Ever since the rules of international corporate taxation were written in 1920s by the League of Nations – the permanent establishment (PE) requirement for a multinational corporation for the source state to levy tax has not been removed. The present exercise by the OECD led Inclusive Framework reviews this notion after almost 100 years. What happens to the future of transfer pricing or arm’s length principle? At stake is the allocation of taxing rights between jurisdictions; fundamental features of the international tax system, such as the traditional notions of PE and the applicability of the arm’s length principle; the future of multilateral tax cooperation; the prevention of aggressive unilateral measures; and the intense political pressure to tax highly digitalised MNEs.
The current framework for international taxation goes back to 1920s when the League of Nations submitted a report on international taxation. From these, resulted Vienna convention, the model tax convention by Organization for Economic Cooperation and Development (OECD) and the United Nations (UN). The UN model tax convention is similar to the OECD’s but for more emphasis on the right of source state to levy tax.
At a very simplistic level, according to the current international corporate tax rules, a multinational enterprise (MNE) operating across borders is liable to tax in the market/ source jurisdiction only where such MNE has a physical presence in the country. This physical presence is known as ‘Permanent Establishment’ or PE. With the growing advancements in technology, it has become easy for MNEs to participate in the economic life of market/ source country without a physical presence therein. Accordingly, the current rules for taxation of cross order activities seem outdated. The dissatisfaction with these rules begin to gain momentum in the aftermath of global financial crisis of 2008 when governments, particularly of emerging economies, found themselves struggling to mop up tax revenues in an era of tepid global growth.
In 2013, following a mandate from the G20 Finance Ministers, OECD and G20 countries, working together on an equal footing, adopted a 15-point Action Plan to address Base Erosion and Profit Shifting (BEPS). One of the biggest aims of the BEPS project was to secure revenues by realigning taxation with economic activities and value creation.
In 2015, the OECD released final reports on all 15 action plans. Amongst other things, the BEPS project will amend around 3,000 tax treaties with the help of a multilateral agreement or MLI1 . Action Plan 1 of the BEPS project dealt with ‘Tax Challenges Arising from Digitalisation’. In the absence of any consensus in the report, multiple interim solutions were suggested like ‘Significant Economic Presence’ or a withholding tax in the form of ‘equalization levy’. It was agreed that further work was required to be undertaken to reach a consensus based solution by 2020.
Unilateral Action by jurisdictions including India
Pending a consensus based solution and in an effort to ramp up tax revenues, countries across the globe started implementing unilateral uncoordinated measures, mostly outside the tax treaty framework, to tax digital companies. India introduced ‘equalization levy’ in Finance Act, 2016 – a 6% final withholding tax on payment to non-residents for online advertisement or any provision for digital advertising space or facilities/ service for the purpose of online advertisement. This levy is supposedly outside the tax treaty framework and therefore credit of tax paid is not creditable in the home jurisdiction. Finance Act, 2018 amendment section 9(1) (i) of the Act to provide that ‘Significant Economic Presence’ of non-resident taxpayers would also constitute taxable presence in the form of ‘business connection’ in India. The latter is within the tax treaty framework and is relevant for non-resident taxpayers coming from non-tax treaty covered jurisdictions. Similarly, other jurisdictions introduced unilateral measures.
Post BEPS work
Following up and pursuant to Action Plan 1 report, the OECD released in March 2018 – an interim report on ‘Tax Challenges Arising from Digitalisation’.
In May 2019, the OECD came out with a Programme of Work (“PoW”) to develop a consensus solution to tax challenges arising from Digitalisation of the Economy. This PoW was approved by Inclusive Framework2 countries and laid down two pillars on which further was required to be done. Pillar 1 is the profit allocation in case of highly digitalised businesses and Pillar 2 is the development of a Global Anti-Base Erosion or the ‘GLOBE’ proposal. In respect of pillar 1, three proposals were considered by the PoW namely “user participation”, “marketing intangibles”, and “significant economic presence”.
OECD’s public consultation document on Secretariat Proposal for a “Unified Approach” under Pillar One
Building on the public consultations and consistent with the objective of developing a consensus solution to Pillar 1 issues, the Secretariat prepared a proposed “Unified Approach” combining the elements of all these three proposals. The OECD floated a public consultation document providing an overview of the proposed unified approach
It is important to bear in mind that this is a proposal developed by OECD secretariat4 and does not represent the approach agreed by members. The broad contours of the “Unified Approach” are below.
- Scope: Large consumerfacing businesses. There may be certain carve-outs like extractive industries
- New Nexus: Not dependent on physical presence but largely based on sales. Could have threshold including country specific threshold.
- The New Profit Allocation Rule: Going beyond the Arm’s length Principle (“ALP”) for attributing a portion of nonrouting profits to market jurisdiction.
Firstly, the scope of this approach is to cover highly digital consumer facing business models but includes certain B2B models. Extractive industries are assumed to be out of the scope. Secondly, the approach proposes a new nexus rule – not dependent on physical presence but largely based on sales. It would be designed as a new selfstanding treaty provision and may have country specific sales thresholds.
Thirdly, the approach propose going beyond the ALP and using a simple formulaic approach. The departure from the ALP appears to be for the determination of ‘residual profits’. The approach consists of three tier profit allocation mechanism consisting of Amount A, B and C.
Amount A is a share of deemed residual profit allocated to market jurisdictions using a formulaic approach, i.e. the new taxing right. This constitutes the primary response of the unified approach to the tax challenges of the digitalisation of the economy. Amount B is a fixed remuneration for baseline marketing and distribution functions that take place in the market jurisdiction. Amount C would be additional return over compensation of Amount B, if any, based on transfer pricing analysis. Amount C would also involve developing binding and effective dispute prevention and resolution mechanisms relating to all elements of the proposal.
Cost Inflation Index is a measure of inflation, used to calculate long-term capital gains from sale of capital assets. Capital gains is the profit that you make from selling an asset, which can be real estate, jewellery, stock, etc
The underlying objective is to improve tax certainty for taxpayers as well as tax administrations especially for countries which don’t have enough resources to monitor and administer a complex profit allocation system.
Given that the proposal amounts to fundamental rewriting of the international tax rules, it would be useful to see whether countries are able to reach a consensus. The PoW and the consultation paper note that ‘the stakes are very high. In the balance are: the allocation of taxing rights between jurisdictions; fundamental features of the international tax system, such as the traditional notions of permanent establishment and the applicability of the arm’s length principle; the future of multilateral tax co-operation; the prevention of aggressive unilateral measures; and the intense political pressure to tax highly digitalised MNEs.’
Update by OECD on 31st January 2020
Given that a lot of tech giants that would be impacted especially by Pillar 1 proposal are domiciled in the United States of America (“US”) – the global community was eagerly waiting for the US’s reaction to the both these proposals. As a background, it is important to note that while the USA was not part of BEPS 1 but is a part of the IF. The Tax Cuts and Jobs Act (“TCJA”) of 2017 was significant and brought the US tax framework at par with a global post BEPS era framework.
With this background, the US’ secretary of the treasury wrote a letter to the OECD stating that US has serious concerns regarding potential mandatory departures from arm’s-length transfer pricing and taxable nexus standards – longstanding pillars of the international tax system upon which U.S. taxpayers rely. Instead, the US advocated that goals of Pillar 1 could be substantially achieved by making Pillar 1 a safe-harbor regime. The letter also stated that US supports a GILTI2 like Pillar 2 solution. In its reply, OECD replied that the consultations within the IF had not contemplated the notion that Pillar 1 could be a safe-harbour regime. Further, this may impact the ability of IF member countries to move forward within the tight deadline of achieving a consensus based solution by 2020.
Conclusion / Way Forward
Ever since the report issued by the league of nations in 1920s, a fundamental premise of the international tax system has been the prerequisite of an MNE constituting PE (mostly by a sustained physical presence) in source country for allocating taxation rights to the source country. This fundamental rule is set to change involving a host of other issues – some as outlined above. This initiative by the OECD and the IF comes at a time when multilateralism is under attack from all quarters – some examples include India not joining the Regional Comprehensive Economic Partnership (RCEP), US getting out of the Paris climate deal and the Trans-Pacific Partnership. Hence, the ability to reach a consensus based solution and parting with tax sovereignty at least in a limited sense seems challenging.
After the 2008 global financial crises and in order to stimulate demand, many countries went on a spending spree and ran huge fiscal deficits. As such, the proposals are expected to increase tax revenues across the globe.
An important part of the OECD PoW released in May 2019 was to carry out more in-depth analysis of each proposal and their interlinkages with a particular focus on the importance of assessing the revenue, economic and behavioural implications of the proposals in order to inform the IF in its decision making. On 13 February 2020 – OECD gave a high level update on the economic analysis & impact assessment done so far.
