THREE weeks ago, on October 9, the Organisation for Economic Co-operation and Development secretariat published its proposed ‘unified approach’ to reform international tax rules, seeking to address the tax challenges of digitalisation. Under the current rules, there is little chance of a company being taxed without a physical presence in the country. This is far from suitable for a digital economy, where many businesses can remotely conduct economic activities.
The OECD proposal aims 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 profit generation.
Consumer-facing activities describe any role, service, technology or information that is directed at customers, including sales and marketing. Therefore, the proposal relates to allocating a taxing right to countries and jurisdictions where multinational enterprises have their markets, and not to countries where the product is produced, or where they have a physical presence.
The proposal follows the G20 request to the OECD to find consensus-based solutions to tackle the under-taxation of multination enterprises in an increasingly digitalised economy. It is open for public consultation until November 12. The OECD is seeking agreement in principle from the G20 by the end of January so that it can work up detailed rules.
THE OECD proposal includes a new formula to ‘residual profits’; that is the taxing rights of countries whenever revenues arising from sales in respective countries exceed a certain level (yet to be determined). The proposal is based on a three-tiered approach:
1. A portion of multinational enterprises’ residual profits would be allocated to market jurisdictions (where sales occur) in proportion to the total volume of sales. This is a form of unitary taxation, whereby profits of an multinational enterprise would be identified globally, on the basis of consolidated accounts. The rest of the profits would continue to be taxed entity-by-entity, applying the arm’s length principle which treats the parties of a transaction as independent and on an equal footing even when they are related or subsidiaries of the same parent company.
2. A minimum amount of return would be assigned to market jurisdictions, to be taxed in accordance with the current transfer-pricing rules, applying the arm’s length principle. The justification for this new rule might be that certain market jurisdictions need to be compensated for limited tax collection under the current rules.
3. Market jurisdictions would be able to claim more taxing rights, to the extent that they agree in advance to a mandatory dispute resolution mechanism.
In parallel, discussions are continuing on the establishment of a global minimum tax rate. Concrete proposals should be expected before the end of the 2019.
Pascal Saint-Amans, director of OECD Centre for Tax Policy and Administration, explained the proposed tax rules using the following example. If a company has 100 sales and a worldwide profitability rate of 35 per cent of which, say 10 per cent is ‘normal’ or ‘routine’, a profit of 25 per cent will be deemed ‘residual’ profit. An agreed percentage, say 20 per cent, of 25 per cent, which is 5 per cent of the global profit of the company, will be reallocated to the market jurisdiction according to sales shares or market size. So, if a country has 10 per cent of the company’s sales, the country would get taxing rights on 0.5 per cent of the total profits of the company.
These numbers are open to negotiation, but what is clear is that it would have to be a formula-based solution to ensure sales are given enough weight and not a bottom-up approach. This is supposed to prevent gamesmanship over what counts as routine and residual profit.
If agreed, it would mark a key first step in establishing one of the most significant shifts in the international tax transfer system since the 1920s.
BIG multinational enterprises, including Amazon, Facebook and Google, have backed the OECD proposed multilateral solution to digital taxes. This gives them certainty and removes the risk of double taxation as countries challenge arrangements to pay tax in low-tax countries like Ireland instead of where their markets are.
Large countries, such as France and India cautiously welcomed the proposal. A French finance ministry official said that the OECD’s proposal ‘is a promising basis for further work.’ According to an Indian official, the OECD proposal is a step in the right direction; but it will address only one issue - the loss on account of tax revenue. It does not address the issue of storing data in countries where they operate.
Small countries are more circumspect. For example, Austria passed a digital advertising tax just a day after the OECD proposal was announced, positioning the country to start taxing large tech companies from next year. The Dutch finance ministry said that while the OECD plan is a ‘great step,’ a number of questions remain for the country to consider. Switzerland’s spokesperson said, although, Switzerland is prepared in principle to adopt international standards, it is not possible to say whether it will adopt such a standard or not as there is still no consensus on it.’
Tinkering at the margins, worsening inequality
ALTHOUGH billed as the most dramatic change to the century old international tax rules, the OECD proposal is a tinkering at the margins — ‘doing little to redistribute profits from tax havens, and even less for the lower-income countries that lose the most to corporate tax abuse’, according to the Tax Justice Network. While the poorer countries often lose out the most through tax abuses, the OECD reforms could end up seeing their tax bases shrink by 3 per cent, while about 80 per cent of the taxes clawed back are likely to be redistributed in high income countries.
The winners will be large economies such as the US, UK, Germany, France, Italy and large developing economies like China and India. Small economies, in particular the small developing economies where multinational enterprises locate their production, will lose out.
As Sorley McCaughey, Christian Aid Head of Advocacy and Policy, notes, ‘it will likely be of very limited value for developing countries that would benefit more from a focus on numbers of employees rather than size of used market.’
ACCORDING to the Trade Union Advisory Committee to the OECD, the OECD proposal heads in the right direction as it recognises unitary taxation as unavoidable in an increasingly digitalised economy. However, it posits that the scope of the proposed changes are too timid and falls short of what is required to achieve fair and sustainable taxation. In particular, the impact of international tax rules on employment is insufficiently taken into account in the current debates.
The scope is limited to consumer-facing businesses, with some carve-outs yet to be decided, while excluding pure ‘business to business’ companies and extractive industries. There is also a question mark on the scope over the financial industry because it is largely B2B whilst also ‘business to consumer’ to some extent.
The Independent Commission for the Reform of International Corporate Taxation recognises that the OECD proposals to move ‘beyond the arm’s length principle’ and focus on the allocation of the global profits of multinational enterprises, together with the ambition to stem the race to the bottom in tax competition by providing a floor with a global minimum tax, shows real progress. However, they fall short of explicitly adopting a unitary enterprise principle advocated by ICRICT, many developing countries (led by the G24 of developing countries) and civil society. According to ICRICT, a global minimum tax should be 25 per cent.
Aggressive transfer pricing
ICRICT is concerned about the proposal to separate ‘routine’ and ‘residual’ profits, and make only the latter subject to formulary apportionment, as well as the proposal to rely only on sales for determining the distribution of taxable profits.
Aiming to allocate only a tiny fraction of residual profits based on formulary apportionment means that the dysfunctional arm’s length principle is still guiding the allocation of the vast bulk of a company’s profits. Additionally, by leaving out B2B activities, the OECD proposal does not address the main vehicle for transfer pricing. The OECD proposal, therefore, will not stop transfer pricing — multinational enterprises will still be able to aggressively shift routine or so-called normal profit.
THE ideal formula will need to take into account many factors such as weightage of market factors, contribution of intangibles, life cycle of digital product or service, mobility of different production factors etc. Identifying an ideal formula would require the test of time.
Real concerns remain as to the extent of the current reform process and whether it will be watered down by pressure from multinational enterprises and some governments. A crucial issue is the distinction between residual and routine profits. The key test would be how much of the profits were drawn from sales and what would be the cut-off point for routine profits.
GREATER tax transparency is needed for informed discussions on reforms. The current publicly available data on multinational enterprises’ country-by-country reporting fall short of what is needed for countries to be able to scrutinise the proposals fully.
As the Tax Justice Network highlighted, countries ‘should demand the OECD release its full country-by-country data so that governments can make informed decisions on the likely impacts on their economies and their citizens.’
WHILST the institutional framework has been made more inclusive by including developing countries, the credibility of OECD as the appropriate body to continue to lead this work remains in question, and much still needs to be done to ensure effective participation and representation of developing countries.
As the French finance ministry official revealed, the principles and the unified approach follow the approach decided by the G7 ministers last July in Chantilly. This is not surprising as they have the largest share of multinational enterprises.
The proposal was discussed on October 1 behind closed doors by OECD member states participating in the OECD Task Force on the Digital Economy.
Creating a genuinely fair international tax architecture will require multilateral discussions extending well beyond current process, and must involve the United Nations system, because it is the only forum where all countries are represented.
Anis Chowdhury is adjunct professor at Western Sydney University and the University of New South Wales (Australia), held senior United Nations positions in New York and Bangkok.
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