The OECD recently published a policy note followed by a public consultation document addressing the tax challenges of the digitalization of the economy. Through the public consultation, the OECD seeks comments from different economic and social sectors affected by or interested in how the process is being developed under the Inclusive Framework on BEPS. Perhaps, some time in the future, when looking at how international taxation has evolved post-BEPS, the enormous importance of this OECD document and the step forward it represents will be clearly seen in retrospect. For now, the OECD’s position coincides with criteria such as those recently put forth by Joseph Stiglitz in calling for a debate on the very suitability of the current transfer pricing system.[i]
Although the OECD has yet to adopt a categorical position, the importance of the document lies in the breadth of the alternatives the organization is working with. In the document, the OECD maintains that digitalization of the economy requires fundamental changes in the rules governing international taxation, in particular the definition of permanent establishment and the related profit allocation rules. Moreover, the organization states that this transformation may also require a radical rethinking of the transfer pricing system, passing over traditional systems in favor of profit distribution systems (at least for residual income), with the possibility of using mechanisms to distribute global income or the residual income of a multinational group. The OECD could be seen as straying from the goal of finding a technically reliable solution and instead seeking a consensus among the major member states. In some cases it appears to merely take note of the reforms enacted in these countries, putting forward the United Kingdom’s proposals or those contained in the 2017 US tax reform as global solutions.
The OECD’s document examines proposals involving two pillars. The first pillar addresses the consequences of digitalization of the economy, assuming that these impacts require a substantial modification of both the nexus and profit-allocation rules for permanent establishments. The second pillar, while not related with the digital economy, is no less important. This second pillar is based on the idea of ensuring that the global income of multinational groups is taxed at a minimum rate, following in the wake of the recent United States tax reform.
Under the first pillar, the OECD highlights three possible solutions for addressing the tax challenges of the digitalization of the economy. The organization assumes that any of them will entail a significant change in the rules that have governed international taxation for the past century. In all cases, these proposals entail changes in the understanding of “permanent establishment” and the related profit allocation rules, envisaging that a nexus can exist at source even if there is no physical presence whatsoever. In summary, these proposed solutions are as follows:
- User participation proposal: This first proposal is inspired by European solutions and focuses on attributing profits based on the value created by certain highly digitalized businesses through developing an active and engaged user base. The uniqueness of this proposal lies in its limited scope, given that it attempts to limit the change to social media platforms, search engines and online marketplaces. Profit derived from user participation in these specific business models would be determined through a residual profit split approach, which could involve objective formulas.
- Marketing intangibles proposal: Undoubtedly, this option could bring more extensive consequences than the others. In short, the proposal, which the US could support, is to shift taxation to the applicable market jurisdiction or destination, not only for digital business models but in many other cases in which these marketing intangibles, such as the business’s brands, are considered to have been created, to some extent, by the very market in which they are used, even (or particularly) in those cases in which limited risk distributors exist in the market jurisdiction and contribute, to some extent, in creating certain intangibles. Again, the non-routine or residual profit would be allocated to the different market jurisdictions and must be then split among them according to a predetermined formula. Naturally, this adjustment would not extend to income attributable to technology-related intangibles, which would continue to correspond to the jurisdiction where the technology was developed.
- Significant economic presence: Lastly, the OECD document introduces the third proposal, which would entail amending article 5 of the OECD Model Tax Convention, whereby a taxable presence in a jurisdiction would arise when a non-resident enterprise has a significant economic presence. Although the OECD does not provide a full explanation of the proposal in the document, it does recognize that in accordance with BEPS Action 1, the proposal could contemplate the possible imposition of a withholding tax as a collection mechanism.
The OECD recognizes the difficulties inherent in any of these proposals and their effects on what is already somewhat of a transfer pricing minefield. However, in addition to relying on the corresponding technical solutions, the OECD continues to trust that an effective alternative solution can be found to the conflicts that arise.
As mentioned above, the second part of the OECD document goes beyond the digital economy, given that it reflects proposals to avoid tax evasion by multinational groups, envisaging minimum taxation that, as the OECD itself acknowledged, is in line with the solutions already put into practice in the United States. Two formulas were proposed to avoid this base erosion: Firstly, a new type of international tax transparency was proposed regarding income of branches or subsidiaries that is not sufficiently and effectively taxed in the source state. This proposal is in line with the Global Intangible Low-Taxed Income (GILTI) system developed under the US tax reform. Secondly, a suggestion has been made to deny tax credits or deductions envisaged in tax treaties if certain payments can be considered an erosion of the domestic tax base in line, again, with the base erosion and anti-abuse tax (BEAT), when such payments give rise to income that is not effectively and sufficiently taxed in another jurisdiction. Here, too, the OECD understands that such new rules would also require amendment of the Model Tax Convention.
In conclusion, the OECD’s public consultation document is extremely important, as it broadens the scope of the discussion on the future of international taxation. We should therefore keep a close eye on how these proposals fare and the debates surrounding all of them.
[i] Stiglitz, J.; “How Can We Tax Footloose Multinationals”, Project Syndicate, February 13, 2019.