On 13 February 2019, the OECD outlined three policy options addressing tax challenges posed by the increasing digitalisation of the economy. The OECD also asked for feedback on two measures aimed at tackling remaining BEPS issues, which would effectively amount to a minimum taxation of cross-border profits. The OECD’s earlier policy note published on 29 January 2019 already hinted at this ‘two-pillar’ approach set out in the consultation paper (see our update here). Most policy measures presented in this paper would have a broad impact, affecting companies beyond the taxation of digital services.
Three options for revised profit allocation and nexus rules
The first pillar aims to address the broader challenges of the digitalised economy by focusing on the allocation of taxing rights. The OECD proposals entail that businesses would allocate more profits to markets with whom they interact, regardless of the extent of their physical presence there.
The three policy alternatives to achieve this goal focus on (i) user participation, (ii) marketing intangibles or (iii) defining a ‘significant economic presence’:
- The user participation alternative would involve allocating profits to jurisdictions where “active and participatory user bases” are located, regardless of physical presence. It would affect essentially three business models: social media platforms, search engines and online marketplaces. A residual profit split approach, together with allocation keys, would serve to apportion profits linked to user participation between jurisdictions.
- The marketing intangibles alternative would have a wider scope, as any business operating with little physical presence but earning income thanks to marketing intangibles (brand, trade name, customer data) would be in scope. After allocating income to all other functions, applying existing profit allocation principles, the residual income attributable to marketing intangibles would be allocated to the market jurisdictions based on agreed metrics.
- The significant economic presence alternative is closer to the EU’s “comprehensive solution” (see our publication of 21 March 2018) and is the least developed but also the farthest-reaching proposal. OECD countries would need to agree on (i) defining the tax base, (ii) determining the allocation keys and (iii) how to weigh these allocation keys. The nexus factors triggering a “significant economic presence” as suggested by the OECD may result in this alternative going beyond that proposed by the EU.
All three alternatives would deviate from the current application of the arm’s length principle and existing transfer pricing rules updated further to the OECD Action 8-10 BEPS reports.
The global anti-base erosion proposal
The second pillar deals with remaining BEPS issues. The OECD proposes two measures to go beyond the BEPS reports and further reduce profit shifting to entities with little substance in low-tax jurisdictions:
- An “income inclusion rule”, whereby income of a foreign branch or controlled entity would be included in the tax base of the controlling taxpayer if that income was subject to an excessively low effective tax rate (with credit granted for any foreign tax paid on such income); and
- A “tax on base eroding payments,” which would effectively (i) deny the deduction of payments to a related party if that payment was insufficiently taxed beforehand and (ii) grant tax treaty benefits only if the beneficiary is “sufficiently taxed” in the other treaty jurisdiction.
The income inclusion rule would come in addition to, rather than replace, national CFC rules. It includes a switch-over rule (replacing the exemption method by the credit method to prevent double taxation), but its design may also better prevent double taxation compared to the CFC rules of the EU Anti-Tax Avoidance Directive (“ATAD”). Depending on the minimum rate threshold, this rule may have a significantly broader impact than CFC rules. As to the tax on base eroding payments, it would be farther-reaching than existing anti-treaty abuse rules.
The input of stakeholders will be made public and will be discussed 13-14 March 2019. In May 2019, OECD countries and partner countries will prepare a report, which will subsequently be discussed at the G20 meeting in June 2019. The consultation is open until 1 March 2019. Our digital economy taxation team is available to assist, should you wish to provide input.
Compliments of Loyens & Loeff, a member of the EACCNY