Taxing The Digital Economy: White Smoke Emerges From The OECDBloombergQuintOpinion
The process of forging a consensus for taxing the digital economy is analogous to a Papal Conclave. Representatives of countries of the Inclusive Framework (‘IF’) are sequestered in Working Party discussions until proposals emerge and are made public for comment; and once comments are received, the Working Parties again turn them over to arrive at the next set of funneled propositions, with the objective of ultimately reaching a grand bargain. Several interim reports, policy notes and discussion drafts later, we have a public consultation document that suggests that traces of white smoke are emerging from the offices of the OECD at Paris, just as it happens when a new Pope is elected after multiple rounds of elections in the Sistine Chapel in the Vatican.
The difference is that whereas a two-thirds super-majority is required to elect the Pope, here the need for unanimity—for practically every country to buy-into the OECD Secretariat proposal—is compelling, in order to avoid double or multiple taxation or obviate unilateral measures by individual countries (as we have seen with several countries, more recently France with Digital Services Tax, and earlier, India with Equalisation Levy). And therefore, the OECD has been engaged in a race against time to resolve the digital economy conundrum, on the basis of 2 Pillars—Pillar 1 being re-writing the nexus and allocation rules, and Pillar 2 being the Global Anti-Base Erosion Proposal.
The Secretariat proposal for Pillar 1, released on Oct. 9, 2019, is intended to provide a unified approach to the new nexus and allocation rules for the digital economy. It establishes a framework that the Task Force for the Digital Economy has endorsed, and the G20 Finance Ministers are expected to take on board in the coming few months, pursuant to feedback.
OECD Proposal: Scope, Profit Allocation And Nexus
The Secretariat proposal suggests that a “Unified Approach” under Pillar 1 should focus on consumer-facing businesses, which would cover highly digitalised business models as well as businesses interacting with final customers. It proposes a new nexus, distinct and separate from the existing concept of the permanent establishment, which would ensure a company is taxable in a territory where its sales exceed a certain threshold even if it is not physically present in that market. The scope of consumer-facing businesses, which would be limited to large companies, would also capture digitalised business models.
The Secretariat proposal aims to reallocate to market jurisdictions a share of the deemed residual profit of MNEs falling within the scope through a formula and based on consolidated financial statements of the group (referred to as Amount A). It also proposes to allocate an appropriate fixed return for distribution activities, to simplify and improve the administrability of the current rules (referred to as Amount B). Finally, it recognises that the facts and circumstances approach under the existing arm’s length principle rules may, in any particular case, trigger further taxing rights in the market/user jurisdictions but, in that case, effective dispute prevention and binding dispute resolution between member jurisdictions will be called for (referred to as Amount C).
At a technical level, as mentioned above, there are three Amounts in question that are dealt with by the Unified Approach. Amount A goes into the “profit split” mode, or is a formulary apportionment method. As an example, consider that the global profit margin is 25 percent on group consolidated global sales. Supposing the “bright line” routine profit margin is taken to be 15 percent that is representative of industry norms. This means that 10 percent (25 percent minus 15 percent) is the global non-routine profit. A fraction of this profit, say 20 percent, would be regarded as the non-routine profit allocable to market jurisdictions and hence in this case, 2 percent (i.e. 20 percent of 10 percent) would be apportioned among all the market jurisdictions based on sales.
The IMF in its policy paper entitled Corporate Taxation in the Global Economy issued in March 2019, conducted a statistical analysis of companies across sectors and determined an average earnings before tax on costs of goods sold between 12 percent and 13 percent and an average return on fixed assets of between 12 percent and 15 percent. Of this, routine returns are reckoned at 7.5 percent of cost of goods sold, or 10 percent of fixed assets, which could be an indicator for determination of residual profit for Amount A. Amount A would apply to every jurisdiction that crosses a materiality threshold because it is agnostic to presence.
Amount B is the baseline, or de minimus profit margin based on arm’s length principle, for marketing and distribution functions performed in-country (akin to a mandatory, safe harbor Return on Sales). This could, for instance, be taken to be 3 percent of sales made in-country by the distributor.
Normally, for most MNCs, Amount A will be a zero-sum game from a taxable income (not tax) perspective, i.e. it entails re-distribution of profits from one jurisdiction to another; however market countries would incrementally benefit by virtue of Amount A.
Corporations would however experience differing post-tax incomes due to the redistribution from low tax residual profit jurisdictions to higher tax market jurisdictions.
Further, Amount A and Amount B will, for most MNCs, be the sum total of profits that will be subject to tax on account of marketing and distribution functions.
Amount C, if any, is the profit that may be additionally allocable, under arm’s length principles, for functions performed by distributors, that go beyond routine marketing and distribution functions, and which Amounts A and B collectively are inadequate to address. This is subject to forms of bilateral or multilateral dispute resolution and what one would expect to see in rare cases. This could be applied in a case where say the advertising and marketing expenses in a jurisdiction are relatively disproportionate to the rest of the world.
Turning to nexus, there are two significant aspects. One, that the threshold of physical presence is being supplemented by a standalone, sales nexus. Two, the revenue threshold would also take into account certain activities, such as online advertising services, which are directed at non-paying users in locations that are different from those in which the relevant revenues are booked.
Put differently, while calculating jurisdictional revenues, sales made outside the jurisdiction for value created by the country’s user base (for example advertising) would be counted towards it.
To note that there is a difference being made between marketing and distribution presence in-country, and the absence of a distribution and sales entity. In the former case, only Amount A will apply; and in the latter case, Amount A and Amount B will apply. Many entities have a marketing entity in the country that does not undertake sales functions, but only provides support services – how Amount B should be moderated in such cases is a matter of debate.
OECD Proposal and India’s Approach
For India, the Unified Approach comes as a booster shot in a number of ways:
- It represents a partial endorsement of the fractional formulary approach that India has maintained for attribution of profits to a permanent establishment (with the exception being that the apportionment is limited to the non-routine profits instead of the full profits);
- It vindicates its stand on the market being an active ingredient towards profit (a FAR+M approach); and therefore addresses the assertion around advertising, marketing and promotion expenses, albeit in a different way;
- It leaves open the door for argumentation around profits beyond the baseline if the activities are so intense as to warrant an excess compensation, albeit through a multi-country controversy resolution process.
And just maybe, in turn, India could consider adopting mandatory binding arbitration to solve multi-jurisdiction taxation disputes, which should extend to Amounts A, B and C to represent the totality of a solution.
Shefali Goradia and Suchint Majumdar are partners at Deloitte Touche Tohmatsu India.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.