On October 9 2019, the OECD’s Secretariat published a proposal for public comment on the allocation of taxing rights and profits in the digitalised economy. The Secretariat also submitted the proposal to the G20. Comments are requested up until November 12, and will be followed by a consultation meeting on November 21-22.
The OECD’s work on addressing the tax challenges of the digital economy is currently divided into two segments. Pillar One deals with the allocation of taxing rights to market and user jurisdictions, and Pillar Two focuses on global minimum taxation. Together, the OECD anticipates that these proposals will lead to a significant increase in global tax revenues. The recent proposal from the Secretariat relates to Pillar One. A consultation document on Pillar Two is expected to be released in November.
Previously, members of the Inclusive Framework on BEPS had put forward three distinct proposals on taxing the digital economy: a user participation proposal, a marketing intangibles proposal, and a significant economic presence proposal. The Secretariat’s proposal does not reflect consensus among the OECD countries or Inclusive Framework members; rather, the Secretariat has put forward the proposal on its own initiative in an attempt to address the concerns of advocates of all three proposals and achieve a consensus solution. Achieving a consensus has become critical in light of unilateral measures to tax digital businesses that have been proposed and implemented by a number of countries. If this trend continues, it would lead to more tax uncertainty and a greater risk of double taxation.
The OECD’s new proposal for a ‘unified approach’, under Pillar One, would broadly cover consumer-facing businesses, even if they are not highly digitalised. It would create new nexus rules that are based on sales and that do not require physical presence in a jurisdiction. What is most innovative is the new proposal’s approach to determining the amount of income subject to tax in a market jurisdiction. First, the proposal would look at a multinational enterprise’s profit, possibly on a business line rather than an overall basis, and would subtract from it deemed routine profits for activities carried out by the business. A portion of the residual would then be allocated to non-routine profits not attributable to market jurisdictions, for example trade intangibles, capital, and risk, with the remaining non-routine profit allocated to each market jurisdiction. The proposal refers to this as ‘Amount A’, and makes it clear that simplifying conventions – rather than conventional transfer pricing rules – would be needed to determine such amount. Amount A therefore represents a limited override of the arm’s length principle.
The proposal does not stop there, however. It takes the position that Amount A should not replace the allocation of profit to distribution and marketing functions under traditional TP principles, and would therefore provide an additional allocation based on the presence of these functions: ‘Amount B’. While Amount B aims to reflect the value of functions performed, the proposal notes that it may be desirable again to apply simplifying conventions to approximate this value, rather than benchmark it on a case-by-case basis.
Of course, Pillar One is meant to ensure that market jurisdictions receive taxing rights, and not to limit their existing ability to tax profits properly allocable under traditional TP principles. Therefore, the proposal also includes an ‘Amount C’, which covers any amount in excess of the assumed return under Amount B that is allocable to the taxpayer’s activity in the jurisdiction in question.
Significant work remains to be done in hammering out the details of the proposal. While the proposal notes the need for effective mechanisms for dispute prevention and resolution, including the possibility of mandatory dispute resolution, it remains to be seen what these will be. Without an efficient system for eliminating double taxation, it is questionable whether an OECD solution would in practice be much more effective than the proliferation of unilateral measures.
Nonetheless, the OECD should be applauded for taking proactive steps that will encourage consensus and further progress. The Secretariat’s proposal aims to balance adherence to the arm’s-length principle, which has been the mainstay of TP for decades, with the need to placate countries that favoured the fractional apportionment approach. The result is a somewhat limited overlay that employs assumptions and simplified conventions to determine the profits allocable to market jurisdictions, but otherwise leaves the current TP system intact. It is to be hoped that the Inclusive Framework will be able to develop consensus on this basis.