The Organisation for Economic Co-operation and Development (OECD) has issued a policy note document (Note) addressing the tax challenges of the digitalization of the economy under its action plan with respect to base erosion and profit shifting (BEPS). The Note follows the 2015 OECD BEPS Action 1 Report and the 2018 OECD Interim Report on tax challenges arising from digitalization, which provided an analysis of value creation across business models in a digital economy and noted that a final report will be provided in 2020 with an update in 2019.
The notion of creating a digital permanent establishment is inconsistent with the OECD’s initial conclusion that “it would be difficult, if not impossible, to ring-fence the digital economy,” yet the consensus seems to have moved towards determining whether an entity has a “digital presence.” For a detailed discussion on the background of the Note and the implementation of unilateral digital tax measures in a number of jurisdictions, see the Eversheds Sutherland articles on Taxing the digital economy –OECD update and Taxing the Digital Economy (published in Tax Journal on March 2, 2018).
Specifically, the Note identifies two central pillars under which proposals will be evaluated to reach a consensus. The first pillar focuses on modifying the existing rules that allocate the taxing rights for the income of multinationals among jurisdictions to address the tax challenges of the digital economy. This would include how to determine the connection a business has with a given jurisdiction (i.e., nexus), and how much profit should be allocated to the business conducted there under transfer pricing rules and the arm’s length principle. On nexus, changes to the permanent establishment threshold, including concepts of significant economic presence and significant digital presence, will be examined. Several proposals under review would allocate additional taxing rights to market or user jurisdictions when value is created by a business activity through customer participation in the user or market jurisdiction that is not recognized in the existing allocation of profit rules. The inclusive framework recognizes that these issues of nexus and profit allocation would need to be developed contemporaneously and may require changes to tax treaties.
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Eversheds Sutherland Observation: The evolving concepts of nexus and profit allocation under consideration are fundamental conceptual changes and are blurring the lines between direct and indirect taxation concepts. These developments also parallel developments happening in US state and local taxes as illustrated by South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (U.S. 2018). In Wayfair, a state’s right to require three large online sellers to collect sales tax was upheld by the US Supreme Court where the sellers’ only connections to the state were state residents who purchased goods. The decision overruled a series of long-standing decisions that a seller must have a physical presence in the state. A closer dialogue among international direct and indirect tax practitioners and their US state and local tax colleagues should enhance everyone’s ability to navigate these rapidly changing environments and determine whether there is in fact a yellow brick road. |
The second pillar focuses on the remaining BEPS challenges to strengthen the ability of jurisdictions to tax profits where the other jurisdiction with taxing rights applies a low effective rate of tax to those profits. The proposals under review for this pillar would develop two interlocking rules (i.e., an income inclusion rule and a tax on base eroding payments) designed to address the risk of profit shifting to entities subject to no or very low taxation. The inclusive framework takes into account that these proposals would reflect recent developments including US tax reform. This second pillar also reflects the approach outlined by Germany, France and Spain in their global anti-base-erosion (GLOBE) tax proposal, which would impose an effective minimum tax on digital companies globally.
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Eversheds Sutherland Observation: While the GLOBE tax proposal is still at an early stage, similar to the Note, the goal is to prevent unfair tax competition by effectively preventing multinational companies from artificially shifting profits to no or very low tax locations by setting an international floor for corporate tax rates. The effects of the GLOBE tax proposal could be significant since the focus of the measure appears to be “effective” tax rates, not “nominal” tax rates. Potential state aid and World Trade Organization (WTO) compatibility issues may arise, depending on the tax deductions/credits/exemptions to be included (if at all) in calculating the effective tax rate. Further, double taxation issues may also be an issue with respect to domestic global minimum and base erosion taxes that are unilaterally implemented and under controlled foreign corporation (CFC) regimes generally.
The United States has sought to address both the income inclusion and base erosion points in US tax reform as acknowledged in the Note. This includes a global intangible low-taxed income (GILTI) regime, which requires income inclusion of much of the income of CFCs to ensure it is subject to a minimum global rate of tax after a partial foreign tax credit. There is also a base erosion and anti-abuse tax (BEAT) that effectively disallows related party deductions if they exceed 3% of the taxpayer’s total expense base. On the WTO compatibility point, the United States has permitted foreign tax credits under GILTI but not under the BEAT.
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In light of the significance of the approaches and the development work required, the inclusive framework will issue a consultation document describing the two pillars in more detail, and a public consultation will be held March 13 and 14 of this year in Paris. Further details on the consultation process, including how stakeholders can provide input and most effectively participate, along with the consultation document, will be published in the coming weeks. A detailed work program will be presented at the next inclusive framework meeting in May, and the progress will be reported to the G20 finance ministers in June, with the solution anticipated to be delivered in 2020.
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