On Feb. 13, 2019, the OECD released a public consultation paper titled “Addressing the Tax Challenges of the Digitalisation of the Economy” (Consultation). The Consultation follows the policy note issued by the Inclusive Framework on Base Erosion and Profit Shifting (BEPS) several weeks earlier and is a significant step towards the OECD’s objective of reaching consensus on proposals to tax the digitalized economy by 2020.
The potential scope and application of the proposals contained in the Consultation is wide-reaching. Many of these proposals would apply not only to highly digitalized business models (e.g. search engines, social media platforms, and online marketplaces) but also to the activities of many traditional business models operating in the digital age (potentially affecting any business that, for example, collates and utilizes customer data). Consequently, all businesses should closely monitor these developments.
In this respect, the Consultation is helpful, despite stressing that the outlined proposals are still at the design phase and are consequently described only at a high level, because this is the first time the OECD has put forward, at some level of detail, practical proposals for taxing the digital economy. Thus, the Consultation provides a current snapshot of what is being discussed by OECD member countries and at least some clarity for businesses on the likely direction of these efforts.
Eversheds Sutherland Observation: The OECD’s Task Force on the Digital Economy (TFDE) held a hearing to discuss these proposals with the public on March 13-14, 2019 (comments were due by March 6, 2019). Speakers and other participants were selected from among those having provided timely written comments.
The Consultation’s taxing proposals are broadly divided into two areas:
- (1) Revised Profit Allocation and Nexus Rules
These proposed rules are intended to recognize (and tax) value created by a business from its activities or participation in user/market jurisdictions not recognized under existing international tax rules. Under these new profit allocation and nexus rules, that value would be allocated to such user/market jurisdictions, allowing them to tax this value, regardless of a business’s physical presence (or lack thereof) in such jurisdictions. Specifically, the Consultation puts forward three separate proposals to effect this revised profit allocation concept:
(a) The “user participation” proposal,
(b) The “marketing intangibles” proposal, and
(c) The “significant economic presence” proposal.
The main features of these proposals are summarized below.
- (2) Global Anti-Base Erosion Proposal
This proposal is intended to address remaining BEPS concerns accentuated by a digitalized economy. For that purpose, the proposal sets out two inter-connected rules designed to give jurisdictions taxing rights where income is subject to no or only very low taxation. In this regard, this proposal seems to borrow heavily from the global intangible low-taxed income (GILTI) and base erosion and anti-abuse tax (BEAT) regimes introduced in the U.S. as part of its recent, comprehensive tax reform.
Eversheds Sutherland Observation: The Consultation explicitly notes that these proposals are being considered by the members on a “without prejudice” basis, meaning that these countries are not in any way committed to implement any of them, but that they agree to at least examine them.
1. Revised Profit Allocation and Nexus Rules
The Consultation, first, presents proposals addressing the “broader tax challenges” to the existing profit allocation and nexus rules, which would modify those rules based on the concepts of: (1) user participation, (2) marketing intangibles, and (3) significant economic presence, each of which is further described below. As stated above, these proposals are intended to recognize (and tax) value created by the activities or participation of a business in a jurisdiction that is not currently recognized (and taxed) by the existing international taxation framework. This issue typically arises where a business can significantly engage with a user/market jurisdiction with little or no physical presence therein, a phenomenon that digitalisation is making increasingly prevalent. As the Consultation notes, citing the OECD’s 2018 Interim Report, generally three key characteristics (sometimes working together)—i.e. scale without mass, a heavy reliance on intangible assets, and the role of data and user participation—enable highly digitalized businesses to create value by activities closely linked with a jurisdiction without needing to establish a physical presence therein.
It is recognised in the Consultation that significant overlap exists between these proposals and that a final proposal might involve a combination of features from all three proposals described.
a. The ‘User Participation’ Proposal
The “user participation” proposal focuses on capturing the value created by certain highly digitalized businesses through developing an active and engaged user base and then soliciting data and content contributions from them. This proposal is relatively targeted, with affected businesses broadly falling into one of three categories: (1) social media platforms, (2) search engines, and (3) online marketplaces.
For this purpose, this proposal would modify existing profit allocation rules to require that, for certain (highly digitalized) businesses, a portion of their profits be allocated to jurisdictions in which those businesses have an active and participatory user base (the so-called “user jurisdictions”), irrespective of whether those businesses have a local physical presence.
The Consultation document recognizes the difficulties in using traditional transfer pricing methods to determine the specific amount of profit that should be (re-)allocated to such a user jurisdiction, and instead, proposes that such amount should be calculated based on a non-routine or residual profit split approach. On a basic level, this would involve:
(1) Calculating the residual or non-routine profits of a business (i.e., the profits that remain after routine activities have been allocated an arm’s length return);
(2) Attributing a proportion of these profits to the value created by the activities of the user base of a business (this could be determined, for example, through quantitative/qualitative information or a pre-agreed percentage);
(3) Allocating these profits between the user jurisdictions using an agreed allocation metric; and
(4) Giving those jurisdictions a right to tax the allocated profits, irrespective of whether the business has a taxable presence in their jurisdictions that meets the current nexus threshold.
Eversheds Sutherland Observation: While the U.K. supports this “user participation” proposal, the U.S. opposes it, arguing that it improperly targets mainly large U.S. digital companies and not businesses generally.
b. The ‘Marketing Intangibles’ Proposal
The “marketing intangibles” proposal looks at the value of “marketing intangibles” to businesses, either: (1) used to reach into customer/user jurisdictions, or (2) derived from such jurisdictions. “Marketing intangibles,” as proposed in the Consultation, is a wide concept. Examples include the brand or trade name of a business created by the favorable attitudes of customers in a market jurisdiction, or customer lists and customer data derived from activities in a market jurisdiction.
The basis of this proposal is that such marketing intangibles have a value to businesses and that value is derived from these market jurisdictions. Consequently, this value should be attributed to and taxed by the relevant market jurisdictions.
The proposal would operate similarly to the “user participation” proposal by modifying current profit allocation and nexus rules to require that non-routine or residual income of businesses attributable to such marketing intangibles be allocated to the relevant market jurisdictions. The market jurisdictions would then have the right to tax this income, regardless of physical presence considerations.
The allocation of non-routine or residual income between marketing intangibles and other income producing factors could, as envisioned in the Consultation, be determined through different methods. One possible approach would be to apply normal transactional transfer pricing principles. Alternatively, the allocation could be made under a revised residual profit split analysis that uses more mechanical approximations (involving, broadly speaking, the deduction of routine profit from total profit and the division of the remaining or “residual” profit). Once the amount of income attributable to marketing intangibles is determined, it would be allocated to the relevant market jurisdictions based on an agreed metric. Similarly to the “user participation” proposal, this could be determined by reference to the customers being targeted by the marketing or advertisement.
Eversheds Sutherland Observation: The members advancing this proposal already seem to anticipate significant risks of controversy and double-taxation for businesses. For that reason, the Consultation emphasises that in connection with the implementation of the “marketing intangibles” concept, taxpayers should also be afforded early certainty on their taxation under this approach and have a strong dispute resolution mechanism available. On this point, Lafayette G. “Chip” Harter, deputy assistant secretary of international tax affairs at the Treasury Department, remarked at a February 14 Tax Council Policy Institute conference in Washington, DC, that a workable solution will be “something that gives the market jurisdiction somewhat more than they’re getting now, plus a very administrable rule to avoid and minimize controversies on exam in various market jurisdictions, which have been a real problem under the current system.”
c. The ‘Significant Economic Presence’ Proposal
Under the “significant economic presence” proposal, a taxable presence in a jurisdiction would arise when a non-resident enterprise has a significant economic presence on the basis of factors that evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means. Revenue generated on a sustained basis would be a factor in determining significant economic presence, but alone would not be sufficient to establish relevant nexus. Thus, only when combined with other factors—such as: (1) existence of an active and engaged user base in the jurisdiction, (2) the volume of digital content derived from the jurisdiction, or (3) sustained marketing and sales promotion activities to attract customers in the jurisdiction—would revenue potentially be sufficient to create nexus in the form of a significant economic presence.
The proposal contemplates that the allocation of profit to a significant economic presence could be based on a fractional apportionment method, as follows:
(1) Defining the tax base to be divided,
(2) Determining the allocation keys to divide that tax base, and
(3) Weighting these allocation keys.
The Consultation suggests that the tax base could be determined by applying the global profit rate of a business (or group) to the revenue (sales) generated in a particular jurisdiction. The tax base would then be apportioned by taking into account factors such as sales, assets, and employees. In addition, the proposal further contemplates that for businesses for which users meaningfully contribute to the value creation process, users would also be taken into account as a factor in apportioning income.
Eversheds Sutherland Observation: This proposal (in line with the BEPS Action 1 Report) also contemplates the addition of a withholding tax as a collection mechanism and enforcement tool that would apply on a gross basis at a low rate to payments to any business with a significant economic presence. Such businesses would then have the right to file an income tax return in the relevant jurisdiction and seek a refund of amounts withheld exceeding its actual income tax liability. Even at a low rate, a gross-basis withholding tax may result in a high final tax relative to net income. In addition, such a withholding tax would severely increase tax compliance burdens and costs for businesses with digital activities in many current non-filing jurisdictions.
2. Global Anti-Base Erosion Proposal
The main policy rationale behind the introduction of this proposal is to tackle issues of double non-taxation. Although the BEPS project has already tackled this issue to some extent (particularly through substantive changes brought in to double tax treaties through the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“Multilateral Instrument” or “MLI”)), the OECD notes that some countries consider that the BEPS measures introduced do not entirely eliminate the risks of profit shifting to low- or no-tax jurisdictions.
The proposal is intended to ensure that all internationally operating businesses pay a minimum level of tax, and its scope is not limited to highly digitalized businesses. To this end, two inter-related rules that are intended to operate in tandem have been proposed:
(1) An income inclusion rule, and
(2) A tax on base eroding payments.
a. Income Inclusion Rule
The OECD describes this rule as a “rule that would tax the income of a foreign branch or a controlled entity if that income was subject to a low effective tax rate in the jurisdiction of establishment or residence.” It is targeted at disincentivising profit shifting from high-tax jurisdictions to low-tax jurisdictions.
This rule is intended to operate akin to a controlled foreign corporation (CFC) rule and will draw on aspects of the new U.S. tax measures in relation to the GILTI regime. Significantly, however, the OECD version currently under discussion would be determined on a CFC-by-CFC basis unlike the U.S. aggregated CFC approach. As a recap, under tax code Section 951A, a U.S. shareholder must include in gross income its GILTI with respect to CFCs whose taxable years begin after Dec. 31, 2017. A U.S. shareholder does not compute a separate GILTI inclusion with respect to each CFC, but rather, it computes a single GILTI inclusion amount by reference to all of its CFCs. For a detailed discussion on GILTI, see the Eversheds Sutherland article. GILTI requires income inclusion of much of the income of CFCs to ensure that it is subject to a minimum global rate of tax after a partial foreign tax credit.
In the OECD proposal, if the income of a corporation is not subject to tax at the minimum tax rate (as yet undetermined), then shareholders of the company with a “significant” direct or indirect ownership interest will be required to bring into account a proportionate share of that income and pay tax on it, with such shareholders being entitled to credit for any underlying tax paid on the attributed income. The OECD suggests “significant” direct or indirect ownership could be 25 percent ownership; however, this percentage may change subject to the Consultation guidelines.
In relation to permanent establishments, this rule would modify the operation of the existing rules. If foreign branches are not taxed at the minimum rate of tax, this rule would necessitate “turning off” the existing rule that provides for an exemption of the foreign branch’s profits from tax and instead introduce a credit system. This would align the taxation of permanent establishments with subsidiaries.
Many countries already have established CFC rules in place. This income inclusion rule is not intended to replace existing CFC rules but is intended to “supplement” jurisdictions’ CFC rules.
b. Tax on Base Eroding Payments
This element has two measures to allow a source jurisdiction to protect itself from the risk of base eroding payments:
i. Undertaxed payments rule
This rule intends to deny a deduction for certain categories of payments (not yet defined) made to a related party (potentially based on a 25 percent ownership test like the income inclusion rule) unless those payments were subject to a minimum effective tax rate. This effective tax rate would consider any withholding taxes imposed on the payments and, taking into account changes brought in by the MLI, would include those withholding taxes imposed due to the denial of treaty benefits (i.e. through the operation of the principal purpose test or the limitation on benefits). By taking into account the tax rate in the recipient jurisdiction, this rule differs significantly from the BEAT. The BEAT functions as a minimum tax on corporations that have annual average gross receipts over a three-year period ending with the prior taxable year of at least $500 million, and have a “base erosion percentage” of at least 3 percent (or 2 percent in the case of banks and registered securities dealers). For a detailed discussion on the BEAT, see the Eversheds Sutherland article.
ii. Subject to tax rule
This rule would apply to undertaxed payments that would otherwise be eligible for double tax relief and would operate to deny tax treaty benefits if the income is insufficiently taxed in other jurisdictions. The main double tax treaty articles that would likely be impacted are Article 7 (business profits), Article 9 (associated enterprises), Article 10 (dividends), Articles 11-13 (interests, royalties and capital gains), and Article 21 (other income). It is undecided whether this rule will apply only to payments between related parties or more broadly to any payments, which the OECD is considering at least in relation to the interest, royalties, and capital gains articles.
Eversheds Sutherland Observation: While it may be challenging to implement a minimum tax or a comprehensive base erosion tax in practice, global consensus may be more easily reached on this proposal as the U.S. has already adopted a similar concept under the GILTI regime. The U.S. also has incentives to work on improvements on BEAT to make it more consistent with the proposal to protect its multinationals from being at a disadvantage. Also, based on recent EU digital tax negotiations, France and Germany seems to favor this approach.
As has been noted above, these proposals will potentially impact a very wide range of businesses, possibly far beyond the scope that many may have anticipated. If all or a portion of these proposals are eventually introduced on a consensus basis by OECD countries, these measures will represent a fundamental shift in international tax policy and a move away from traditional physical presence-based taxation.
The logistics for effecting such change appear significant, not only in terms of achieving agreement on these proposals in principle and the more granular mechanical details set out in the Consultation, but also in terms of all the “knock-on” changes required to treaty and domestic law to implement the proposals. However, this Consultation does seem to indicate a growing consensus within the OECD for new measures to tax the digitalized economy and this—coupled with the increasing quantity of unilateral tax measures targeting digital transactions and business models—means that all businesses with digitalized operations need to pay close attention to the continuing developments in this area.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Randy Buchanan and Carol Tello are partners in Eversheds Sutherland’s Washington office. Ben Jones is a partner in London. Amanda Cooper is counsel in Atlanta. Robert Christoffel and Hyowon Lee are associates in Washington, and Kunal Nathwani is an associate in London.