In February 2019, the Organisation for Economic Co-operation and Development (OECD) issued a discussion draft on proposals to change the rules on income taxation of digitalised companies. The proposed changes could radically rewrite the international profit allocation and right-to-tax (nexus) rules that have been in place for almost a century.
Here’s the rub. Traditionally, a company could generally only be subject to income tax in a foreign jurisdiction if the local economic presence rose to a sufficient level, called a permanent establishment (PE). A key requirement to establish a PE, and thus be subject to tax in the foreign country, has traditionally been that the company must have some sort of local physical presence. Thus, a company could sell into a foreign jurisdiction but wasn’t generally subject to local income taxes on those sales unless it established a physical presence and met other requirements.
Over the past few years, many countries have attempted to expand the definition of a PE. Proposals have included taxing any company that is represented by an in-country sales agent — known as a dependent agent — acting exclusively or almost exclusively on its behalf. In other words, even if the company didn’t have a physical presence but operated in a country through a dependent agent, the dependent agent’s actions could cause the company to be deemed to have a PE and owe tax in the country.
A question has also recently arisen whether a country has the right to tax value that is created within its borders, such as from advertising used in social media, a search engine, or a digital download of a product, if the company has only a digital presence locally. Under the traditional PE rules, no physical presence exists, but, arguably, value has been created within that country — possibly a lot of value — but under the existing rules, that value couldn’t be taxed.
The OECD proposal is designed to address this issue. Countries have watched as large digital-based companies expand their digital presence. They see how many people in their country purchase products or download movies, and these countries want to tax some of the profit from those transactions. However, to subject that profit to tax, it is first necessary to change the PE rules in every country around the world that has adhered to the traditional physical presence standard.
To address this, the OECD has issued a discussion draft of certain proposals made up in two parallel and nonoverlapping pillars. The first pillar contains three possible proposals to change how the international tax community would tax profits in a country.
The first proposal is called “user participation” and would apply only to “highly digitalised businesses” that develop active and engaged user bases and solicit data and content from users. Under this proposal, profits from digitalised companies — and it is unclear who that is — would be taxable in every country where consumers use the companies’ social media, search engines, or online marketplaces. One key problem with this proposal is that many companies are now going digital and are using data from their customers as a key part of their business plans. It appears that taxing only companies that qualify as “highly digitalised businesses” under this proposal is treating them unfairly compared to other companies.
A second proposal is a “significant economic presence” proposal that would completely do away with all PE and nexus rules as we know them and replace the international tax system with global apportionment, similar to the apportionment in place in the US for state taxation. A business would be taxable in a country on the basis of factors that “evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means.”
Although simple in concept, this would be difficult to administer. In the US, each state starts with US federal taxable income. The Internal Revenue Service (IRS) is the US’s national taxing authority, and it audits and confirms the federal tax base that flows down to the states. As there is no global IRS, any country that wants to challenge the apportionment factors would be required to do a global audit on the company, and any change in apportionment could trigger multiple other countries to also perform a global audit. In addition, as in the US states, each country could determine its own definition and weighting of the factors, leading to potential taxation of less than or more than 100% of the income earned by the company. This system simply doesn’t appear administrable.
The final proposal would allocate profit and loss from marketing intangibles to the different jurisdictions where the marketing intangibles generate revenue. Marketing intangibles include brands, trade names, and customer data. This is a similar approach to the “user participation” proposal. However, instead of being limited to digitalised companies, it would be applied to all companies. The proposal is gaining some traction, and within the next year or two, we may see this type of proposal becoming law in many countries.
The second pillar in the OECD proposal would impose a worldwide minimum tax in most countries, with features like what the US enacted under the law known as the Tax Cuts and Jobs Act with its provisions relating to global intangible low-taxed income (GILTI) and the base-erosion and anti-abuse tax (BEAT). This “global anti-base erosion” proposal would tax income of a foreign branch or controlled entity if that income was subject to a low effective tax rate in the branch’s or entity’s jurisdiction. It would also deny a deduction for certain payments unless the payment was subject to an effective tax rate above a minimum rate. The details of the OECD proposal are unclear, but many observers hope the minimum tax would be limited to companies headquartered in those countries.
The OECD held public consultation on these two pillars in March 2019 in Paris, is now developing high-level proposals, and is aiming to reach consensus among the 129 countries participating in the discussions. Although agreement on these changes to the international tax system is not guaranteed, many countries have expressed optimism that consensus at the OECD will be reached. Although details are still lacking, some level of change appears likely.
The OECD expects to present the following to the G20, which is an organisation of 19 countries and the EU, in June 2019 in Fukuoka, Japan: the outcome of these proposals, the outline of the general framework, and the progress towards reaching a consensus-based, long-term solution. A final report is to be delivered to the G20 by the end of 2020 containing agreed-upon details and mechanisms to implement the agreed changes. Due to the large number of participating countries, if a consensus can be reached, widespread adoption would be expected.
In any event, there are potentially major changes coming in the international tax world. If you have clients or operations internationally, keep an eye open for them.
— Blake Vickers, CPA, CGMA, is the chair of the American Institute of CPAs Global Tax Issues Task Force. To comment on this article or to suggest an idea for another article, contact Alistair M. Nevius (Alistair.Nevius@aicpa-cima.com), editor-in-chief, tax, for FM magazine.