As we have already discussed in this blog, the OECD, commissioned the task of implementing and promoting G20’s mandates, has focused its most recent work on taxation in the digital economy. This priority gave rise to a Policy Note on January 23, 2019, followed immediately by a public consultation document on February 13 this year. After receiving public input, the OECD, through the Inclusive Framework on BEPS which met on May 28 and May 29, has launched a new document with a work program to achieve a consensus solution in 2020 on the tax challenges of the digital economy.
This new document draws on the previous document released in February which sought public comments, and as a result, on the two pillars around which the document revolved; a Pillar One, focused on reforming the principles of international taxation, and a Pillar II, targeted at the outstanding challenges of BEPS and giving rise to the proposal of two possible measures: an income inclusion rule and what is referred to as a tax on base eroding payments, both aimed at allowing some countries to tax certain types of income where the country with primary taxing rights has not exercised its fiscal sovereignty in a way considered to be sufficient. The new document takes up the two pillars and sets out a range of options to explore over the coming months.
In relation to Pillar One, the OECD recognizes that we are no longer talking about a solution for the problems posed by the digital economy ring-fenced from the rest of the economy, or about addressing the tax treatment of the profits of specific highly digitalized businesses. Digitalization has transformed the whole economy and, in any event, what we are addressing is a new approach to fundamental aspects of the rules of international tax law, in that they essentially involve an allocation of countries’ fiscal sovereignty.
The OECD takes for granted that any reform will involve recognizing more taxing rights for what are referred to as market jurisdictions. Although we are still a long way off from a destination corporate income tax or destination based cash flow tax, we are moving towards a solution that will enable countries to tax to a greater extent, or to a fairer extent, if you like, the profits of groups of companies in the market or destination countries of their operations, even if those groups of companies do not have a physical presence in those countries or territories. Among the three proposals considered in the above document, the OECD appears to lean towards what is known as the marketing intangibles proposal, which is behind its proposal that may be summed up as profit allocation rules for global income enabling those profits to be allocated to the market jurisdiction. Though the new document also addresses the idea of a new nexus or connecting factor that moves away from the physical presence requirement, it only mentions the need to change articles 5, 7 and 9, among others, of the OECD Model Tax Convention.
In short, the OECD is proposing a transformation of the current transfer pricing rules, a changed based on a global profit allocation method that will allow greater participation in the international taxation of a group for the market or destination countries of its operations. To achieve this, the OECD offers various alternatives. One method would be to remove routine profit first, then allocate the remaining, non-routine, profit falling within the scope of the new taxing right to the destination market jurisdiction. Another method, according to the OECD, would be not to make that distinction and calculate the group’s global profit to be allocated among the market jurisdictions involved which in short means that the OECD accepts an allocation method for that global profit by reference to an established mechanism that would be based on customers and users. And the OECD offers yet another a third option to attribute a greater percentage of global income to the destination countries, by reference to a baseline amount to be attributed and allocated. It leaves to be explored in later work the determination of the allocation rules among the various destination jurisdictions, the treatment of losses, certain simplification rules and even an in-depth assessment of the economic impact of these methods in terms of the levels and distribution of tax revenues and their overall effects on the location of investments and activities.
Pillar Two includes two different components. First, the OECD describes a minimum tax rate on global income seeing the issue from the country of residence of the ultimate or intermediate parent company of a group, to attribute to that company and as a result to its country of residence the right to tax profits of a subsidiary that have not been sufficiently taxed in the subsidiary’s country of residence. This rule is complemented with another switch-over rule that applies this same principle to profits attributable to a permanent establishment that are exempt in the parent company’s country.
This first component of Pillar II may be seen as an expansion of the international fiscal transparency system influenced by the global intangible low tax income (GILTI) system that came out of the 2017 U.S. tax reform. The new rule, however, could be applied to any profits on the basis of a baseline percentage of tax, which would have to be agreed internationally, for which the base would be calculated under the rules of the parent company’s country although the calculation could be simplified using international accounting standards. On top of this, the OECD opens the door to certain exceptions based on abstract tests such as the existence of substance in the subsidiary’s country or a return on fixed assets.
The second component of Pilar Two consists of two anti-base erosion rules from the standpoint of the source jurisdiction. One rule would deny a deduction or impose a tax or withholding tax for a payment giving rise to deductible expenses in that jurisdiction if the payment is made to a related party resident in another jurisdiction where the related revenue was not subject to sufficient tax at a minimum rate. The second is a subject to tax rule that would be included in tax treaties and would allow the source jurisdiction to deny treaty benefits in the absence of sufficient tax on the item of income in the other jurisdiction.
Once again, it has postponed to a later date the decision on crucial issues such as the coordination between the two components of this Pillar Two, what sufficient tax at a minimum rate means, how to calculate the effective rate of tax in each country for this comparison, and the impact of the timing of recognition rules or the tax base calculation systems, or how to carry out the necessary modification of the bilateral tax treaties or the inclusion in the scope of the second of these rules of transactions between non-related parties in certain cases.
The OECD confines to a footnote the view of some countries that these rules in Pillar Two may affect their fiscal sovereignty where for a variety of reasons they have no or low taxes on income arising from activities with genuine substance. It might be thought this could only be the view of countries that have favored base erosion in recent years. And the OECD document starts out from a belief in the suitability of these rules which would now stop an endless race in the reduction of tax rates on the profits of businesses by making all countries adopt harmonized minimum taxation. What is lacking again, however, is a realistic analysis of these Pilar II rules in some territories, starting with the ultraperipheral regions of the EU or developing countries, when it is also the case that Pillar One appears to favor the market jurisdictions in the new allocation of fiscal sovereignty.
In any event, we must be aware that we are facing a process of change that may radically transform international taxation as we now know it. And it would of course change international taxation as a whole without being confined to some digital companies. As the OECD itself recognizes, this process involves the adoption of transcendental fiscal policy decisions which should lead to national debates at the relevant levels starting with the parliaments of every country. And as the OECD also recognizes, this change has economic and fiscal effects that require the most careful possible consideration.