In February the OECD issued a public consultation document inviting comments on proposals to address the challenges digitalisation poses for the international tax system.
The consultation period was very short, it ended on 6 March, reflecting the time pressure on the OECD to offer a solution. Some countries such as the UK, France and India, are pressing ahead with their own digital services taxes which the OECD understandably perceives as potentially harmful to all countries.
The proposals are grouped into two ‘pillars’. The first is the revision of profit allocation and nexus rules and the second is the global anti-base erosion proposal. These proposals are not new but are now set out clearly in the consultation document.
Profit allocation and nexus rules
The first pillar addresses the profit allocation and nexus rules. Three different proposals - user participation, marketing intangibles and significant economic presence - are put forward in order to recognise value created by a business’s activity or participation in user/market jurisdictions that is not recognised in the current framework for allocation of profits.
This proposal seeks to change profit allocation rules to reflect the value created by digitalised businesses through developing an active and engaged user base, and soliciting data and content contributions from them. This proposal is aimed at social media platforms, search engines and online marketplaces – the obvious examples being Facebook, Google and Amazon. Under this proposal the change in rules would be limited to businesses which benefit from this type of ‘user base’.
The mechanics would be applied by:
- calculating residual profit, meaning profits after routine activities have been allocated an arm’s length return;
- attributing a proportion of those profits to the value created by users, which could be determined though quantitative/qualitative information, or through a simple pre-agreed percentage; and
- allocating those profits between user jurisdictions, based on an agreed allocation metric, such as revenues.
There could clearly be challenges in attributing profits fairly and correctly to users.
In contrast to the ‘user participation’ proposal, the 'marketing intangibles' proposal would not apply only to certain types of business but would have a wide scope in an effort to respond to the broader impact of digitalisation on the economy.
The thinking behind this proposal is that, at present, a MNE group can access a jurisdiction to develop a user base and other marketing intangibles without creating a significant taxable presence in that jurisdiction.
The proposal is based on the premise of an intrinsic functional link between ‘marketing intangibles’ and the market jurisdiction. Marketing intangibles, with their link to the market jurisdiction, are illustrated by contrasting them with trade intangibles. The example given in the paper is that of a trade patent used to build an efficient car engine, enabling it to achieve the same mileage in one country as it does in another, regardless of where it was made or where it was purchased.
The proposal would be implemented by modifying existing transfer pricing rules and treaty rules to recognise marketing intangibles and require the risks associated with them to be allocated to the market jurisdiction.
Non-routine or residual income of the MNE group would be attributed to the market jurisdiction, regardless of where in the MNE group legal title is held or functions of design etc. are performed.
Once the amount of income attributable to marketing intangibles has been determined, it would be allocated to the relevant market jurisdictions based on an agreed metric, such as sales or revenues.
‘Significant economic presence’
This proposal is based on the premise that digitalisation of the economy has enabled businesses to be heavily involved in the economic life of a jurisdiction without having a significant presence, rendering existing nexus and profit allocation rules ineffective.
To address this, a taxable presence would arise when a business has significant economic presence, to be assessed on the basis of a range of factors that evidence a ‘purposeful and sustained interaction with the jurisdiction via digital technology and other automated means’. The starting point would be revenue generated on a sustained basis, but nexus would only be established when this is combined with other factors and a link is established between the revenue generating activity of the non-resident business and its significant economic presence.
The factors proposed are:
- the existence of a user base and the associated data input;
- the volume of digital content derived from the jurisdiction;
- billing and collection in local currency or with a local form of payment;
- the maintenance of a website in a local language;
- 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; and
- sustained marketing and sales promotion activities, either online or otherwise, to attract customers.
Withholding tax could be used as a collection method and enforcement tool.
Global anti-base erosion proposal
The second pillar is the 'global anti-base erosion' proposal, which seeks to address the continued risk of profit shifting to entities subject to low or zero taxation. Existing BEPS measures in the OECD’s mind arguably do not go far enough.
Two inter-related rules are proposed, namely:
- an income inclusion rule, which would tax the income of a foreign branch or controlled entity if it was subject to a low effective tax rate in the foreign jurisdiction; and
- a tax on base eroding payments, which would deny deductions or treaty relief for certain payments unless they were subject to tax above a minimum rate.
The income inclusion rule
The income inclusion rule is essentially a minimum tax rule. It would operate by requiring a shareholder in a company to bring into account a proportionate share of the income of the company if that income was not subject to tax at a minimum rate. The rule would only apply to shareholders with a significant interest, the example given being 25%.
It would supplement rather than replace a jurisdiction’s CFC rules. The amount of income to be included would be calculated under domestic rules and shareholders could claim a credit for any underlying tax paid on the attributed income.
The income inclusion rule would build on the BEPS Action 3 recommendations and the task force expressly notes that it would draw on aspects of the US tax regime for taxing global intangible low-taxed income (GILTI).
The effect of the rule would be to ensure that the income of a MNE group would effectively be subject to a minimum tax rate and would thereby reduce the incentive to shift profits to jurisdictions for tax reasons.
Tax on base eroding payments
This rule would complement the income inclusion rule by protecting a source jurisdiction from the risk of base eroding payments out from it.
An 'undertaxed payments' rule would deny deductions for certain payments made to related parties, unless the receipts by the related parties were subject to a minimum effective rate of tax. The related party test could be a 25% common ownership test.
A 'subject to tax' rule would complement the undertaxed payments rule. It would deny treaty benefits under the business profits, associated enterprises, dividends, interest, royalties, capital gains and other income articles of double tax treaties.
Taking the interest article as an example, the subject to tax rule could deny treaty benefits in the source state if the residence state does not tax the interest at a minimum effective rate of tax. The rule could be limited to payments between related parties, but the document notes that a broader scope could be explored in the interest, royalties and capital gains articles.
The consultation paper sets out clearly the possibilities that are being considered. The principles are clear but there is clearly a lot to be done in terms of the detail, in particular how to measure the profits to be allocated to jurisdictions.
It will become increasingly difficult to claim that profit is earned in low tax jurisdictions without having meaningful substance in those jurisdictions.
The clear message from the OECD to multilaterals is to think carefully about any attempts to use low tax jurisdictions for tax structuring purposes. More complex tax legislation is on its way and operating in low tax jurisdictions will leave MNEs exposed to increasing risk of being taxed one way or another.
The OECD will need to take care to ensure that the proposals do not go too far. For example, could the UK’s dividend exemption or substantial shareholding exemption potentially fall foul of the subject to tax rule so that treaty benefits would not apply?
The task force intends to produce a final report in 2020, aimed at providing a consensus-based long-term solution to the perceived problem. Consensus seems a long way off, but it can only be helpful that the OECD is setting out its proposals as there is always the hope that it will steer
states, including the UK, which are consulting on and implementing their own unilateral solutions.
Jeremy Webster is a corporate tax expert at Pinsent Masons, the law firm behind Out-law.com. This update is based on an article which was first published in Tax Journal on 22 February 2019.