxation of digital business. As a result, in March 2018 in its Interim Report, the OECD returned to the question of whether, and if so what, further measures to tackle taxation of digital services were needed.

Impetus for an international consensus has continued to mount since then as the EU Commission put forward proposals to address the tax treatment of companies operating in the digital economy and several jurisdictions have commenced implementation of unilateral, domestic measures, such as France’s current Digital Services Tax and the UK’s proposed Digital Services Tax.

This continued political pressure led to the publication of a Policy Note in January 2019, quickly followed by a Public Consultation which set out a number of proposals for reform, grouped under two “pillars”: revised profit allocation and nexus rules (Pillar One); and a global anti-base erosion proposal for a minimum level of taxation (Pillar Two). The public consultation document launched on 09 October 2019, seeks to put forward a unified approach with respect to Pillar One and will be presented to the G20 Finance Ministers in a meeting scheduled to take place in Washington DC on 17 October 2019.

Pillar One

Pillar One concerns the need for a revised approach to “nexus” for tax purposes, stemming from the perception that the current approach to the allocation of profits (based on physical presence and the “permanent establishment” definition) can no longer be the exclusive method in a digital age as it fails to recognise value created by business activities taking place (remotely) in a market jurisdiction. Three possible approaches were recognised in the earlier programme of work based on: the use of “user participation”; “marketing intangibles”; or some other “significant economic presence”.

The October 9, 2019, Public Consultation seeks to recognise the commonalities in these three approaches, including the fact that all the suggested approaches would: reallocate taxing rights in favour of the user/market jurisdiction; envisage a new nexus rule which would not depend on physical presence; go beyond the arm’s length principle and the separate entity principle; and seek to provide tax certainty.

The Unified Approach seeks to put forward a “possible new approach based on the commonalities between the three proposals, taking account of the ultimate aim of these proposals, the views expressed during consultations, as well as the need to deliver a solution that is as simple as possible”.

The Proposed Unified Approach

The proposed Unified Approach sets out the key features of the proposed single solution.

Scope

The approach would cover highly digital business models but goes wider, broadly focusing on large consumer-facing businesses (such as businesses that generate revenue from supplying consumer products or providing digital services that have consumer-facing elements) with further work to be carried out on scope and carve-outs (for example, size limitations). This approach would also mean that some sectors, such as extractive industries, would be out of scope, based on the rationale that any benefit or rent resulting from extraction is linked to the territory where the extraction takes place.

New Nexus

For businesses within the scope, it creates a new nexus, not dependent on physical presence, but based on exceeding a sales threshold. The new nexus could have thresholds including country specific sales thresholds calibrated to ensure that jurisdictions with smaller economies can also benefit. The new rule would be adopted as a new self-standing treaty provision operating in addition to the existing PE rule. The rule would apply not only to businesses selling remotely, but also to those selling into a market through a distributor to ensure neutrality.

New Profit Allocation Rule going beyond the Arm’s Length Principle

The proposed approach would create a new profit allocation rule applicable to taxpayers within scope, and irrespective of whether they have an in-country marketing or distribution presence (permanent establishment or separate subsidiary) or sell via unrelated distributors. At the same time, the approach largely retains the current transfer pricing rules based on the arm’s length principle but complements them with formula based solutions in areas where tension in the current system is highest.

Increased Tax Certainty delivered via a Three-Tier Mechanism

The Unified Approach aims to increase tax certainty for taxpayers and tax administrations by presenting three separate returns to market/user jurisdictions:

• Amount A: a share of deemed residual profit allocated to market jurisdictions using a formulaic approach. This component constitutes an entirely new taxing right. In broad terms, this deemed residual profit would be the profit that remains after allocating what would be regarded as a deemed routine profit on activities to the countries where the activities are performed
• Amount B: a fixed return for baseline/routine marketing and distribution functions that take place in the market jurisdiction
• Amount C: profit above the baseline activity is allocated to the market jurisdiction for taxation, based on the existing arm’s length principle and eligible for binding and effective dispute resolution mechanisms.

At the core of the proposal, therefore, are new nexus and profit allocation rules which step beyond the current approaches based on physical presence and the arm’s length principle. Indeed, the consultation document notes that the traditional transfer pricing approach is not only seen as unable to provide an appropriate result in all cases (such as cases involving non-routine profits from intangibles) but also suggests that it is becoming “an increasing source of complexity” and that simplification would be desirable to contain the increasing administration and compliance costs of trying to apply it.

The proposed approach, therefore, is to retain the arm’s length method in cases where it is widely regarded as working effectively but to replace it with a “formula-based” solution in other cases, especially where it is impacted by digitalisation of the economy. Clearly, however, there are many detailed aspects of the formula that would still need agreement relating to, for example, determination of the level of the deemed routine profit and the proportion or percentage of the deemed residual profit that should go to the market jurisdiction.

The Public Consultation recognises that elimination of double taxation will be an important element of the proposal and one that is not straightforward. In particular, because existing provisions relieving double taxation apply to individual entities and individual countries, the implementation of the proposed approach would require the identification of the member(s) of an MNE group that should be treated as owning the taxable profit in such market jurisdictions under Amount A. In particular, therefore, it will be important to determine to what extent identifying the relevant taxpayers and the relevant profit to be reallocated would allow existing mechanisms for eliminating double taxation to continue to operate effectively. This depends on how domestic and treaty rules to relieve double taxation might operate under the Unified Approach.

Comment

The proposal summarised in the Public Consultation is at a relatively general level, recognising that certain aspects still require further work. Clearly, a large number of implementation and administration questions remain to be addressed and many of these are recognised in the document, such as those that arise in relation to double taxation. Whether it is realistic to reach agreement on such detailed matters within the OECD’s timeframe is at this stage a matter of conjecture.

However, a single approach based on international consensus would offer significant advantages over the prospect of the proliferation of a large number of separate “digital taxes” that are currently being put forward.

A public consultation meeting will be held on 21 and 22 November 2019. The OECD recognises that if it is to meet its deadline to deliver a solution in 2020, then at the very least the outlines of an approach will need to be agreed by January 2020. Interested parties are invited to send comments on the Consultation by 12 November 2019 to TFDE@oecd.org

It is intended that a further consultation document on Pillar Two proposals will be released in early November and a separate public consultation meeting on those proposals will be held in December 2019.