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INSIGHT: Taxing the Digital Economy—Pillar One Is Not BEPS 2 (Part I)

Nov. 8, 2019, 8:01 AM

The Unified Approach issued by the OECD Secretariat on Oct. 9, 2019, is the OECD’s most recent attempt to find international consensus on BEPS Action Item 1, “Taxing the Digital Economy.” Our assessment is that the Pillar One proposals in the Unified Approach suffer from several defects, the most important of which is their apparent abandonment of the arm’s-length principle. The overarching goal behind the 15 BEPS Action Items issued in 2013 was to strengthen the international tax system by removing egregious tax loopholes and ensuring that profits were taxed where economic activities occurred and value was created.

The Pillar One proposals, however, are not “BEPS 2”; they do not share the same agenda, do not build on international tax and transfer pricing principles, and will weaken not strengthen the current system. We believe that the current tax and transfer pricing rules, inclusive of BEPS 1 changes, can encompass the digital economy. We offer six policy recommendations designed to move the global economy onto the BEPS 2 path, a path appropriate for 21st century digital multinationals that will benefit both developed and developing countries. This article is Part I of a two-part analysis of the Pillar One proposals. In Part I, we provide a summary and analysis of the proposals. In Part II, we examine their implications and provide some recommendations.


The transfer pricing world is currently holding its breath. Virtually all international tax professionals appear to be preparing comments on the OECD Public Consultation Document Secretariat Proposal for a “Unified Approach”, released on Oct. 9, 2019 (referred to hereinafter as the Unified Approach), with its Pillar One proposals for taxing the digital economy. The stakes are high and the political pressure is mounting. As highlighted in the Unified Approach (para. 8), the key issues at stake are:

  • the allocation of taxing rights between jurisdictions;

  • the future of multilateral tax co-operation; the prevention of aggressive unilateral measures; and the intense political pressure to tax highly digitalised MNEs; [and]

  • fundamental features of the international tax system, such as the […] applicability of the arm’s length principle (ALP).

In other words, we are witnessing a watershed moment in international taxation.

In view of the magnitude of the issues being discussed, it is somewhat disturbing that the Unified Approach and its request for comments have been issued in such apparent haste. The first Pillar One and Pillar Two proposals were distributed by the OECD as a Policy Note on Jan. 23, 2019, followed by a Public Consultation Document on Feb. 13, 2019, and a Programme of Work in May 2019. Total time between the Policy Note and the Unified Approach: a mere nine months. (As of this writing, the OECD was expected to issue new proposals for Pillar Two in November 2019.)

Has nine months been sufficient time to create a healthy and robust international tax baby? We fear that the time allocated has been too short for the difficulty of the task. Moreover, the link from the Policy Note to the Unified Approach is far from direct and many fundamental concerns remain unattended. The Unified Approach suffers from several defects, the most important of which is its movement away from the arm’s length principle (ALP). Kaeser, Owens, and Sim (2019, p. 219) concluded in July 2019 that it was too early to predict whether the Pillar One proposals were a continuation of BEPS (i.e., BEPS 2) or a new project that could spell the end of the ALP (Christian Kaeser, Jeffrey Owens, and Sam Sim, Going the Way of the Polaroid: Digital Taxation and the End of the Arm’s Length Principle? Tax Notes Int’l (July 15, 2019), pp. 211–219). If the proposals in the Unified Approach are adopted, the answer will be the latter.

Below, we examine the Unified Approach and explore its fundamental conceptual and practical problems. We argue that the existing international tax/transfer pricing rules, which are both flexible and principle based, can be broadened and represent a better approach to taxing digital multinationals. We conclude with six policy recommendations designed to move us back onto the BEPS 2 path. We hope that this article may serve as a wake-up call to national tax authorities, the OECD, and United Nations, encouraging a principled and conceptually coherent stance to taxing the digital economy, one that endorses and supports the ALP, one that is truly BEPS 2.


Digital multinationals (MNEs) are highly mobile. While the technologies employed by digital businesses vary widely (e.g., robotics, cloud computing, social platforms, 3D printing), they share key features such as scale without mass, heavy reliance on intangibles and data, and network effects. (See, e.g., Eli Hadzhieva, Impact of Digitalisation on International Tax Matters: Challenges and Remedies, Policy Department, European Parliament (Luxembourg, Feb. 2019.) Digital MNEs are therefore perceived to be more difficult to tax than “brick and mortar” firms.

When the BEPS Action Plan was announced by the OECD in 2013, taxing the digital economy was listed as the first Action Item. The OECD argued that the digital economy exacerbated BEPS issues and created challenges for ensuring that profits were taxed where economic activities occurred and value was created (Cecile Remeur, Briefing: Understanding the OECD Tax Plan to Address ‘Base Erosion and Profit Shifting —BEPS, European Parliamentary Research Service (EPRS). Members’ Research Service (Apr. 2016)). The question therefore for the OECD was whether new policies were needed or old policies could be fine-tuned for the digital economy.

These concerns have been exacerbated by the potentially large amounts of global profits being earned by these new digital businesses, creating a “virtual land grab” by tax authorities eager for new sources of revenues. In particular, the so-called “Big Five” digital giants: Alphabet (Google), Amazon, Apple, Facebook, and Microsoft are sitting targets. Their market capitalization in May 2019 totaled $4.22 trillion, which is a staggering amount any way you measure it. For example, the Big Five represent 11% of total U.S. market capitalization and 5% of world market capitalization, or 20.5% of U.S. GDP and 5% of world GDP. If we expand the list to the Forbes “Top 100 Digital MNEs,” their share of the global economy is even more dominant.It is useful also to recognize that all five of the Big Five are U.S. multinationals. In fact, Forbes estimates that 12 of the top 20, and 39 of the top 100 digital companies, are headquartered in the U.S. in 2019. Thirteen are headquartered in Japan and nine in mainland China (12 if Hong Kong is included).

It is important to recognize that firm size, of course, is not necessarily correlated with tax payments. For example, Bauer (2018, p. 15), in his study of European firms during 2012–2016 found “no systematic difference in income taxes paid by digital corporations compared to their traditional peers.” (See Matthias Bauer, 2018, “Digital Companies and Their Fair Share of Taxes: Myths and Misconceptions”, ECIPE Occasional Paper 03/2018, European Centre for International Political Economy.) Still, the public opinion that digital MNEs are “highly profitable” and “not paying their fair share” has been a catalyst encouraging revenue-hungry governments to tax the digital giants.

In a race to raise revenues from digital MNEs, several governments have either introduced (e.g., France and Hungary) or proposed (e.g., Spain, Italy, the U.K., India, and New Zealand) digital sales/services taxes (DSTs). The question facing the U.S. government, and other home countries to the digital MNEs, is how to respond to the flurry of new DST proposals. (For a review of possible US reactions to DSTs see Peter A. Glicklich and Heath Martin. 2019. Not Whether but When and How: U.S. Response to Unilateral Digital Taxation. Bloomberg Law News, 2019-10-30T09:54:56594-0:400.) The question for other governments, particularly the so-called “market jurisdictions” where digital users/consumers reside, is whether to jump on the bandwagon with their own DSTs or work together on a coordinated solution to taxing digital MNEs.

The precipitating factor behind the OECD’s Pillar One proposals has therefore been the immediate threat of multiple, unilateral DSTs if the OECD could not get consensus on a coordinated approach. The original BEPS goals (including Action Item 1) of curbing base erosion and ensuring that profits were taxed where economic activities occurred and value was created appear, however, to be no longer driving the project; the new goal is simply to get consensus before the end of 2020. Considering the divergent interests of the countries involved, getting consensus by 2020 is a herculean task. (See Julie Martin, “Unanimity not required to update global rules for taxing multinational groups, OECD Saint-Amans says”, MNE Tax, October 18, 2019.) The Unified Approach is the OECD Secretariat’s newest attempt to broker such an agreement.


Outline of the Proposed Approach

The Unified Approach proposes a new mechanism whereby market jurisdictions would be allocated three pieces of an MNE group’s global profits (i.e., three slices of the global pie).

  • Amount A (New Taxing Right): A new taxing right would be created for market/user jurisdictions, which would be based on a fractional share of an MNE group’s deemed non-routine global profits. Non-routine global profits—either for the MNE group as a whole or by line of business—would be calculated as the residual left over after routine returns to the MNE group’s activities in source and residence countries. Routine returns could be proxied, for example, by a percentage of the MNE group’s return on sales. The non-routine remainder would be split, using some metric, between the return to market jurisdictions and other non-routine returns (e.g., to trade intangibles and synergies). Finally, the amount for market jurisdictions would be divided among them using an allocation key such as local sales revenues, activity or users. Amount A is therefore, simply put, a brand-new fiat apportionment obligation for MNEs, requiring them to pay market/user jurisdictions on top of existing tax payments to residence and source countries. The only way to avoid double taxation is for a residence or source country to make tax room for the new taxing right.

  • Amount B: Local activities (e.g., marketing and distribution) in market/user jurisdictions would be allocated “fixed remunerations reflecting an assumed baseline activity,” i.e., there would be a fixed minimum floor for local marketing and distribution activities. How this floor would be calculated (e.g., whether it would vary by firm, industry, and/or country) and how differences would be handled between countries remain to be determined.

  • Amount C: An additional amount over and above Amount B could be added for situations where the taxpayer or tax authority, using the ALP, argued for a return to local marketing and distribution (or other local) activities above “baseline functionality” and the fixed minimum return. In such cases, Amount C would likely generate transfer pricing disputes and possible double taxation so that (possibly new) dispute settlement methods would be needed.

Analysis of the Proposed Approach

Given the level of complexity of the proposal, it may be helpful to illustrate Amounts A, B, and C with both graphical and numerical examples. Figure 1 provides a graph of the Appendix example in paragraphs 41–49 of the Unified Approach. In the example, Group X consists of parent firm P Co resident in Country 1, and its subsidiary Q C resident in Country 2. P Co owns the group intangibles and so is entitled to Group X’s non-routine group profits. (It is useful to note here that “owns” must be interpreted here as P Co having economic ownership of the intangibles since legal title is no longer sufficient to claim rights to intangible returns after BEPS Action Items 8–10 were incorporated into the OECD Transfer Pricing Guidelines in 2017.) Q Co markets and distributes P Co’s streaming services in Countries 2 and 3.

Under the current international tax and transfer pricing rules, Country 1 is the residence (home) country of P Co and therefore has the right to tax or exempt P Co’s foreign-source income. Most residence countries currently exempt foreign-source income (notably, active business income) from taxation. (For a more detailed explanation, see Lorraine Eden, 1998, Taxing Multinationals: Transfer Pricing and Corporate Income Taxation in North America (Toronto: Univ. of Toronto Press), Chapter 2 and Appendix 2.1.) The U.S., for example, recently moved from worldwide to quasi-territorial taxation in the 2017 Tax Cuts and Jobs Act.

Q Co, as a foreign subsidiary of P Co, has nexus (a taxable presence) in Country 2. Therefore, Country 2 has “first crack”, as a source country, at taxing Q Co’s income. Country 1 must make “tax room” for Country 2’s tax, by providing either a foreign tax credit or a deduction for Country 2’s corporate income and withholding taxes, should Country 1 choose to tax P Co’s worldwide income. Country 2 can therefore levy a corporate income tax (CIT) and withholding taxes on Q Co’s profits, and transfer pricing rules, applying the arm’s-length principle (ALP), must be used to determine arm’s-length prices between P Co and Q Co. Under current approaches to the ALP (giving rise to one of the core complaints that developing countries have about the ALP), Q Co would often be treated as a routine distributor and allocated a minimal taxable return in Country 2.

P Co does not have a foreign affiliate in Country 3. As a result, Country 3 is neither a residence nor a source country under current international tax rules and does not have the right to tax any of Group X’s income that is earned in its jurisdiction.

Both Countries 2 and 3 are “market jurisdictions” since their residents purchase and/or consume Group X’s remote streaming services. In the example, the services are provided free of charge to users/consumers (e.g., on social media platforms such as Facebook) but they could also be sold by subscription. P Co receives remote sales income from selling advertising space on the social platform to third parties, directly selling the data collected from the platform, or by subscription sales.

If Countries 2 and 3 wish to tax these revenues, they could levy a value-added or sales tax on P Co’s remote exports to their countries. The market jurisdictions could also levy a customs duty on the remote sales, but a tariff would likely be declared a violation of WTO rules and therefore subject to retaliation by Country 1. The example, however, assumes that neither Country 2 nor Country 3 could levy a corporate income tax on the profits earned by P Co in their countries because the remote sales do not meet the nexus tests required for a permanent establishment.

Let us now turn to the three-piece proposal for taxing Group X’s streaming sales into market jurisdictions. Figure 2 shows the three amounts proposed under the Unified Approach.

The steps involved in determining Amounts A, B, and C are the following. First, the firms and industries to which the Pillar One proposals apply (i.e., the scope) must be determined. The current proposal favors “market-facing industries.” Next, the countries where P Co provides remote streaming services must be identified (i.e., Countries 2 and 3 in the example). As market jurisdictions, they are deemed eligible for Amount A and possibly Amounts B and C.

Third, Amount A must be calculated, and pages 13–15 of the Unified Approach provide an algebraic example of how to do it. Assume the MNE group’s profits are z% of worldwide sales. Routine returns are assumed to be x% so that non-routine returns are z% – x% = y%. In the example, all non-routine profits belong to P Co, the entrepreneur, so P Co has a taxable return of y% in Country 1. Non-routine returns are then separated into two categories: intangibles and “market jurisdiction” returns. The return to intangibles includes all sources of non-routine returns such as non-routine trade and marketing intangibles and risks. Assume the return to intangibles is v%. That leaves y% – v% = w% as the (virtual) market jurisdiction return. If N is the number of market jurisdictions, some allocation key (for example, sales) is used to allocate the w% return among the N jurisdictions.

Fourth, Amount B creates a floor (minimum rate of return) for Group X’s local activities in each market jurisdiction. In the example, this would be Q Co’s marketing and distribution activities in Country 2 but could also be defined more broadly. Local activities in each market jurisdiction are assigned a formulaic fixed minimum return.

Fifth, Amount C occurs only if a tax authority or P Co wishes to assign a return to Group X’s local activities in a market jurisdiction that is higher than the floor under Amount B. They can do so by applying the ALP, but the result is subject to dispute settlement procedures (e.g., dispute settlement procedures under the double tax treaty between the two countries, assuming one exists). Otherwise, double taxation occurs.

Finally, note that that Country 2 could, in theory, receive all three forms of return (Amounts A, B, and C); whereas Country 3 is limited to Amount A (and possibly C).

Summary and a Look Ahead

The questions in the Unified Approach on which the OECD Secretariat wants input from stakeholders are narrowly focused on technical details related to calculating Amounts A and B, together with providing some comments on double tax relief and dispute settlement issues if Amount C exists. The specific questions for public comments are: (1) Amount A: scope, sales as a criterion for nexus; calculation of group profits, routine returns and the market allocation key; and double tax relief; (2) Amount B: fixed remuneration; and (3) Amount C: dispute settlement mechanisms (Unified Approach, pp. 17-18). There are no broad questions where stakeholders are asked to comment on the general merits (and demerits) of the OECD Secretariat’s proposal.

We believe that the Pillar One proposals suffer from several flaws that could potentially wreak havoc on the international tax system and the ALP. In the next section of this paper, we explain our key concerns with Pillar One, illustrating our points using the example in Figures 1 and 2. We also offer six recommendations designed to respond to and remedy these concerns. Our goal is to offer a roadmap designed to move the global economy back onto the BEPS 2 path. We believe our recommendations can benefit both developed and developing countries in their roles as source, residence and market jurisdictions.

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

Author Information

Lorraine Eden is Professor Emerita of Management and Research Professor of Law at Texas A&M University ( Oliver Treidler is CEO and founder of TP&C, a transfer pricing firm based in Berlin, Germany, and author of Transfer Pricing in One Lesson (2019, Springer) ( We thank William Byrnes and Niraja Srinivasan for helpful comments on an earlier draft; the responsibility for any remaining errors is ours. Last update: Nov. 5, 2019. All rights reserved.