Mr. Manesh Kumar Gupta, IRS (IT: 2018)
Assistant Commissioner of Income-Tax, Kolkata
camaneshgupta@gmail.com

Mr. Manesh Kumar Gupta

Manesh Kumar Gupta is presently working as an Assistant Commissioner of Income Tax. He has previously worked with BMR & Associates LLP it its Transfer Pricing practice. He is a Chartered Accountant by qualification and a commerce graduate from Shri Ram College of Commerce, University of Delhi.

OECD’s Unified Approach on Pillar One to Address the Tax Challenges Arising from the Digitalization of the Economy: A Critical Analysis

Executive Summary

This article provides a comprehensive summary of the efforts undertaken by OECD in addressing the issues relating to the Tax Challenges Arising from the Digitalisation of the Economy. The article then discusses the intricacies of the proposed Unified Approach issued by OECD Secretariat and endorsed by the OECD Inclusive Framework on Base Erosion and Profit Shifting Project. A sample illustration has been presented to show how the proposal would apply to multi-national groups. It then goes on to highlights the probable economic impact of Unified Approach on all tax jurisdictions. It also deals with the basic shortfalls in conceptualisation of the Unified Approach.

BACKGROUND

BEPS Action Plan

The tax challenges of digital economy were identified as one of the main areas of focus of the OECD/ G20 Base Erosion and Profit Shifting (BEPS) Project, leading to the 2015 Action 1 Report1. The Action 1 Report observed that process of value creation have significantly evolved, especially for digital enterprises. It highlighted three key features of digitalized businesses:

  • Ability to conduct business activities without any (significant) physical presence, called cross-jurisdictional scale without mass.
  • The heavy reliance on intangible assets, especially intellectual property (IP); and
  • The importance of data, user participation and their synergies with IP.

The OECD Action 1 reportargues that the sespecific characteristics enable value creation by activities closely linked with a jurisdiction without needing to establish a physical presence there. Based on that understanding, it is commonly argued that the concept of permanent establishment (PE) in the era of digitalization appears less relevant, or even obsolete2, and that a new threshold is therefore needed to source taxation3. Also, the Arm’s Length Principle fails to capture this value creation as businesses conducted through a website involves little, if any, functions, assets, or risks in market jurisdiction. And under the Transfer Pricing Rules, the focus is too much on the location of functions performed (i.e. the supply side) and too little on the location of markets and customers (i.e. the demand side),4 particularly where enterprises, such as Internet companies, serve markets in which they have no or only a very modest presence5.

OECD’s interim report released in 2018 highlights that a number of companies dealing in digital products and services, have altered their structures in respect of their cross-border sales (e.g. Amazon, E-bay, Facebook, Google) in response to measures developed under Action 7(prevent the artificial avoidance of PE status)6. These entities, which operated on a remote basis through centralized structures, have created local re-sellers as limited risk distributors LRDs). However, these local affiliates are commonly structured to have no ownership interest in intangible assets, not to perform any development, enhancement, maintenance, protection, exploitation (DEMPE) functions, and not to assume any risks related to such assets. Accordingly, the transfer pricing policy typically leaves the LRD with a modest profit margin for its local sales and marketing activities. Another popular structure involves recording third-party sales from local customers remotely in a foreign principal entity and structuring the local affiliate as a routine market support service provider. Under this model, the local affiliate often receives a cost-plus service fee from the principal entity. The concern that often arises here is whether these LRD and service fee models (and associated transfer pricing) adequately compensate local affiliates for their local marketing intangibles development efforts for digital and non-digital companies alike7. Thus, without effective changes to profit allocation rules, an MNE group may seek to sidestep the nexus issue by establishing local affiliates that are not entitled to an appropriate share of the group’s profit8.

Therefore, the primary issue here is that an MNE can ‘reach into’ a jurisdiction, either remotely or through an LRD/ services provider, to develop user and customer base and other marketing intangibles with limited exposure to taxation in the market jurisdiction. This kind of remote participation or at very best, modest participation in a domestic economy is the key issue in the digital tax debate, despite different views on the scale and nature of those challenges, as well as whether and to what extent the international tax rules should be changed9. Basis this, it is a widely held view that digitalization tends to exacerbate BEPS issues, with a study highlighting that the effective tax rate for digitalised businesses is only 9.5 per cent compared to 23.2 per cent of traditional business models. The OECD Action 1 Report described this tax challenge from digitalization as primarily relating to the question of how taxing rights on income generated from cross-border activities in the digital age should be allocated among jurisdictions.

In January 2019, OECD/G20 Inclusive Framework on BEPS (Inclusive Framework), agreed a Policy Note that grouped the proposals to resolve these challenges into two pillars10

Pillar One: Focuses on the taxing rights, undertake coherent and concurrent review of the profit allocation and nexus rules.

Pillar Two: Focuses on rest of the BEPS issues and deals with new rules that would establish a global minimum tax regime for multinational corporations.

CONSULTATION DOCUMENT

Following the January Policy Note, the Inclusive Framework in March 2019 sought input from external stakeholders through a public consultation process on three proposals to define how taxing rights on income should be allocated between jurisdictions11:

The User Participation Proposal: It is intended to apply to highly digitalized businesses where users play a significant role in value creation such as social media, search engines etc. It involves calculating non-routine profits and attributing a portion of the same to the value created by the activities of the users. Subsequently, these profits would be allocated in the jurisdiction in which the business has users based on revenue or any other allocation metrics.

Marketing Intangible Proposal: The scope of the Marketing Intangible Proposal is broader than the User Participation Proposal. It addresses a situation in which a multinational enterprise group can essentially “reach into’ a jurisdiction, either remotely or through a limited local presence, to develop a user or customer base and other marketing intangibles.12 It proposes allowing market jurisdictions to tax some or all of the non-routine income associated with marketing intangible and their attendant risk, while all other income would be allocated among members of the group based on existing Transfer Pricing principles. This special allocation would bypass the legal ownership or the DEMPE criteria enshrined in the Transfer Pricing Rules for assigning income arising from intangibles. The proposal puts forward different conceptual and mathematical approaches to attributing the marketing intangible, the most prominent of which is the revised profit split.

Significant Economic Presence Proposal: It brings in a factor presence test to broaden the scope of the current nexus rules. It is similar to the provisions introduced by Finance Act 2019 which amended Section 9 of the Income-tax Act, 1961 to expand the meaning of the term ‘Business Connection’ to include ‘Significant Economic Presence’. The Indian provision uses Revenue and User base as two distinct tests for establishing taxable presence. Similarly, the European Commission issued a proposal laying down rules relating to the corporate taxation of a significant digital presence based on criteria of turnover, number of users and number of business contracts concluded in a year. The OECD Proposal envisages Revenue as an essential criteria coupled with any of the following factors to establish nexus:

  • The existence of a user-base and the associated data input.
  • The volume of digital content derived from the jurisdiction.
  • Billing and collection in local currency or with a local form of payment.
  • Maintenance of a website in a local language.
  •  Responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance.
  • Sustained marketing and sales promotion activities, either online or otherwise, to attract customers.

The proposal then contemplates using Fractional Apportionment method to allocate profits by taking into account factors such sales, assets and employees to apportion the tax base.

A comparative analysis of the three proposals is presented below:13

User Participation Proposal Marketing Intangible Proposal Significant Economic Presence Proposal
Policy rationale Taxing power to the jurisdiction where active users are located Taxing powers to the jurisdiction where marketing intangibles are ‘used’ Taxing powers to the jurisdiction where the company has a virtual presence, through a minimum number of users, sales or contracts etc.
Scope Very narrow in scope as applied to businesses where user play a critical role in value creation Applies to a wider range of businesses in comparison with the user participation Proposal Applies to a very wide number of remotely operated businesses
Profit allocation Residual profit split method Residual profit split method Fractional Apportionment method
Complexity Fairly complicated due to issues like diverging interpretations on what constitutes routine and non-routine profits and application of different methods for allocation of profits – arm’s length and profit split. Complexity may arise due to issues similar to the User Participation proposal as well as the need to differentiate between marketing and trade intangible. Also, a portion of profits arising from marketing intangibles may be reflected in normal returns. Similarly, evaluation of the value of marketing intangibles can prove difficult in practice. No ring-fencing of digitalized businesses. No differentiation between routine and non-routine profits or marketing and trade intangible profits is needed.

The 13three alternatives discussed above have a number of significant commonalities 14:

  • All proposals would reallocate taxing rights in favour of the user/ market jurisdiction;
  • All the proposals envisage a new nexus rule that would not depend on physical presence in the user/ market jurisdiction;
  • They all go beyond the arm’s length principle and depart from the separate entity approach;
  • They all search for simplicity, stabilization of the tax system, and increased tax certainty in implementation; and
  • Their methodology involves apportionment of global profits.

PROGRAM OF WORK

In May, the OECD presented the G-20 a new program of work on developing a consensus solution to tax challenges arising from the digitalization of the economy15. The program of work addresses that more and more jurisdictions are unhappy with the existing framework of international taxation and if inclusive framework does not give a comprehensive consensus-based solution within the agreed time-frame, the countries will adopt uncoordinated unilateral tax measures. The second chapter of the paper deals with technical issues that need to be resolved to take a coherent review of profit allocation and nexus rules.

Under the Pillar One, OECD discussed three methods for profit allocation amongst jurisdictions:

Modified Residual Profit Split (‘MRPS’):

Allocating a portion of non-routine profits of the group to markets jurisdictions creating value.

The 4 steps for profit allocation involves:

a. identifying the group profits, (b) excluding routine returns, (c) determine the portion of non-routine profit to be allocated to market, and (d) allocating the profit using an allocation key.

The technical challenges for using this method can be deciding the accounting standards to arrive at the group profits to be allocated, determination of portion of non-routine profits using simplified convention as it can be highly subjective and subject to litigation. Further, identifying the accurate allocation key is also challenging. Apart from the technical issues, a political and economic concern here is picking the markets generating value and justifying the value being created to the tax authorities as each jurisdiction would want a share of non-routine profits.

Fractional Apportionment Method: This method allocates the total profits to market jurisdictions creating value using an allocation key, eradicates the need for identifying routine and non-routine profits separately. This method involves three steps:

b. Identifying the profits, b) identifying the allocation key, c) allocation of profits.

The technical and political challenges would be similar to MRPS.

Simplified Distribution Approach: This contemplates using fixed baseline payment approach for marketing and distribution jurisdictions and adjusting the profitability based on group’s overall profitability and other relevant factors.

This is a highly subjective method, as the basis for deciding the baseline payment for each jurisdiction would require a consensus among all the jurisdictions will be questioned by the revenue authorities leading to more litigation.

UNIFIED APPROACH

In October 2019, the OECD secretariat issued a document proposing the Unified Approach to facilitate progress towards consensus on Pillar One which built on the commonalities identified in the Program of Work and taking into account the views expressed during the March public consultation16. This was a non-consensus document but provided the modalities of a solution that could be acceptable to all the members of the Inclusive Framework and was subsequently released to the public for comments.

In a statement issued in January 202017, the Inclusive Framework endorsed the Unified Approach as the basis for the negotiation of a consensus-based solution to be agreed in 2020. This document is complemented by a separate revised Programme of Work for Pillar One that defines the remaining work that needs to be undertaken by the end of 2020 to address all the open ended questions and produce a consensus-based agreement.

SCOPE AND NEXUS

For the applicability of Amount A, the twin criteria of Scope and Nexus must be met in the market jurisdiction.There are two categories of businesses that are in scope: (1) automated digital services, and (2) consumer-facing businesses.

Automated digital services have been described as, ‘services that are provided on a standardized basis to a large population of customers or users across multiple jurisdictions’. They include online search engines, social media platforms, online intermediation platforms, digital content streaming online gaming, cloud computing services; and online advertising services. The second category includes businesses that generate revenue from the sale of goods and services of a type commonly sold to consumers, i.e. individuals that are purchasing items for personal use and not for commercial or professional purposes. This would also include businesses that generate revenue from licensing rights over trademarked consumer products and businesses that generate revenue through licensing a consumer brand (and commercial know-how) such as under a franchise model.

Specific carve-outs have also been mentioned in this document. Extractive industries and other producers and sellers of raw materials and commodities would not come within the scope of consumer-facing definition. Similarly, most of the activities of the financial services sector (which includes insurance activities) take place with commercial customers and will therefore be out of scope.

The Unified Approach will be limited to MNE groups that meet a certain gross revenue threshold. Second, even for those MNE groups that meet the gross revenue threshold, a further carve-out will be considered where the total aggregated in-scope revenue is less than a certain threshold. Third, consideration will be given to a carve-out for situations where the total profit to be allocated under the new taxing right would not meet a certain de minimis amount. Once this de minimis threshold of profitability is met, country-wise nexus criteria based on revenue (for automated digital services) or revenue plus based parameters (for consumer facing businesses) would have to be met.

ALLOCATION MECHANISM

The document uses a three tier profit allocation mechanism which allows a greater share of taxing rights to market jurisdictions. They are as follows:

Amount A: This is a result of pure reallocation and has nothing to do with Arm’s Length Principle. It has been introduced as a possible solution to the problem created by the fact that digitalized enterprises can be heavily involved in the economic life of a country without having any physical presence in its territory and therefore market jurisdictions need greater taxing rights to capture this value creation. This greater taxing right has been granted by way of formulaic reallocation of an MNE’s group deemed residual profit on a business line basis. The deemed residual profits of an MNE group would be calculated by excluding the MNE’s deemed routine profits as represented by profitability thresholds determined on the basis of fixed percentages. Once that amount of the group’s residual profit is determined, a share again, based on a pre-specified fixed percentage that could vary by industry will be deemed allocable in total to the market jurisdictions meeting the new nexus rules. Finally, the total residual profit as determined under the preceding steps will be allocated among the relevant market jurisdictions via a formula based on the sales in each jurisdiction (and possibly other factors that serve as indicia of consumer or user involvement with the relevant MNE)18.

Amount B: A prescribed set of remuneration based on fixed/ formulaic method for defined baseline distribution and marketing functions that take place in the market jurisdiction. Amount

B is expected to approximate the Arm’s Length price but is fixed with the goal of reducing complexity associated with the Arm’s Length standard which requires a deep understanding of the taxpayer’s activities, identification of comparables, an analysis of pricing factors, and a comparison of pricing19.

Amount C: Again Amount C is expected to approximate to Transfer Pricing based allocation of business profit and is calculated as an excess to ‘Amount B’ in cases where an activity in a specific market jurisdiction extends beyond baseline or routine marketing and distribution activities or is unrelated to marketing and distribution activities20. Specifically, it could refer to additional profit that should be assigned in the local jurisdiction that results from (a) a higher rate of profit than the fixed rate of profit on marketing and distribution expenses (or on sales) used to compute amount B; or (b) a larger amount of marketing and distribution expenses than used to compute amount B; or

(c) returns from functions other than marketing and distribution (such as manufacturing and research) that might be performed in the local jurisdiction21.

An illustration to explain the workings is presented below:

The following example illustrates with simplified figures how the proposal would be applied to a hypothetical multinational group ‘Group X’, which sells streaming and financial services worldwide. Assume the following facts regarding Group X’s operations:

  • Group X has two business lines – streaming services and financial services. It has no other business line. The group is highly profitable, earning non-routine profits, significantly above both the market average and those of its competitors.
  • P Co (resident in Country A) is the parent company of Group X. P Co owns all the intangible assets exploited in the group’s streaming services business. Hence, P Co is entitled to all the non-routine profit earned by Group X.
  • Q Co, a subsidiary of P Co, resident in Country B, is responsible for marketing and distributing Group X’s streaming services and therefore performs only these baseline activities. It is structured as a limited risk distributor, owns no intangibles and purchases content from P Co for sale to third party customers with no further value addition. The transaction between P Co. and Q Co. is at arm’s length.
  • Q Co sells streaming services directly to customers in Country C and Country D, where it does not have any form of taxable presence under current rules.
  • Q Co sells financial services to customers in Country E, where it does not have any form of taxable presence under current rules.

Fig. 1 Group X’s Worldwide Operations

See Table 1 for Group X’s consolidated income statement:

Table 1: Group X’s Factual Data

In Million USD
Particulars P Co-Streaming Service Q Co Eliminations Consolidated – Streaming Service
Related Party Sale Third Party Sales Streaming Service Financial Services
Country A sales 1200 1200
Country B sales 500 500
Country C sales 300 300
Country D sales 50 50
Country E sales 600
Related party sales 550
Total Income (A) 550 1200 850 600 -550 2050
Employee cost 206 450 120 330 776
Marketing and distribution expense 100 100 100
Related party purchase 550
Other Expenses 160 350 54 100 564
Total Expense (B) 367 800 824 530 -550 1441
Profit before Tax (A-B) 183 400 26 70 609
PBT/TC 50.00% 50.00% 3.16% 42.30%

Calculating Amount B

The Unified Approach calls for calculating Amount B and Amount C before Amount A. Amount C workings have not been shown in this illustration because given the guidance available at this point of time, it is really difficult to pin it down in a definite manner. Therefore only Amount B workings have been presented.

Amount B is a simple fixed return on marketing and distribution functions. It can either be a fixed markup on the marketing and distribution expense or it could be expressed as a percentage return on sales. Here we assume the fixed mark-up on cost to be 10 percent and the fixed return on sale to be 3 percent for the baseline marketing and distribution functions performed by Q Co. The OECD proposal lays out the future path in terms of technical aspects that needs to be agreed for Amount B. This includes defining the baseline activities, choosing the right profit level indicator as well as determining the extent of differentiation required in the mark-up for different industries and regions in line with the arm’s length principle.

The calculation of Amount B is presented below:

Table 2: Calculation of Amount B – Simplified Method to Compute Profits From Baseline Marketing and Distribution Functions

Fixed percentage of mark-up on cost (assumed) (1a) 10%
Local marketing and distribution expenses (1b) 100
Fixed return as percentage of sales (assumed) (2a) 3%
Total sales of Q Co in Country B, Country C and Country D (2b) 850
Taking amount B as higher of (1a*1b) & (2a*2b) 26

Calculating Amount A

Step 1: The first step involves determining the total profit to be split. For this only the streaming service segment has been considered since financial services have been explicitly carved out from the scope of Unified Approach. The proposal suggests using the group’s audited financial statement to arrive at the consolidated worldwide group operating profit using Profit before tax as the preferred profit measure. For illustrating the mechanics of this proposal, the example uses only a single line of business. However, the proposal recommends that where a MNE group has multiple business line or operates in different regions, segmentation may be needed to account for variability in profit margin across segment or regions. Reliance on financial statement data is intended to ensure that the operating profit figures are from a verifiable source with safeguards to ensure that the data are reliable and not tax-motivated22.

Step 2: This involves calculating the routine profit earned by the Group. OECD in its proposal acknowledges the need to arrive at a level of profitability above which Amount A would apply. This relates to deeming a portion of return to be routine and is intended to act as an approximation of the amount that would result under a principle-based profit split, while dramatically reducing complexity and the potential for disputes over what constitutes a routine return in a particular case23. We assume a routine profit margin of 10 percent on worldwide sales. OECD, in its Economic Analysis and Impact Assessment presentation (discussed later), has taken routine profit margin figures of 10 percent and 20 percent on sales, yielding a remainder of either 90% or 80% as non-routine profit or Deemed residual profit. So in addition to being in scope, businesses must have profit margin above the routine level for the proposal to work with regards to Amount A (Amount B allocation in any case would apply since the same is in nature of routine profits).

Step 3: A portion of the deemed residual profit, corresponding with the share of total profit from intangibles attributable to marketing intangibles has to be re-allocated to market jurisdiction. OECD, in its Economic Analysis and Impact Assessment presentation, has taken this at 20 percent of the Deemed residual profit (there seems to be no reasoned justification for the choice of that specific percentage). The same figure has been considered in this illustration. OECD in its proposal has considered the need to determine whether the relative portion of the profit allocated to the market under Amount A should be the same across all in-scope businesses or whether, to reflect the different degrees of relevance of the policy rationale, there should be different percentages applied for different businesses24.

Step 4: This portion of deemed residual profit is then allocated to market jurisdictions that meet the nexus criteria. This is determined on the basis of the revenue arising from a jurisdiction. In this illustration, no profit is allocated to Country D precisely because of this reason i.e. since its revenue fails to meet our presumed revenue threshold. OECD in its proposal talks about using revenue threshold as the only criteria for creating nexus in case of in-scope automated digital services. But for other consumer facing activities which are in-scope, there would be a plus requirement. Merely sale into a jurisdiction would not create taxable nexus. Revenue threshold plus certain other test (to be determined) would be required to create nexus. The next step involves allocating this portion of residual profits to eligible market jurisdiction, based on an agreed allocation key. The illustration uses Sales as the allocation key. However sales of a type that generate nexus for different in-scope businesses would be used as the allocation key as per the OECD proposal. The document also calls for designing specific revenue sourcing rules to support its application by reference to different business models. Such rules are needed because monetization strategies of digital business models are unique. They are also needed because the customer base of digital businesses is mobile. Therefore there is a need to bring clarity to as to how the location of users would be determined in few cases like subscription based business models etc.

Table 3: Calculation of Amount A—Portion of Residual Profits Attributable to Marketing Intangibles Allocated to Sales Jurisdiction

Routine Profit Margin(assumed) (1) 10%
Total Sales (2) 2050
Total Profits (3) 609
Routine Profits (4 = 1*2) 205
Deemed residual profit (5 = 3 – 4) 404
Fraction attributable to marketing

jurisdictions (assumed)(6)

20%

 

Amount A (5*6) 81

Table 4: Calculation of Amount A Allocation for Each Country

Country

 

 

Sales

 

Proportion of

Total Sales

Share in

Amount A

Country A 1200 0.6 49
Country B 500 0.25 20
Country C 300 0.15 12
Total Sales 2000 81

Note: Country D has not been allocated Amount A as it fails to meet the nexus threshold

Table 5: Change in Tax Base after Applying Unified Approach

Country Before Unified Approach After Unified Approach Difference
Country A 583 551 -32
Country B 26 46 20
Country C 0 12 12

ECONOMIC ANALYSIS AND IMPACT ASSESSMENT

OECD held a webcast in February 2020 highlighting the projected impact of the OECD’s proposed reforms, which estimated global net revenue gains of up to 4 percent of global corporate tax revenues, or $100 billion annually. The OECD said those gains are broadly similar across high-, middle-, and low-income economies, however most of the tax revenue is expected from Pillar Two (a minimum tax plus anti-base-erosion tax). It projected only small global revenue gains from Pillar One (a residual profit allocation proposal), including small revenue increases for most countries with some losses by investment hubs25. On average, middle and low income countries would gain relatively more in revenues than advanced economies. It also showed that more than half of the profit reallocated comes form 100 MNE groups.

One possible explanation for the low impact of Pillar One is that profitability margin of the tech industry varies significantly. Many tech companies may have low profit margins, or are not profitable at all, because of how much they invest in the growth of their business in order to gain increased consumer attention. For instance, take the case of Amazon which does not have any amount A reallocations because it has no residual profits. In 2017 Amazon profits before tax were 2 percent of sales. In 2019 it was still below threshold, with profits before tax equal to 5 percent of sales. Most or all of Amazon’s businesses would seem to fit comfortably under the OECD’s conception of business in scope of amount A because they provide digital content, an online marketplace, and cloud computing web services.

An IMF working paper shows that while in the aggregate there may be large residual profits, many large multi national sappear to have negative residual profits. The IMF work also shows that consolidating corporate earnings (as proposed for computing the tax base under OECD pillars One and Two) requires consolidating losses as well. IMF concludes that under a formulary apportionment system, the global tax base could be reduced by up to 10 percent because of cross-border loss consolidation. The IMF projects that cross-border loss consolidation would reduce multinationals’ overall tax bases. They’re not reflected in the proposals’ projections, because the proposals seem to account only for profits and not losses.

For India, Pillar One does not bring much cheer as was expected. An analysis by Martin Sullivan based on 2017 statistics of Country-by-Country data of top 25 companies released by US IRS showed that India was a net loser when it comes to amount A with a net outflow of 48 billion USD in terms of tax base26. This is because the data showed that the country’s share of profit as a percentage of global profit is higher than the country’s share of sales as a percentage of global sales. However this paper acknowledges that the foreign revenue changes are speculative because they are based on aggregate data, not taking into account company-by-company differences in the composition of foreign profits and sales. Nevertheless, it serves as a clear warning signal and gives a preliminary idea as to where India is headed in terms of revenue gains from Pillar One. Therefore there is an urgent need to get a clearer understanding of this based on access to confidential, company-specific data sources that government has.

TECHNICAL ISSUES27

Conceptually Canard:

The Value Creation Fallacy

The underlying narrative of the OECD with regards to the BEPS project has been to align taxation with value creation. This involves the assignment of the primary right to tax to an economically correct jurisdiction which further implies that a correct jurisdiction to tax can in fact be ascertained as an empirical matter. However this is loaded with faulty assumption. First, the assumption that multinational profit can be fragmented and that fragmentation is a neutral, even scientific task; and second, that accordingly, all countries should agree to the agreed fragmentation, and not some other fragmentation. The basic bedrock of this assertion is based on widely held view that assigning origin to income is scientifically impossible. Many types of income would have several places of origin, and the whole would be fundamentally indivisible into parts. There were too many variables, and too much interdependence among them, to extract a precise origin for the income earned in a global economy28. Therefore division of global income tax base has always been a political question and not an economic one. The question here arises is why is the OECD alluding so tightly to the concept of value creation as the base for division of taxing rights. Some would say the entire point of focusing on value creation is to find a way to leave minimum for low-income countries as this emerging concept of value creation may be substantially biased towards ‘brains’ as opposed to ‘hands’.

The Unified Approach acknowledges the fact that mere cross-border sale of tangible goods into a market jurisdiction does not in itself amount to a significant and sustained engagement in that jurisdiction and therefore does not create any new taxing rights for it. What is needed is value creation in the market jurisdiction through either a physical presence or targeted advertising or an active user base contributing in the form of either data or subscription.

It has been demonstrated that user engagement on online platforms create value through their usage of the product and thereby pay for their use of the platform many times ‘in kind’ in the form of data instead of, for example, by means of a paid subscription. The relevant tech companies capture and collect these data units and then process them into commercially tradable market knowledge. This user value, so it is claimed, would not be created if the digital (or other) service were to be paid for in money. Otherwise the market would, in itself, constitute a source of income, and that would not seem to be what the OECD envisages. This immediately pinpoints the weakness in the user value idea – i.e. the idea that if you pay for digital (or other) services in kind, you create value, but if you pay for these services in money, you do not create value. That sounds completely arbitrary, as if the method of payment makes the difference in terms of creating value29.

Allocation of tax base to marketing jurisdiction is also based on the idea that engagement in market jurisdiction creates favourable attitude in the mind of the taxpayer and so leads to generation of marketing intangible by way of better brand value and trade name. However it is improper to think that only marketing intangibles create favorable attitudes in the minds of customers. Customer value of this nature is also created by other components of business capital that contributed to developing and producing the goods and services supplied and this includes product quality, underlying research and development (R&D) and the logistics process (i.e. the supply chain) etc. This segregation between marketing intangibles from other business assets give rise to all sorts of delineation issues and legal uncertainties, to double taxation resulting from income allocation mismatches, to different treatment being afforded to cases that are economically equal and to distortions in the economy30.

Cacophony and Confusion:

Scope and Nexus Entanglement

The proposal is intended to be applicable to consumer facing businesses. However defining what would constitute consumer facing business is very difficult and would create numerous boundary issues and would lead to likely disputes between tax authorities and taxpayers. There are products that are used as both final consumer products as well as intermediate product. Also with evolving business models, any attempt at defining what constitutes consumer facing business would quickly become outdated.

The proposal talks about different approaches for digital and non-digital businesses. However the dividing line between digital and non-digital products is increasingly getting blurred. Take for instance a new kind of diapers in the market. These digital diapers come with a tiny RFID sensor that can detect diaper moisture, signal a nearby receiver, and send caregivers an alert. They say that the sensor can be manufactured for less than 2 cents, making it suitable for disposable diapers without adding bulk31. Now the differentiation of whether it is a consumer facing product or a service becomes an issue here. Many would argue that this is a product and not a service but then this is just the beginning and the case in point here is that things are going to get really mixed-up in the future as technology progresses. Any proposal separating one from the other for tax base division purposes would be prone to causing market distortion, arbitrary situations, inequities and manipulation. This differentiation would also force companies to prepare bespoke, segmented financials, which would lead to complexity, uncertainty and dispute amongst authorities32.

The Unified Approach calls for using revenue along with other factors such to determine nexus and as a criteria for allocation of residual profits to markets jurisdiction. One such possible criteria is the user base to take into account situation where the location of non-paying users are different from those in which the relevant revenue is booked. The assignment of taxing rights based on user location creates many issues. First, Businesses generally do not collect data regarding the location of the end users. And if they start doing that then a lot of time and cost will be required to do so. Also, in doing so there may be violation of a lot of privacy laws enacted recently. Secondly, the IP address and other such geo-location indicators are generally accepted to not be fail-proof since virtual private networks (VPNs) and proxy servers that allow users to show that they are acting out of states other than where they are actually located are ubiquitous the market33.

Conflation and Conflict–Amount A

The Unified Approach is a conflation of two ideas -destination-based formulary apportionment and the existing origin state-based transfer pricing model. The solution that is on the table currently seeks to blend these two incompatible apportionment systems which is likely to result in a series of alignment problems in all of the areas in which these various apportionment models would, in practice, interact. These alignment problems will create all types of problems of both substantive (e.g., multiple taxation) and administrative natures (e.g., disputes); on top of that, they will occur on a worldwide scale. One system refers to taxpayers, taxable profits, and the arm’s length principle whereas the other system refers to multinationals/ business lines, commercial profits, and formulary apportionment. Successfully incorporating Amount A into the current international tax framework would require incorporating a full profit tax apportionment system into national legislation and regulations as well as the tax treaty networks of every country around the world; otherwise stated, tax harmonization on a global scale. The two apportionment systems, in the synthesis as outlined, must not be allowed to result in double taxation. In order to achieve single taxation and prevent mismatches at a tax entity, tax base, and tax base allocation level, therefore, the countries that are affected will also have to reach agreements with each other on all of the reference points, both in policy terms and in a more legal and technical sense. This is an undaunted and extremely difficult process to implement and looking at the way multilateralism has floundered recently, it appears nearly impossible to accomplish34.

Can of Worms–Amount B and Amount C

Although defining baseline marketing and distribution functions is a necessary predicate to the operation of Amounts B and C, it seems unlikely that such activities could be objectively defined. If in market baseline marketing and distribution functions are subjectively defined, then it could lead to a proliferation of tax disputes35.

There is a risk that if the baseline activities are more broadly defined with commensurately higher returns and if actual the actual distribution and marketing activities are significantly less than the baseline amount then the allocation may be under Amount B would be unjustified36. Therefore there is a need to consider the possibility of structuring Amount B as a safe harbor rather than as fixed returns.

While it is understandable that there is an attempt to prescribe fixed returns for marketing and distribution function to provide greater certainty, what is a little perplexing is the idea of fixing returns for all additional activities in a country (e.g., services such as research and development) through Amount C. This is an attempt to go way ahead of the original purpose for which this whole project was conceived. The Unified Approach should stay rooted in advising on marketing and distribution type activities, and that the arm’s length standard be left in place with the OECD Guidelines for the rest of the supply chain. While the stronger dispute resolution rules in Amount C is appreciable, however stronger dispute resolution on transfer pricing for the rest of the supply chain would be better addressed in a separate initiative. Low income countries may see this as attempt to push fixed rates down their throats and limit their administrative flexibilities under the garb of assigning more taxing rights to them.

CONCLUSION

The OECD has a come a long way since it first released its 2005 publication of E-commerce: Transfer Pricing and Business Profits Taxation to address the challenges arising from the digitalization of multinational enterprises’ business models and the evolution of cross-border ecommerce. In this long period of 15 years, the last few have been really productive with OECD accepting the need for a system overhaul, setting the agenda through BEPS and post-BEPS initiatives and doing couple of very dynamic public consultation through which it has considered every possible option on the table and heard every possible voice. But one thing that has set this apart from all previous efforts is the attempt to broaden the discussion by creating an Inclusive Framework and giving a formal position to every interested country. This was something indispensable, without which the whole initiative couldn’t progress as overhauling global rules requires that every country comes on board.

However many believe that this ambitious timeline of December 2020 for a final pillar one outcome is resulting in significant policy decisions being made with limited conceptual and empirical understanding of the likely consequences. The amount of administrative and technical pain that is going to result from transitioning to this radical system from a system which has been in place for almost hundred years may not deliver the tax gains and the economic efficiencies that many countries are hoping for.

With multilateralism taking a hit (more severely recently due to the pandemic) and with many countries already having unilateral measures in place, the question now is will they be interested in a solution at all, if at all it exists, especially when it requires an unimaginable level of cooperation and agreements globally and placing their faith in institutions which many see as serving the interest of only a few.

For low income countries (but with high tax jurisdictions), a deeper introspection may make many feel shortchanged. Just consider this for example. If a company’s worldwide rate of profit is 25 percent (very few MNE groups operate at this level of operating margins) and its average foreign tax rate is 20 percent, then in all jurisdictions where it is above the local threshold amount, it would pay, and the local government would collect, a tax equal to 0.3 per cent of local sales. This is based on the assumption that the deemed rate of routine-return is 10 per cent and share of market jurisdiction is 10 per cent of residual profits. Now isn’t this sum paltry!

REFERENCES

[1] OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http:// dx.doi.org/10.1787/9789264241046-en

[2] Vishesh Dhuldhoya, ‘The Future of the Permanent Establishment Concept,’ 72(4a) Bull. Int’l Tax’n 12 (2018)

[3] Peter Hongler and Pistone, ‘Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital Economy,’ Working Paper, at 14 (2015); and Michael P. Devereux and John Vella, ‘Implications of Digitalization for International Corporate Tax Reform,’ WP 17/07, at 25 (July 2017).

[4] B. Musgrave, Interjurisdictional Equity in Company Taxation: Principles and Applications to the European Union, in Taxing Capital Income in the European Union: Issues and Options for Reform pp. 46-77 (S. Cnossen ed., Oxford University Press 2000); P.B. Musgrave, Principles for Dividing the State Corporate Tax Base, in The State Corporation Income Tax: Issues in Worldwide Unitary Combination pp. 228-246 (C.E. McLure, Jr. ed., Hoover Institution Press 1984).

[5] Maarten de Wilde and Ciska Wisman, ‘OECD Consultations on the Digital Economy: ‘Tax Base Reallocation’ and ‘I’ll Tax If You Don’t’?’, IBFD (2019)

[6] OECD (2018), Tax Challenges Arising from Digitalisation – Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi. org/10.1787/9789264293083-en

[7] bloombergtax.com, INSIGHT: Cost-Plus Transfer Pricing for Marketing Support Services Between BEPS 1.0 and BEPS 2.0, Aug. 13, 2019

[8] OECD, Addressing the Tax Challenges of the Digitalisation of the Economy — Public Consultation Document (Feb. 13, 2019-Mar. 6, 2019), 2019

[9] Jakob Bundgaard and Louise Fjord Kjærsgaard, taxable presence and highly digitalized business models, tax notes int’l, mar. 2, 2020, p. 977

[10] OECD, Addressing the Tax Challenges of the Digitalisation of the Economy – Policy Note, 23 January 2019

[11] Tatiana Falcão, The OECD’s Digital Economy Taxing Rights Allocation Mash-Up, Tax Notes International, August 5, 2019

[12] IBFD, Comments submitted by The International Bureau of Fiscal Documentation (IBFD) Task Force on the Digital Economy, 6 March 2019

[13] OECD Secretariat, Public consultation document – Secretariat Proposal for a ‘Unified Approach’ under Pillar One (October 2019 – 12 November 2019)

[14] OECD, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising From the Digitalisation of the Economy, May 2019

[15] Kartikeya Singh, W. Joe Murphy, and Gregory J. Ossi, ‘The OECD’s Unified Approach–An Analysis of the Revised Regime for Taxing Rights and Income Allocation’, Tax Notes Int’l, Feb. 3, 2020, P. 549

[16] Johnson & Johnson, Comments submitted to OECD, November 11, 2019

[17] Vasiliki Agianni, Associate – IBFD, Proposal for ‘Unified Approach’ under Pillar One–details, 10 October 2019

[18] Martin A. Sullivan, Economic Analysis: Spreadsheets for the OECD’s Unified Approach and Two Alternatives, Tax Notes Int’l, Dec. 9, 2019, P. 877

[19] Francois Chadwick, International Tax Rules for the Digital Era, Tax Notes International, Sep 4, 2019

[20] Allison Christians, Taxing According To Value Creation, Tax Notes International, June 18, 2018

[21] www. theverge.com, RFID sensor is powered by dirty diapers, Feb 14,2020

[22] Amazon, Comments on the Secretariat Proposal for a Unified Approach under Pillar one, Nov 11, 2019

[23] Sriram Govind, Unilateralism in Taxing the Digitalized Economy: Comparing the EU Digital Services Tax Proposal and the Indian Equalization Levy, IBFD 2019

[24] de Wilde, Maarten Floris, On the OECD’s ‘Unified Approach’ As Frankenstein’s Monster and a Dented Shape Sorter (November 3, 2019). Available at SSRN: https://ssrn.com/ abstract=3479949or http://dx.doi.org/10.2139/ ssrn.3479949

[25] Uber, Uber’s Comments and Observations with respect to the Unified Approach, November 2019

[26] EY, Comments on Public Consultation Document

– Secretariat Proposal for a ‘Unified Approach’ Under Pillar One, 12 November 2019

[27] Mindy Herzfeld, An Off-Ramp for the OECD’s Digital Tax Project, Tax Notes Int’l, May 18, 2020, p. 750

[28] Martin Sullivan, Economic Analysis: OECD Pillar 1 ‘Amount A’ Shakes Up Worldwide Profit, 97 Tax Notes Int’l 849 (Feb. 24, 2020)

Notes:-

1. OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi.org/10.1787/9789264241046-en

2. Vishesh Dhuldhoya, “The Future of the Permanent Establishment Concept,” 72(4a) Bull. Int’l Tax’n 12 (2018)

3. Peter Hongler and Pistone, “Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital Economy,” Working Paper, at 14 (2015); and Michael P. Devereux and John Vella, “Implications of Digitalization for International Corporate Tax Reform,” WP 17/07, at 25 (July 2017).

4. P.B. Musgrave, Interjurisdictional Equity in Company Taxation: Principles and Applications to the European Union, in Taxing Capital Income in the European Union: Issues and Options for Reform pp. 46-77 (S. Cnossen ed., Oxford University Press 2000); P.B. Musgrave, Principles for Dividing the State Corporate Tax Base, in The State Corporation Income Tax: Issues in Worldwide Unitary Combination pp. 228-246 (C.E. McLure, Jr. ed., Hoover Institution Press 1984).

5. Maarten de Wilde and Ciska Wisman, “OECD Consultations on the Digital Economy: “Tax Base Reallocation” and “I’ll Tax If You Don’t”?”, IBFD

6. OECD (2018), Tax Challenges Arising from Digitalisation

– Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi. org/10.1787/9789264293083-en

7. News.bloombergtax.com, INSIGHT: Cost-Plus Transfer Pricing for Marketing Support Services Between BEPS 1.0 and BEPS 2.0, Aug. 13, 2019.

8. OECD, Addressing the Tax Challenges of the Digitalization of the Economy—Public Consultation Document (Feb. 13, 2019–Mar. 6, 2019), 2019.

9. Jakob Bundgaard and Louise Fjord Kjærsgaard, Taxable Presence and Highly Digitalized Business Models, Tax Notes Int’l, Mar. 2, 2020, p. 977.

10. OECD, Addressing the Tax Challenges of the Digitalization of the Economy – Policy Note, 23 January 2019.

11. Supra note 7.

12. Tatiana Falcão, The OECD’s Digital Economy Taxing Rights Allocation Mash-Up, Tax Notes International, August 5, 2019

13. IBFD, Comments submitted by The International Bureau of Fiscal Documentation (IBFD) Task Force on the Digital Economy, 6 March 2019

14. OECD Secretariat, Public consultation document-Secretariat Proposal for a “Unified Approach” under Pillar One (October 2019–12 November 2019)

15. OECD, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalization of the Economy, May 2019.

16. OECD Secretariat, Public Consultation Document-Secretariat Proposal for a “Unified Approach” under Pillar One (October 2019–12 November 2019).

17. OECD (2020), Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalization of the Economy – January 2020, OECD/G20 Inclusive Framework on BEPS, OECD, Paris.

18. Kartikeya Singh, W. Joe Murphy, and Gregory J. Ossi, “The OECD’s Unified Approach—An Analysis of the Revised Regime for Taxing Rights and Income Allocation”, Tax Notes Int’l, Feb. 3, 2020, p. 549.

19. Johnson & Johnson, Comments submitted to OECD, November 11, 2019.

20. Vasiliki Agianni, Associate – IBFD, Proposal for “Unified Approach” under Pillar One – details, 10 October 2019. 21Martin A. Sullivan, Economic Analysis: Spreadsheets for the OECD’s Unified Approach and Two Alternatives, Tax Notes Int’l, Dec. 9, 2019, p. 877.

22. Francois Chadwick, International Tax Rules for the Digital Era, Tax Notes International, Sep 4, 2019.

23. Supra note 17.

24. Supra note 12.

25. Mindy Herzfeld, An Off-Ramp for the OECD’s Digital Tax Project, Tax Notes Int’l, May 18, 2020, p. 750.

26. Martin Sullivan, Economic Analysis: OECD Pillar 1 ‘Amount A’ Shakes Up Worldwide Profit, 97 Tax Notes Int’l 849 (Feb. 24, 2020).

27. The scope of this article is limited to highlighting the basic shortfalls in conceptualisation of the Unified Approach. It does not attempt to analyse and make recommendations on various design issues and other technicalities which are still under consideration and have not been agreed. Therefore the article focuses on only those aspects which have been accepted by the Inclusive Framework as fixed.

28. Allison Christians, Taxing According To Value Creation, Tax Notes International, June 18, 2018

29. Supra note 5

30. Supra note 5.

31. www.theverge.com, RFID sensor is powered by dirty diapers, Feb 14, 2020.

32. Amazon, Comments on the Secretariat Proposal for a Unified Approach under Pillar one, Nov 11, 2019.

33. Sriram Govind, Unilateralism in Taxing the Digitalized Economy: Comparing the EU Digital Services Tax Proposal and the Indian Equalization Levy, IBFD 2019.

34. de Wilde, Maarten Floris, On the OECD’s ‘Unified Approach’ As Frankenstein’s Monster and a Dented Shape Sorter (November 3, 2019). Available at SSRN: https:// ssrn.com/abstract=3479949or http://dx.doi.org/10.2139/ ssrn.3479949.

35. Uber, Uber’s Comments and Observations with respect to the Unified Approach, November 2019.

36. EY, Comments on Public Consultation Document – Secretariat Proposal for a “Unified Approach” Under Pillar One, 12 November 2019.

Source- Taxalogue 3- April to June 2020

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