The new taxing right will take the form of a formula-based apportionment of profits by allocating a deemed routine profit to the countries where activities are performed but leaving the balance (non-routine) deemed profit for the market jurisdiction to tax.
A business enterprise in Country X (home country) interacts with customers in Country Y (market jurisdiction / host country) through a website or other digital means (say an application on a mobile device). The business generates significant revenues and profits without having any physical nexus or the need for any local activity in Country Y. Are these profits to be taxed by country X or Y and how?
The question while seemingly simplistic is at the core of the international debate on tax challenges in a digital economy. Traditionally business models have required physical presence in the form of manufacturing, marketing or distribution in an overseas market jurisdiction and have accordingly been taxed by the host country. Advances in information and communication technology have aided the development of new business models that preclude nexus with any jurisdiction, provide flexibility in carrying out functions remotely and create value from data and consumers.
The digital economy is characterised by three distinctive features viz- a) businesses can access customers across the globe without setting up any presence in a location, i.e. operating at scale without mass; b) significant investment and reliance on intellectual property are central to the business model; and c) data and user participation / content plays an important role. These combined have important implications for what creates value and where this value is created. This ultimately feeds into the paradigm that profits should be taxed in line with value creation and economic activity. But it is possible for a business today to exploit a large consumer base in a country but not pay any tax there since all economic activity happens outside. Consequently, traditional cross-border international tax principles were found ill-equipped to answer this question fairly and new thinking was required.
The Organisation for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project initiated in 2013 identified the challenges of taxing the digital economy as one of its focus areas. Six years of inter-governmental debate and discussions culminated in July this year with the release of a Programme of Work (PoW) on the process of achieving a consensus-based solution by year end 2020. The PoW envisages two pillars – first, to revise existing profit allocation and nexus rules to redistribute taxing rights to market jurisdictions, and second, to develop a new global anti-base erosion rule to subject all business income to a minimum level of taxation. These are significant because they represent deviations from existing standards and rules.
A Unified Approach to Pillar One has been released for public consultation by the OECD Secretariat. Herein, it is proposed that multinational enterprises conducting businesses in places where they do not have a physical presence will be taxed in such jurisdictions through a new ‘nexus’ rule and the portion of profits on which the tax would apply will be determined through a new ‘profit allocation’ rule. This is designed to cover highly digitised business models broadly focussing on consumer facing businesses subject to carve-outs to be specified.
Market jurisdictions with large population like China and India stand to gain by reallocation of taxing rights in their favour because companies generating revenues remotely from users / consumers here would now be subject to tax in these countries irrespective of whether they have physical presence or not. On the other hand, developed countries which conventionally house value driving activities, risk control functions and intellectual property but may not always have a consumer base are likely to give up tax revenues.
Existing rules tend to allocate profits based on functions performed, risks assumed, and assets utilised in a country. In the absence of these being present in a market jurisdiction, there would be no profit allocated and hence, no tax. Hence, the need for a new profit allocation rule that goes beyond. The new taxing right will take the form of a formula-based apportionment of profits by allocating a deemed routine profit to the countries where activities are performed but leaving the balance (non-routine) deemed profit for the market jurisdiction to tax.
Interestingly, activities being performed in the market jurisdiction would continue to remain taxable according to existing rules. However, given the propensity for disputes on this, the suggestions include a fixed compensation for these activities and further room for any additional profit where in-country functions exceed the baseline activities remunerated on a fixed basis.
These changes call for use of quantitative thresholds and mathematical formulae to split global profits. Defining these parameters is not going to be easy. It will continue to be open to challenges of validation, objectivity and consistency.
While the focus appears to be on digital business, no business is immune from the touch of technology today. Hence, it would be short-sighted for companies to imagine themselves not being impacted by these proposals since they would be interacting or functioning in some form or fashion within the digital ecosystem.
The current proposal is in no way final. There is substantial work to be completed before it can be operationalised. This includes identifying business model differentiation, eliminating potential double taxation, enforcement and collection issues, and changes to existing tax treaties.
New rules will come with their own limitations. Taxpayers will have to spend time understanding these, examining them in the context of their business models, share feedback to stakeholders and be prepared to dispute them in case it leads to sub-optimal outcomes.
Policy makers will have to ensure that the quest for tax revenues does not generate a new wave of controversy and result in further uncertainty. Most importantly, every country would need to weigh political considerations and economic realities before signing up to a global consensus.
Need to pursue options
As business models continue to evolve in the face of unprecedented digital disruption, tax rules must keep up. These proposals pave a path in that direction. But technology changes have taught us that today’s imagination could be tomorrow’s reality and day after tomorrow’s history. It is difficult to imagine a silver bullet for taxing the digital economy. It is much better to pursue options knowing each would have consequences. Crafting an effective but flexible framework is important since we don’t know tomorrow’s reality.
Ashwin Vishwanathan is Partner - International Tax and Transaction Services at EY India. The views expressed are personal.