OECD proposals could change the way we tax the digital economy

24 October 2019
Digital devices are everywhere these days, making water cleaner, helping educate children in remote regions, and letting some of us watch TV shows on our smartphones during morning commutes.

Technology is generally considered to be a force for good, but there are serious concerns, from the potential negative effects of screen-time on children to worries over how artificial intelligence could make many occupations obsolete. For their part, government regulators have found evolving technology to be particularly nettlesome. Security and data protection legislation make front page news in this area, but the challenges of regulating the digital economy are being addressed by authorities in all areas of government, including those in tax offices.

Especially concerning for tax authorities is that digitalisation allows large multinational groups to legally avoid paying taxes, because digital services can be divorced from a local physical presence — long the standard for determining whether a business must pay tax in a country. This enables technology companies in particular to lower their overall tax bills by positioning valuable intellectual property (to which profits are attributed) in low-tax jurisdictions.

The current principles of taxation which underpin domestic tax legislation in most countries date back to the 1920s. In an increasingly globalised and digitalised world, these principles are no longer sufficient to ensure a fair allocation of taxing rights. There have been a number of recent proposals by tax authorities and the Organisation for Co-operation and Development (the arbiters of global taxation policy, followed by 134 countries) to address highly digitised businesses. But these often fail to capture significant parts of the digitalised economy. France’s digital services tax, for example, only targets the provision of digital interfaces and certain advertisers.

OECD's proposed new rules

In an important announcement this month, the OECD proposed new rules for public consultation. The rules — captured in the document Secretariat Proposal for a "Unified Approach" under Pillar One — bring together concepts from previous proposals. According to the OECD announcement, they are intended “to advance international negotiations to ensure large and highly profitable multinational enterprises, including digital companies, pay tax wherever they have significant consumer-facing activities and generate their profits.” If implemented, the rules will effect a radical shift in how multinational groups are taxed and fundamentally alter taxing rights between countries.

The “Pillar One” of the proposal’s title refers to one of two pillars into which the OECD has grouped proposals related to the tax challenges of the digitalisation of the economy. Pillar One examines taxing-rights allocation, profit allocation and nexus rules. (Pillar Two will address remaining OECD BEPS digitalisation issues and looks to ensure that multinational enterprises pay a minimum level of tax.) The Unified Approach proposal seeks to “develop a possible new approach based on the commonalities between the three proposals” of Pillar One, and will also be based on public consultation.

A Unified Approach to Pillar One should be agreed to by January 2020. Agreement will essentially allocate taxing power to countries based on where consumers are present, rather than where patents, licenses and brands are owned or where businesses are headquartered. Although the proposed rules haven’t been settled, they should reflect the following two principles:

  • A business will no longer need to have a physical or legal presence in a country to have a taxable presence there. If a business sells online to customers in another country, then, the business may need to pay tax in that country, even if it doesn’t have a physical or legal presence there.
  • Once a business establishes a taxable presence in a country, a portion of the business’ global profits will need to be allocated to that country for tax purposes. The allocation method — including any related formulas — has not yet been defined.

The tax proposal was sent to finance ministers from the G20, and the OECD has invited comments from any stakeholders before 12 November, with a public consultation to follow.

Implications for businesses and tax jurisdictions

Many US businesses and politicians believe that some recently implemented tax legislation — such as France’s digital services tax — have unfairly targeted US-based technology giants. It may seem at first glance that the newly proposed OECD rules are subject to the same criticism. For one thing, the proposed rules do in fact target larger multinational groups. That said, the fundamental alteration of taxation rights between countries under the proposed rules will affect all businesses across all jurisdictions.

Significantly, the newly proposed OECD rules do not focus solely on technology companies; they also affect car and luxury-goods manufacturers headquartered in Europe and elsewhere. As a result, the White House is backing the new OECD rules. This support from US authorities increases the likelihood that the new rules will come into force globally.

For US tax collectors, the impact of the new rules on net tax take is difficult to predict. The impact may be limited, however, as the US comprises a very large consumer market, but it’s also home to many companies that own and develop considerable intellectual property. For similar reasons, the net tax effect of the new rules in China may also be limited.

The situation in Europe is different. Larger European countries with big consumer bases may see an increase in net tax take, while smaller European countries may be adversely affected. In particular, Ireland and Switzerland — now magnets for business headquarters and intellectual property because of low tax rates — may lose out on revenues due to their relatively small populations and consumer markets.

These rules are in their infancy and designed to target larger multinationals. That said, all groups operating in multiple jurisdictions should prepare to pay tax where their customers are based, even if they do not have a physical or legal presence in those jurisdictions. American groups in particular need to be mindful of the impact of the changes on earnings and profits.

Sandeep Samra, Director, International Tax Advisory, contributed to this article.