The OECD’s ‘Unified Approach” to digital taxation

By George L. Salis, Principal Economist & Tax Policy Advisor, Vertex, Inc., King of Prussia, Pennsylvania

 As predicted for some time, the OECD finally had its Wayfair moment. Compelled to take action to bring digital taxation under a uniformed international standard and prevent countries from going “unilateral” with their own digital tax regimes, the OECD has proposed to not only expand the taxing rights of most digital market countries, but also re-write international taxation, well beyond the original OECD/G20 Base Erosion and Profit Shifting (BEPS) initiative.

The OECD appears well on its way to following the US Supreme Court’s June 2018 South Dakota v. Wayfair decision by signaling its intention to abandon the longstanding physical presence standard for determining nexus. Instead, the OECD envisions a new global tax framework in which remote sellers operating beyond state and country borders are taxed by the countries in which their customers live according to specific sales thresholds.

On October 9, the OCED released a 21-page public consultation document that describes a proposal from the OECD Secretariat (the division that carries out the OECD’s policy work) for a “Unified Approach under Pillar One.” This document represents the latest chapter—a pivotal one—in the sweeping revision and re-alignment of global tax policy and the operative international tax rules that the OECD has been working on for years.

In its 2015 BEPS Action Plan, the OECD identified the tax challenges of an increasingly digital economy as a primary focal point. A subsequent document published by the G20 Finance Ministers (working in concert with the OECD) in March 2018, Tax Challenges Arising from Digitalization – Interim Report, examined this issue in more detail. A joint OECD/G20 Inclusive Framework earlier this year grouped the global tax policy revision effort into two categories: Pillar One, which includes user participation, marketing intangibles, and significant economic presence proposals; and Pillar Two, which focuses on other BEPS-related expanding issues, such as an “alternative” minimum global tax for multinational organizations.

For many in the US, the new Pillar One Unified Approach and Pillar Two bring familiar tax compliance concepts, including economic or business activity nexus that can reach remote sellers beyond any border as well as the new methods of profit allocation and formulary apportionment.

The OECD Secretariat consultation document summarizes the Pillar One proposal, describes several pending questions for consideration, provides taxable-presence illustrations under the Unified Approach, and includes an appendix that delves into greater detail on the proposed profit allocation change.

This document shows that the OECD is now closer to its ultimate objective of leveling the playing field in global tax and trade through greater reassignment of taxing rights (nexus) to countries where digital consumers are located.

In economic terms, this represents value creation from the demand side. In addition to revamping nexus, the Pillar One proposal addresses transfer pricing (in some cases, going beyond the arm’s length principle), the reallocation and apportionment of profits to jurisdiction, and a new schedule of quasi-formulary apportionment.

These proposed changes were largely expected, as governments and tax jurisdictions throughout the world have long been frustrated by traditional permanent establishment rules and policies that focused only on physical presence. These rules created harmful tax competition, and in some cases, aggressive tax planning opportunities for business and individuals alike. 

Although many of the changes contained in the OECD Secretariat’s new proposal were anticipated, they still qualify as momentous. As such, they should stimulate contentious, and hopefully constructive, discussions among OECD and G20 countries, businesses, and other stakeholders by the end of 2020, when the OECD and G20 hope to reach a consensus on a new international tax framework. The OECD emphasizes this point in the public consultation document, stating:

As highlighted in the Program of Work, 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 digitalized [multinational enterprises].

As such, here are several high-level takeaways and observations about the proposed changes to keep in mind:

• This is not a done deal: Although the G20 finance ministers have endorsed the OECD Secretariat proposal, supporting an Inclusive Framework-based solution for taxing the global digital economy by June 2020, it is not a done deal. While it will not be necessary to have the majority of countries assent to proceed with its implementation, a large amount of substantive work remains to be done prior to ratification. This work includes revising the OECD’s own Model Tax Convention along with numerous bilateral tax treaties.
• US-based tech giants will pay more: Under the proposal, the largest digital multinational enterprises (MNEs) will pay a heavier share of their profits, allocated to the countries where their digital customers are located, regardless of the MNE’s physical presence. In addition, other “consumer-facing” businesses can also expect to see their tax bills increase, although the precise terms for these changes have yet to be defined.
• Digital presence replaces physical presence: The proposal represents an expanded form of unitary taxation on a global scale, as both formulary apportionment and jurisdictional profit allocation methods are inevitably included. However, the taxable presence, or nexus, under the proposal is a “digital” presence instead of being strictly physical. This is an application of a virtual permanent establishment pretense based upon digital sales and commercial footprints, leading to jurisdictional economic and business activity. The individual and precise national metrics are still to be detailed and specified.
• Tax certainty is delivered via a three-tiered mechanism: Based to some extent on transfer pricing principles and like US state tax formulary apportionment, the proposal’s profit allocation method includes a three-tier mechanism (amounts), each of which is centered around specific “routine” tax activities and functions. Each amount is designed to capture a percentage of the primary total or residual profits, which is based on a company’s or group’s financial statements and consolidated position.
• Beyond the arm’s length principle: Although the proposal deviates in the application of the arm’s length principle when it comes to transfer pricing, the change is to some degree based upon the modified residual profit split transfer pricing method. Each amount will establish an MNE’s global profits, the attribution of profits and taxes to be paid to each country, the pro rata calculation of profits that would be allocated and taxed in each country, and the dispute-resolution mechanism.

Much work remains to be completed by June 2020. Although recently approved by the finance ministers of the G20, the proposal it is neither unified or uniformed.

On October 16, during the session of the UN’s Committee of Experts on International Cooperation in Tax Matters, the Committee formally discussed the tax consequences of the digitalized economy.

In this session, the primary concerns of fairness and certainty as well as the advantages and disadvantages for developing countries were openly addressed and debated. It was evident that considerable questions and concerns remain for developing countries.

As a regular on-site Observer, my own impression is that issues regarding equity and practical administrability continue to linger. It is obvious that for many in developing countries, continual “inclusive and fairness” assertions may not necessarily entail equity.

At this point in digital taxation, we should be asking just how “inclusive” the Inclusive Framework really is. This was especially apparent after the OECD’s designated representative presented the official Unified Approach under Pillar 1 outlook and the time enhanced intended blueprint. 

A good example of this type of trepidation presently experienced by many in developing countries is captured in a November 6 article by Jose Antonio Ocampo. According to Ocampo, “an OECD proposal to reduce transnational tax evasion contains flaws which developing countries must challenge before it is set in stone.”

Ocampo seems to be focused more upon tax havens, as represented by quoting economist Gabriel Zucman: “…every year, developing countries lose at least $100 billion, hidden by multinationals in tax havens. Globally, this diverts 40 percent of foreign profits to such havens….” He also alludes to the permissiveness of the US legal system, which allows multinational organizations to do the same.

When the Supreme Court released its South Dakota v. Wayfair ruling, the European Union and OECD were taking notes on a decision that established the legal and policy parameters for the world’s first digital tax. The OECD Secretariat’s proposal shows that they were doing just that.