It is not possible to understand the measures included in the "Unified Approach" presented by the OECD Secretariat without a brief reminder of the context in which such measures were created. The 2015 Action 1 report of the BEPS Project, addressing the Tax Challenges of the Digital Economy, highlighted a crucial idea which permeates the debate on tax models in the new economy: it would be impossible to ring-fence the digital economy from the rest of the economy for tax purposes, because the digital economy is increasingly becoming the economy itself. Therefore, the report acknowledged the need to continue working to reach a consensus on measures to address the tax challenges of the digital economy and committed to producing a report in by 2020.
In January 2019, the OECD published a policy note and a public consultation document which grouped the proposals under consideration into two pillars. Pillar One focuses on the allocation of taxing rights and seeks to undertake a coherent and concurrent review of the profit allocation and nexus rules ("nexus" implies the determination that sufficient elements exist to infer that a company has an economic relationship with a certain jurisdiction which would allow such jurisdiction to tax this particular company). Pillar Two is concerned with the remaining BEPS issues.
Within Pillar One, 3 proposals are put forward which seek to expand the taxing rights of the market jurisdiction, each with its own nexus and profit allocation rules.
The proposal is premised on the idea that soliciting the sustained engagement and active participation of users is a critical value-driver for digitalised businesses and is geared towards business models such as social media platforms, search engines and online marketplaces.
Under this proposal, profit would be allocated to those jurisdictions in which those businesses hold active and participatory user bases. Such allocation would not be made under traditional arm's length principles but rather through a residual profit split allocation calculation which, at a very basic level, would involve:
- Determining the remainder (non-routine) profit after routine activities have been remunerated on an arm's length basis.
- Attributing a portion of such profits to the value created by the activities of users.
- Allocating such profits between the jurisdictions in which the business has users based on agreed metric (e.g. revenues).
Given the significant challenges to implementation (allocating value to users, localising such user bases, profit segmentation and calculation…), the proposal acknowledges that it would require to rely on "pragmatic" formulae to approximate the data (such as the value of users to a business, etc.) limiting its scope to the above mentioned digital business models: social media platforms, search engines and digital marketplaces. Finally, a strong dispute resolution component would also be needed.
Marketing intangibles proposal
In an effort to respond to the wider impact of digitalisation in the economy, the proposal would have a wider scope and not be intended to apply only to a subset of highly digitalised businesses. This model conceptualises an intrinsic functional link between marketing intangibles and the market jurisdictions where such intangibles allow the business to generate value. This functional link can be conceived either because
- some marketing intangibles, such as brand and trade name, are reflected in the favourable attitudes in the minds of customers present in the market jurisdiction; or
- other marketing intangibles, such as customer data, customer relationships and customer lists are derived from activities targeted at customers and users in the market jurisdiction.
Under this proposal, right to tax is attributed to a jurisdiction regardless of whether entities owning the legal title to the marketing intangibles or performing functions closely associated to the intangible are located in such jurisdiction.
Two alternative methods are put forward to allocate the residual income of the business between marketing intangibles and other income producing factors:
- Through application of transactional transfer pricing principles, which would require determining the marketing intangibles and their contribution to profit under two assumptions:
- an assumption that the marketing intangibles are allocated under the current transfer pricing rules; and
- an assumption that the marketing intangibles (and their attendant risks) are allocated to the market jurisdiction.
The difference between both assumptions would create the marketing intangible adjustment.
- Through a revised residual profit split analysis, based on the following mechanical steps:
- determination of relevant profit;
- determination of routine functions and their compensation (possible methods range from the full transfer pricing analysis to more mechanical systems such as mark-ups on costs…);
- deduction of routine profit;
- division of the remaining or “residual” profit to determine the portion attributable to the marketing intangibles (again though various possible methods ranging from cost based methods to approaches using fixed contribution percentages); and
- allocation to each market jurisdiction based on an agreed metric, such as sales or revenues.
The proposal should be supported by strong dispute resolution mechanism.
Significant economic presence proposal
The model is based on the view that the digitalisation of the economy has enabled business enterprises to be heavily involved in the economic life of a jurisdiction without a significant physical presence. Therefore, the taxable nexus would be defined in terms of "significant economic presence" on the basis of various factors. Revenue generated on a sustained basis would be the main element but not be sufficient in and of itself. Additional factors would be needed such as:
- the existence of a user base and the associated data input;
- the volume of digital content derived from the jurisdiction;
- billing and collection in local currency or with a local form of payment;
- the maintenance of a website in a local language; etc.
Profits would be allocated to this taxable presence on the basis of a fractional apportionment method, which would require 3 steps:
- the definition of the tax base to be divided (for instance by applying the global profit rate of the group to the sales generated in a particular jurisdiction);
- the determination of the allocation keys to divide that tax base (e.g. by taking into account factors such as sales, assets, employees, or users); and
- the weighting of these allocation keys.
This proposal would include a withholding tax as a collection mechanism: a low rate would be applied on a gross basis (e.g. on the local payments) and the taxpayer would then be entitled to file an income tax return to recoup any excess tax withheld.
The "Unified Approach"
On 9 October 2019 and faced with lack of progress on these proposals, the OCDE put forward a new "Unified Approach", based on the commonalities of the above 3 proposals.
The scope of the "Unified Approach" is wide, drawing from the significant economic approach proposal, and would be directed at large consumer-facing businesses. The digital element would be necessarily present but would not be the defining feature. The proposal, therefore, recognises that further discussion is necessary to articulate and clarify the scope (for instance, extractive industries and commodities would be carved-out and size limitations thresholds may be considered).
The nexus rule to establish presence in the state of source would centre on sustained and significant involvement in the economy of a market jurisdiction, such as through consumer interaction and engagement, irrespective of the level of physical presence in that jurisdiction. A revenue threshold in the market could be defined as the primary indicator of a sustained and significant involvement in that jurisdiction. Moreover, this new nexus would be introduced through a standalone rule, on top of the permanent establishment rule.
In terms of allocation of benefits, the "Unified Approach" proposes a 3-tier mechanism:
- Amount A, which would be calculated over the profit that remains after allocating profit to routine activities. The calculation would also require a determination of the proportion of the deemed residual profit that should be allocated and, in turn, an attribution to particular markets through a formula based on sales.
- Amount B, which explores the possibility of allocating profit to distribution activities, carried out in the market jurisdiction, using fixed remunerations reflecting an assumed baseline activity.
- Amount C, which allows, in cases where there are more functions in the market jurisdiction than have been accounted for by reference to the local entity’s assumed baseline activity (which is subject to the fixed return in B above), an additional profit allocation in accordance with the existing transfer pricing rules.
Mechanisms to address any risk of double counting or duplications between the three possible types of taxable profit, will be necessary.
The "Unified Approach" represents an important effort to progress in the design of tax measures to address the challenges of current business models. The amendments proposed to international tax rules are profound, have the potential to affect more than only digital business models and will entail important consequences in terms of the tax liability of entities and the tax revenues of states.
Regardless of whether there is political will to implement these proposals, the complexity in the design and implementation of these measures is undeniable. The OECD is committed to simplification to achieve measures, which would both be practical and not give rise to unnecessary litigation between taxpayers and authorities. However, this simplification can easily result in technically deficient instruments. The proposals are at a theoretical stage and there is still a long way to go for a radical shake-up of the current international taxation rules.