On February 13, 2019, the OECD issued a public consultation document on digital economy taxation titled "Addressing Tax Challenges of the Digitalization of the Economy" (the "Discussion Draft"). The Discussion Draft presents proposals which the OECD's 128 Inclusive Framework members are considering for tackling the tax challenges arising from digitalization of the economy. The OECD is seeking public comments on the proposals with the aim to deliver a set of consensus-based solutions to the G20 by 2020.
The Discussion Draft proposes fundamental changes to bedrock principals of international taxation, including:
- Significant broadening the minimal threshold for a taxable presence (referred therein as "tax nexus");
- Loosening reliance on the existing arm's length standard to allow allocation of income among related parties by reference to user participation and/or marketing intangibles;
- Recognition of a new class of value creating factors and assets that may give rise to taxation in user/market jurisdictions; and
- Proposed minimum global taxation levels or enhanced anti-avoidance provisions for multinational enterprises ("MNEs").
The Discussion Draft
The Discussion Draft builds on earlier OECD work of 2015 (under Action 1 of the OECD Base Erosion and Profit Shifting ("BEPS") Action Plan) and of 2018 (under the Interim Report). Those two reports informed the OECD's current policy views, which have been presented in the Discussion Draft in two pillars: (i) views on tax nexus and profit allocation rules; and (ii) views on enhanced BEPS actions. The first pillar contains three proposals that develop alternative conceptual frameworks of income taxation that upend the existing fundamental rules on tax nexus and profit allocation. The second pillar outlines BEPS-enhancing proposals to limit income shifting post-BEPS implementation with the development of two interrelated rules: an income inclusion rule and a tax on base-eroding payments.
Proposals for addressing tax nexus and profit allocation issues
For tax nexus and profit allocation, the first of the three tax models is called "User Participation". This model would only apply to a narrow set of companies that are in the search engine, social media, and online market place businesses. The User Participation proposal would enable a tax authority to assert taxation based upon local digital platform users' participation regardless of the physical (or other) presence of the companies maintaining or using the digital platform. The level of tax would be based on a residual profit split method ("RPSM"), driven by the level of "user participation" (defined as engagement with the online platform) and the revenue generated through advertising or other transactions in the jurisdiction. The proposal acknowledges that there are many complexities to applying RPSM, and suggests a role for formulas and pre-agreed percentages to simplify the computations and administration.
The second proposed digital tax model is called "Marketing Intangibles". This proposal would apply to all taxpayers regardless of the type of their digital business model. This proposal advocates a separate regime for taxing all forms of marketing intangibles, including the identification and pricing of a new form of marketing intangible (that is not owned by the legal entity that develops, funds and manages the intangible), ascribed to the jurisdiction where the digital user intangible is exploited, regardless of physical presence. Similar to the User Participation proposal, the Marketing Intangible proposal envisions the application of a RPSM to identify income associated with marketing intangibles; this residual income would be allocated among jurisdictions by certain metrics of value (for example, revenue), without regard to the DEMPE functions performed to create the intangible. Like the first proposal, this proposal also sees a role for formulary apportionment to simplify the calculations and administration.
The third proposal, the "Significant Economic Presence" proposal, is largely based on ideas in the Action 1 Report and the Interim Report, and would establish a three-factor allocation model of global income if a company meets the threshold of a significant digital presence. The Discussion Draft notes that this proposal was a late addition, and implementation discussions are still ongoing.
Global anti-base erosion proposals
The Discussion Draft proposes to address the continued risk of profit shifting to entities subject to no or very low taxation through the development of two interrelated rules: (i) an income inclusion rule; and (ii) a tax on base eroding payments:
- An income inclusion rule would tax the income of a foreign branch or a controlled entity if that income was subject to a low effective tax rate in the jurisdiction of establishment or residence; and
- A tax on base eroding payments would deny a deduction or treaty relief for certain payments unless that payment was subject to an effective tax rate at or above a minimum rate. More specifically, this element of the proposal would include (i) an "undertaxed payments" rule that would deny a deduction for a payment to a related party if that payment was not subject to tax at a minimum rate; and (ii) a "subject to tax" rule to be included in tax treaties that would only grant certain treaty benefits if the item of income is sufficiently taxed in the other state.
The proposals for new nexus and profit allocation rules all rely upon some form of RPSM and formulary apportionment, coupled with the absence of a requirement to meet any minimum taxable presence (or permanent establishment) rules, that until now, were the globally accepted international taxation principles. In all cases the Discussion Draft concludes that the principle of the existing arm's length standard ("ALS"), where each taxable entity should be evaluated as a separate entity operating at arm's length, does not work for digital business models, thus requiring a new set of transfer pricing methods/rules to capture the role of users and/or marketing in the new economy.
These proposals challenge the ALS in at least three ways. First, unlike the OECD Transfer Pricing Guidelines, they look beyond the three-fold building blocks of functions performed, assets owned, and risks borne to establish the basis for taxable income allocation. Second, they broaden the definition and ownership of intangible assets to include online user input regardless of jurisdiction or local presence. Third, they de-link the place where a function is performed (and tax deduction taken) and where the income is recognized.
The proposals retain the ALS for all functions other than those related to user participation and marketing intangibles, necessitating the adoption of a hybrid transfer pricing policy that will put great emphasis on properly delineating a taxpayer's income that fall within the scope of this new approach.
The Discussion Draft proposals have significant income identification and computational issues. The User Participation proposal must resolve issues around the role of 'clicks' in creating marketing value, as users are not necessarily customers and are difficult to identify by jurisdiction. Moreover, tracking users may trigger privacy issues, such as those covered by the recently adopted EU General Data Privacy Regulations. Mandating wide-spread use of the RPSM under all three proposal creates a number of complex computational issues, such as how value routine contributions to income and how to separate the value of marketing intangibles from product-related intangibles. The RPSM is a notoriously difficult transfer pricing method, with no generally accepted calculation. Recognizing the difficulties in computing an RPSM, the Discussion Draft makes frequent references to the potential use of formulary methods.
We observe that the ALS has been the bedrock of international taxation for the better part of a century, serving as a guiding principle for taxpayers and tax authorities to resolve disputes. The unmooring of this bedrock principle risks a tax system based on arbitrary rules and formulas, and the creation of confusion and uncertainty.
There are significant administrative issues to be overcome before any of the proposals concerning profit allocation can be implemented. The OECD Guidelines and the US transfer pricing regulations both mandate the use of the ALS to allocate income among related parties. How these proposals can be modified to meet this standard is an open question. They also require new nexus rules to modify the threshold for taxation, with implications for the permanent establishment rules in the OECD Model Tax Convention. As the significant economic presence idea was not properly fleshed out, it is unclear whether the intention is to use this concept to address this threshold question.
The income inclusion rule appears to be modeled on the US Global Intangible Low-Tax Income (GILTI) regime. It would operate alongside a jurisdiction's CFC rules as a minimum tax by requiring a shareholder in a corporation to take into account a proportionate share of the income of that corporation if that income was not subject to tax at a minimum rate. These rules are potentially very complex and the complexity is likely to be compounded if multiple countries adopt similar rules, as that would require an agreed ordering to be applied when determining whether income has been subject to the minimum rate. The possibility of double, even multiple, taxation is high.
Regardless of the measures that are finally agreed, there will be significant controversy risks resulting from countries' ongoing unilateral and inconsistent actions with respect to the measures being proposed. The OECD's continued efforts to implement pro-active and responsive dispute resolution mechanisms need to be an integral part of the digital taxation package. In particular, mandatory arbitration provisions in tax treaties need to be considered as a minimum standard in the context of these proposed measures.