Tax and the digital economy: latest OECD proposals

Earlier this month the OECD published a proposal for Multinational Enterprises (MNEs) including digital companies to pay tax where they have significant consumer-facing activities. MNEs should be paying attention to the debate as change in this area will happen, either through an agreed international approach – the preferred method of most jurisdictions – or through an increasing number of local, piecemeal solutions, such as digital services taxes which are becoming increasingly prevalent.

The impact of these rules in the longer term may have a significant effect on how MNEs are taxed, including on the compliance burden placed upon such enterprises to capture information that may be required under these rules. The changes may also lead to changes in how such businesses are structured in the longer term.

We look at what the OECD's latest proposals in respect of direct taxation of the digital economy means for where MNEs may be taxed.

Background

As we have discussed in previous insights, the OECD and G20 have been considering the tax challenges of the digital economy as part of the wider base erosion and profit shifting (BEPS) project. A Final Paper was published in October 2015, but the paper made little progress in addressing questions for corporate taxes such as which jurisdiction should have primary taxing rights over the profits of online activities.

Further work on this area is ongoing at the OECD level. The OECD has established an Inclusive Framework of 134 jurisdictions which in turn has delegated work on this area to the Task Force on the Digital Economy. They are working towards a consensus based solution in 2020.

The OECD has published further reports on the taxation of the digital economy since 2015, including, in January 2019 a short Policy Notice which grouped the proposals into two pillars: Pillar One looks at allocation of taxing rights for digital businesses and Pillar Two concerns remaining issues around BEPS.

Pillar One looks in particular at nexus rules (what is required to determine a taxable presence) and profit allocation (how much profit to allocate if there is sufficient nexus). In June 2019 there were three proposals for Pillar One to be explored:

• A "user participation" proposal. There is value to be taxed in user participation, particularly for social media platforms, search engines and online market places, which is not captured by existing permanent establishment rules. Under this proposal, the nexus rules would be changed to give user jurisdictions the right to tax. The UK government has advocated this approach as its preferred option.
• A proposal based on "marketing intangibles" rules. This would also change profit allocation and nexus rules, but would be intended to have wider application than just a narrow subset of digital businesses. It would allow for MNEs to be taxed where they "reach into" a jurisdiction to develop a user/customer base; seeing a link between marketing intangibles and the market jurisdiction, such that profits from marketing intangibles could be allocated to that jurisdiction.
• A "significant economic presence" proposal. This proposal sees that business enterprises can be heavily involved in the economic life of a jurisdiction without a significant physical presence. The significant economic presence would be on the basis of factors that evidence a purposeful and sustained interaction with the jurisdiction via digital technology or other automated means, such as a country-dedicated or targeted website. This would require more than just revenue generation.

A further Programme of Work is being followed to develop a consensus approach on these issues and this has led to the latest OECD proposals.

Latest OECD proposals

On 9 October 2019, the OECD Secretariat published a proposal for a unified approach in respect of Pillar One for MNEs, including digital companies, to pay tax where they have significant consumer-facing activities.

The proposal is to reallocate for tax purposes some profits and corresponding taxing rights to jurisdictions where MNEs have their markets. It applies where MNEs are conducting significant business in places they do not have a physical presence. The proposal does this through a new nexus rule to determine where tax should be paid and a profit allocation rule on the proportion of profits to be taxed there.

Under this new unified approach:

• The businesses covered are wider than just highly digital businesses, applying to consumer facing businesses generally. Further work is proposed on the definition of the scope and carve-outs. Some sectors, such as extractive industries and commodities, should be specifically excluded but further discussion is required on whether other sectors (in particular, financial services) should be carved out.
• There is a new nexus approach: current rules define nexus by reference to having a physical presence, (i.e. a permanent establishment). The proposal in respect of nexus is that this is not dependent on physical presence. Instead, there would be a nexus where a business has a sustained and significant involvement in the economy of a market jurisdiction, such as through consumer interaction and engagement, irrespective of physical presence. The suggestion is that the primary indicator of such a presence should be based on sales, subject to group wide thresholds, including country specific thresholds which could be calibrated by size of economy. The nexus rule would be a new self-standing treaty provision – it would apply on top of the current permanent establishment rules. The proposal does not define the potential thresholds that may be applied, but they do suggest that consideration should be given to the €750m worldwide threshold used for country by country transfer pricing reporting.
• There would be a new profit allocation rule. The rules would be based on the Arm's Length Principle (ALP) which currently allocates profits to a permanent establishment, but this will be complemented with a formula-based approach where the ALP does not work. The rule would apply irrespective of whether the taxpayer has an in-country marketing or distribution function or whether the taxpayer sells via unrelated distributors.

Profit allocation rule

Under the profit allocation rule, there would be a three tier mechanism to create certainty for taxpayers and tax administrations, based on the determination of Amounts A, B and C, as explained below.

• Amount A: a share of deemed residual profit (possibly calculated on a business line basis) might be allocated to market jurisdictions using a formulaic approach under this new taxing right. This is necessary as, in the absence of this allocation there would be no allocation under existing rules as there would be no functions performed in, no assets used in and no risks assumed in the market jurisdiction where there is no physical presence. It is suggested that group consolidated profits would be the starting point of any allocation. It may also be important to split this according to business lines, regions or markets as the profits in each may vary. It would then be necessary to approximate the remuneration for routine activities, as well as excluding from this amount any profits allocated on the basis of other factors such as trade intangibles, capital and risk. A deemed proportion of such non-routine profit would then be allocated to the market jurisdiction in accordance with a simplified convention (such as a fixed percentage, either globally or by industry/business lines).
•  Amount B: activities in market jurisdictions, particularly distribution functions, would remain subject to existing allocation rules. For certain "baseline" or routine marketing and distribution activities the proposal is to explore the use of fixed remuneration. This fixed amount (which could be a single fixed percentage; a percentage based upon industry/region; or some other agreed method) would help reduce compliance costs.
• Amount C: where there are more functions in a market jurisdiction than the assumed baseline activity for which a fixed return is assumed at Amount B the jurisdiction where such activities take place can seek tax on the additional profit on the basis of the ALP. It would in this instance (and generally) be crucial that there are robust dispute measures to resolve disputes and prevent double taxation. In particular, it will be important that any profit in Amount C would not duplicate profit in Amount A.

What next?

The new unified approach sets out a model that may be workable in principle, but further work is required in a number of areas before consensus can be reached. As well as political agreement for the proposals, amongst the areas that require further work are:

• the possible use of business line or regional segmentation and local variations to the rules;
• challenges associated with determination of location of sales;
• definitions/quantum in respect of activities covered under Amount B or possible variations in what is covered in Amount A;
• elimination of double taxation; and
• how the rules will be enforced.

The new proposals are open to consultation until 12 November 2019.

Osborne Clarke comment

The latest OECD proposals are a useful step forward towards reaching a consensus as to how MNEs are to be taxed on profits earned remotely in an increasingly digital economy. Reaching consensus on these issues is becoming more urgent as many jurisdictions are introducing interim unilateral solutions in this area due to political pressure to do something. Such solutions are often turnover based and as such are controversial and are not widely welcomed by business. They can lead to complexities and risks of double taxation.

The proposal outlined by the Secretariat is certainly not straightforward and requires significant further work and political agreement but in the long run a consensus based unified approach is to be welcomed as a huge improvement on piecemeal unilateral measures.