INTERNATIONAL TAXATION (R)evolution in international taxation
The OECD is continuing the fight for fairer distribution of profits of companies active in the field of digital economy. In recent days the OECD has taken another important step and published a proposal for a “unified approach” which combines all three previous proposals of the cooperating countries relating to the question of how to achieve higher taxation of profits of digitalised companies in countries where they offer their products. Thus, the whole issue is gaining considerable momentum which may lead to a mutually accepted solution. It follows from the proposal, however, that the solution will not be concerned with the digital economy only in the strict sense of the term.
Many countries are acting faster than the OECD and have announced their own unilateral measures for taxation of the digital economy. France has already introduced a digital tax, and Italy, the UK, Austria, and the Czech Republic are currently working on the implementation of a digital tax (you can find more information for example here: https://www.fucik.cz/publikace/ceska-republika-zavede-digitalni-dan/). However, the OECD views these actions as unilateral solutions lacking in conception and that is why they are proposing a global solution: the unified approach, which should ensure that a part of the profit would be divided among the states which figure as selling markets for the company, and at the same time this would be coordinated withing the framework of the international taxation system.
The OECD is currently trying actively to reach a consensus on the final shape of the solution. On 9 October 2019 it published a rough outline of the unified approach concept including a list of open points and questions. The proposal is open to the opinions of the public until 12 November 2019. The next crucial month will be January 2020 when the OECD hopes to have the foundations of the unified approach prepared well enough, so that the proposal may attract political support by mid-2020. The final shape of the global solution will be known at the end of 2020. At that point the discussion should turn to how it will be implemented into the standing international taxation system.
You can find the entire proposal via this link: https://www.oecd.org/tax/beps/public-consultation-document-secretariat-proposal-unified-approach-pillar-one.pdf. But we will sum up its contents in the text below.
1. What is the scope of the unified approach?
Taxation according to the unified approach does not cover only digital services but broadly focuses on consumer-facing businesses. The exact scope of entities, or rather activities which will be subject to this new type of taxation is yet to be discussed (and so is the exact definition of the term “consumer-facing business”). A potential threshold from which the uniform approach would apply to a multinational enterprise will also be discussed. There are talks about the same limit which is currently used for country-by-country reporting, that is EUR 750 million revenue threshold. If a multinational enterprise does not reach this threshold, the currently in force rules will apply.
The proposal further states that the new approach will definitely not be used in extractive industries. Further discussion should also take place to consider whether other sectors (such as financial services) should also be carved out.
2. New Nexus
At the moment, a non-resident company is taxable on its business profits in the country of its market only if it has a permanent establishment there. In other words, it must have some form of physical presence there in accordance with Article 5 (Permanent Establishment) of the relevant double taxation treaty. If the permanent establishment is present in the market jurisdiction, then according to the authorized OECD approach for allocation the market state basically has a right to tax the profit using the arm’s length principle. The situation is not changed noticeably even if the multinational enterprise has a subsidiary in the market state. Even in such cases the taxable profit in the market state is assessed in accordance with the arm’s length principle. In both cases it sometimes happens that the profit taxable in the market state corresponds only to the remuneration of routine activities, and the residual profit is taxed outside of the market jurisdiction. Thus, digitalisation and electronic communication have strained the applicability of the rules currently in force to a significant degree. Companies have still more opportunities to do business with customers in any jurisdiction without having a physical presence there, and create significant value there.
That is why the unified approach brings a new nexus concept. The nexus rule defines the minimum involvement in the economy which gives right to profit taxation of a multinational enterprise exceeding the framework of currently effective rules. The unified approach would link the nexus rule to a revenue threshold of the multinational enterprise in the market of a given jurisdiction. Once this threshold is reached, new tax liabilities arise. The amount of the revenue threshold should be set up in order to respect and adapt to the size of the market (smaller economy = lower threshold). The new rules would also take into account certain specific activities, such as online advertising services.
The revenue threshold would not only be observed with business models involving remote selling to consumers, but would also apply to groups that sell in a market using a distributor (reseller) – even an independent one – to get their product to the final customer. This is to maintain neutrality between different business models. We would like to point out that the aim is to tax in the market state beyond the scope of the current provisions.
Therefore, if a multinational enterprise belongs to the “Consumer Facing Businesses” category and is not exempt (see the discussed limit of EUR 750 million), then the profits from the market jurisdiction which exceed the threshold for the local market will be cause for new tax liabilities. But the definite tax rate depends on the new allocation rules for these new “nexuses”.
3. New profit allocation rule applicable to the nexuses and increased certainty
The new unified approach wants to maintain the current profit allocation rules for permanent establishments, and retains the current transfer pricing rules (based on the arm’s length principle). However, it creates new profit allocation rules which will ensure partial taxation of the residual profit in the market state. The unified approach proposal wants to assess the taxable amount of residual profit in the market state using a specific formula (the parameters shall be further discussed). Of course the proposal also accentuates the increased tax certainty for taxpayers and tax administrations.
Specifically, it is that the new allocation rules within the unified approach are based on a three tier profit allocation mechanism in the state where the new nexus is present. The proposal presents the concept of these three types of profit which shall be liable to taxation in the market state:
Amount A: It stems from the deemed residual profit of a multinational enterprise, or as the case may be, of its business line. This amount would be the profit that remains after allocating what would be regarded as deemed routine profit on activities and calculated on a business line basis. Part of the deemed residual profit will be allocated to jurisdictions in which the multinational enterprise, or its business line, has its nexus. This should be done using a formalised formula agreed on in advance. The details of the assessment process for the Amount A will be further discussed, together with the parameters of the formula.
Amount B: This should be a fixed remuneration for baseline marketing and routine distribution activities that take place in the market jurisdiction and are ascertained based on its previously given profitability. This fixed profitability should prevent a large amount of disputes regarding transfer pricing related to the remuneration for marketing and distribution functions between taxpayers and tax administrations alike. The specific method for assessing the fixed return for marketing and distribution activities will be further discussed, and so will the exact definition. However, the aim is to ensure a certain minimum standard and certainty.
Amount C: This type of profit which a jurisdiction seeks to tax is supposed to retain the ability of taxpayers and tax authorities to argue that (i) marketing and distribution activities taking place in the market jurisdiction go beyond the baseline level of functionality remunerated by the Amount B (fixed return for activities), or (ii) that the multinational enterprise or company perform other business activities in the market state unrelated to marketing and distribution. This additional profit would be assessed using the arm’s length principle (as the currently effective rules state). The following discussions are to focus on the prevention of potential duplication of taxation. For example, if certain significant functional activities performed in the market state generated residual profit (allocated to the market jurisdiction under Amount A), then the same profit should not be taxed under Amount C as well. That is why rules specifying the relationship and interaction of Amounts A and B are expected.
Although it may seem that the new global approach has to overcome many obstacles and that political support and consensus for universal acceptance will be hard to find, the OECD still plans on presenting viable rules by the end of 2020. If the support and consensus is found, it will take same time to implement the rules into international taxation which is based on a system of bilateral treaties for the avoidance of double taxation. To change the system through bilateral adjustments would take a very long time. But the Multilateral Instrument (MLI) presents another way how to speed up the process of implementation.
We will keep you informed about any further developments. Should you have any questions regarding these issues, please don’t hesitate to contact us.
Veronika Džalavjan & Štěpán Osička