Taxing The Digital Economy: OECD Releases Proposals To Prevent Unilateral Measures By Countries

Global impatience with digital companies not paying their fair share of tax is on the rise. The impatience mostly stems from the fact that consumer-facing businesses, including digital companies, physically locate themselves in low-tax jurisdictions and avoid taxes in countries where they derive significant sales. Technology giants like Facebook Inc., Google, Amazon.com Inc., Alibaba Group Holding Ltd. and other digital companies derive considerable value from a large user base and sales but minimise their tax liability in these countries by locating elsewhere.

Europe has responded to this by proposing a tax on turnover; Australia is mulling a tax on digital advertising; and Singapore has announced a sales tax on digital services. Countries have resorted to unilateral measures since global consensus via the Organisation for Economic Cooperation and Development remains a work in progress. Laying down a tax framework for digital companies first became the policy objective of the OECD in its Base Erosion and Profit Shifting plan in 2015.

Now, the OECD has released a set of proposals to tax consumer-facing businesses, including digital businesses, after several rounds of interim reports and consultations. The proposals are a response to competing approaches to digital taxation put forth by the U.S., Europe and emerging countries.

Broadly, the OECD has outlined the scope of businesses to which its proposals would apply to, a new nexus rule for taxpayers who fall in this scope, and finally the way profit could be allocated to different jurisdictions where these businesses operate.

Scope: The proposals should apply to large consumer-facing businesses, broadly defined as businesses that generate revenue from supplying consumer products or providing digital services that have a consumer-facing element.

New Nexus Rule: Multinationals are taxed in a country only if they have a permanent establishment, or a physical presence, there. Digitalisation has strained the applicability of this rule as more and more businesses are engaging with users from remote locations. This can be addressed by giving taxing rights to jurisdictions where a multinational has a sustained and significant involvement in the economy. Revenue threshold could be the primary indicator of such involvement.

This would be important to ensure neutrality between different business models and capture all forms of remote involvement in the economy, the OECD has said.

New Profit Allocation Rules: Once it's determined that a country has a right to tax profits of a non-resident company, the next question is how much profit should be allocated to that jurisdiction.

The starting point should be to identify a multinational group's profits. The second step would be to calculate the group's routine profits in a country based on existing arm's length principles, meaning the profit this entity would make if it were to deal not with associated entities but a third party in a country. The remaining amount would be the non-routine profit of this multinational group in a country.

Then it would need to be determined how much of this non-routine profit can be attributed to a market against how much is a result of other factors such as trade intangibles, capital and risk. For example, a social media business may not only generate non-routine profit from its customers' data and valuable brand, but also from its innovative algorithms and software.

The finals step of this approach would be to allocate the relevant portion of the non-routine profit among the eligible market jurisdictions. This could be based on variables such as sales in a jurisdiction.

Any dispute between a country and the taxpayer should be subject to legally binding and effective dispute prevention and resolution mechanisms, the OECD has proposed.