On October 9, the OECD announced its much-anticipated proposed “Unified Approach” to tackling tax challenges arising from the digitalization of the economy. The Unified Approach, as expected, would make dramatic changes to the existing international tax system. Focused on consumer-facing businesses, the Unified Approach would:
- Create a new nexus rule – a new self-standing treaty provision not dependent on physical presence and based largely on in-country sales;
- Introduce a modified “Residual Profit Split” method involving a “Three Tier Mechanism” with formulary elements overlaying existing arm’s length principles as a means of allocating a pre-determined slice of income to market jurisdictions; and
- Provide for enhanced dispute resolution, which purportedly means mandatory binding arbitration for certain disputes.
The Unified Approach is presented as, and may seem, simple. However, for now, the Approach represents only a recommendation from the OECD Secretariat. Successful implementation will require consensus among the 130+ countries of the Inclusive Framework not only on the Approach as sketched out by the Secretariat, but also on a multitude of further technical details, potentially including fixed margin percentages (by industry or business line) to approximate a routine return, non-routine margins by industry or business line, how to distinguish between consumer-facing and business-to-business companies or business lines (again, by industry or product line). Local GAAP differences may require different percentages for different countries of regions. This is anything but simple. In fact, unless negotiators can develop conventions that eliminate the need for these very specific determinations, the Unified Approach seems destined to be anything but simple.
We explain here the basics of the Unified Approach and some of the challenges it presents.
Key Steps involved in the Three Tier Mechanism
The core of the Unified Approach is its Three Tier Mechanism for calculating income allocable to market jurisdictions. As the label implies, the total income allocable to a market jurisdiction would be the sum of three component amounts:
- Amount A. The amount attributable to a ”new taxing right” for market jurisdictions, calculated as follows:
- Step 1. Identify the MNE group’s worldwide profit from the consolidated financial statement with needed adjustments. This may be measured on a business line and/or regional/market basis (z%).
- Step 2. Calculate the level of profitability deemed to represent the baseline “routine” profit (x%) and deduct it from the overall profitability (z% - x% = y%). The remainder (y%) would represent the deemed non-routine profit.
- Step 3. A portion of the non-routine profit (w%) would then be attributed to market jurisdictions, with the remaining portion (1 - w% = v%) allocated among other value-creating factors such as trade intangibles, capital and risk, etc., presumably through traditional arm’s length methods. The portion of non-routine profit attributable to market jurisdictions (w%) could be an internationally-agreed fixed percentage.
- Step 4. Allocate the relevant portion of the deemed non-routine profit (w% x y%) among eligible market jurisdictions. In-country sales may be used as the allocation key. The market jurisdictions – regardless of the existence of a local PE – would have the (new) right to tax the allocated income.
- Amount B. A fixed, baseline return for certain routine marketing and distribution activities taking place in market jurisdictions. This amount would not be subject to the new taxing right. That is, only a jurisdiction in which a taxpayer has a local presence may tax Amount B. The Unified Approach suggests using “agreed fixed returns” (i.e., a formulary approach) to establish routine marketing and distribution returns.
- Amount C. A return for any additional activities not accounted for in the assumed baseline return (Amount B), to be determined using traditional arm’s length methods. Any dispute between the market jurisdiction and the taxpayer over an Amount C (including its relationship to Amount A) would be subject to legally binding and effective dispute prevention and resolution mechanisms.
Short-Term Outlook: Continued Uncertainty
As noted above, the Unified Approach is not yet a consensus proposal. Even if it gains momentum, it remains but a rough sketch of an implementable plan. Open questions include:
- Using “deemed” amounts: The proposal endorses the use of a “deemed” amount for non-routine profit subject to the new taxing right (Amount A). Yet, it obliquely acknowledges the possibility that this could lead to double-counting of taxable income. If, for example, countries seek to tax high-intensity marketing efforts (Amount C), to what extent should Amount A be viewed as already rewarding those efforts? Similarly, could there be conflicts between the deemed benchmark returns used to determine Amount A and the actual routine returns compensated through Amounts B and C, and how would such differences be reconciled (e.g., would arbitration be available to reconcile all such differences)? Lastly, given that Amount C will continue to be determined under the arm’s length principle, what if the whole resulting from the Three Tier Mechanism exceeds the sum of its parts—i.e., the sum of a taxpayer’s worldwide Amounts A, B, and C exceeds its actual worldwide profit?
- Treatment of losses: Although the proposal acknowledges the need for incorporating rules to address losses, it does not present a clear solution on how losses—particularly common among early-stage digital companies—would be taken into account in computing income subject to the new taxing right and the related income allocations, how losses might be carried forward or back, whether expanded statutes of limitations would need to be provided, or other, similar issues.
- Defining “consumer-facing businesses”: The Unified Approach carves out extractive industries and possibly the financial services industry. What other industries should be exempt? Must they be industries that predominantly include non-consumer-facing businesses? For instance, if a multi-sided online platform provides advertisement services to companies, is it a platform operator, an advertising business, or both, and are these consumer-facing businesses?
- Identifying the “Losers”: From where would the profit newly allocated to market jurisdictions be drawn, i.e., which jurisdictions (and companies within the MNE group) would lose out? Will source countries accept a model that gives back some of their perceived DEMPE gains?
- Unforeseen Consequences: What are the implications of the Unified Approach, and future refinements thereof, under non-tax laws and regulations, such as international trade law and treaties?
- Alignment with Value Creation: To the extent a refined Unified Approach applies a uniform, “rough justice” allocation methodology to a broad range of business models and circumstances—e.g., multi-sided platforms, for which a substantial portion of the “market” factors are already compensated and taxed in local jurisdictions through the tax returns of independent participants such as app developers and “gig economy” participants—will it be consistent with the principle that profit should be taxed where value is created?
Perhaps the biggest open question is whether the Unified Approach will gain momentum. Notably, many Inclusive Framework member countries have developed “unilateral measures” related to the tax challenges of digitalization that differ in both scope and methodology from the Unified Approach.
For example, digital service taxes (DSTs) proposed in the UK and implemented in France generally align to the “User Participation” approach. The French tax, which was enacted July 24, 2019, imposes a 3% levy on the French revenue of a small group of large multinational technology companies. According to a policy paper published in July 2019, the UK plans to impose a 2% levy on revenues of search engines, social media platforms, and online marketplaces that derive value from UK users. Spain and New Zealand have also introduced their own unilateral DST regimes.
Other countries have adopted unilateral measures that align to the “Significant Economic Presence” approach. India and Italy introduced their own versions of a significant economic presence. Israel’s Significant Digital Presence Nexus, Saudi Arabia and Kuwait’s Virtual Service PEs, Taiwan’s Economic Nexus for E-Commerce Services, and Slovakia’s Intermediation PE all illustrate the efforts of countries trying to expand their taxing rights to the income of highly digitalized multinational companies derived from local activities.
Amid this complicated landscape, the OECD expects its newly narrowed proposal may advance its objective of arriving at a consensus solution by 2020. Nevertheless, it is far from clear that the Unified Approach will gain a critical mass of support among Inclusive Framework members. Implementation of the approach could have complicated fiscal impacts for each country, and the OECD’s empirical analyses are ongoing.
If the Unified Approach gains consensus among the member states, all large multinational companies within the applicable scope would have to allocate a portion of their taxable income to the jurisdictions in which they make sales. This may, in many cases, increase the overall group-wide tax burden and would almost surely lead to double-taxation, at least in the short-term. Equally important, for companies with diversified geographic markets and multiple business lines, complying with the new rule may be cumbersome and costly.
With all that said, companies—operating in an environment of extreme uncertainty—have the opportunity to make their voices heard. Public comments on the Unified Approach are due November 12, with a public consultation to follow on November 21-22. Ideas submitted by participants in response to the February 2019 consultation heavily influenced the OECD’s May 2019 Work Programme, and elements of the Unified Approach echo those proposals. Companies with a stake in the stability and predictability of the international tax system should take advantage of this historic opportunity to engage with and help to shape the coming changes.
[Appendix] Genesis of the Unified Approach
If approved, the Unified Approach would replace the three Pillar I proposals identified in the February 2019 public consultation document.
- User Participation Approach: Proposed by the UK, this approach would apply a residual profit split approach to allocate taxable income of social media platforms, search engines, and online marketplaces to jurisdictions where their users are located. The user jurisdiction would have the right to tax the allocated income even in the absence of a local PE.
- Marketing Intangible Approach: Proposed by the US, this approach would apply a residual profit split approach notionally predicated on the presence of local marketing intangibles to allocate MNE income to market jurisdictions, which would have the right to tax the allocated income even in absence of a local PE. Unlike the User Participation Approach, this approach would not have focused on specific digitalized business models.
- Significant Economic Presence Approach: Proposed by India, this approach would apply a new PE standard (“significant economic presence”) divorced from physical nexus and allocate income to the new PEs based on a fractional apportionment method.
Again, if approved, the Unified Approach would also replace—and, as noted, incorporate elements of—the three profit allocation methods detailed in the OECD’s May 2019 Work Programme.
- Modified Residual Profit Split Method: This method would rely primarily on existing transfer pricing principles, possibly with certain simplifications to enhance administrability. Unlike traditional transactional profit split methods, it would be applied at some level of aggregation (e.g., business line, region, or group). The recently introduced IRS APMA Functional Cost Diagnostic model reflects some similar characteristics.
- Fractional Apportionment Method: Originally part of the “Substantial Economic Presence” approach, this method is analogous to the formulary apportionment methods found in the US state tax system and in the EU’s proposed Common Consolidated Corporate Tax Base frameworks.
- Distribution-based Method: Aimed at simplicity and administrability, this method would ascribe to market jurisdictions a baseline profit loosely linked to arm’s length returns to distribution activities, with levers to increase or reduce profit relative to the baseline by reference to local marketing spend, global non-routine returns, or other factors. This method could be a good fit for consumer goods companies, for which localized marketing activities are heavily emphasized, but would be less reflective of the underlying economic dynamics of highly digitalized companies, for which user participation and synergies with technology and other intangible assets are a key source of value.