Taxing the digital economy – new taxing right under OECD Pillar One

On 12 October 2020, the Organisation for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on BEPS released a series of documents in connection with the BEPS 2.0 project, including a detailed report on the Blueprint on Pillar One (the Blueprint). The aim of Pillar One is to reach a global agreement on adapting the allocation of taxing rights on business profits in a way that expands the taxing rights of market jurisdictions. In order to achieve this, Pillar One contains three elements:

(a) New taxing rights for market jurisdictions over a share of the (deemed) residual profits of a multinational enterprises group (MNE) or segment of such a group (Amount A)

(b) A fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction (Amount B)

(c) Processes to improve tax certainty through effective dispute prevention and resolution mechanisms

As the OECD documents make clear, the Blueprint does not reflect agreement by the member jurisdictions of the Inclusive Framework on BEPS because there are political and technical issues that still need to be resolved. However, the cover statement of the Inclusive Framework refers to the Blueprint as a “solid basis for future agreement” and states that the member jurisdictions have agreed to keep working “to swiftly address the remaining issues with a view to bringing the process to a successful conclusion  by mid-2021.”

The Blueprint indicates that the follow up work on Pillar One will focus on resolving the remaining political and technical issues, which include essential elements of Pillar One, such as issues around scope, quantum, the choice between mandatory and safe harbour implementation, and aspects of the new tax certainty procedures connected to Pillar One. There are a number of aspects relating to design and implementation elements of the Blueprint that would require a consideration.

Scope

The new taxing rights under Amount A apply to multi-national enterprises that fall within the defined scope. Two categories of activities are proposed to be included in the scope: (a) Automated Digital Services (ADS); and (b) Consumer Facing Businesses (CFB). Given that the concern of most countries around base erosion arises from digital businesses, the OECD could consider a phased implementation with ADS coming first and CFB following later.

Amount of profit to be reallocated

Agreement on how much residual profit would be reallocated under the new taxing right is conditioned on agreement on scope. The quantum would depend on the determination of different threshold amounts and percentages for the purpose of scope, nexus and profit allocation (the formula). Much work has been completed on the impact of different thresholds and percentages of profit to be allocated. The current approach seeks to allocate only a portion of the residual profit to market jurisdictions. There may be merit in considering whether market jurisdictions should be allocated, beyond residual profit, a portion of routine profit as well in the case of remote marketing and distribution activities facilitated by digitalization. In addition, the OECD should also consider “differentiation mechanisms” in order to increase the quantum of profit reallocated to market jurisdictions for certain business activities (for example, ADS), or a scalable reallocation depending on the profitability of the business (profit escalator). These variations to the Amount A profit allocation rules would need serious consideration if a consensus is to be reached.

Extent of tax certainty

While all members have agreed on the need for an innovative solution to deliver early certainty and effective dispute prevention and resolution for Amount A, there continue to be differences of view on the scope of mandatory binding dispute resolution beyond Amount A. The Blueprint contains proposals to bridge these divergent views. A decision on this issue will need to be part of a comprehensive agreement also covering the other two open political issues on quantum and scope. While India has historically not been in favour of resolving tax disputes through binding arbitration, considering the overarching objective of providing tax certainty, it may consider revisiting its historical position.

Scope and application of Amount B

While the Blueprint contains an outline of a solution that assumes that in-scope distributors are to be identified based on a narrow scope of baseline activities, there may be merit in exploring the feasibility of broadening the scope of Amount B. There may also be a need to further refine the design of Amount B such that the intended simplification benefits are achieved, and further consider that implementation through a pilot program at first may allow for some evaluation of the benefits in practice.

Concluding thoughts

Taxation of the digital economy raises complex technical questions, and there are also differing views among countries on the extent of changes to the international tax rules. Concerns about the inadequacy of the current rules to deal with the broader tax challenges is evidenced by the increasing number of uncoordinated, unilateral actions. Hence, it is important to find a multi-lateral solution to the issues. The proposals under Pillar One represent a substantial change to the tax architecture and go well beyond digital businesses. These proposals could lead to significant changes to international tax rules under which businesses operate. If no agreement can be reached by mid-2021, it is expected that many countries will introduce digital services taxes. Moreover, countries could introduce other elements of the Pillar One architecture through their domestic legislation, such as for example a variation of Amount B. If there is no coordinated global agreement, this could lead to a rise in double taxation and controversy.