All options on the table would mean a drastic change in international tax norms and the end of the arm’s-length principle (ALP) looks increasingly certain, but many companies are searching for a ‘lesser evil’ in this debate.
“The residual profit split makes a distinction between routine and non-routine profits that the fractional apportionment method does not,” said Severine Baranger, counsellor at the Centre for Tax Policy and Administration at the OECD.
“Each proposal would allocate more taxing rights to market jurisdictions and each would depart from the traditional arm’s-length principle based on transactional prices by taking into consideration total profits and simplification measures,” Baranger said.
Both businesses and NGOs have concerns about tax certainty and the risks of double taxation and non-taxation. The OECD has tried to address these concerns by holding consultations with major business groups and NGOs.
The February-March consultation 2019 took on more than 200 submissions and over 2,000 pages of comments. The organisation even adopted a proposal by Johnson & Johnson to use marketing intangibles as part of a destination-based solution.
Nevertheless, the business community is still very concerned about the proposals to abandon the ALP in favour of less well-known standards. “The arm’s-length principle is something that we know and understand well,” said one head of TP at a pharmaceutical company.
“We know how to attribute profit appropriately under the existing system,” the head of tax told TP Week. “It’s a useful mechanism.”
Businesses fear that the erosion of arm’s length will inevitably open the door to formulary apportionment, but this shift is far from certain given that the OECD is still navigating the different interests in this debate.
“We’ve gone from technical and economic approaches to more political discussions about making everyone happy,” one TP director at an energy group said. “It’s a shame from an economist’s perspective.”
Others are still confident the existing rules will be difficult to throw out completely. However, the risks of revising the rules and getting it wrong are very real.
“The principle will not become redundant any time soon, but it seems inevitable that we will move away from it,” the tax executive said.
“The risk is that this will encourage businesses to take investments elsewhere, where there aren’t a lot of users and marketing expenditure is low,” she said. “This is a problem if you care about investment.”
What happens in the next year may determine the course of the next century of tax policy. The OECD has its work cut out for it, the deadline is not getting any longer and the results are unlikely to satisfy everyone.
The next century of tax
The OECD does not just have to listen to big business when it comes to digital tax. A whole eco-system of progressive NGOs, centre-left think tanks and anti-tax avoidance campaigns has emerged in recent years.
One of the key figures in this eco-system is Sol Picciotto, senior advisor to the Tax Justice Network, who coordinates the BEPS Monitoring Group.
“Large companies exploited this independent entity principle – known as the arm’s-length principle – by creating intermediary entities in convenient locations,” Picciotto said. “Those locations became the first tax havens.”
“Companies would transfer assets or activities to low-tax jurisdictions and charge the entity for the use of those assets or activities, for example IP rights, to reduce taxes on business profits,” he said.
As far as Picciotto is concerned, the BEPS project has not gone far enough. However, the OECD has adopted key parts of what the NGO community has advocated and the renewed focus on fractional apportionment is a sign of their influence.
The Tax Justice Network had three aims when it was launched in 2003: country-by-country reporting (CbCR), automatic information exchange (AEOI) and unitary taxation. The big question is whether the third aim is about to become the norm in international tax.
At the same time, there are serious questions about how exactly to implement the formula necessary for a unitary tax system. The Independent Commission on the Reform of International Corporate Taxation (ICRICT) takes a different line on this.
“A move to allocate greater taxing rights on sales in market jurisdictions will mostly benefit developed countries,” said Valpy FitzGerald, commissioner at ICRICT. “All apportionment rules are arbitrary and politically negotiated.”
“The standard formula – assets, staff and sales – might shift revenue to developed countries, but there would be no great gains to developing countries unless employment was given much greater weight in the formula,” he explained.
The world has been here before. The League of Nations considered formulary apportionment back in the 1920s when it was designing the existing tax system. It was possible to offset fundamental questions about tax when the global economy was based on physical assets and activities.
Today tech companies can operate globally without ever opening shop in more than a handful of locations. NGOs are now wondering how formulary apportionment could address the imbalance between the developed and developing world.
“Another possibility is the addition of a fourth weight, taking into account the level of development in the country itself,” FitzGerald said. “This has been used in trade negotiations and GATT includes special provisions to do this.”
“You take the GDP per capita of the country and the poorer the country, the larger the share of the apportioned profits,” he added.
The OECD has to sift through the different policy positions and find a consensus. The debate on digital tax may seem far-fetched, but the international tax system has already undergone several changes that were once unimaginable. Watch this space.