21 February 2019
As Christmas 2018 approached, publicly it seemed like the wheels were coming off the digital tax bus, with Australia distracted by other matters following its lukewarm October Discussion Paper, the EU Council failing again to reach agreement on its digital services tax proposal and the UK in meltdown over Brexit.
But the Task Force on the Digital Economy was busy burrowing away on the project in December, and in late January after approval by the BEPS Inclusive Framework, which now drives the international tax agenda, the OECD released a Policy Note on the digitalisation of the economy signalling forward momentum. Significantly a new “second pillar” has been added to the mix based on two of the most controversial elements of the 2017 US Tax Reform, the GILTI (global intangible low-taxed income) and the BEAT (base erosion anti-abuse tax) regimes – see our tax brief on US tax reform. In mid-February the OECD released a more detailed Consultation Document on the new directions.
Although all the proposals raised have been released on a “without prejudice” basis, the OECD is giving the impression that consensus is within reach by the current time limit in 2020. The next major public testing of the viability of the proposals will likely be the June 2019 meetings in Japan of G20 Finance Ministers and Leaders. So what is new?
Exit the digital services tax?
The proposals specifically in relation to the digitalisation of the economy, which is referred to as the “first pillar” of the emerging approach are more concrete and developed thinking on the policy and details, though the same three main ideas are still involved. More importantly the digital services final tax which was previously mooted as an interim solution has gone from OECD discussions and along with it the idea that an end-run would be done around tax treaty rules by introducing a tax not covered by treaties. Surprisingly New Zealand has just announced, however, that it is still running with the digital services tax, with a discussion paper due in May 2019, and apparently hinting that the idea is still alive in Australia.
In the new OECD documents the digital services tax which has previously been linked to the first proposal described below is gone but there is still a non-final withholding tax as part of the administrative mechanism for the third (and broadest) of the revised proposals, using “significant economic presence” sometimes referred to as the “virtual” permanent establishment (PE). The withholding tax would be credited against the final tax payable on a net basis on the profits of the virtual PE (or refunded to the extent it exceeds the final tax), following the filing of a tax return.
Enter the three digital contenders in greater detail
It is acknowledged by the OECD that all the current proposals require tax treaty changes, which no longer is viewed as a downside. Presumably with the MLI now coming on stream, including for withholding tax in Australia from 1 January 2019 in relation to its treaties most notably with France, Japan, New Zealand and the UK, a protocol to the MLI seems to be the likely mechanism for dealing with treaty barriers to the proposals. The treaty changes may well be executed by a separate treaty regime for the relevant profits rather than trying to rewrite existing provisions.
The first proposal examined under the first pillar is the “user related data” idea that having users in a state of digital platforms in the form of social networks, search engines or marketplaces is sufficient to found tax jurisdiction. This is now seen as closely allied with the broader second proposal which would extend to all businesses which rely heavily on the internet but is not limited to quintessential digital companies. Here the justification for taxing in the state of users (not necessarily the state of the platform’s customers in the case of platforms relying on advertising revenue) is reliance on marketing intangibles which will be deemed for tax purposes to be located in the users’ state to the extent of the users there. The second proposal will extend the reach of the tax but will still mainly be directed at business-to-consumer transactions.
The preferred method of taxation for the first two approaches is a residual profit split, but on a group global basis rather than company by company, with transfer pricing still having a role in separating out returns to routine activities and trade intangibles from the residual profit to be split. There is now much more extended discussion of the technical issues involved, including whether it would be possible effectively to merge the two proposals in some way.
The third significant economic presence approach would use a sales revenue metric as an initial threshold but would require some reliance on digital or automated means to engage users in the jurisdiction or other indicators of economic presence. Merely selling goods into another country without the necessary economic presence will not give rise to tax in the country of the users/customers, which is of great significance to Australia with its reliance on export of natural resources and primary products. The method of taxation here would likely be “fractional apportionment”, which looks like formulary apportionment by another name, with the global profits of the corporate group split according to allocation keys.
Given that all of the proposals would significantly reshape the international tax threshold and profit allocation methods for business profits (and tax treaties along with them), there is constant reassurance that double taxation will be avoided and robust dispute resolution available along with advance rulings to provide certainty,
Apart from the specifics and the preservation of a role for the legion of transfer pricing professionals around the world, the Consultation Document suggests there will be a decisive shift away from the detailed facts and circumstances functional analysis of transfer pricing to a more robust and simpler use of proxies for allocating profits, and a tax threshold driven by modern ways of doing business, rather than the bricks-and-mortar concepts underlying the current PE rule. Administrability and (greater) simplicity may come to prevail over facts and circumstances.
Corporate tax must be paid somewhere: Two new tax avoidance regimes
The new second pillar effectively builds on BEPS Actions 2 (hybrid mismatches), 3 (CFCs), 4 (interest deductions) and 5 (harmful tax practices). The subtext is that while the BEPS 2015 measures went some way to removing BEPS, they did not nail down residual profits especially in relation to intangibles and financing, so more is needed. The measures will primarily be implemented through domestic law changes as is the case for those BEPS Actions, but will be supplemented by further wind back of treaty protection against source taxation on top of the principal purpose test and other BEPS measures in the MLI.
At the policy level the second pillar represents a departure from the underlying BEPS Action Plan philosophy that “No or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it.” Substance requirements in BEPS measures to date have still not been enough to prevent residual profits ending up in tax havens.
Now as with hybrid mismatches (and especially the Australian anti-avoidance addition to the OECD hybrid rules), it is likely to be expected that income will be taxed somewhere (with rules for pickup of income in ultimate source or residence countries if not elsewhere), or, in other words, as a number of important EU countries have suggested, there is likely to be a global minimum tax on corporate income, with a coordination rule to ensure that double taxation does not arise. The main target of the second pillar will be internal shuffling of income within corporate groups so that it ends up in the most advantageous tax location.
The first part of the second pillar takes its inspiration from the US GILTI regime (which is mentioned by name in the Consultation Document) and in effect is a supplementary minimum tax CFC regime. BEPS did not establish any obligation for residence countries to have a CFC regime, but now they may get one by another name. The regime would target 25% or more interests in foreign entities and ensure a minimum tax on the income of the company with a credit for foreign taxes, thus reducing the incentive for the group to move its income to a low tax regime. The rate of minimum tax is not specified. The US GILTI regime effectively has a 10.5-13.125% tax rate. The Consultation Document lists as one of the technical issues “whether the included income should be taxed at the minimum rate or the full domestic rate”. Equivalent changes would occur to exemption regimes for foreign branches.
The second part of the second pillar is based on the US BEAT but the US rule is not mentioned by name. The OECD rule would work by denying deductions to the paying entity for related party payments unless the payments were subject to a minimum effective rate of tax elsewhere. It would cover a broad range of payments and deal with conduit and imported arrangements like the hybrid mismatch rules. In determining whether a payment is undertaxed, the level of substance of the payee under Action 5 harmful tax practices nexus principles may be taken as a guide. Consideration will also be given to a fat capitalisation rule applying to the payee which, although not mentioned, could introduce elements of a worldwide interest deduction limit into BEPS Action 4 interest limitations.
In addition some or all tax treaty source country taxing limits would have a subject to tax rule introduced into them so that they do not apply if the payments are not subject to the minimum required level of tax elsewhere. The need for coordination with the global minimum tax proposal is recognised, with a hint that the GILTI-style minimum tax will take precedence.
Ambitious but not pie-in-the-sky
This new OECD package is an ambitious set of proposals indeed. Submissions are due by 6 March 2019 and a consultation meeting will be held the same month. Potentially the package will remake much of the current international tax landscape for business income. Many countries have signalled that their first priority is a consensus on measures at the Inclusive Framework level, rather than unilateral action. The US is already effectively on board with the second pillar through its 2017 tax reform and seems to be attracted to the marketing intangibles approach to the digitalisation of the economy. For their part the UK and the main powers in mainland Europe have indicated that they want more on base erosion and action on the digital economy. The main problem has been finding a practical way forward. One gets the sense that there is movement on the international tax station.