INSIGHT: Will OECD’s ‘Unified Approach’ Find Consensus Among 130 Countries?

A few weeks ago, the OECD released the highly anticipated public consultation document regarding the allocation of international taxing rights. It remains to be seen whether this proposal, dubbed the “Unified Approach,” can bring together the countries involved; however, for all 130 countries involved in the base erosion and profit shifting (BEPS) Inclusive Framework, it does present a starting point for negotiations on taxing digital companies.

The proposal, although likely far from final, indeed unified elements of three leading plans recommended by member countries: the user participation element supported by the U.K., the marketing intangibles feature proposed by the U.S., and the significant economic presence model favored by developing economics including India. The overarching principle of the proposal is to allocate more taxing rights to user or market jurisdictions. In addition, it does not completely invalidate existing rules, including the arm’s-length principle and permanent establishment rules that largely rely on physical presence.

Defining In-Scope Businesses

The proposal is applicable to large, consumer-facing multinational companies. In terms of size, it indicates that the 750 million euros ($823 million) revenue threshold would be a natural reference point to define “large” companies given the amount of work that has been done for BEPS Action 13. In addition, although the proposal covers highly digitalized businesses that interact with customers or users remotely as well as businesses that utilize digital technologies to develop their consumer base, whether a company has a highly digitalized business model, or whether it directly interacts with end users, is not a precondition to be subject to the proposal. For instance, Facebook’s commercial relationship is with advertisers; although it directly interacts with end users, it does not generate revenue from them. Amazon’s products may not be digital goods or services themselves, but the company uses its platform to reach customers. Both business models would fall under the scope of the proposal.

The task of defining what businesses are in the proposal’s scope is not as straightforward as it appears. Depending on how the “consumer-facing” business is defined, certain companies could break operations into different business lines, divide products into different components, or separate services into different stages to avoid being in scope to reduce their total tax burden. Overall, the substance of the overall transaction could still be the same, but different “pack and crack” approaches could lead to different tax outcomes. In addition, the proposal indicates that extractive industries, commodities, and perhaps financial services may be excluded; however, some financial service enterprises have become increasingly digital and proactively use new technologies to reach customers.

New Economic Nexus

For businesses that are covered, the proposal creates a new nexus based on sales revenue to supplement rather than replace the existing physical presence rules. Essentially, revenue is used as an indication of a company’s level of economic presence and engagement with customers in a certain country. The sales amount that would create a taxable presence is not yet specified in the proposal; however, the OECD has indicated that the amount could be country-specific so smaller jurisdictions can benefit. It has also mentioned that a time threshold could be considered. What is noteworthy is that under this proposal, together with the existing physical presence rules, a nonresident business may create nexus in a given market jurisdiction through subsidiaries, a permanent establishment, third-party distributors, or remote connection with customers.

New Profit Allocation

Once it is determined that a country has rights to tax the profits of a nonresident company, the multinational group’s consolidated financial statements, either in aggregate or segregated by business lines, will be the relevant measure of total profits. The proposed three-tier profit allocation mechanism then kicks in. First, the baseline marketing and distribution functions that take place in the market country will be compensated with a fixed return (“Amount B” in proposal), and the calculation will still be consistent with the arm’s-length principle.

Based on different business realities, the local country may perform more complex marketing and distribution functions that are beyond the “baseline,” or perform other functions that are unrelated to distribution or marketing but justifiably deserve more than the above-mentioned fixed routine returns. In these cases, additional compensation is warranted (“Amount C” in proposal); the calculation of such returns would still follow the arm’s-length principle.

The proposal also introduces a new concept—deemed residual profit—which governs the allocation of returns that exceed fixed returns and is not subject to the arm’s-length principle. The deemed residual profit (“Amount A” in proposal) will be allocated to all market jurisdictions based on a formulaic approach. It is worth noting that the deemed residual profit would consider other intangibles that provide the group entities non-routine returns, such as know-how, trade intangibles, and patents; these non-routine returns will be carved out of calculations for the deemed residual profit using a simplifying convention, such as multiplying a non-routine profit by a fixed percentage. Once the deemed residual profit attributable to market jurisdictions is determined, compensation based on sales is allocated to all market countries.

The OECD proposal spends much effort discussing fixed returns (Amount B) and its potential controversies. Appropriate and negotiated fixed returns can provide certainty and simplicity, and it is appealing because no jurisdictions would be required to give up taxing rights on activities physically located in their countries, which are taxed under current rules. In addition, the OECD rightly cautions that when it comes to computing additional compensations (Amount C), robust dispute prevention and resolution mechanisms are critical to avoid double taxation. Nevertheless, the proposal does not discuss much about the fixed percentage that could be used to separate the non-routine returns attributable to other intangibles from the deemed residual profit attributable to market jurisdictions (Amount A). This “fixed percentage” directly affects the amount of deemed residual profit that can be allocated to jurisdictions, and the importance of “other non-market intangibles” could arguably vary across different types of business models covered by this proposal. Given OECD’s intent to highlight the difference between marketing and trade intangibles, more discussion is certainly needed to achieve commonly acceptable results.

By bifurcating the total returns into routine and non-routine returns, the OECD sends the message that the economic nature of these returns are different. Routine returns are typical, and the arm’s-length principle and traditional permanent establishment rules will suffice. However, the proposal takes the view that non-routine returns are unique and no comparables exist; as such, a formula-driven approach based on sales is the best proxy. An intriguing implication of granting a portion of the deemed residual profit (Amount A) to market jurisdictions is whether a country would be treated as owning a certain amount of intangible property, such as a customer or user base, or simply owning the taxable profit but not the intangible property. In addition, granting countries new rights to tax nonresident companies also triggers the question of whether current U.S. tax information reporting requirements need to expand to accommodate these activities, or simply reflect these treatments in the foreign tax credit calculation.

Conclusion

Whether countries like the OECD proposal or not, this time, they cannot blame the OECD for not trying to come up with a solution for coordinating international taxing rights on multinational corporations. It is hard enough to have a deal between two countries (think of the recent U.S.-China trade negotiations); reaching agreements across 130 countries is no easy task. As the OECD states, because it aims to have a solution by the end of 2020, exclusively choosing any one of the three leading plans is not going to meet all countries’ expectations; instead, a compromise is necessary to close the gaps.

One thing to watch would be how the emergence of this proposal affects current unilateral measures by countries like France, the U.K., and Australia. Most jurisdictions agree that these short-term measures are highly undesirable, harm economic growth and innovation, and pose wasteful compliance costs. However, these measures also serve as a reminder to all countries involved that they should not be looking for a perfect solution. Instead, they need a solution that all can live with, because the alternative for not reaching a solution—the unilateral measures—would be worse.

The near term feedback for this proposal will come between the G20 Finance Ministers and Central Bank Governors meeting in mid-October and the public consultation meetings in late November. The OECD’s preliminary analyses suggest that although this proposal would only impose modest increase in tax revenues, it would involve significant reallocation of taxing rights among jurisdictions: low- and middle-income countries and large market jurisdictions would gain tax revenue, whereas investment hubs would experience losses in tax base.

The heavy lifting starts now—countries will sharpen their pencils, calculate the tax impact, and begin multilateral discussions. The Unified Approach may have created more questions than answers at this point, but it is a promising development.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Joyce Beebe is a research fellow at the Center for Public Finance at Rice University’s Baker Institute for Public Policy.