The OECD released its long-awaited report on digital tax just in time for the US Council for International Business (USCIB) to analyse the document at its conference in Washington DC, where business leaders and tax officials came together to discuss the topic.
The document lays out the OECD’s pillar one proposals to reform digital tax, such as marketing intangibles, user participation and significant economic presence. Pillar two attempts to complete the work of the BEPS project with three possible routes: fractional apportionment, destination-based taxation or a global minimum corporate rate.
“The big difference between pillar one and the BEPS project is that pillar one is a process that will involve re-allocating income and tax bases from active trade or businesses in higher tax countries, whereas with BEPS it was starting to tax non-taxed income located 'nowhere',” Sample said.
“Many countries were not hurt so much when BEPS re-allocated non-taxed income from nowhere, but in the case of pillar one, countries will lose income and their tax base,” he stressed. “Pillar one is a highly political process, even more so than BEPS was. It requires a political solution.”
Sample chairs the USCIB tax committee, but he also serves as vice chair of the Business at the OECD (BIAC) tax committee. He represented Microsoft on all worldwide tax policy and regulatory matters for more than a decade as corporate tax director, before taking on the role of tax policy advisor in 2017.
Sample told TP Week that whatever route governments agree to on taxing the digital economy, it is important that the income allocation is modest and the mechanism for allocating that income is simple. “But it also needs to be based on agreed principles to be sustainable,” Sample added.
Back to first principles
What those agreed principles will look like is still uncertain. However, the trend may be to seek out alternatives to the arm’s-length principle (ALP) and possibly even a completely different international tax system.
“The principles are not going to be the same as the arm’s-length standards that govern international transactions,” Sample said. “The objective of pillar one is to allocate more income to the marketing jurisdiction away from the R&D and production jurisdictions – even though there may be no business activities in the marketing jurisdiction in many cases. That’s quite different to the current arm’s-length principle.”
“Whatever the arm’s-length standard is for the modest allocation, there needs to be a firm consensus among the governments on the mechanism in place,” he explained. “Some governments are going to have to give up tax revenue for others to gain revenue.”
Many technology companies fear that the outcome of the OECD talks will be more double taxation and legal problems. The danger is that if governments fail to abide by the rules there could be irreconcilable disputes all over the world.
Yet it is not clear if the OECD is about to abandon the ALP either. Even though the organisation has made it clear that it is willing to “look beyond” this fundamental principle. The documents released still fall back on the ALP in all but a couple of instances.
“The arm’s-length principle still plays a significant role in the pillar one items with the exception of the significant economic presence proposal and formulary apportionment,” Sample pointed out.
“Pillar one is about allocating incremental, non-routine returns to the marketing jurisdiction and there is still a significant role for arm’s-length pricing to play in computing that allocation,” he added.
There are good reasons for businesses to fear the erosion of arm’s length. Some companies would argue that the OECD has already gone too far down this road.
“The nice thing about the arm’s-length standard is that it does give you a common basis for transacting in a variety of situations, regions and operating models,” one tax director at a chemical company said.
“When you talk about digital apportionment you are almost singling out and identifying certain taxpayers to pay more than other taxpayers,” the tax director told TP Week. “This creates incentives that you may not like.”
At the same time, the ALP still seems to be out of date in a global economy rich with hard-to-value intangible assets and ‘disruptive’ business models. The difficulty of putting a price tag on certain intangibles is why many tax administrations are turning towards a value chain analysis.
“Arm’s length is still workable, it still gives the right result in a lot of cases,” said one head of international tax at a software company. “It’s more of an art than a science when it comes to data and comparable sets.”
Arm’s-length pricing has been a key fiscal principle for decades. It’s going to be difficult for the international community to move away from this deeply entrenched standard. But this is not the only possibility.
“You can bend the arm’s-length principle without breaking it,” Sample said. “There are also ways to allocate a pool of income that are a little more accurate than formulary apportionment. You could say formulary apportionment is brutally simple.”
When it comes to positive solutions, Sample sees the residual profit split method (RPSM) as a possible route out of this predicament. He suggested that the complexity of the method is not a problem for large-scale corporations and it might actually end up being simpler for governments in the end.
“The residual profit split is probably the most accurate way to determine how to attribute non-routine profits to the marketing jurisdiction,” he said. “Once you’ve done that you can allocate very easily, it’s just a question of a percentage.”
Bill Sample was speaking in a personal capacity in this interview.