United States: OECD BEPS Project's Digital Economy Proposals

Last Updated: November 11 2019
Article by Beau Sheil

The Organization for Economic Cooperation and Development (OECD) has been executing on its initiative to address perceived exploitation of the global taxation system by multinational enterprises for several years. This effort, referred to as the Base Erosion and Profit Shifting (BEPS) project, has resulted in new OECD guidance related to tax matters including transfer pricing, treaties and the identification and taxation of permanent establishments. From the outset of its BEPS work, the OECD has voiced concern about the tax challenges created by the digitalization of the global economy. In early 2019, the OECD issued draft proposals for new approaches to tax global digital companies and sought comments from industry and tax authorities on the strengths and weaknesses of these proposals. Most recently, in May of 2019, the OECD issued the Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalization of the Economy (the Digital Economy Draft), outlining revisions to the initial proposals and next steps for this initiative.

The proposals under consideration would create a significant change to the current tax system for certain multinational companies. Under the current global tax system, a company generally must have a substantial physical presence (referred to as nexus) in a jurisdiction before it may be taxed by that jurisdiction. However, certain tax authorities argue that because some digital businesses are able to participate in the economic life of a jurisdiction with no or limited physical presence, the current system provides those tax authorities with inadequate taxing rights. Other tax authorities and many of the potentially impacted multinational companies would counter that nexus is a foundational principal of the international tax system and global profits should only be taxable within a multinational company's global footprint. The OECD's Digital Economy Draft's "Pillar One" lays out a framework to potentially rewrite these rules, with proposals addressing both the nexus issue and the methods by which the resulting pool of newly taxable income might be allocated among jurisdictions. It is important to note that while these proposals originate from a focus on digital economy operating models, the repercussions of this project could reach far beyond anything most would consider as digital economy participants.

The draft proposes three potential approaches: the modified residual profit split method (MRPSM), fractional apportionment and a group of methods referred to as distribution approaches. Broadly speaking, the MRPSM attempts to apply existing transfer pricing approaches to identify a non-routine portion of profit attributable to the new taxing right and allocate it based on new definitions of where value is created (e.g., user networks). Fractional apportionment, on the other hand, is more formulaic and relies on concepts similar to the formulary apportionment used by some state taxation authorities in the U.S. Lastly, the distribution approaches take a bottoms up approach by attributing value to market jurisdictions such as a baseline level of profits and adjusting further from that as a starting point. Importantly, all the proposed methods represent some level of departure from the arm's-length standard and the general notion that a multinational company's allocation of functions, assets and risks across its global footprint should determine its global division of taxable profits.

"Pillar Two" of the Digital Economy Draft is a global anti-base erosion proposal which seeks to address the remaining risk of profit shifting to entities subject to no or very low tax. The OECD envisions this as a systematic solution to ensure that all global businesses pay a minimum level of tax. This proposal was provided in response to the notion that digitalized businesses are especially reliant on intangible property and tend to pursue profit shifting planning structures to a larger extent than is possible in other industries. Pillar Two proposes two interrelated rules: 1) the income inclusion rule levies a minimum tax globally, and 2) the tax on base eroding payments denies deductions or imposes source-based taxation for certain payments unless that payment is subject to tax at or above a minimum rate. The OECD is considering these rules both separately and as a collective mechanism to disincentivize international tax structures that put significant income in no or low tax jurisdictions.

The OECD has established a tight timeline for reaching consensus on these issues, with an expectation that a consensus report will be issued by the end of 2020. This timeline is being
driven, in part, by a desire to keep countries from taking unilateral actions around digital economy issues. France has already done this by recently enacting a digital services tax which will largely target digital economy companies based outside of France. Other countries have also taken steps towards unilateral solutions. Multinational companies should watch these developments closely and be aware that substantial changes to the international taxation system may be coming.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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