On March 13, 2019, the OECD began its two-day meeting with stakeholders on its February 13th consultation document to address tax challenges of the digitalization of the economy in Paris. The following individuals spoke on day one, among others, which covered the OECD pillar one proposals on the need for revised profit allocation and nexus rules:
- Paul Oosterhuis, Of Counsel, Skadden, Washington, D.C.
- Sol Picciotto, Emeritus Professor, Lancaster University, the U.K.
- Katherine Amos, Senior Director, Global Transfer Pricing and Tax Controversy, Johnson & Johnson, N.J.
- Ed McNally, Keidanren (Japan Business Federation)
- Francois Chadwick, Chief Tax Officer, Uber, California
- Manal Corwin, Principal in Charger, Washington National Tax Practice, KPMG
- Tommaso Faccio, Head of Secretariat, Independent Commission for the Reform of International Corporate Taxation (ICRICT), the U.K.
- Alison Lobb, Partner, Deloitte, the U.K.
On February 13, 2019, the OECD released a highly-anticipated consultation document on several proposals to better address the tax challenges of the digitalization of the economy. The purpose of the consultation is for members of the OECD Task Force on the Digital Economy (TFDE) to obtain feedback from the public, which had to be submitted in writing (Word format) to the OECD by March 6, 2019.
The consultation document reflects – at a high level – the work done by the TFDE since early 2017, and reflects several proposals revolving around two pillars: (1) the need for revised profit allocation and nexus rules; and (2) global anti-base erosion rules. The latter are modeled off, in part, the global intangible low tax income (GILTI) and base erosion anti-abuse tax (BEAT) rules, introduced by the U.S. Tax Cuts and Jobs Act (TCJA) in December 2017.
Regarding the allocation of taxing rights, the consultation document sets out the following proposals considered by member of the TFDE: user participation; marketing intangibles; and significant economic presence. All three proposals have the same goal of modifying current international tax rules to expand taxing rights of source and residence jurisdictions, to include activities that do not require a physical presence in a jurisdiction.
Paragraph 7 of the consultation document says that the proposals are being considered by TFDE members on a “without prejudice” basis, meaning that the member countries are not committing to implement any of the proposals, but they agree to examine the proposals.
Day 1 Consultation Meeting Highlights
Design and Administration Considerations
In summation, Mr. Oosterhuis said that the OECD BEPS project recommendations on development, enhancement, maintenance, protection, and exploitation (DEMPE) functions to determine transfer pricing treatment of intangibles do not solve all problems, because multinational enterprise (MNE) activities are now migrating to centralized locations, not to local jurisdictions. Countries must decide as part of the current TFDE digital work whether to move from a “value creation” to “value realization” model as a result. He added that safe harbors are needed to make the OECD “marketing intangibles” approach reasonable in application. Also, the legislative process to implement any OECD consensus could be challenging, such as with the current U.S. trade issues.
As the BEPS Action 8-10 report found, tax treatment of intangibles should be determined based on where underlying work related to it occurs, not based on legal ownership, according to Mr. Picciotto. Business models have become more integrated over the past 50 years, so the separate-entity transfer pricing system developed in 1935 should be updated. He added that the OECD technical work on the digital proposals will likely take more than two years. He agrees that data is now an important MNE asset, so it should be considered as a factor, if a formulary apportionment approach is adopted. He also tends to prioritize payroll as a factor for the formulary approach, since that is how MNEs tend to value their employees. Lastly, he does not favor baseball-style arbitration for dispute resolution in the new post-BEPS tax system that has increased transparency. Instead, tax authorities should use a more open process that results in a reasoned tax opinion.
Johnson & Johnson supports the arm’s-length principal, said Ms. Amos. She encourages others to look at what her company has done to simplify the amount of tax disputes and to propose their own solutions on the digitalization topic, rather than just reacting to whatever consensus the OECD reaches.
Mr. McNally finished the panel discussion by suggesting that the TFDE should confirm what principals to follow first as part of its digital tax work. He supports the “marketing intangibles” approach as of now, but the TFDE needs to develop a simple method that is easy to apply.
Overall Assessment of Pillar 1 Proposals
To start off the final panel session for day one of the consultation meeting, Mr. Chadwick said that the TFDE should not overlook the need to (1) create work for the general public and (2) stability in the international tax system. He added that now is the time to reassess the international tax framework with the OECD, based on various political pressures globally, without naming an example. He supports an approach that does not ring fence tax treatment of the digital economy, minimizes double taxation, and increases certainty and simplicity of understanding. Also, any OECD proposal should be able to survive the test of time.
Mr. Chadwick added that Uber’s business model was developed 10 years ago, so the current TFDE digital proposals should address ever-changing business models. Uber currently has a high amount of losses, so any turnover tax model is not reasonable. Uber is leaning towards adoption of the marketing intangibles approach, with some form of strengthened mandatory arbitration. He also said that the “user participation” approach picks winners and losers, and will lead to economic distortions, if adopted. Uber has many competitors with operations only at a local level in a country, so their business model may be different than that of Uber.
The “significant economic presence” approach creates two tax systems, according to Mr. Chadwick: formulary apportionment; and traditional rules for any residual income. The “marketing intangibles” approach can address expansion of tax nexus rules, and is the only TFDE approach that has any long-term sustainability, while maintaining use of current DEMPE function rules. In contrast, he said that the significant economic presence approach is not effective in taxing a company like Uber, as Uber already has boots on the ground in every country it operates in, due to regulatory requirements. While we would be moving away from the arm’s-length standard if consensus is reached on the marketing intangibles approach, using some safe harbors could extend the use of current transfer pricing rules.
Finally, Mr. Chadwick said that the TFDE needs to find common group as quickly as possible, and any consensus should not hinder business growth. He also does not understand the need for different tax treatment of financial and market intermediaries under the TFDE proposals.
Ms. Corwin said that two lenses should be used to evaluate the TFDE proposals for a solution: what is the problem that we are trying to solve; and what is the solution that is most likely to achieve consensus. Regarding the former, the impetus for the current TFDE conversation originates with the previous OECD BEPS negotiations. In fact, the BEPS project recommendations did increase allocation of taxing rights to market jurisdictions, especially via expansion of the dependent agent permanent establishment rules, among others. The OECD consultation document shows that concerns remain on effectively treating highly-mobile income. Principal-based solution should be adopted to ensure stability, and avoid need for third round of BEPS talks if businesses evolve to avoid application of second round rules.
Regarding the latter (i.e., what is the solution that is most likely to achieve consensus), Ms. Corwin said that there appears to be broad consensus on several principles (e.g., stability and global application) in the current TFDE discussions. We should not throw out the baby without the bathwater, meaning the value of the traditional international tax system and the BEPS project work to refine that system, to ensure stability in the tax system. She added that the TFDE should also think about what standards should be used to evaluate success of the new tax system.
Looking at the current OECD BEPS tax data that shows there is still a big difference in the effective tax rate (ETR) of regular and digital companies is not reliable, according to Ms. Corwin, since some BEPS recommendations are still being implemented by countries. Accordingly, more time is needed to evaluate the effect of the BEPS recommendations on ETRs.
Finally, Ms. Corwin said that any TFDE consensus needs to include a process to transition the unilateral country digital tax measures to the OECD’s ultimate approach, when reached. It will take time for the TFDE discussions to get the digital tax issue right, as there are many collateral issues (e.g., impact on income tax treaties). Regarding arbitration, she said that dispute prevention is the key.
Mr. Faccio said that complexity leads to increased avoidance of international tax rules, so the goal of the TFDE discussions should be to simplify the international tax system. ICRICT favors use of objective factors (e.g., value of R&D) in a formulary apportionment approach. The “user participation” approach is limited in scope, whereas the “marketing intangibles” approach is broad-based. However, he added that the marketing intangibles approach suffers from intangible valuation issues, because MNEs can use several tax advisors to come up with different values, which can lead to tax avoidance opportunities. ICRICT likes the simplicity of the “significant economic presence” approach, because it uses a formulaic approach with objective factors. ICRICT’s proposal consists of broader application of the profit split method (using total profits) through standardized splitting factors and weightings for common business models. Lastly, he agreed with others above that there needs to be transitions rules for any new tax system that may result out of the TDFE work.
Ms. Lobb finished the panel discussion by saying it is essential that there is broad agreement among countries on any revised international tax framework, based on consistent principals that minimize distortions between business types and locations. Corporate tax should be based on profits, allowing for deductions for business costs and losses incurred. She added that efficient dispute resolution mechanisms, including something like binding arbitration, will be needed. Simplification should be considered, where possible. A stable international tax framework is needed for the long term to ensure economic growth.
A lot of work remains to develop each TFDE proposal, according to Ms. Lobb. Regarding the “user participation” approach, she wonders whether there is enough profit margin in a business to reward “routine” returns and user participation. The “marketing intangibles” approach will require a high level of agreement among countries, as to the amount and share of the marketing intangibles residual profit. However, all of the proposals in pillar one of OECD consultation document require consideration of their interaction with other areas of tax, such as withholding taxes on royalties, customs and other duties, VAT/GST rules, and specific sector taxes (e.g., bank levies).
Lastly, any TFDE approach should allow for allocation of losses in the same way as for profits, said Ms. Lobb. Administrative simplification would be extremely helpful as well.
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