The Organization for Economic Cooperation and Development (OECD) released a draft proposal today detailing how countries should approach the taxation of multinational companies in an increasingly digitalized global economy. The proposed principles would require companies to pay taxes based on the location where customers utilize services or purchase products. This is a shift from the current system, which generally imposes taxes based on where profits are located, or where businesses are headquartered.
This proposed destination-based approach will affect both U.S. tech giants, such as Facebook, Amazon, Apple, Netflix and Google (FAANG), as well as multinational European companies that sell consumer goods. The Trump administration has not released an official statement in response to the OECD draft proposal.
The U.S. and other large developed countries, as well as populous developing countries, may benefit from the proposed principles, as they are consumer-based economies. Smaller European countries that are low-tax jurisdictions may lose revenue. For example, in recent years, an increasing number of companies have based their intellectual property (IP) in Ireland. Under the proposed principles, taxes would be levied based on the location of the customer, not the location of the IP. Representatives from France and the Netherlands have already released statements of support of the proposed principles, while Irish officials have cautioned against hurried action and the implementation of individual country regimes in the meantime.
The proposal comes as an increasing number of European countries have introduced taxes on digital services (DST), which largely affect only U.S. tech companies. By releasing a unified proposal with support from major economic powers, the OECD hopes to stop countries from enacting their own DST regimes. OECD countries will engage in additional discussions and negotiations before rules are finalized. A public consultation meeting will be held in Paris on Nov. 21 and 22 and the OECD hopes the G20 will approve the draft principles by January 2020. This timeline will allow the OECD to release more detailed final rules by June 2020.
The proposed principles are part of the OECD’s ongoing work on its Base Erosion Profit Shifting (BEPS) Action Plan—the first action deals with challenges arising from digitalization. To address this issue, the OECD adopted a two pillars approach. The proposed rules stem from the OECD’s Pillar One—reallocation of profit and revised nexus rules, which grapples with the expanding base of international stakeholders in the economy and policy ramifications on profit allocation and where taxes should be paid. Earlier this year the OECD released a report titled “Developing a Consensus Solution to the Tax Challenges Arising from the Digitalization of the Economy.” The proposed principles contain the OECD’s “Unified Approach” under Pillar One. The proposal includes principles on taxation rights, profit allocation based on a formulaic system, and nexus rules.
A summary of the principles are below:
- Scope. In addition to covering highly digital business models, the principles also focus on consumer-facing businesses. The proposed principles do not flesh out the full scope of the tax or potential carve-outs. Extractive industries, such as mining and oil and gas, are assumed to be out of the scope.
- New Nexus. For businesses within the scope, the principles create a new nexus that is dependent on sales, rather than physical presence. The new nexus could have thresholds, including country-specific sales thresholds calibrated to ensure that jurisdictions with smaller economies can also benefit. It would be designed as a new self-standing treaty provision.
- New Profit Allocation Rule Going Beyond the Arm’s Length Principle. The principles create a new profit allocation rule applicable to taxpayers within the scope, regardless of whether they have an in-country marketing or distribution presence (permanent establishment or separate subsidiary) or sell via unrelated distributors. At the same time, the approach largely retains the current transfer pricing rules based on the arm’s length principle but complements them with formula-based solutions in areas where tensions in the current system are the highest.
- Increased Tax Certainty Delivered Via a Three-Tier Mechanism. The approach increases tax certainty for taxpayers and tax administrations. It consists of the following three-tier profit allocation mechanism:
- Amount A: A share of deemed residual profit, allocated to market jurisdictions using a formulaic approach, i.e., the new destination-based taxing right. As a result, deemed residual profit of multinational businesses (on a consolidated group or business line basis) would be reallocated to market jurisdictions, regardless of the location or residence of the business. The starting point for determining Amount A would be the multinational business’s profits, derived from consolidated financial statements, not tax data. Determining profitability along business or group lines will help prevent income-shifting across low-margin and high-margin business lines. Deemed residual profit calculations would also only take non-routine profits (NRP) into account and would distinguish between NRP that is attributable to the market jurisdiction versus the portion that is attributable to other factors such as trade intangibles, and capital and risk.
- Amount B: A fixed remuneration for baseline marketing and distribution functions that take place in the market jurisdiction. This calculation is intended to reduce the risk of double taxation and reduce disputes in this area that result from the application of transfer pricing rules.
- Amount C: An amount potentially in excess of Amount B, or related to other business activities in the jurisdiction, unrelated to marketing and distribution. It is contemplated that binding and effective dispute prevention and resolution mechanisms will be necessary to determine such amounts.
The draft suggests targeting consumer-facing companies with annual revenues in excess of €750 million ($822 million) and the sales of which reach a specified level in each country, the latter of which has yet to be determined. Country-specific sales will be calculated using a number of factors, including physical presence, number of consumers, and online advertising within the specific country.
While the proposal attempts to address some issues, it leaves others unresolved. For example, the proposed principles acknowledge that further debate will be required on whether or not to apply mechanisms to reflect digital differentiation, the scale and amount of profits reallocated to market jurisdictions, the elimination of double taxation, and other implementation issues.
The OECD has requested public comments on several outstanding issues, including:
- definition of scope, including what constitutes a multinational group and potential carve-outs
- application of new nexus, including the application of country-specific sales thresholds and formulas to ensure that smaller economies also benefit
- calculation of group profits for Amount A, including an appropriate metric for group profits, how to distinguish between business lines or groups, and whether regional profitability should also be considered
- determination of Amount A, including how best to distinguish between routine and nonroutine profits and any challenges or opportunities that would arise from this approach
- elimination of double taxation in relation to Amount A, in context of existing domestic and treaty provisions that also aim to relieve double taxation for multinational companies
- identification of challenges and opportunities for the simplifying dispute resolution, including the need for a clear definition of fixed returns
- experiences with current dispute resolution mechanisms, such as International Compliance Assurance Pilot (ICAP), unilateral or multilateral advance pricing agreements, and mandatory binding arbitration through a mutual agreement procedure (MAP).
This document is intended to provide you with general information regarding the OECD’s digital tax draft proposal. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions.