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 Task Force on the Digital Economy (TFDE) to obtain feedback from the public, which must be submitted in writing (Word format) to the OECD by March 1, 2019. The TFDE will then hold a public hearing on the consultation proposals on March 13-14th at the OECD headquarters in Paris. Speakers and participants will be chosen based on written submissions on the consultation document.
Editor’s Note: While not stated in the consultation document, the Director of the OECD Tax Policy Centre, Pascal Saint-Amans, said during a “Tax Talks” webcast on January 29th that the results of the public consultation would be evaluated by members of the TFDE to prepare an updated digital tax interim report during their May 2019 meeting, before being delivered at the G20 Finance Ministers meeting in June 2019 in Japan.
Lack of multilateral agreement on the BEPS Action 1 final report in 2015 led to unilateral country measures, with the German G20 Presidency asking the OECD for an interim report in March 2017. As a result, in March 2018, the OECD released an interim report, which discusses the following key features of the digitalized economy: (1) cross-jurisdictional scale without mass; (2) heavy reliance on intangible assets; and (3) the importance of data and user participation. Three groups of jurisdictions emerged in the multilateral negotiations leading up to the 2018 interim report, with some saying no major changes are needed due to increasing BEPS project implementation, and others advocating for changes to address broader challenges caused by digitalization of the economy. However, all countries agreed to work towards a consensus-based, long-term solution. (Paras. 2-4 of consultation)
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.
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.
Revised Profit Allocation and Nexus Rules
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.
The consultation document says that while the BEPS Action 7 recommendations on preventing permanent establishment (PE) avoidance tightened the rules on creating taxing rights (i.e., nexus), the Action 7 recommendations still allow for certain digitalized businesses to structure their operations by using local affiliates, with no ownership interest in intangible assets and that do not perform any DEMPE functions, to avoid creating a taxable presence. This allows multinationals to allocate only a modest return to such limited risk distributor models. Members of the TFDE see a need to expand current nexus rules to address these deficiencies of the OECD BEPS project. (Para. 7 of consultation)
User Participation and Marketing Intangibles Proposals
The U.K. supports the “user participation” proposal; whereas, the U.S. opposes it as it would only apply to digitalized business models (e.g., social media platforms, search engines, and online marketplaces), not to all businesses. Supporters of this proposal say that users of digitalized businesses contribute to their growth and generation of valuable data, according to the consultation document.
Regarding the allocation of profits, the “user participation” proposal would use a residual profit split approach to calculate non-routine profits, similar to the approach of the “marketing intangibles” proposal. Under the “user participation” and “marketing intangibles” proposals, profits from routine business activities would be allocated under existing arm’s-length principles. Once the residual or non-routine profits are calculated, they would then need to be allocated among affected jurisdictions where the business has users, based on some agreed allocation metric, such as revenues. The consultation document says that the allocation could alternatively be based on formulas that would approximate the value of users. Realizing that such formula could lead to differing interpretations among jurisdictions, the consultation document says that both proposals would have to include strong dispute resolution rules.
While the “marketing intangibles” proposal would also apply a profit split approach to allocate profits, it would apply to a wider range of businesses that have marketing intangibles. Covered intangibles would have the same meaning as in the 2017 OECD Transfer Pricing Guidelines, to include such things as trademarks, customer lists and data, among others. (Para. 29 of consultation)
Focusing on trade intangibles would be lead to more accurate tax results, because such intangibles have the same value wherever they are located. Focusing on marketing intangibles allows for more accurate tax allocations, because their value can change in various jurisdictions. (Paras. 34-36 of consultation)
Paragraph 35 of the consultation document says that while the BEPS Action 8-10 final report made progress on mitigating BEPS concerns, companies are still able to shift income attributable to marketing tangibles by exercising only a relatively modest degree of decision making capacity in a jurisdiction. Also, marketing intangibles are easier to shift across jurisdictions, compared to trade intangibles that consist of substantial and observable activities in specific locations. In contrast, lower communication and transportation costs have allowed multinationals to interact with customers in various markets without any physical presence, according to paragraph 38 of the consultation document.
Accordingly, the marketing intangibles proposal would allow allocations of some (or all) non-routine returns, regardless of which entity in the multinational group owns legal title to the intangibles, performs or controls DEMPE functions (i.e., development, enhancement, maintenance, protection, and exploitation of intangibles), and how risks related to the intangibles are allocated, among others. (Para. 44 of consultation)
Significant Economic Presence
The first pillar of the consultation document also discusses the “significant economic presence” proposal, which Mr. Saint-Amans said is supported by Colombia, India, and other developing jurisdictions, during the January 29th OECD webcast. This proposal would create a taxable presence in a jurisdiction based on a significant economic presence of a non-resident taxpayer, through purposeful and sustained customer interaction via digital technology or other automated means.
The following factors could be relevant to determine whether an entity has a significant economic presence in a jurisdiction:
- Existence of a user base and the associated data input.
- Volume of digital content derived from the jurisdiction.
- Billing and collection in local currency or with a local form of payment.
- Maintenance of a website in a local language.
- Responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services, such as after sales service or repairs and maintenance.
- Sustained marketing and sales promotion activities to attract customers. (Para. 51 of consultation)
Unlike the first two proposals (i.e., user participation and marketing intangibles) that would apply some form of a profit split approach to allocate income among jurisdictions, the significant economic presence proposal would allocate income based on fractional apportionment, determined as follows:
- The definition of the tax base to be divided.
- The determination of the allocation keys to divide that tax base.
- The weighting of these allocation keys. (Para. 52 of consultation)
The tax base could be determined based on factors (e.g., sales, assets, and employees). The significant economic presence proposals would use a withholding tax as a way to collect and enforce the expanded nexus rules. (Para. 55 of consultation)
Other Considerations
The user participation and marketing intangibles proposals could be determined based on each member of a consolidated group, as opposed to a consolidated approach. However, the consultation document says that this approach could raise data availability issues, and cause increased complexity and uncertainty for taxpayers. (Para. 72 of consultation)
Mindful of the impact the allocation proposals may have on income tax treaties, the consultation document says that existing treaties would need to be amended to eliminate any double taxation, such as in Articles 5 (definition of a PE) and 7 (allocation rules). (Para. 82 of consultation)
To ensure effective application of the allocation proposals, tax authorities could gather information from tax accounting or financial data, and country-by-country report filings. (Para. 85 of consultation)
Global Anti-Base Erosion Proposal
The second pillar addressed by the consultation document involves global anti-base erosion proposals modelled off the U.S. GILTI and BEAT rules, an approach favored by France and Germany based on recent EU digital tax negotiations.
This pillar would include two related rules: an income inclusion rule; and a tax on base eroding payments. The income inclusion rule would tax income of a foreign branch or controlled entity, when it is subject to a low effective tax rate. (Para. 92 of consultation)
According to paragraph 96 of the consultation document, the income inclusion rule “would supplement rather than replace a jurisdiction’s [controlled foreign company]
rules,” as with the U.S. GILTI rules. The proposal would apply to any shareholder with a significant direct or indirect ownership interest in another country. In contrast to the U.S. GILTI rules, the proposed income inclusion rule would apply on a per jurisdiction basis.
Among the outstanding technical issues to be discussed by the TFDE regarding the income inclusion rule are (1) the minimum level of ownership or control required for the rule to apply, (2) the design of any thresholds or safe harbors, (3) whether the covered income should be taxed at a minimum rate (e.g., the U.S. GILTI approach) or under the full corporate income tax rate, and (4) ways for avoiding double taxation through use of foreign tax credits or corresponding adjustments. (Para. 100 of consultation)
The tax on base eroding payments would protect source jurisdictions from the risk of such payments. This would be broken down into two rules: an (1) undertaxed payments rule to deny deductions for payments to related parties; and a (2) subject to tax rule to deny tax treaty benefits when the applicable income is not sufficiently taxed in the other treaty jurisdiction. (Para. 101 of consultation)
According to paragraph 103, the TFDE proposes using a 25% common ownership test to determine whether a payment is to a related party for the undertaxed payments rule, which is similar to the BEPS Action 2 recommendations for hybrid mismatch arrangements.
Among the technical issues to be worked out by the TFDE for the undertaxed payments rule are (1) determining the scope of payments to be covered, (2) whether applicable deductions should be denied and full or in part, and (3) whether the effective tax rate should be determined on an entity-by-entity or transaction-by-transaction basis. (Para. 105 of consultation)
With regards to tax treaties, the subject to tax rule could deny treaty benefits in the source jurisdiction if the residence jurisdiction does not sufficiently tax dividend, interest, royalty, or capital gain payments. (Para. 106 of consultation)
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