Is the EU (unintentionally) undermining ongoing OECD work on digital taxation?

By Oliver Treidler, TP&C GmbH

On 14 January, the European Commission published a so-called inception impact assessment and requested feedback on the design of an EU digital levy.

According to the Commission, the EU digital levy will be targeted to address the EU’s need for a modern, stable regulatory and tax framework to appropriately address the developments and challenges of the digital economy.

As such, the initiative exhibits a substantial overlap with the ongoing work of the OECD on Pillar 1 and Pillar 2 (see my previous discussion of the proceedings on the OECD level).

The Commission invited stakeholders to submit comments on the EU digital levy (roadmap) until 12 February. As of 11 February, 38 comments were submitted.

Considering that the Commission limited the comments to a total of 4,000 characters, only some of the key issues could be commented upon. Compared to the OECD’s comprehensive public consultation process, the scope of discussion allowed by the EU is rather limited.

Pursuant to the current timeline, the Commission is expected to propose a directive in the second quarter of 2021.

If the Commission pushes forward with the EU digital levy, substantial additional taxes and compliance procedures are a foregone conclusion – irrespective of the policy options ultimately implemented. For Europeans and those having business interests in Europe, it is thus pertinent to keep an eye on further developments.

At issue is whether there is a sound rationale for the EU to pursue an EU digital levy in parallel with the OECD and whether such a levy, based on a differing conceptual framework (i.e., understanding of value creation), could undermine the work of the OECD.

Pillar1 is about new nexus rules for market jurisdiction, NOT about profit shifting

As can be seen in the current OECD work on Pillar 1 and Pillar 2, taxing digital activities of MNEs translates to one of the most comprehensive and complex reforms of the rules and regulations governing international taxation.

The complexity primarily originates from the fact that, due to the nature of the digital activities, i.e. not requiring a physical presence to sell products to customers in a specific “market jurisdiction”, a new nexus (taxing right) in these market jurisdiction needs to be established (defined) to put market jurisdiction in the position to tax the activities (sales) occurring in their territory.

Fundamentally, it needs to be understood that the OECD reform proposals (especially Pillar 1) are conceptionally first and foremost about creating such a new nexus and not about tackling the issue of profit shifting.

In other words, Pillar 1 is not to be misunderstood as BEPS 2.0 (see Eden, L. and Treidler, O. (2019); INSIGHT: Taxing the Digital Economy—Pillar One Is Not BEPS 2, Bloomberg Tax). As evidenced by the comprehensive blueprints published by the OECD, as well as by the respective public discussion process, tackling the political and technical issues at stake requires a principled discussion on how to define fundamental concepts underlying the overhaul of taxing the digital economy (e.g., defining the concept of value generation, defining nexus thresholds, and differentiating different types of digital activities).

The European Commission needs to have a clear understanding of the issues at stake and appreciate the technical concepts underlying OECD reform proposals.

Failing to appropriately take these issues into account will inevitably result in a disconnect between the EU and OECD initiatives, with such a disconnect potentially undermining the ongoing OECD work (consensus-building) and fueling international trade tensions.

Considering that the inception impact assessment states that such a disconnect is to be avoided, any policy designed on the European level should be contextualized with the international tax framework.

However, several aspects of the EU digital levy seem problematic and need to be addressed.

The EU digital levy is focused on profit shifting and overestimates the problem

One fundamental shortcoming of the EU digital levy is a failure to accurately capture the problem to be addressed.

Among others, this is reflected in the Commission’s statement that “Much of this value created by users is not captured by the current tax systems“.

The statement is imprecise, as neither “much” nor the concept of “value”, as understood by the EU, are clearly defined.

The current tax system, based on the arm’s length principle, does conceptually capture contributions, such as marketing intangibles, with the caveat that for market jurisdictions without a physical presence, a taxable nexus is missing.

The fundamental problem is thus the nexus (see above).

Insofar as marketing intangibles (attributable to a local sales entity) do not capture user data and user-created content, there would indeed be a conceptual “gap” in the current tax system.

This issue, however, is currently addressed by the OECD in designing the so-called Amount A. As such, it is also unclear whether the EU would conceptually agree that the OECD blueprints are, in the view of the EU, appropriate to ensure that the value created is captured.

The OECD’s ongoing work on Amount A is a conscious attempt to establish a refined definition of “value creation” within the context of digital activities.

Without a respective definition, it is neither feasible to accurately capture the (perceived) problem nor design a principle-based policy framework.

Despite all (partially justified) criticism, the OECD has made substantial progress on this issue, culminating in a quantitative economic impact assessment for the effects of implementing Amount A.

Based on its EU digital levy’s content (wording), it appears that the Commission is currently not operating based on a clearly defined concept of value creation. If the EU should develop (apply) a concept of value creation that deviates from the (emerging) consensus on the OECD level, a disconnect and conflict seem inevitable.

Furthermore, the Commission’s description of the problem is (unduly heavily) emphasizing (potential) profit shifting of MNEs relating to intangibles.

As highlighted above, the OECD’s ongoing work on digital taxation is focused on designing new nexus rules and refining the concept of value creation, which is conceptually different from the earlier BEPS reforms targeted at profit shifting (e.g., introduction of the DEMPE concept)

As such, the Commission fails to delineate the problem accurately. Mixing the two conceptually distinct problems not only leads to an overstatement of the scale of the problem (of profit shifting), but it is also incompatible with finding targeted and principle-based policy solutions.

The “overstatement” of the scale of the (perceived) problem is evident in the notions of the Commission regarding “fair recovery” and “major instruments“.

In this context, it would seem imperative that the EU explicitly takes the economic impact assessment compiled by the OECD into account.

Despite existing technical limitations, the economic impact assessment provides a sensible and valuable starting point for accurately capturing the scale of the problem and rationally manage (political) expectations regarding additional taxes to be derived from taxing digital activities.

Based on the key results of the OECD economic impact assessment, it is evident that Pillar 1 (Amount A) is anticipated to yield merely an increase of 0.2% to 0.5% of global corporate income tax revenues (between 5 to 12 USD billion) – only a fraction of which would be allocated to EU Member States (with some of the more tax competitive EU Member States being likely to surrender corporate income tax revenues).

It is also important to understand that the OECD estimates are based on the implied value creation parameters being most likely to gain international consensus (10% threshold for residual profits of which 20% are subsequently deemed eligible for allocation under Amount A).

While changing the respective parameters (i.e., lowering the threshold and/or increasing the share of Amount A eligibility) would increase the additional corporate income tax revenues, the effects are not likely to be substantial – especially when considering that the applied parameters are required to facilitate international consensus.

In other words, the anticipated increase in corporate income tax could only amount to substantial amounts when applying parameters that conflict with the definitions of value creations underlying the OECD proposal. Thus, the EU should be careful to keep potential gains in a realistic perspective and acknowledge that there is a clear tradeoff between the amount of potential corporate income tax to be raised and undermining the ongoing OECD work.

Thus, the EU should be careful to keep potential gains in a realistic perspective and acknowledge that there is a clear tradeoff between the amount of potential corporate income tax to be raised and undermining the ongoing OECD work.

Thus, the EU should be careful to keep potential gains in a realistic perspective and acknowledge that there is a clear tradeoff between the amount of potential corporate income tax to be raised and undermining the ongoing OECD work.

The Commission also heavily emphasizes the issue of (perceived) “fairness”.

From the perspective of policymakers, the appeal of referring to increased “fairness” is understandable. Considering, however, that finding an international consensus on what actually constitutes “fairness” will likely remain elusive (as fairness is a notorious weasel word). Focusing on achieving a working consensus on value creation (which is difficult enough) seems more promising. For additional views expressed by EU citizens regarding “fairness”, please refer to the comments submitted to the EU (notably F1456467 and F1456441).

Would an intervention by the EU survive a subsidiarity check?

As emphasized in the previous section, the ongoing work of the OECD is in a comparatively advanced stage.

It is unclear how the EU, if intending to adopt a principle-based solution, intends to supplement or improve the OECD’s conceptual framework. Actively engaging in the OECD work programme seems much more sensible in this respect.

Specifically, it should be considered that a truly sustainable tax framework for the digital economy requires a consensus-based approach on a global level, while multiple idiosyncratic regional (national) approaches would likely be detrimental to international cooperation and economic development. Clearly, a global solution build-on the OECD proposal seems preferable to an EU solution.

Also, it is unclear how the Commission derives the conclusion that coordinated action at the EU level is necessary to address these challenges in an efficient and comprehensive manner and preserve the functioning of the internal market.

Within the EU, one would need to consider the fact that there are no (substantial) externalities.

A tax gap attributable to a missing nexus would yet have to be quantified for the EU but can safely be assumed to be comparatively small based on the OECD impact assessment. Also, Member States can react on their own (i.e., in accordance with their individual preferences) by implementing national taxes (affecting their citizens and businesses operating in their jurisdiction).

A broad criterion of optimality regarding the allocation of policy prerogatives between the EU and the Member States can be defined as follows: Policy areas where the heterogeneity of preferences is high should be allocated to member States. Policy areas in which economics of scale and/or externalities are dominant should be allocated to the EU.

This definition can easily be applied to the concept of subsidiarity (so-called “functional subsidarity test” – see Treidler, O. (2014), From the Lisbon Strategy to Europe 2020 and Beyond).

When applied to digital taxation, it seems highly unlikely to support shifting prerogatives to the EU. The Commission needs to respect that taxation is not subject to qualified majority voting. Any argument or policy initiative aimed at shifting prerogatives to the EU would need to be based on a respective assessment identifying substantial externalities.

As a respective assessment for the digital economy is missing and contemporary (post-BEPS) assessments of the broader phenomenon of profit shifting strongly suggest that earlier (pre-BEPS) assessment of potential tax gaps are no longer valid and (grossly) overestimate the extent of profit shifting (see Fuest, C. et al. (2021), Corporate Profit Shifting and the Role of Tax Havens: Evidence from German Country-By-Country Reporting Data, cesifo Working Paper), the existence of substantial externalities appears doubtful.

Considering the tradeoff between, arguably, limited externalities and heterogeneous preferences of the Member States and the complex technical issues at stake, the EU should, at least for the time being, explore policy alternatives outside the community method (such as the open method of coordination).

To shift prerogatives, the burden of proof should, in my view, lie with the EU (but that is an issue for the lawyers and beyond the scope of this article).

Objectives and policy options outlined by the Commission remain vague

The Commission lists a rather broad and unspecific menu of potential policy options and general objectives.

The policy options include a corporate income tax top-up to be applied to all companies conducting certain digital activities in the EU, a tax on revenues created by certain digital activities conducted in the EU, and a tax on digital transactions conducted business-to-business in the EU.

Considering that no specifics are provided, it is not possible to provide feedback on these issues. This, however, is not necessarily to be seen as detrimental considering that, as highlighted above, the problems with the EU digital levy are of much more fundamental nature.

In other words, as long as the conceptual issues are not accurately delineated and the rationale for an intervention by the EU remains questionable, discussing individual policy options is premature.

Still, when designing future policy options, the Commission should be mindful of addressing several critical building blocks.

First, the Commission needs to explain and operationalize the objective of “fairness”. The following (non-exhaustive) questions would need to be answered: What is the applied understanding of value creation?  How are contributions (gaps) from MNEs measured – individually and in the aggregate? What are the anticipated effects (externalities) on corporate income tax income?

Second, and perhaps most importantly, if the Commission is serious about not wanting to undermine the ongoing work of the OECD, the core tenets of the OECD reform proposal should be identified and applied as a “frame” within which any EU policy should be constructed (including the scope of digital activities to be included).

Second, and perhaps most importantly, if the Commission is serious about not wanting to undermine the ongoing work of the OECD, the core tenets of the OECD reform proposal should be identified and applied as a “frame” within which any EU policy should be constructed (including the scope of digital activities to be included).

Further issues to consider include that a tax on revenues seems incompatible with sustaining competitiveness and economic growth in an increasingly vital sector of the economy. It is also unclear why a policy option based on a revenue-based tax could meet the functional subsidarity test.

Looking, again, at the OECD economic impact assessment, one of the most uncontroversial conclusions to be derived is the fact that the revenue threshold for MNEs being subjected to Amount A (EUR 750,000,000) must be considered as already being comparatively low, i.e., the assessment shows that further lowering the threshold would not yield additional corporate income tax income.

Thus, the EU, irrespective of the policy options to be pursued, should make an explicit statement that SMEs (below the threshold) will be excluded (out of scope). Any design to the contrary would be an unjustifiable violation of the principle of proportionality.

Economic and social impacts appear negligible

Naturally, the economic impact will depend on the policy option ultimately implemented.

It must, however, be recognized that there are clear tradeoffs, i.e. the amount of potential additional corporate income tax to be generated is limited by a.) a principled-based policy design (link to value creation) and b.) negative effects (trade wars) in case a. is not confined to internationally acceptable limits.’

Overall, based on the existing empiric literature, it is unclear how the EU expects to raise substantial tax revenues while operating within a global tax framework, keeping compliance burdens at acceptable levels and sustaining competitiveness (not hurting the consumers).

Considering that a substantial positive economic impact seems questionable, it is also difficult to see any meaningful social impact. The “perception of tax fairness” addressed by the Commission is certainly important.

 In this context, however, the EU should rely more explicitly on empirical evidence. The public discussion tends to be influenced by anecdotal evidence of large-scale (endemic) tax avoidance, while the underlying reasons are not discussed in appropriate detail.

One of the core issues, persisting throughout the last ten years or so, is that the EU tends to favor formulary approaches (i.e., supporting the adoption of the CCCTB), while often portraying the arm’s length principle as being susceptible to manipulation.

The concept of value creation underlying formulary apportionment is, however, drastically different [not superior] from the arm’s length paradigm and does neither reflect an international consensus nor any “ideal” of aligning value creation with taxation (see Treidler, O. (2020), Debunking Claims Regarding the Shortcomings of the Arm’s Length Standard, see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3582877 ).

The narrative often adopted in this context by proponents of formulary apportionment is fueling the perceived unfairness and has corrosive effects on the ongoing work of the OECD.

To address perceived tax fairness, the EU should make a deliberate effort to refrain from portraying the arm’s length principle as being synonymous with profit shifting and acknowledge that the OECD has worked hard (and is largely successful) to modify the international transfer pricing framework.

Failure to adopt a clear and unambiguous policy stance would threaten to undermine the OECD’s work not only in respect to digital taxation but on all fundamental policies on international taxation.

In other words, the EU needs to explicitly declare whether it supports the arm’s length paradigm applied by the OECD. In the absence of such a declaration and vital point of orientation for tax policies, competing proposals from the EU will inevitably generate international conflict – not facilitate consensus.

In the firm belief that we, as Europeans, do not need more conflict in the current difficult situation, I kindly ask European policymakers to proceed with utmost care and consideration.