The OECD’s Digital Taxation Proposal: A Contradiction of the Original BEPS Project?

When the Organization for Economic Cooperation and Development (OECD) initiated its Base Erosion and Profit Shifting (BEPS) Project in 2013, one of the main focus areas was the tax challenges arising from the digitalization of the global economy (Action 1). Specifically, many policymakers and government authorities believed that the existing international tax rules and regulations, many of which have been in place for decades, had not kept pace with the rapid digitalization of the global economy, which has fundamentally changed the way many businesses are structured, how companies interact, and how consumers often obtain services, goods, and information. In this context, the “digital economy” refers to the economic activity generated through the online connections among people, businesses, devices, data, and processes.

While the 2015 final reports on the BEPS action items provided a range of tax and transfer pricing guidance along with a number of recommended anti-tax avoidance measures, additional work was recommended for Action 1. Since 2015, the OECD and other stakeholders have worked extensively to develop the architecture of a draft proposal in response to these perceived challenges. This proposal now resides with the member countries of the Inclusive Framework (the countries and jurisdictions that collaborate on BEPS monitoring and implementation) for review and discussion in fall 2020.

The OECD has received a significant amount of commentary related to this complex project, and numerous questions and challenges still need to be resolved before it is likely that the proposal will be accepted by OECD member countries. The Covid -19 pandemic, coupled with differing opinions among member countries about the project (notably the U.S.), has further complicated the initiative. Frustrated by the lack of progress, some countries unilaterally have proposed or implemented their own version of a digital tax, creating a sense of urgency for the OECD to quickly develop a multilateral solution.

The difficulty the OECD faces that one of the primary outcomes of the original BEPS project was that profitability should be aligned with value creation instead of legal ownership (of intangible property, for instance). However, as shown in what follows (and already embodied in proposed or enacted legislation by certain member countries), the OECD’s current proposal for the digital economy is in conflict with this premise. Furthermore, to some extent, the current proposal disregards certain long-established tax standards such as the arm’s-length principle, the likely impact of which will be more far reaching in nature than this current proposal.

The OECD’s current digital taxation proposal

The OECD’s current work on addressing the tax challenges of the digital economy is divided into two pillars:

• Pillar One. The first pillar addresses the new business models that have developed in the broader digital economy by expanding the taxing rights of market jurisdictions, wherein multinational enterprises (MNEs) might or might not have a physical presence (or legal entity). In the OECD’s current digital taxation proposal, “market jurisdictions” are defined as jurisdictions where an MNE group sells its products or services or solicits or collects data or contributions from users. Accordingly, this pillar creates a new nexus test for income taxation.
• Pillar Two. Also referred to as the Global Anti-Base Erosion (GloBE) Proposal, the second pillar focuses on addressing tax avoidance through global minimum taxation and is intended to further limit the incentives for businesses to locate functions and activities (and profitability) in low-tax jurisdictions.

Pillar One in particular has created the most controversy and confusion and will be the primary focus for the remainder of this article. The OECD’s current proposal for Pillar One, which was released in January 2020, defines three types of taxable profit that may be allocated to a market jurisdiction (Amounts A, B, and C):

• Amount A. A share of residual profit allocated to market jurisdictions after accounting for Amounts B and C. This amount is determined based on a formulaic approach and is applied using the consolidated group financial accounts. Once determined, Amount A is distributed among the eligible market jurisdictions based on an allocation key agreed to during further discussions, though it likely will be a revenue-related key.
• Amount B. A fixed remuneration based on the arm’s-length principle for defined baseline distribution and marketing functions that take place in the market jurisdiction.
• Amount C. A return to account for any in-country functions that exceed the baseline activity compensated under Amount B.

Amounts B and C do not create any new taxing rights and thus generally are reliant on physical presence and consistent with the arm’s-length principle. Amount A, on the other hand, is not dependent on physical presence and therefore constitutes the OECD’s primary response to the perceived challenges of the digitalization of the global economy. Furthermore, since Amount A represents the residual profit allocated to market jurisdictions and is determined using a formulaic approach, it is not consistent with the arm’s length-principle, a long-held international standard that has informed international taxation for decades.

Pillar One’s primary goal is to tackle concerns that current global tax rules do not account for the fact that companies, particularly global digital companies, can have a significant business presence in a country but not have any physical presence, which results in little or no income tax being paid in these countries (given the lack of nexus under current rules).

Contradictions raised by the digital tax proposal

The OECD’s current work on digital tax issues is popularly referred to as “BEPS 2.0”; however, after a closer look at the OECD’s proposal, this moniker, at least with respect to Pillar One, is not accurate because the issues addressed do not necessarily concern tax avoidance. The original BEPS project’s premise was based on the perception that MNEs commonly employed tax planning strategies to artificially shift profits to low- or no-tax jurisdictions where the MNE had little or no economic activity, thus undermining the fairness and integrity of the global tax system. In response, the OECD concluded that profit should be aligned with where value is created rather than strictly focusing on legal or contractual terms. For example, under BEPS, if an entity in a low-tax jurisdiction merely legally owns an intangible asset but performs few, if any, functions related to its development, the entity is not automatically entitled to all of the residual profits related to that asset. Rather, more substantial profits should be assigned to the entity(ies) performing the associated research and development (R&D) and managing and controlling risk. Throughout the BEPS project, the OECD strongly emphasized the importance and significance of value creation in the context of where profit should be recognized.

Pillar One, however, assigns some profits to market jurisdictions where MNEs might have consumers or users but no physical presence, thereby assigning profits to jurisdictions where MNEs operationally have no substance and, by extension, do not create any value. With respect to Amount A profits, no consideration is given to the MNE’s functions performed, assets employed, and risks assumed in determining the allocation of profit, which, as previously stated, is inconsistent with the arm’s-length principle. This position seems to be inconsistent with the OECD’s emphasis on the role and importance of value creation, and that entities with limited or no economic substance should not be earning profits (or only limited profits). In this instance, there might be no legal entity in a jurisdiction at all, let alone any substance, but somehow, there now should be profit recognized there.

In order for the OECD’s position to be consistent, it must assert that customer or user bases are intangible assets in and of themselves for which some profit should be allocated. However, a customer or user base is ubiquitous across all businesses and is not unique to the digital economy. Furthermore, for many companies, some (or a majority) of their customer base might not be in their primary country of operation. For instance, consider a simple example in which a British manufacturing entity sells a significant amount of product directly to customers in Germany via phone orders. All the functions, risks, assets, and intangible property are in the U.K.; the product is merely exported to third-party customers in Germany. While the German market is quite important to the British entity, no legal entity or any form of business operations exist in Germany. In this situation, it is likely that the British entity would not have income tax nexus in Germany and, accordingly, would not be subject to German income tax.

Under current rules, the German tax authority would not be able to assert that the importance of the German customer base to the British entity constitutes an intangible asset, therefore giving it the right to tax the associated profits from the sale of the product (though sales or other consumption taxes may apply). Consistent with the original BEPS project and the OECD transfer pricing guidelines, the profits would be assigned to the U.K., where all R&D is performed and funded, where all other significant functions are performed, where the associated risks are assumed, and where assets are employed. The U.K. entity is making all the investments, creating all the ideas, and operating the business (in other words, creating all the value), while the German market merely is purchasing the products. The OECD certainly would disagree with the German tax authority if it tried to assert income taxation rights.

While this example admittedly is simplistic and some unique aspects to operating in the digital economy (for instance, user-contributed content) exist, it demonstrates that the OECD’s current position with respect to Pillar One is not entirely consistent with the conclusions of the original BEPS project, and it seems to somewhat unfairly target a specific business model. While the initial impact of this proposal might be limited to a relatively small group of companies, it could open the door for this type of approach to be applied to other business models and industries (for instance, if in the example provided orders were made online rather than via phone), especially since such an approach could set the precedent for disregarding the arm’s-length principle and, more broadly, open the door to global formulary apportionment.

As currently structured, the OECD’s proposed approach to address the challenges arising from the digitalization of the global economy raises additional questions that need to be addressed before a consensus agreement can be reached. It also seems to be inconsistent with certain aspects of the original BEPS project, notably the alignment of profits with value creation. In general, the proposed approach appears to place less emphasis on the functions performed, assets employed, or risks assumed by MNEs. Instead, it allocates some profits to jurisdictions where only consumers or users might exist, disregarding the arm’s-length principle to some extent, which has been an international tax fixture for decades. The proposal likely would have a limited initial impact, but given the effort expended and interest in the project, it is unlikely to stop there. This likelihood begs the question: If the OECD is disregarding long-established tax principles to tax this small subset of companies, how much further is it willing to go?

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

Author Information

Daniel Bowie
Crowe LLP
+1 312 605 3322
daniel.bowie@crowe.com

Barry Freeman, Ph.D.
Principal
Crowe LLP
+1 646 965 5697
barry.freeman@crowe.com

John Lamszus, CPA
Crowe LLP
+1 312 605 3333
john.lamszus@crowe.com