OECD update on its Two-Pillar Approach to taxing the digital economy

On 31 January 2020, the OECD delivered an update on progress in relation to its two-pillar approach to addressing the challenges of the digital economy. The update, “Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy”, sets out the progress that has been made as well as the very significant challenges still to be overcome if the solutions are to be implemented by the end 2020 deadline.

The Unified Approach under Pillar One requires a broadening of the recognition of a market jurisdiction’s taxing rights when there is active and sustained participation of a business in its economy, irrespective of any physical presence. To deal with this wider concept of tax nexus, new profit allocation rules are required which will need to go beyond the existing arm’s length principle and apply a formulaic approach to profit recognition in certain aspects. As with the Pillar One proposals, the Pillar Two proposals have the potential to fundamentally change the international tax landscape for MNEs.

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 ability of the international community to compromise on 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 and the UK’s proposed Digital Services Taxes.

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 OECD Secretariat published a Public Consultation document in October 2019 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”, put forward a Secretariat proposal to define scope, tax nexus and a new profit allocation rule for public comment. A public consultation document on Pillar Two, seeking solutions to the ongoing risks from structures which allow MNEs to shift profits to low tax jurisdictions through additional global anti-base erosion (GloBE) proposals, was published in November 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 (remotely) in a market jurisdiction. The October 2019 public consultation put forward a “Unified Approach” to addressing these issues and the latest report builds on this proposal.

The suggested approach encompasses three types of taxable profit that may be allocated to a market jurisdiction, described as Amount A, Amount B and Amount C.

• Amount A – This would affect 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). This
  is a share of residual profit allocated to market jurisdictions using
  a formulaic approach applied at an MNE group (or business line)
  level. This new taxing right can apply irrespective of the existence
  of physical presence, especially for automated digital services. It
  reflects profits associated with the active and sustained
  participation of a business in the economy of a market jurisdiction,
  through activities in, or remotely directed at that jurisdiction, and
  therefore constitutes the primary response of the Unified Approach to
  the tax challenges of the digitalisation of the economy.

• Amount B – This is a fixed remuneration based on the arm’s length
  principle (ALP) for “baseline distribution and marketing functions”
  that take place in the market jurisdiction.

• Amount C – This covers any additional profit where in-country
  functions exceed the baseline activity compensated under Amount B.
  The scope of Amount C is still being discussed and considered as a
  critical element in reaching an overall agreement on Pillar One and
  the document is silent on the detail.

Amount A

Amount A is the primary response to the tax challenges of the digital economy. It will provide a taxing right over a portion of residual profits allocable to market jurisdictions and will be limited to large MNE groups which meet a new nexus test in the market jurisdiction concerned. The target is businesses that provide automated and standardised digital services to a large and global customer or user base in a way that operates remotely in markets using little or no local infrastructure. Examples given by the latest document include: online search engines: social media platforms; online intermediation platforms, including the operation of online marketplaces, irrespective of whether used by businesses or consumers; digital content streaming; online gaming; cloud computing services; and online advertising services.

However, the scope is wider than simply automated digital platform providers and extends to other businesses which generate revenue from the sale of goods and services of a type commonly sold to consumers (ie. individuals that are purchasing items for personal use and not for commercial or professional purposes) whether directly or indirectly through third-party resellers or intermediaries that perform routine tasks such as minor assembly and packaging. In addition, the intention is to bring into scope businesses that generate revenue from licensing rights over trademarked consumer products and businesses that generate revenue through licensing a consumer brand (and commercial know-how) such as under a franchise model.

However, certain industries can be excluded, such as extractive industries and other producers of raw materials and commodities. Most of the activities of the financial services sector (which includes insurance activities) are considered to be out of scope, though consideration might be given to whether there are unregulated elements of the financial services sector or related to the sector which require special consideration, such as digital peer-to-peer lending platforms. Airline and shipping businesses will also be out of scope due to the specific bilateral treaty approach to such businesses.

It is proposed that there will be a number of thresholds applied to limit the number of businesses subject to the rules. These include:

• It will be limited to MNE groups with a minimum gross revenue
  threshold (which might be aligned with that for CbC reporting at
  €750m);
• A carve-out will be considered for groups with total in-scope
  revenues of less than a certain threshold; and
• Consideration will be given to excluding businesses where the total
  profit to be allocated under the new taxing right is below a certain
  de minimis threshold.

In terms of nexus, a new nexus rule will be created based on indicators of a significant and sustained engagement with market jurisdictions. The generation of in-scope revenue in a market jurisdiction over a period of years would be the primary evidence of a significant and sustained engagement. Thresholds will need to be agreed based on the size of a market, with an absolute minimum to be determined.

For consumer-facing businesses selling consumer goods into a market jurisdiction, the aim is not to create a new nexus if the MNE is merely selling consumer goods into a market jurisdiction without a sustained interaction with the market. Further work will be required to explore the use of possible additional or “plus” factors, such as the existence of a physical presence of the MNE in the market jurisdiction or targeted advertising directed at the market jurisdiction.

The aim is to design these tests in a way that is “simple, avoids double taxation, and can be designed to work alongside the ALP, including as represented by Amounts B and C”. Equally, administration is a key concern. The intention is to design the new nexus rule so as to eliminate (or limit to a bare minimum) any filing and other tax related obligations arising from the allocation of the new taxing right to multiple market jurisdictions. This will include exploration of simplified reporting and registration-based mechanisms (such as a “one stop shop”) and exclusive filing in the ultimate parent jurisdiction (as with CbC).

Much of the detail will need to be focussed on the calculation of Amount A and its allocation amongst market jurisdictions. Amount A will be based on a measure of profit derived from consolidated group financial statements. As such, where the out-of-scope revenues of a multinational group are material, segmented accounts may be required to capture only in-scope business segments in the allocation of Amount A profits. In some cases, segmentation among multiple regions and/or in-scope business lines may be required where a taxpayer’s profitability varies materially between different business lines or regions.

Once Amount A has been calculated, it will then be necessary to allocate it amongst eligible market jurisdictions using an agreed “allocation key”. The allocation key will be based on sales of a type that generate nexus, however specific revenue-sourcing rules to support its application by reference to different business models will need to be developed. For example, for online advertising such rules will deem revenue to arise in the jurisdiction where the advertising is viewed rather than the jurisdiction where the advertising is purchased.

The document recognises that eliminating double taxation is key to the success of the rules. However, any traditional approach to eliminating double taxation is not straightforward as the calculation of Amount A applies to the profits of an MNE group and not on an individual entity or individual country basis. It will therefore be necessary to establish methods to identify particular members of an MNE which are to be treated as owning the residual profits taxed under Amount A “in a way that is both administrable and fair”.

Amount B

Amount B involves a fixed return for baseline distribution and marketing activities as a means to standardise the remuneration of businesses which buy products from related parties for resale. It is intended as a method for simplifying the process for agreeing returns for both businesses and tax administrations.

It will be important to clearly define the scope of “baseline distribution and marketing activities” which will likely “include distribution arrangements with routine levels of functionality, no ownership of intangibles and no or limited risks”.

The OECD recognises that reaching agreement on the amount of the fixed percentage will require countries to make trade-offs between strict compliance with the arm’s length principle and the administrability of Amount B. “That is, while the fixed percentage approach may not encapsulate all the facts and circumstances of each individual case, it does have the potential to significantly simplify the determination of the return for the activities within its scope.”

Implementation

The document envisages the possible use of a multilateral instrument to implement aspects of the unified approach. This would contain all of the rules necessary to implement the approach (scope, nexus, profit allocation, elimination of double taxation, and dispute resolution). The OECD candidly recognises, however, that this will require “a strong impetus at the highest political level”. Importantly, the implementation of the new taxing right and the allocation of additional profits to the market jurisdiction should also be “contingent on the acceptance of the new dispute prevention and resolution rules”. The document notes that all Inclusive Framework members recognise that “reaching agreement on the breadth of the application of new enhanced dispute resolution is critical and agree to return to the matter as part of arriving at a consensus-based solution in 2020”. Also, as some jurisdictions may have domestic obstacles to the adoption of mandatory binding arbitration, it may be necessary to consider mechanisms that do not present the same issues and that can be adopted by all members of the Inclusive Framework.

In addition, the document recognises that as the new taxing rights will create novel compliance and implementation requirements, it may be appropriate to introduce the rules on a phased basis, and/or adopt a simplified approach to the compliance requirements for a designated initial period through transitional rules.

Finally, it is expected that agreement on the new taxing rights pre-supposes a commitment to withdraw unilateral measures and not adopt such unilateral actions in the future.

Global safe harbour alternative

The US compromise position put forward in December 2019 was for Pillar One to apply as an optional safe harbour regime that MNE’s could opt into to achieve tax certainty. The US concerns on Pillar One relate to the “potential mandatory departures from arm’s length transfer pricing and taxable nexus standards — longstanding pillars of the international tax system upon which US taxpayers rely”. The US considers that these concerns could be addressed and the goals of Pillar One could be substantially achieved by making Pillar One an optional safe harbour regime. In essence, in exchange for paying more foreign tax under a Pillar One election, the MNE would obtain the benefits of enhanced tax dispute resolution and administration.

Other jurisdictions, however, are known to be very concerned that an optional approach to Pillar One would essentially drive a coach and horses through the OECD’s efforts to reach consensus.

Pillar Two

The update published by the OECD also covers the Pillar Two proposals (also referred to as the “GloBE” proposal), though in far less detail than Pillar One. The purpose of the Pillar Two proposals is to address remaining BEPS challenges by ensuring that the profits of internationally operating businesses are subject to a minimum rate of tax. A minimum tax rate on all income would reduce the incentive for taxpayers to engage in profit shifting and for jurisdictions to engage in a “harmful race to the bottom on corporate tax rates”, so risking shifting the tax burden to less mobile tax bases. In particular, this is seen as posing a particular threat to developing countries with small economies. As with Pillar One, there is a desire to put forward a co-ordinated international solution to avoid the potential proliferation of uncoordinated and unilateral action by individual jurisdictions.

In essence, the GloBE proposal focuses on the remaining BEPS issues and seeks to develop rules that would provide jurisdictions with a right to top up tax to an agreed minimum rate where other jurisdictions have not exercised their primary taxing rights or the payment is otherwise subject to low levels of effective taxation. The actual rate to be applied under GloBE is yet to be determined, however.

There area number of aspects to the GloBE rule including:

• An income inclusion rule – requiring a shareholder to bring into
  account a proportionate share of the income of a subsidiary where
  that income is not subject to tax at an effective rate above the
  minimum rate;
• A switch-over rule – which applies a similar treatment to foreign
  branches taxed at an effective rate below the agreed minimum by
  switching off any exemption from tax provided in a bilateral tax
  treaty;
• Under-taxed payment rule – which denies a deduction in respect of
  intra-group payments in similar circumstances; and
• A subject to tax rule – which would subject payments to a withholding
  tax at source and deny treaty benefits on items of income where the
  payment is not subject to tax at the minimum rate.

There is little new to report on Pillar Two other than the Working Groups continue to make “good technical progress” to address the issues that the proposal raises, whilst “significant work still remains”. In particular, extensive work is being conducted on the feasibility of using financial accounts as a basis for determining the application of the rule.

Comment

The document candidly recognises the considerable amount of work still required to reach any consensus on Pillar One and Pillar Two, whilst remaining committed to an end 2020 deadline. Clearly, a large number of technical, implementation and administration questions remain to be determined and whether it is realistic to reach agreement on such detailed matters within the OECD’s timeframe is, at this stage, a matter of conjecture.

On top of that, the US attitude to the proposals remain uncertain following its suggestion that the Pillar One Unified Approach should be downgraded to an optional safe harbour only. Whilst the OECD has committed to continue to consider this option, there seems little enthusiasm for it outside the US.

However, it should be recognised that a single approach based on international consensus may offer significant advantages over the prospect of the proliferation of a large number of separate “digital taxes” that are currently coming forward. Much will ultimately depend on the ability of the OECD to put together detailed rules which offer certainty and are not unduly burdensome for businesses to operate.