Over the past 35 years, the internet has disrupted business, governments and wider society. One unsolved challenge is how to ensure a fair allocation of taxing rights over online activities given the internet does not respect national boundaries. The OECD secretariat has published proposals for a dramatic reform of the international tax rules to address this challenge.
Taxing the internet
The OECD’s proposals follow from the programme of work on this topic published by the OECD earlier in the year. They do not represent a consensus view, but instead bring together common elements of three competing proposals from member countries.
The proposals remain high level and are open to consultation. Following this public consultation process, the OECD is hopeful that political agreement could be reached in the first half of 2020.
The OECD’s proposals sit alongside other unilateral initiatives such as the UK’s proposed 2% digital services tax, to be introduced from April 2020. That new tax focuses on revenues generated from specific internet services, namely search engines, social media platforms and online marketplaces. However, it does not include a tax on online sales of goods nor is it a generalised tax on online advertising. The tax will apply to revenues from those activities that are linked to the participation of UK users and include various safe harbours and contain various de minimis thresholds.
Similarly, the EU proposed a new digital tax that would apply a 3% rate to online advertising; digital intermediary activities, including social platforms or e-commerce; and the sale of data. This was put on the back-burner at the start of the year following opposition from Member States and the EU Commission is focusing its energies on obtaining consensus on the OECD proposals. However, if that consensus is not forthcoming, the EU may well put its own digital tax proposals back on the menu.
Scope of the new internet tax
The OECD notes that in today’s globalised and increasingly digitalised economy, a range of businesses can project themselves into the daily lives of consumers (including users), interact with their consumer base and create meaningful value without establishing an actual physical presence in a market.
Accordingly, a unified approach to taxing the digital economy should apply to all large consumer-facing businesses. This would encompass all businesses that generate revenue from supplying consumer products or providing digital services that have a consumer-facing element.
The OECD does not propose limiting its approach to highly digitalised business models, such as the social media platforms, search engines and online marketplaces (unlike the draft UK digital services tax). However, it does suggest a carve out for some sectors such as extractive industries, commodities and possibly financial services.
The OECD also considers there should be de minimis size limitations so that the only large businesses are targeted. It suggests the EUR 750 million revenue threshold used for country-by-country reporting.
A new tax nexus for cyberspace
Key to the new approach would be a new, standalone nexus rule. This would be distinct and separate from the existing concept of a permanent establishment.
The new nexus rule would result in a business having a taxable presence in any jurisdiction where it had “a sustained and significant involvement in the economy of [that] jurisdiction, such as through consumer interaction and engagement, irrespective of its level of physical presence”. The OECD considers that the simplest way of implementing this rule would be to define a revenue threshold for a particular market, above which “sustained and significant involvement” would be taken to exist.
If a nexus with a particular jurisdiction were to be established under this new rule, a new approach to allocating taxing rights would also be needed. The existing methods of using arm’s length principles to allocate profit for tax purposes would not be suitable. The OECD suggests a three-tier mechanism.
- Allocation of residual profits (Amount A): “Market jurisdictions” would have a new right to tax a proportion of the deemed residual profit of businesses within scope. This would likely be calculated using a formulaic approach based on the consolidated financial accounts of the business and the sales in the particular market jurisdiction. Again, this approach can be contrasted with the position under the draft UK legislation for a digital services tax (which would be calculated as a percentage of UK-derived revenue).
- Fixed returns (Amount B): Activities within market jurisdictions would remain taxable according to existing rules under the arm’s length principle. However, given the large number of disputes over the value of distribution functions (i.e. the value that should be given to logistics activities for the purpose of attributing tax) the possibility of allocating an appropriate fixed return for these activities based on an assumed baseline activity would be explored.
- Dispute resolution (Amount C): Finally, the OECD recognises that disputes are likely to arise, such as where a market jurisdiction claims distribution activities in that jurisdiction warrant greater profit allocation because they go beyond the baseline level of activity set out in Amount B above. Any dispute between the jurisdiction and the taxpayer should be subject to legally binding and effective dispute resolution mechanisms.
The devil is in the detail
The OECD recognises there are a number of significant implementation and administrative concerns to iron out. For example:
- It would be necessary to consider how the existing mechanisms for eliminating double taxation (under domestic rules and treaties) would operate.
- Enforcement and collection may be complex. In the light of this, the OECD considers a withholding tax may be worthwhile.
- Treaties would need to be changed to allow profit allocation on the basis outlined above.
- Crucially, the re-allocation of taxing rights would need to be implemented simultaneously by all jurisdictions to ensure a level playing field.
However, if adopted, these proposals would represent a fundamental shift in the basis of international taxation. The OECD itself recognises this, and the very high stakes. It explains,
“in the balance are: the allocation of taxing rights between jurisdictions; fundamental features of the international tax system, such as the traditional notions of permanent establishment and the applicability of the arm’s length principle; the future of multilateral tax co-operation; the prevention of aggressive unilateral measures; and the intense political pressure to tax highly digitalised [multi-nationals].”
The proposal is open for public consultation, with comments requested by 12 November 2019.