US disputes need for special digital economy tax rules, seeks consensus on profit allocation issues

by Julie Martin

The highly-anticipated interim report of the Task Force on the Digital Economy (TFDE), slated for release in April, will state that countries are divided on a long-term solution for taxing the digital economy, with the US arguing that there is no need for special tax rules in this area, said Chip Harter, Deputy Assistant Secretary (International Tax Affairs) at the US Department of the Treasury.

Speaking in Washington at a Tax Council Policy Institute conference held February 15–16, Harter discussed the US’s position on both long and short-term proposals to tax the digital economy. He also maintained that recently enacted US international tax reform provisions do not violate international agreements.

Martin Kreienbaum, Director General of International Taxation for the German Federal Ministry of Finance and Chair of the OECD Committee on Fiscal Affairs (CFA), provided an overview of the OECD’s international taxation work plan.

TFDE stall

The TFDE, a subsidiary body of the CFA which includes non-OECD countries, is preparing an important interim report on the implications for taxation of digitalization, set to be delivered to G20 Finance Ministers at their April 2018 meeting.

According to Harter, though, consensus cannot be reached and the report is now being drafted to reflect that fact.

The big sticking point in the negotiation is a fundamental disagreement between countries on whether a special tax regime should be created to address the digital economy, Harter said. The US does not believe there are sufficient unique aspects of digital businesses to warrant separate treatment.

Harter said that the world has changed since 2015, when the digital task force considered fixes to respond to action 1 of the OECD/G20 base erosion profit shifting (BEPS) plan.

He said that while the digital economy discussions were prompted, in large part, because of concerns about US digital companies’ business models that facilitated base erosion, US tax reform has now put those concerns to rest.

Foreign subsidiaries of US companies now face US tax on their historic earnings at an 8 to 15 ½ percent rate and will be taxed on an ongoing basis at a 13 1/8 percent or higher rate, Harter observed.

Moreover, Harter said, permanent establishment (PE) issues are no longer a factor in the digital tax debate because the largest MNEs have shifted or are in the process of shifting to structures that use local low-risk distributors to report income on locally filed tax returns, relying on transfer pricing principles to determine how much profit to report.

As such, Harter said, the only remaining issues concern how much profit should be allocated to the jurisdiction where the customers are located.

Harter said there is no principled basis for arguing that a different amount of profit should be allocated to a low-risk distributor of digital services located in France as compared to a luxury goods manufacturer’s low-risk distributor located in the US.

In the absence of a principled distinction between those business models, the US does not believe it is appropriate to have a separate tax regime limited to digital business, Harter said.

Profit allocation

Harter added that the real problem may be a fundamental dissatisfaction in some countries about the level of profit allocated to countries where customers are located.

He said the US is open to discussing whether the PE or profit attribution standards should be revised but reiterated this should be done in a broader context, not as part of a special regime limited to digital companies premised on the fact that they are somehow inherently different.

Kreienbaum said that TFDE discussions about taxation of the digital economy have included analyzing the specific features in value chains that digital companies substitute for traditional elements in value chains. Such features include, for example, user participation, the provision of data, market presence, intangibles, and the ability to be present in a market without having physical presence or having an agent in a country, he reported.

Robert Stack, Managing Director, International Tax Group – Washington National Tax, Deloitte Tax LLP, said that those that advocate greater taxation of digital firms seem to believe that the market country should be given greater rights to tax multinationals. If market countries want to assert greater taxing rights in the digital space, then other countries might want to assert their taxing rights over MNEs even outside the digital space, Stack said.

According to Kreienbaum, though, that Stack’s argument is “completely misleading.” Kreienbaum said that he would not advocate greater taxation rights to market jurisdictions. This is not a residence versus source discussion, he said.

Short-term digital tax measures

Harter said that the TFDE interim report will include a chapter on short-term, temporary, measures to tax the digital economy, such as a digital excise tax, which would be used until countries reach agreement on a more permanent fix.

He said the US delegation is keen to make certain that this chapter in no way reads like an endorsement of a short-term digital tax. The report discusses in detail why it is bad policy to adopt a short-term tax, which is important because the EU is also considering such a tax.

The TFDE draft states that if a short-term tax is adopted, the harm caused by the tax should be minimized by requiring that international obligations are complied with and by adding an explicit term limiting the duration of the tax, Harter said. The draft will state that even with these safeguards, short-term measures are still a bad idea, he said.

Harter said he disagrees with those that argue that the US should not engage in discussions about short-term fixes to the digital economy. He noted that Italy has already adopted such a tax and others will likely follow. If this report is not released, some countries will view that as a licensee to do whatever they want. Moreover, he said, if the US does not engage, this would likely end multilateral discussions on international taxation at the OECD for many years.

Transfer pricing issues

Harter said that, although it would be a major undertaking, it may be wise for the US to begin to try to reach multilateral consensus on the more fundamental international tax issues of transfer pricing and allocation of taxing rights.

He that the US may not have been well-served in the BEPS negotiations, which addressed single and double nontaxation, but took issues of taxing jurisdiction off the table. Countries’ recent unilateral actions, including the US’s enactment of the base erosion and anti-abuse tax (BEAT), stem from frustrations due to the failure to tackle these fundamental tax issues, he said.

William Morris, who chairs the Committee on Taxation and Fiscal Affairs Business at OECD (BIAC), agreed, stating that during the BEPS exercise, questions about the allocation of taxing rights, relative strength of companies, and value creation were “bubbling under the surface” but not worked out. This has led to an international tax system of “maximum uncertainty,” Morris said.

Now, in addition to unresolved source versus residence issues, there is the new concept in the mix of “destination,” namely how to treat the value of a market, versus residence, Morris observed. Given the differing interests of the countries that make up the Inclusive Framework on BEPS, it will be difficult to reach any agreement on these issues, he said.

The OECD’s work plan

Kreienbaum said the OECD is attempting to educate Inclusive Framework members so that all countries can participate in OECD tax discussions on an equal footing. These capacity building initiatives will also promote tax certainty, Kreienbaum said, because, as jurisdictions become more educated and supported, tax disputes will be avoided or resolved.

He said that the OECD’s tax agenda also includes an effort to make certain that beneficial ownership information is correct, verified, and complete. This work must be done before the issues of exchanging that information can be addressed, he said. Kreienbaum added that the CFA is following Financial Action Task Force recommendations, but said that there are special considerations in the tax context.

The OECD has also again taken up the TRACE project, Kreienbaum said. Another project seeks to better coordinate the work of CFA Working Party 1, which addresses OECD model treaty issues, and CFA Working Party 6, which addresses transfer pricing.

Further, the OECD is working to enhance tax cooperation with other tax bodies through the Platform for Collaboration on Tax, he said.

US tax reform

Turning to US tax reform, Harter said US trade representatives will speak for the US regarding any WTO issues.

Treasury will seek to convince the OECD Forum on Harmful tax practices that the US’s new foreign-derived intangible income (FDII) regime is not a harmful tax practice within the meaning of the BEPS minimum standards, and will advance similar arguments before the EU regarding its listing process.

Harter said that the FDII is not harmful because it is part of the overall architecture of US tax reform, intended to equalize the minimum tax rates of foreign activities of US MNEs regardless of whether they are earned by a US company’s controlled foreign company or earned directly by a US company.

He said that though the FDII has some formal characteristics similar to harmful tax regimes, it does not actually create the types of harm targeted by those rules. The FDII rules merely take away the tax incentive to transfer intangibles outside the US to a low tax jurisdiction, and thus the motives for enacting the FDII is different from a typical patent box, he said.

Kreienbaum commented the US tax reform certainly changes the competitive landscape, though the US tax rates do not reflect a race to the bottom. With respect to the BEAT, he noted that it was difficult to understand how a deductible payment to a German taxpayer would be considered abusive.