Emerging technologies have stirred fresh tax challenges, due to which governments of various countries have demanded more transparency in introducing new rules for the digital economy.
The digital economy has revolutionized the traditional ways of conducting business across the world. Emerging production and consumer models along with new technologies have created a set of fresh tax challenges and have strained existing international tax rules which have been slow to adapt to the new business environment. It is against this backdrop that governments of different countries are demanding greater transparency and introducing new rules and regulations for the digital economy.
The prelude
In January 2019, the Organisation for Economic Co-operation and Development (OECD) released a policy note communicating that renewed international discussions will focus on two central pillars. Pillar One will address the broader challenges related to the digitalization of the economy and will focus on the allocation of taxing rights, and Pillar Two will sort out the remaining Base Erosion and Profit Shifting (BEPS) concerns (collectively, BEPS 2.0 project). In May 2019, the OECD released the ’Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy‘ (the workplan). The workplan’s timeline summarizes a long-term solution to address the digitalization challenges, which is to be submitted to the BEPS Inclusive Framework (IF) for an agreement in January 2020, and work on elaborating the policy and technical details of the solution will continue in 2020 to deliver a consensus agreement on the new international tax rules by the end of 2020.
While OECD is working towards achieving a global consensus on a unified approach, the United Nations Committee of Experts on International Co-operation in Tax Matters (UN Committee) has decided to work independently on the ‘tax consequences of digitalized economy’ taking note of work done in other forums. Accordingly, the UN Committee has released a draft paper on introduction of a new Article 12B along with commentary in the United Nations (UN) Model Convention. The new Article 12B defines the nexus and determination of profits for automated digital services (ADS), thereby providing taxing right over such income to the source jurisdiction. The proposal currently requires further consideration.
The workplan
Pillar One contains three alternative proposals: the user participation proposal, the marketing intangibles proposal and the significant economic presence proposal. These proposals differ in objective and scope of reallocation of taxing rights. However, common aspects in these proposals will allow to resolve the technical issues under Pillar One by grouping these issues into three building blocks, namely, new profit allocation rules, new nexus rules and implementation of new market jurisdiction taxing right. The workplan sets out three different methods – modified residual profit split method, fractional apportionment method and distribution-based approach – to quantify the amount of profit to be reallocated to market jurisdictions and methods to determine how profits should be allocated. The workplan stated that OECD will explore the development of remote taxable presence and a new set of standards for identifying the existence of such taxable presence.
OECD’s proposal for a ’unified approach’
On 9 October 2019, the OECD released a public consultation document outlining a proposal from the OECD Secretariat for a ’unified approach‘ under Pillar One. The scope of the Secretariat Proposal covers highly digitalized business models and consumer-facing non-digitalized businesses. The proposal also includes a new nexus concept that is not dependent on physical presence and is largely based on sales. It is proposed to be separate from the existing permanent establishment (PE) concept. The new nexus would operate regardless of whether taxpayers have an in-country marketing or distribution presence or the taxpayers sell through related or unrelated distributors. In addition, the proposal contains a three-part approach to new and revised profit allocation rules, which would provide a formulaic method to allocate deemed non-routine profits to market jurisdictions under the new nexus concept (Amount A). Besides this, the approach provides a formulaic approach for a fixed return to baseline marketing and distribution activities in situations where there is nexus under the existing principles (Amount B), and an approach for allocating additional profit to the market jurisdiction where the local activities exceed such baseline activity. Finally, the proposal contemplates binding effective dispute prevention and resolution mechanisms that would cover all three parts of the profit allocation approach (Amount C). The proposal acknowledges that further technical work is required and includes an annexure with a series of specific questions for public comment on significant policy, technical and administrability issues.
The statement
On 31 January 2020, the OECD released a statement which is accompanied by annexes that provide more detailed discussion of the work on both Pillars . This includes an outline of the architecture and a revised workplan for Pillar One, relating to revised nexus and profit allocation rules, and a progress update on Pillar Two, relating to new global minimum tax rules. With respect to Pillar One, the IF has endorsed a unified approach as the basis for the ongoing negotiation of a consensus-based solution. With respect to Pillar Two, the IF has welcomed the progress that has been achieved to date. The statement notes that there are technical challenges involved in developing workable rules and highlights the critical policy differences among countries that must be resolved, including the United States (US) proposal for implementation of Pillar One on a ‘safe harbour basis’.
Overall the revised Pillar One Programme of Work organizes the remaining work to be undertaken to further develop the unified approach into eleven workstreams, which align to the elements of the Pillar One outline, i.e., (1) Scope of Amount A; (2) New nexus rules and related treaty considerations for Amount A; (3) Tax base determinations; (4) Quantum of Amount A; (5) Revenue sourcing under Amount A; (6) Elimination of double taxation under Amount A; (7) Interactions between Amounts A, B and C and potential risks of double counting; (8) Features of Amount B; (9) Dispute prevention and resolution for Amount A; (10) Dispute prevention and resolution for Amounts B and C; and (11) Implementation and administration.
Proposed introduction of new Article 12B in the UN Model Convention
The proposed Article 12B grants taxing right to the source country over the income arising from ADS. It provides the option to choose either gross or net basis of taxation. The concept of introducing a new Article is largely based on a proposal presented by a senior Indian IRS officer and UN Committee member Mr. Rajat Bansal . Introduction of the new Article in the UN Model Convention advocates for a simpler approach. Accordingly, in-scope activities will be confined to ADS in respect of revenue from market jurisdictions, other than income attributable to PE under the existing source rule and fee for technical services. Further, the nexus may be established in a market jurisdiction only based on local revenue derived. The profits may be determined through fractional apportionment method by applying the multinational enterprise (MNE) group profit rate derived from in-scope activities on the local sales revenue and attributing a percentage of the same to market jurisdiction. With an introduction of separate Article in the tax treaties, the double taxation relief can continue to be governed by the existing tax treaty provisions.
On the implementation front, since the bilateral tax treaty negotiation will involve substantial time, a multilateral convention similar to Multilateral Instrument is proposed. The draft outline is now before the larger member panel for further discussion.
India’s perspective
India began its digital tax journey in 2012 with the amendment of the term “royalty” in the domestic tax law which now captures most technology/digital economy transactions. Further, the concept of PE as a nexus for taxing business profits has come under significant pressure, with tax authorities sometimes asserting virtual PE under the definition of traditional PE.
India was also the first country to implement an equalization levy of 6% of the amount received or receivable by a non-resident for providing specified digital services and facilities.
India also sought to introduce the concept of Significant Economic Presence (SEP) to amend the rules on profit attribution to a PE. However, Central Board of Direct Taxes (CBDT) is yet to prescribe these rules.
Recently, India has extended the source-based taxation rule to cover income from advertisement, sale of data collected from India, and sale of goods or services using data collected from India. Further, the scope of equalization levy is expanded to cover e-commerce transactions. Currently, the scope is wider and may potentially cover even traditional business models. However, an additional guidance in this regard is much anticipated from the Government of India.
Traditionally, India has sought to have greater source country taxation while allocating taxing rights under a tax treaty by seeking to have a broader definition of PE as compared to the OECD standard. Accordingly, India may look at bilateral negotiation of tax treaties to include new Article 12B or sign a multilateral convention to this effect.
