The work of the OECD started with the recognition that existing tax systems do not adequately address the ability of enterprises to participate in an economy independent of physical presence. This recognition led the OECD to work towards a new international tax system through two “pillars”:
Pillar 1, which introduces a new taxing right on consumer facing businesses and certain highly digitized businesses for jurisdictions in which users or consumers reside, even when the taxpayer has no physical presence in the country; and
Pillar 2, a global minimum tax, which would apply to all large multinational groups, regardless of industry.
The blueprints released on October 12 represent a huge body of technical work on the design of each of these Pillars. However, they also revealed what had already been discussed in various public forums—that many key questions remain unanswered and the 137 members of the Inclusive Framework have not yet reached agreement on a specific, implementable plan. Perhaps of most importance is that we have seen a delay in the timeline for global agreement until mid-2021 (at the earliest).
This begs the question: what is next, and what can we expect over the coming months?
What Has Been Accomplished So Far?
The progress to date could be likened to the creation of a detailed blueprint for a city of the future, without having any agreement over how the construction may be funded, where and when the city should be built and who will be entitled to live in it.
Both reports are comprehensive, but they lack consensus in many key areas, particularly those that relate to policy rather than technical detail. The Pillar 1 proposal, for example, reflects a lack of consensus on the most basic questions of what types of businesses will be included in the new taxing regime, and what quantum of profit should be subject to the new right. The Pillar 2 proposal, in turn, does not yet reflect any global consensus on what an acceptable minimum global rate of tax may be.
It is not surprising in some respects—Pillar 1 and Pillar 2 go to the heart of the international tax system. They discuss how profits should be carved up between jurisdictions in a zero-sum game (Pillar 1) and have the potential to impact on jurisdictional tax sovereignty (Pillar 2). Those are not going to be easy political questions to address.
What is perhaps more surprising is that the technical detail has progressed to the level it has without political agreement on the fundamental building blocks. It is difficult not to feel that we are simply kicking the can down the road on a difficult conversation.
However, the OECD is seeking to create a framework for a discussion on the difficult political questions to make it more likely that agreement can be reached. The effort put in by the OECD reflects the urgency of the issue—while the OECD project is seeking to resolve an inherent tension in the current international tax system, some jurisdictions are simply not willing to wait any longer for a multilateral solution.
The Ticking Time Bomb
The Emergence of New Taxing Rights
Many territories believe that multinational businesses are able to benefit from their economies without contributing to the infrastructure that underpins the market (the issue at the heart of the Pillar 1 proposals). The current international tax framework, through an extensive network of tax treaties intended to promote international trade, actually prevents a jurisdiction from taxing a foreign business unless, in general terms, that foreign business is active through some form of physical presence in the country. Those rules and the treaty network they are built upon have enabled business to become truly global, but the advent of modern technology has placed huge tension on this existing structure.
Therefore, a number of territories (over 30 currently) are exploring or have already implemented new taxes which sit outside of the existing treaty network and are focused on taxing business that are participating in the local economy in a remote/digital manner. These are typically termed “digital services taxes” (DST), but the design and scope varies greatly around the world. To ensure the existing treaty network does not deny the right to taxation, these taxes tend to be based on gross revenues and often without any right to credit against other taxes on profits. Therefore, there are very substantial risks of multiple taxation of the same income, distorting competition and damaging international trade and growth.
The desire to prevent the spread of these unilateral measures is what is driving the OECD timeline. The theory is that if a multilateral solution can be reached quickly, countries can be dissuaded from going it alone with unilateral measures.
Dealing with Old Problems
Meanwhile many territories also continue to believe that there are too many opportunities and incentives for base erosion and profit shifting (BEPS) under current international tax rules. They are keen to prevent what is seen as a “race to the bottom” on corporation tax as countries seek to compete to be the home of international businesses through tax incentives (be it simply a low tax rate or more structured incentives). This is at the heart of Pillar 2.
International tax competition is of course nothing new, and the prevention of BEPS was the focus of the last major global OECD project. The tax authority response is also nothing new; a tendency to increased tax controversy coupled with many new laws against BEPS that create a complex environment for multinational businesses to navigate. Both of these responses are potentially detrimental to global growth as they take business leaders away from planning for future growth and tie them up in often long-term discussions about how historic profits should be carved up.
The OECD is, therefore, also seeking to create a simpler environment for businesses where there is less scope for controversy. This is why we see certain proposed simplifications built into the design of Pillar 1 (the so called “Amount B”) as well as a drive towards a minimum global tax rate to reduce the incentives for businesses seeking to shift profit and therefore diffuse some of the inevitable controversy.
The Coming Months
A delay in the reaching of a consensus is likely to result in two important consequences for businesses.
Firstly, we are likely to see countries push forward with unilateral tax measures focused on remote activities, such as digital services taxes and changes to indirect tax regimes. This will create a complex compliance environment for multinational businesses given the varying scope and focus of these different measures around the world; multinational businesses may be required to track and share data on their customers and their users that they have not had to historically. In some cases, this may require wholesale systems changes.
Secondly, we are likely to see a new wave of tax disputes focused on value creation. The OECD Pillar 1 blueprint explains that many territories believe the current international tax framework does not provide a sustainable basis for the allocation of value around parts of a multinational group.
Current transfer pricing rules are intended to provide the basis for attribution of value between group companies. However, within any transfer pricing analysis, there is a range of potentially acceptable outcomes. It is, therefore, likely that some tax authorities will seek to argue that entities in their jurisdiction are under-rewarded, for example, due to the unique features of the market or the marketing intangibles that are created locally. There is no need for new rules here, existing rules can permit jurisdictions to argue for a higher return in the arm’s-length range. This is something that we are already seeing in some jurisdictions, and we expect some other tax authorities could be galvanized into action by the OECD using the concept of revisiting the question of value creation for a modern economy as one of the guiding principles of the Pillar 1 proposal.
What Should we be Doing?
There are a number of actions businesses could be taking, for example providing feedback to the OECD on the blueprints by December 14, 2020 or modeling how the proposals could affect their global tax positions.
However, businesses should not lose sight of the potential immediate impacts of the deferral in the OECD’s timeline, on both the legislative and tax authority behavioral sides.
On the legislative side, a number of territories have already enacted digital services taxes or similar measures whilst others are actively considering them. Companies should be carefully monitoring these developments to understand the potential effects of such taxes on their businesses. BDO’s Taxation of the Digital Economy Tool is designed to help navigate this emerging landscape. This is not just a question of compliance (although compliance is of course important). These new taxes can directly, and significantly, erode margin if they are not factored into the pricing for products or services supplied into a market. We strongly recommend that multinational business should build a specific review of the evolving tax landscape into their commercial pricing decision processes.
On the behavioral side, while taxpayers cannot, of course, control tax authority processes, they can ensure that they have robust defenses in place to support their current transfer pricing arrangements if they are audited. We expect to see increasing focus on understanding the functionality of sales and marketing teams to determine if the local functionality aligns to the contractual position or if valuable activities may be undertaken, or assets created, which could demand a higher return. Multinational businesses should ensure they are ready for such potential challenges.
Ultimately, no one can say with confidence when, how or even if a comprehensive plan to address the taxation of the digital economy will be enacted. However, taking a “wait and see” approach is risky given the immediate consequences the delay in the OECD’s timeline will cause. Those who wait and fail to address the emerging consequences may find themselves embroiled in compliance audits and face significantly eroded margins in some of their markets.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Ross Robertson is an International Tax Partner at BDO LLP.
Ross can be contacted at email@example.com
Ross Robertson is an International Tax Partner at accountancy and business advisory firm BDO. He specializes in commercially led cross-border corporate structuring and financing and advises on the optimization of capital structures and value chains, as well as the structuring of mergers, acquisitions and divestments. Ross has a particular interest in the taxation of intellectual property, and the on-going impact of disruptive trends in the macro-economic environment on business models and tax strategies.