Taxing the digital economy – OECD update

• United Kingdom

• Tax planning and consultancy

30-01-2019

On 29 January 2019, the OECD released a policy note entitled Addressing the Tax Challenges of the Digitalisation of the Economy. The note provides an update on progress towards reaching a global solution to the tax challenges arising from the digitalisation of the economy.

Key points

• The international community intends to continue to work multilaterally towards achieving a long-term solution to the taxation of the digital economy.

• Going forward, discussion will centre around two central pillars:

o The first pillar considers proposals to allocate profits and taxing rights by reference to factors other than physical presence. This could include changing the definition of permanent establishment, so that profits would be taxed on the basis of a significant digital presence.

o The second pillar considers further proposals to tackle BEPS risks in relation to the digital economy, including minimum tax proposals potentially similar to the GILTI tax and BEAT in the US.

• It is likely that these proposals, if introduced, would impact not only a small group of highly digitalised businesses, but a much wider group of businesses with cross-border operations.

• More detail on these proposals is anticipated to follow in mid-February.

Background

The tax challenges of the digitalisation of the economy were identified as one of the main areas of focus of the Base Erosion and Profit Shifting (“BEPS”) Action Plan. Consequently, the OECD established the Task Force on the Digital Economy (“TFDE”), which in 2015 produced the BEPS Action 1 Report addressing the tax challenges of the digital economy. The Action 1 Report found that the whole economy was becoming increasingly digitalised and that, as such, it would be difficult (if not impossible) to ring-fence the digital economy. The Action 1 Report also considered how the digitalisation of the economy raised a number of broader tax issues, specifically issues concerning nexus, data and the characterisation of income.

Following the Action 1 Report, the TFDE delivered an Interim Report in March 2018 (Tax Challenges Arising from Digitalisation – Interim Report 2018). This provided an in-depth analysis of value creation across new and changing business models in the context of digitalisation. The report also acknowledged the divergences among countries on the tax implications of the digitalisation of the economy and the political pressure faced by some countries to act unilaterally as soon as possible (rather than wait for a multilateral solution to be agreed).

In parallel, the European Commission has been considering proposals to introduce a tax on digital business activities, which was envisaged to be a tax on revenues generated from certain activities in EU Member States. However, the EU Council has not yet agreed to adopt any such proposed tax and the exact structure of the tax is currently uncertain given the criticism the proposal has received, the stances of certain Member States and its potential incompatibility with the World Trade Organisation (“WTO”) General Agreement on Trade in Services.

Separately, the UK has vowed to introduce a digital services tax of its own (which will similarly tax revenues generated from certain business activities in the UK) if no global consensus on the taxation of the digital economy is reached by 2020. For an overview of the key features of the UK’s proposed digital services tax, please refer to our client briefing note.

Furthermore, countries like India, Italy and Turkey have already implemented domestic variations of the digital services tax. For further details on some of the unilateral measures targeting the digital economy which have been introduced by a number of jurisdictions to date, please refer to our article on Taxing the Digital Economy (published in Tax Journal on 2 March 2018).

The policy note

Drawing on the conclusions explored in the reports and the issues raised more generally in discussions on the subject to date, the OECD’s policy note confirms that the international debate will focus on two central pillars with a view to reaching a long term, global solution in 2020. One pillar addresses the broader challenges of the digital economy and focuses on the allocation of taxing rights and a second pillar addresses the remaining BEPS issues. The two pillar approach recognises that the digitalisation of the economy is pervasive and acknowledges that a comprehensive solution is required.

The pillars are summarised below.

• Pillar 1: significant digital presence

This pillar will focus on the allocation of taxing rights between jurisdictions (including nexus issues) and could result in significant changes to the existing international tax rules. This pillar will look at proposals that would allocate taxing rights based on marketing intangibles, user contribution and significant economic or digital presence, rather than physical presence.

All of the proposals would require a reconsideration of the current transfer pricing rules which could lead to solutions that go beyond the arm’s length principle. This would be a major change and, as yet, it is unclear how this would be implemented domestically by countries and across the network of double tax treaties that have largely adopted the arm’s length principle for taxing associated persons.

All these proposals would also go beyond the limitations on taxing rights currently determined by physical presence, which is the principle by which permanent establishments are taxed (also enshrined in double tax treaties generally). On nexus, different concepts, including changes to the permanent establishment threshold (such as the concepts of significant economic or digital presence) would need to be explored, either of which would be significant departures from the way double tax treaties are currently designed. Such changes might result in another round of modifications to double tax treaties (potentially even through the Multilateral Instrument).

However, the OECD is focussed on striking the right balance between accuracy and simplicity and on finding a solution that is administrable by tax authorities and tax payers across the developed and developing world.

• Pillar 2: BEPS/minimum tax

This pillar will focus on addressing the remaining BEPS issues and will consider taxing rights that would strengthen the ability of jurisdictions to tax profits where the other jurisdiction with taxing rights applies a low effective rate of tax to those profits. The proposals under this pillar will seek to address the ongoing challenges of profit shifting to entities subject to no or very low taxation through the development of two inter-related rules: (i) an income inclusion rule and (ii) a tax on base-eroding payments. These proposals recognise that the tax challenges of the digitalisation of the economy form part of the wider landscape relating to remaining BEPS challenges.

Although the exact structure and design of the policy is as yet unclear, there appears to be policy overlap with the GILTI tax and the BEAT introduced in US tax law as a consequence of the Tax Cuts and Jobs Act 2017. (See here for a summary of some of the provisions introduced through the 2017 US tax reform and here for more focussed articles on various issues arising out of the 2017 US tax reform). Countries like Spain and France have also been considering the options of introducing a similar global anti-base erosion (“GLOBE”) tax. Depending on the design of these rules and implementation thereof, the effects could be significant since the focus of the measure appears to be “effective” tax rates and not the “nominal” tax rates. Therefore, jurisdictions which may have high tax rates but offer favourable tax regimes by way of reliefs (as the UK does) could be disadvantaged by such a tax. Further, this together with the changes already ushered in through the Multilateral Instrument could result in a paradigm shift in the allocation of taxing rights and the application of double tax treaties generally.

Much will depend on the structure this “tax” actually takes. For example, depending on which (if not all) tax deductions/credits/exemptions are included in calculating the effective tax rate, there could be potential state aid and WTO compatibility issues (by way of comparison in calculating the base erosion minimum tax amount for BEAT, R&D tax credits are excluded, throwing up potential WTO compatibility law questions). Further, there may be issues of double taxation, with questions such as how this would tie in with domestic taxes unilaterally implemented with similar effect (e.g. GILTI and GLOBE taxes) and CFC regimes generally, remaining as yet unanswered.

It is noted that the effect of this measure (even in the absence of Pillar 1) is wider than a digital services tax, as such a tax (in the absence of any limitations) could have a disproportionate impact on payments from certain jurisdictions and the measure would not only be limited to digital businesses. Further with there being a general downward trend in corporate tax rates globally, it is uncertain how many jurisdictions will benefit from such a tax in reality. This will only become clearer once further guidance/draft provisions are published.

Although at first glance it may appear that these measures are intended to capture only some of the larger digitalised enterprises that provide digital platforms cross-border, this is unlikely to hold true as the OECD specifically notes that it “could affect a much wider group of enterprises with cross-border business operations”. Therefore, these measures could in reality have a much larger impact than even the proposed EU or UK digital services tax which are aimed specifically only at a few digitalised highly valued companies. Therefore, businesses generally operating cross-border should be considering some of these issues.

Next steps

The OECD will issue a consultation document that describes the two pillars in more detail. This is expected to be released in the week commencing 11 February 2019. There will then be a period of roughly three weeks to submit written responses before an OECD public consultation on the proposals to be held in Paris on 13 and 14 March 2019 as part of the meeting of the TFDE.