The Organization for Economic Co-operation and Development (“OECD”) has published its consultation document on possible solutions to the tax challenges arising from the digitalization of the economy.
The consultation, published on February 13, 2019, is the latest in the line of projects started in 2015 with the base erosion and profit shifting ("BEPS") initiative which tackle this complex matter. As there remain significant hurdles to be addressed before a workable consensus can be achieved, global companies might question the benefit of paying much attention to the current debate.
It would, however, be a mistake to take such a view; there are potentially significant implications in both tax and compliance costs which could be very different depending on the agreed policy outcomes. It is worth paying attention to the differing proposals.
The OECD are tasked with finding a global solution which should be the preferred outcome for global businesses—it is also the most difficult to achieve.
It should also be noted that there is strong political momentum behind the introduction of a unilateral response. Both the U.K. and France have indicated that they will put a digital services tax in place if a multilateral outcome cannot be achieved. There are clear advantages especially in ensuring the avoidance of double taxation, in tackling this is with a coordinated global approach.
Although the OECD consultation document is necessarily detailed, there are high level messages that global businesses should focus on. The proposals apply to all companies, not merely digital businesses. This recognizes contemporary reality: the digital economy is all pervasive and cannot be ring fenced from the rest of the economy.
It should be noted, however, that when the detailed proposals are analyzed some of them will impact truly digital companies (e.g. social media platforms, search engines and online market places) more than others.
There will be new reporting and data analysis requirements placed on global companies whichever method is adopted. They will need to be able to identify and analyze market data to enable them to properly allocate their taxable profits and comply with the new rules.
There will be an increased compliance burden on companies and a continuing need to review existing structures to ensure that they continue to be fit for purpose and do not create commercial and tax inefficiencies.
The Tax Challenge of Digitalized Business
The tax challenges of digitalized business stem from their specific characteristics and the fact that traditional taxing measures largely focus on levying tax on activities that are closely linked to a physical presence in a country.
Existing tax rules are ill equipped to deal with digitalized businesses which often have significant scale but little mass in a country. These businesses are often are rich in intangible assets and sometimes develop value from user participation and data analysis. These characteristics work together to create value without physical presence in a country resulting in a country’s residents being heavy contributors to web-based platforms with many transactions but without under current rules a taxable presence.
The proposals to address this work by addressing the question of how businesses establish a taxable connection with a territory (usually referred to as “nexus"). Then the more difficult part of the exercise is to create a means by which profit (and tax) is allocated to the nexus. Nexus without an agreed profit allocation method achieves little in tax terms.
The means by which profit is allocated goes to the heart of the issue since it challenges individual country’s tax sovereignty and profoundly impacts international trade.
The OECD Proposals
The OECD tackles this challenge by putting forward three proposals, the third of which, “the significant Economic presence model”, has little commentary since it was proposed late in the consultation process.
The two other proposals are “the user participation model” and “the marketing and intangibles model.”
The “user participation model” starts with the assumption that users of a service in a given country create value by uploading information and interacting with online platforms. Typically, these are users of social media, search engines and online market places. The value created by such activities is not captured by traditional tax models.
The proposed model provides countries with the right to tax global companies on the basis that they have users in their country. The identification of users is relatively straightforward, the more difficult part concerns the measure of profit to be attributed to the relevant country. It is proposed that the non-routine profit (essentially the profit derived from the digital consumers after taking into account normal profit calculated on existing transfer pricing principles) will be allocated between countries on a formula basis.
The second method, “the marketing intangibles method,” is potentially broader in scope, since unlike the first method it is not solely focused on highly digitized business. This is because it seeks to allocate profit based on characteristics which are present in a wider range of companies. These are market intangibles such as customer lists, trade names or proprietary market intelligence.
Existing rules will be modified to give host countries the right to tax non-routine marketing income. The resulting profits will be allocated on a formula basis it is suggested by the number of customers in a country. This method has the potential to impact a much wider range of companies than the first proposal.
It is understood that different countries favor distinct approaches. The OECD are aware that the more complex allocation models place a disproportionate burden on developing countries which have more limited resources to administer complex processes. A key part of the OECD’s challenge is to arrive at a consensus view.
The third proposal reflects a desire by some countries to avoid complexity and uncertainty by proposing a highly formula-based approach. “The significant economic presence test” proposes that a tax base is calculated for a given country by such factors as the existence of a user base, a website in a local language, billing in local currency and other factors determinative of a local business activity.
Once it is established that a tax base exists, taxable income should then be determined by allocating weight to certain keys and generating a measure of taxable income. There is as stated above limited commentary on this measure, but it is clearly intended to be highly formulaic and simpler to implement and police.
Complexity vs Accuracy
While the above issues might appear on first reading arcane, they have very real tax consequences for global business. The more complex methods are likely to be more accurate methods of profit allocation and will probably reduce the incidence of economic distortions and double tax, since they have some regard to the underlying economic activity and profitability in a country. The highly formulaic approach has the benefit of relative simplicity although it is by no means a quick exercise when the underlying data gathering implications are dealt with. The results arguably have a tenuous connection with value creation.
Each method will have different implications for individual companies depending on the business sector in which they operate or whether it is consumer-based or business-to-business. There will be different outcomes depending on the scale of activities in a country, as, although it is proposed that a de minimus rule will be put in place for each of the methods, inevitably each one will have a different effect depending on the particular circumstances of a particular company.
The OECD have set themselves a target of 2020 to finalize their proposals and they have accomplished much in the four years since the BEPS initiative commenced, however there remains a long way to go.
Achieving a global consensus will not be straightforward; as the proposals challenge individual countries’ tax bases there are also significant procedural hurdles in adapting existing tax treaties to accommodate any revisions made. This should not deter global businesses from following the developments closely, as if implemented, they will have a fundamental impact on many companies’ global tax position.
Paul Falvey is a specialist Tax Partner in the Bristol Tax Group, BDO LLP U.K. He has considerable experience of working with international businesses and regularly advises on a range of corporate transactions including acquisitions and disposals, restructuring, and international tax planning.