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In response to the Organisation for Economic Co-operation and Development (OECD)’s request for comments relating to the public consultation document titled, “Addressing the Tax Challenges of the Digitalization of the Economy” issued on February 13, 2019, managing director Simon Webber and directors Andrew Cousins and Wade Owen in the Transfer Pricing practice submitted a comment letter to the OECD.
Simon, Andrew and Wade considered the proposals for revised profit allocation and nexus rules as well as the new global anti-base erosion proposal.
Revised Profit Allocation and Nexus Rules
The three proposals differ in their range and scope, but the impact of these proposals in moving away from the arm’s length principle, which has successfully underpinned the world tax system for so long, should not be underestimated. We fear the considerable time it is likely to take to achieve consensus between taxing authorities on any of the proposals. In the meantime, digital businesses will face a plethora of uncoordinated, unilateral country-specific digital taxes that are largely, and intentionally, outside of the international tax framework.
As such, it seems likely that, over the course of this international tax re-evaluation process, digital companies will have to navigate three or more different taxation systems, almost inevitably leading to significant levels of double taxation of profits, or even taxation of “manufactured” or deemed profits that do not in fact exist in these businesses. This would seem to be highly punitive and neither of these outcomes is likely to end up being beneficial to individual countries or the global economy. It would also appear to fail at least three of the tests for good tax policy; equity, simplicity and certainty. Therefore, we believe that consideration should be given to making any solution clearly and expressly a replacement of unilateral digital sales taxes rather than just minimum standard for members of the Inclusive Framework, so as to ensure application of a consensus solution within the international tax framework, ideally before unilateral digital taxes become established as another layer of direct corporate and indirect consumer taxation.
Although the UK’s “user participation” proposal and India’s “significant economic presence” proposal appear limited in their focus to highly digitalized businesses and digital income streams, it is already recognized that the U.S. “marketing intangibles” proposal has the potential to be applied across all businesses, highly digitalized or not. The user participation proposal seems to target specific companies or segments and thereby does not offer a more holistic solution for the digitizing economy as a whole. The marketing intangibles proposal, while broader in aspect, will have to take into account different forms of “marketing” and incentives for user engagement between businesses in order not to introduce undesirable and distortive tax incentives to certain business models and/or modes of operation over others. The significant economic presence proposal seems to be nothing other than formulary apportionment by another name.
All three measures represent a move towards global formulary apportionment, which the OECD has historically always rejected for the reasons given in Chapter I of the Transfer Pricing Guidelines. A search for a globally agreed, commonly applied and accepted solution to the tax treatment of digital profits is a worthy endeavor in contrast to potential numerous and inconsistent unilateral measures that result in multiple tax systems and double taxation for many digital companies. The proposals in this discussion draft themselves are uneven with respect to a taxpayer’s risk of double taxation. The risks of all the measures proposed remain those that are listed in the Transfer Pricing Guidelines, the most significant being the challenge of protecting against double taxation and ensuring single taxation. Conflicts can be anticipated in establishing apportionment factors, in agreeing the relative valuation of assets and contributions, and the difficulty of recognizing important geographical differences, as well as in the lack of conformity of accounting standards and the definition of profits. None of this is new or unexpected.
It remains to be seen how the proposals will adequately reflect the significant historical investments and risks that many digital companies faced in establishing a successful business model, developing international markets and related user/customer bases. Businesses in emerging industries must take a long view, investing in a market and incurring costs often without the realistic prospect of making any profits, annually or cumulatively, for many years. These investments are inherently risky and are rewarded only after years of efforts, failures, and restarts. Not to recognize the contribution of riskier historical investments to current profits is an ahistorical view that endangers business innovation and fair taxation among tax jurisdictions.
The cost and risks of investing in and building a global network of users or customers is not to be underestimated. There are examples of multinationals that have historically incurred very significant costs in their home jurisdiction to make a sustained investment in overseas markets, while their operations in local market jurisdictions have been subsidized with limited risk returns. If markets are to be entitled to a share of the residual profits, it should be reasonable to factor in the historic investment made in the home territory in developing the market and the significant losses that have been incurred and which sit on the balance sheet in the home territory.
Furthermore, it should not be overlooked in this discussion that these investments are not only the investments of taxpayers willing to take on outsize risks in exchange for long term, but highly uncertain, potential returns, but that there are investments by the tax authority in the home jurisdiction (e.g., in the form of tax relief related to net operating losses) that must also be compensated. If a home jurisdiction has reasonably supported a growing business or industry through its nascent period, it has done so with an investor’s mindset and should not be deprived of its rights to additional tax in later years without consideration for those investments.
Consequently, any proposals taken forward will need to take account of the stage of development in any multinational group’s evolution, since even a business that is now profitable overall may have taken many years to reach that point. The business may have current or exhausted loss allowances from the original home jurisdiction, and such investment should be matched with the profits earned by the enterprise to ensure a holistic view of the return to that enterprise before allocating additional revenues to a market jurisdiction.
For the purpose of apportioning profit, it will be important that the establishment of a suitable accounting basis is well founded. A group’s global profit and loss account is likely to be too far removed from the circumstances of the individual market to serve as a valid basis for apportionment of residual profit. If, for example, one market is at the early stages of penetration and still incurring costs, whereas another market is more mature and is generating overall profits, apportionment based on global results is likely to lead to serious distortions. Additionally, it should be noted that the allocation of risk in arm’s length arrangements is rarely apportioned evenly among participants but rather some parties will bear a disproportionate amount of the risk commensurate with their ability to bear that risk and in exchange for additional returns.
The appropriate segmentation of profits for apportionment will be heavily dependent on the multinational’s business model but is likely to be the closest segment to the level of the market. In agreeing an allocation of profits between market and home territory, it will also be necessary to agree a weighting between the market intangible and the home-grown intangibles. The latter may well have provided the platform or technology for use by all users and customers and therefore contributed significantly to apparently standalone local profitability. This may be no easy task.
As such there is considerable risk of historical asymmetry inherent within the proposals, that one or other tax jurisdiction may well have borne these losses, while other countries may well tax the subsequent benefits. Observable arm’s length principles in some industries (e.g., the pharmaceutical industry), where this type of bimodal outcome (failure or shades of success) and investment fact pattern is also prevalent, as well as established principles of finance used by actual investors, may well offer useful insights on how equitably to reflect this type of historical investment and should not be ignored.
Global Anti-Base Erosion Proposal
The OECD’s Global anti-base erosion proposal, effectively a global minimum tax regime for multinational enterprises of all types, not just highly digitalized businesses, is evidently a measure that goes well beyond the scope of merely addressing the challenges posed by the digital economy.
The consultation document states that this proposal is intended to respect the sovereign right of each jurisdiction to set its own tax rates, but the way the proposal is currently framed does not appear to respect that principle. There is no mention of any exemption from the minimum tax where a level of substance and activity commensurate with the profits earned is present in the low-tax jurisdiction. Thus, the tax sovereignty of a jurisdiction would appear to be rendered null and void, if activities performed within its territory can be taxed elsewhere.
The genesis of this proposal is very recent, following in the footsteps of the U.S. Tax Cuts and Jobs Act provisions, which are themselves new, and the consequences of which have still not been fully worked out. Nor indeed has the full anti-base eroding impact of the BEPS project in toto yet been given time to be revealed. Originally, the Task Force on the Digital Economy was required to deliver its final report on the tax challenges arising from digitalization in 2020. Given this tight deadline and the original more limited scope of the mandate, it seems impetuous for the Inclusive Framework to attempt to shoehorn such a new and far-reaching measure, touching the entire global economy in ways not yet worked out, into the timeline for the report on the digital economy. Such a proposal needs much more thought as to how it would work and merits separate development in a forum of its own.
1 The opinions and views expressed in this letter are those of the authors and not necessarily those of Duff & Phelps or its clients.