International tax challenges in a ‘digital world’

Julia Cockroft and Miranda Cass discuss recent OECD consultations on international tax challenges arising from the increasing digitalisation of the economy


This article was first published by Lexis Nexis, November 2019.

What is the background to these consultations?

The OECD is currently grappling with fundamental principles of international taxation to try and reach consensus on determining both the tax base and method of taxing multi-national enterprises (‘MNEs’) in a ‘digital world’ where the traditional tax concept of a physical presence is outdated.

The ‘Pillar One’ consultation (which closed on 12 November 2019) proposes a new allocation of taxing rights through new nexus and profit allocation rules. The ‘Pillar Two’ consultation (closing on 2 December 2019) outlines a Global Anti-Base Erosion (or GloBE) proposal to ensure a minimum level of tax.

Although each consultation focuses on different specific issues, both stem from the May 2019 OECD Programme of Work for Addressing the Tax Challenges of the Digitalisation of the Economy. In essence, the consultations aim to draw out acceptable international proposals to ensure that MNEs, which, thanks to digitalisation, can access global markets with relative ease, pay a fair amount of tax in the ‘right place’. The BEPS Project achieved a great deal to ensure that MNEs cannot artificially reduce their overall taxable profits. This next significant phase of OECD work is, very broadly, seeking to build on that progress and establish where the resulting tax should be paid—not an easy task given obvious competing international interests.

What does ‘Pillar One’ cover?

The recently published OECD Secretariat Proposal for a ‘Unified Approach’ under Pillar One outlines a solution that would encompass the following key features:

  • Scope—the focus is on consumer-facing businesses (clearly capturing highly digital business models but not exclusively targeting the technology sector)
  • Nexus—taxing rights will no longer be dependent on a physical presence but will, instead, be largely based on sales into a particular country
  • Profit Allocation—while the current transfer pricing rules and arm’s length principle will (largely) be retained, further formulaic rules will be applied to address particular tensions

In order to move beyond a pure ‘physical’ nexus, the proposal seeks to determine whether an MNE has a ‘sustained and significant involvement in the economy of a market jurisdiction’. Nexus would be largely based on sales and would likely involve defining a revenue threshold (to be set by reference to the size of the market to ensure smaller economies can benefit). If a business is within scope and once the revenue threshold in a particular jurisdiction has been reached, then the profit allocation rules can be engaged in that jurisdiction. This new nexus rule will operate in addition to, rather than in lieu of, the existing permanent establishment (PE) rule. As a consequence, the interaction between the two rules will need close attention so as to avoid double taxation.

Profit Allocation

A ‘three tiered’ profit allocation mechanism has been proposed to identify:

  • Amount A—deemed residual profit (being the surplus profit after allocating a percentage of deemed ‘routine’ profit to the countries where activities are performed) which is to be allocated to market jurisdictions based on the proportion of sales occurring there
  • Amount B—a fixed ‘fee’ for marketing and distribution functions that take place in a market jurisdiction
  • any additional profit on ‘extra’ functions not identified in B above, determined in accordance with existing transfer pricing rules and subject to legally binding and effective dispute resolution mechanisms

Much work still needs to be done in order to define the relevant amounts, prevent double-counting and consider how the principles can be applied to different business models. At a high level, taxing rights in relation to amounts falling within A to C will be allocated ‘away’ from the jurisdiction of tax residency or physical presence and ‘to’ the relevant market jurisdiction.

What does ‘Pillar Two’ cover?

The Pillar Two GLoBE proposal is effectively an extension of the BEPS Project. It seeks to ensure that the profits of international businesses are subject to a minimum level of tax, addressing ongoing risks from structures that allow MNEs to shift profits to jurisdictions where they are subject to no or very low taxation. While this Pillar stems from concerns around digital business models (on the basis that such models present greater opportunities for tax base manipulation) the proposal would have a much wider application. The minimum percentage of global tax is to be determined once the core principles are agreed. The two fundamental principles of the GLoBE proposal are:

  • Income inclusion—taxing the income of a branch or controlled foreign subsidiary if it is subject to tax below a minimum rate in the local jurisdiction
  • Undertaxed payments—either denying deductions or imposing source based tax (ie withholding) on payments to related parties where the payment is not subject to a minimum rate of tax

These rules would be complemented by modifications to tax treaties to allow a residence jurisdiction to elect to switch from an exemption method to a credit method where profits of a PE are subject to tax below a minimum rate and restrict access to treaty benefits where certain income has not been subject to a minimum rate of tax.

The recent consultation explores three technical aspects of the GLoBE proposal in detail, including:

  • using financial accounts to determine an MNE’s tax base and how both permanent and timing differences between accounting profit and profit for tax purposes should be dealt with
  • determining the effective tax rate when an MNE’s income from different sources has been taxed in high-tax and low-tax jurisdictions (so-called blending)
  • what carve-outs, thresholds and exclusions should apply
Do these proposals represent a consensus between OECD member countries?

134 member countries to the ‘Inclusive Framework’ have committed to tackle the challenge of appropriately taxing the digital economy. Achieving consensus among that number is far from straightforward—particularly when the proposals represent a huge shift in approach and create clear ‘winners’ and ‘losers’. Against that backdrop, the progress to date is commendable. There was significant concern that the US may not engage with the ‘Unified Approach’ to Pillar One but, so far, signs from the major players, emerging economies and developing countries are, on the whole, positive.

The devil is certainly in the detail. The OECD public consultation in Paris on 21 November 2019 addressing Pillar One appears to have drawn out a number of diverging views and we suspect that the number of technical questions posed in the Pillar Two consultation will trigger a similar level of debate. However, in the absence of an agreed international strategy, it is likely that more countries will follow the likes of the UK, France and Australia and introduce unilateral measures to tax digital revenue. Preventing a patchwork of unilateral measures is of upmost importance to the OECD and should motivate collaborative international efforts to reach consensus.

Which aspects of these proposals will be of most concern or interest to businesses?

All ‘customer-facing’ MNEs, and particularly those with largely digital business models, will no doubt be closely following Pillar One developments. The Pillar Two consultation is relevant to an even broader base. Businesses currently dealing with the implementation of a ‘Digital Services Tax’ (or similar) in different jurisdictions may welcome the OECD developments. The closer the international community comes to consensus, the more likely it is that unilateral proposals to tax digital revenue in individual jurisdictions (that pose a real risk of double taxation) will be shelved. However, businesses that feel they have only just got to grips with ‘post-BEPS’ operations, particularly those that have reformed arrangements in light of revised transfer pricing guidelines, are unlikely to welcome yet more change.

While a stated aim in the consultations is to achieve simplicity and greater tax certainty, new proposals of this scale inevitably require a period of adjustment and inherent uncertainty. Particularly in relation to the third profit allocation mechanism in Pillar One, it is difficult to see how certainty can be achieved, even in the long term. Neither the Pillar One, nor the Pillar Two proposals, can be described as simple!

What can we expect to happen next, and what are the intended timescales?

Although ‘Pillar One’ and ‘Pillar Two’ are currently following slightly different timetables, the aim is to achieve a consensus solution across both issues by the end of 2020. It is a challenging timeframe, not least because some of the most controversial issues, namely the detailed determination of Amounts A to C in Pillar One and the minimum level of tax in Pillar Two are not yet even tabled for discussion. The OECD have indicated that the ‘unified approach’ to Pillar One needs to be broadly agreed in principle by the Inclusive Framework members at their next meeting in January in order for there to be a realistic prospect of members presenting a solution in their Final Report to the G20 in 2020.