Countries hoped the base erosion and profit-shifting project would carve a path for taxing digital activity. But five years later, it’s still not clear if that path will lead to a new paradigm or chaos.
It was October 5, 2015. The OECD’s Centre for Tax Policy and Administration had pulled off what many had considered an impossible task: It completed a comprehensive, G-20-mandated action plan to address the root causes of BEPS, in the span of just two and a half years.
Well, almost.
Pascal Saint-Amans, director of the Centre for Tax Policy and Administration, held a press conference to present the results of the project: 13 final reports covering 15 action items that OECD and G-20 member countries had just approved.
“Very happy and almost relieved to be able to finally present to you the outcome of our work,” Saint-Amans had said. “We’re happy that we completed the work — almost completed, there are just a couple of leftovers.”
One of those leftovers appeared to be action 1, “addressing the tax challenges of the digital economy” — an issue that governments had been grappling with since the 1990s, when the internet and e-commerce were just taking off.
The action 1 report, produced by the Task Force on the Digital Economy (TFDE), comprised analysis about the nature of the digital economy, the tax challenges associated with it, and next steps.
Perhaps what’s most memorable about the action 1 report is the key conclusion that “because the digital economy is increasingly becoming the economy itself, it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes.”
When the action 1 report work began, it was “a group education,” according to Robert Stack, managing director in Deloitte’s Washington National Tax Practice, who served as U.S. Treasury deputy assistant secretary for international tax affairs and co-chair of the TFDE from March 2013 to January 2017. Stack's successor at Treasury, Lafayette G. "Chip" Harter III, declined to comment for this article.
Many delegates, especially the Europeans, thought big tech companies comprised the well-known “GAFA” companies: Google, Amazon, Facebook, and Apple. But as the TFDE talked to more businesses, it became clear that it was going to be extremely difficult to put borders around the project, because tech and brick-and-mortar businesses were merging, according to Stack.
The report also concluded that other BEPS project measures, such as action 7 (permanent establishment status), action 3 (controlled foreign corporation rules), and actions 8-10 (transfer pricing), would go far in addressing BEPS issues exacerbated by the digital economy.
Although the TFDE had analyzed three possible approaches — a new nexus based on “significant economic presence,” a withholding tax on some types of digital transactions, and an equalization levy — it did leave the door open for countries to adopt those measures domestically as “additional safeguards against BEPS,” as long as they respect their treaty obligations with other countries.
One key observation in the report was that the tax challenges linked to the digital economy appeared to be more related to the allocation of taxing rights and nexus issues rather than BEPS issues, which implied a potential rethink of the international tax system. That observation effectively set action 1 apart from the other action items, which sought to amend the existing tax rules to prevent multinationals from gaming the system.
The report noted that further work on action 1 would continue after follow-up work on the BEPS project, and that the OECD should produce a report detailing the results of ongoing work related to the digital economy by 2020.
A Change in Plan
Nearly five years later, Saint-Amans reflected on the arc of the action 1 work during a September 22 Institute of International and European Affairs webcast. He noted that at the time, countries weren’t planning to deal with nexus and profit allocation issues, especially because the United States wasn’t in a position to agree on a workstream to follow up on the report.
“That’s where we left it,” Saint-Amans said.
The G-20 finance ministers approved the BEPS package at their October 2015 meeting in Lima, Peru, and the G-20 leaders followed suit during their November 2015 summit in Antalya, Turkey. Then came the creation of the inclusive framework on BEPS in February 2016. The inclusive framework, now a group of nearly 140 OECD and non-OECD jurisdictions on an equal footing, was set up to work on BEPS project implementation, including the multilateral instrument, and outstanding standard setting.
But many countries were becoming increasingly frustrated about their inability to tax digital activity and were beginning to take matters into their own hands. The United Kingdom and Australia introduced diverted profits taxes in April 2015 and July 2017, respectively. India, meanwhile, pushed forward in June 2016 with a 6 percent equalization levy on gross payments to nonresident businesses for online advertising services, such as the provision of online ad services and digital advertising space.
The pressure started growing so much that Germany, which held the G-20 presidency in 2017-2018, directed the OECD in March 2017 to come up with an interim report following up on action 1 by March 2018, as the action 1 follow-up work couldn’t wait until 2020.
“What was quite surprising and unexpected was the fact that while . . . the Trump administration was negotiating the U.S. tax reform with Congress, we could see an opening from the U.S.,” Saint-Amans said.
The U.S. Tax Cuts and Jobs Act, passed in December 2017, “really changed the landscape fundamentally in terms of international tax,” according to Brian Jenn of McDermott Will & Emery, who was an attorney-adviser for Treasury’s Office of Tax Policy from January 2012 to December 2017, then Treasury deputy international tax counsel from January 2018 to June 2019. Jenn had also served as co-chair of the TFDE until his departure from Treasury.
“Ultimately, it indicated to Treasury that Congress was willing to think more broadly about different models for international tax rules than it had been in the past,” Jenn told Tax Notes. That was one of the things Treasury took into account while developing an approach at the OECD, he added. Because unilateral actions were starting to accelerate, it began to feel like the consensus around existing rules was dissolving, and Treasury thought it was time to move strategically and start considering fundamental changes to the rules on cross-border transactions more broadly, he added.
“Whether that was a sound judgment, that that . . . move was going to produce the best outcome ultimately for the United States, will debated for some time to come,” Jenn said.
The Road to 2 Pillars
After holding a consultation in November 2017 at the University of California, Berkeley, the OECD published the interim report for the G-20 in March 2018, which contemplated, for the first time, a two-pillar approach as the foundation for a consensus-based multilateral solution to update the global international tax rules.
It also identified divergent views among countries within the inclusive framework about the best way forward and tried to provide some guidelines for countries that wanted to introduce unilateral measures to tax digital activity. But ultimately, inclusive framework members agreed to carry out a “coherent and concurrent review of the nexus and profit allocation rules,” the report said. Moreover, the report started referring to the “digitalization of the economy,” rather than the “digital economy.”
The inclusive framework later produced a policy note in January 2019, which set out a strategy for guiding the focus of discussions among its members to reach consensus on an approach to modernize global tax rules by the end of 2020.
Following a public consultation period, the inclusive framework then further refined its mission with a work program, published in May 2019. That document laid the groundwork for the technical development of options under pillar 1, which focused on profit allocation and nexus issues, and under pillar 2, which focused on remaining BEPS issues through a global anti-base-erosion proposal championed by Germany and France.
The work program identified three options under pillar 1 that reflected different countries’ divergent views on how to move the work forward. The first option was based on user participation, which EU countries such as France preferred; the second, proposed by the United States, focused on marketing intangibles; and the third involved a significant economic presence concept, favored by India and others.
However, inclusive framework talks deadlocked, and the OECD secretariat decided to propose the so-called unified approach in November 2019, drawing from elements of the three options, to get negotiations moving again.
The approach initially called for a three-tiered profit allocation method, under which in-scope consumer-facing multinationals would be taxed on three groupwide profit categories — amounts A, B, and C — in market jurisdictions.
Amount A in particular would represent a new taxing right for markets, based on a new nexus possibly linked to sales and allocation of an affected company’s nonroutine profits, also known as residual profits. The concept signaled a departure from the arm’s-length standard.
The unified approach drew mixed reviews, and U.S. Treasury Secretary Steven Mnuchin shook up the international tax world in December 2019 with a letter to OECD Secretary-General Ángel Gurría, raising “serious concerns regarding potential mandatory departures from arm’s-length transfer pricing and taxable nexus standards.” He also called for pillar 1 to be a “safe harbor regime” that companies could opt into — an option that did not find favor with other countries, such as France.
Despite the unexpected twist, the inclusive framework pressed on and endorsed pillar 1 at the end of January as part of the two-pillar solution, and agreed to take a closer look at possibly implementing pillar 1 on a safe harbor basis. The G-20 finance ministers endorsed the new roadmap for the global tax overhaul on February 23 and pressed for agreement on the solution by July.
While the inclusive framework had initially hoped to reach political agreement on the solution at their July 1-2 meeting, that timeline had to be pushed to October because of the coronavirus crisis.
Complicating matters further, the United States toughened its position. In a June 12 letter, Mnuchin told his counterparts in Spain, Italy, France, and the United Kingdom that negotiations on pillar 1 had hit an impasse and should be delayed, not only because of the pandemic, but also because of the U.S. election on November 3. However, he indicated that the United States would be likely to agree on pillar 2, since it closely resembles the U.S. global intangible low-taxed income regime under the TCJA.
Political challenges notwithstanding on pillar 1, the inclusive framework continued its work and is aiming to produce blueprints for both pillars by October 12, with further consultations to follow. But questions remain about what the inclusive framework will be able to agree on by the end of 2020 and whether the two pillars will have to be decoupled.
An Uphill Battle?
Pillar 1 has proven to be the more politically fraught of the two pillars, given that the majority of large multinational companies with significant digital activities are American. Many inclusive framework members, particularly in the EU, are keen to tax companies providing “automated digital services” under pillar 1, despite the action 1 report’s conclusion that the digital economy cannot be ring-fenced.
The current U.S. administration tried to address this issue by pushing to include consumer-facing businesses in pillar 1’s scope so that all countries have the same stakes, but the tension is still there, according to Stack. “If it’s only one country’s companies that are going to have to pay the price, in a consensus organization it’s easy for everyone else in the room to agree because they have no skin in the game,” he said. “It’s an uncomfortable position for the U.S. government to be in, and I think that remains.”
The United States was very much in a defensive position on action 1, and the subsequent work reflects an understanding that the political pressure on mostly U.S. tech companies was not going to disappear anytime soon, according to Jenn. The TFDE, therefore, was seen to be an outlet for the United States to manage that pressure more broadly instead of dealing with unilateral measures one by one, he added. “That approach probably did forestall unilateral actions to some degree,” Jenn said.
Of course, throughout the action 1 follow-up project, countries continued to push ahead with their own measures to tax digital activity. Although the EU famously tried and failed to pass a bloc-wide, revenue-based digital tax in 2018 and 2019, the United Kingdom, France, Italy, Turkey, and others chose to introduce their own digital services taxes. India introduced another equalization levy on March 27 to capture foreign e-commerce, while Indonesia planned an electronic transactions tax. Most recently, the African Tax Administration Forum published guidance for African countries interested in establishing their own digital services taxes.
The United States has hit back against many of these unilateral measures with trade threats, further stoking political tensions and raising the stakes for agreement on a multilateral solution through the OECD framework.
But even if the inclusive framework were able to agree on the two-pillar proposal, it will be an uphill battle for the United States to push the solution through Congress.
The complexity of both draft pillars raises questions about whether they can really be enacted on a global level, according to Stack. “The expectation is that Congress will enact [pillar 1] as it is finally agreed at the inclusive framework, and that’s a very heavy lift in our system of government,” he said.
Congress would get “pre-cooked” statutes and treaty provisions, but it’s difficult for the legislative and executive branches of government to coordinate on that level of detail, according to Stack. Even in the best of times, Treasury still has to convince the two houses, two parties, and 535 members, he added.
“How much can the Treasury department of either party commit the U.S. government in a forum like the OECD?” Stack asked. “Because if it can’t, it’s a real problem for how this thing gets across the finish line.”
Stack also raised questions about the timing between pillar 1 implementation and the proliferation of DSTs. In the best-case scenario, countries are not likely to start getting related statutes and treaty provisions until 2024-2025 at the earliest, he said. But in the meantime, DSTs are coming into effect now, and countries may speed up the introduction of such taxes because they need revenue and because they perceive digital companies as performing well during the pandemic, he added.
“It remains unclear to me how pillar 1 solves the unilateral measure problem since the unilateral measures are coming at us well in advance of any implementation,” Stack said.
Best Case, Worst Case
The best-case scenario would be that all countries come up with a multilateral solution based on a new set of sound international tax principles to bring the work forward — but there are lots of obstacles in the path, Stack noted. The worst case would be having gross revenue-based taxes proliferate and expand beyond the targeting of digital companies, according to Stack. “If gross-based taxes become a thing, we’ve taken a step back in terms of international tax policy,” he said.
In Jenn’s view, it’s probably more realistic that Congress wouldn't start drafting tax legislation based on a declaration of an agreement at the OECD. Instead, it’s likely that Congress would revisit the international provisions in the tax code, taking into account the work that the OECD has done, he said.
What’s being discussed in the inclusive framework “is much more consequential than what was agreed in BEPS,” Jenn said. It’s unclear what could happen in the absence of congressional action and what the implications would be for U.S. companies if other countries adopt pillar 1, he added.
Whatever might be agreed in the inclusive framework could be more akin to a “down payment” for a more durable agreement in the future, according to Jenn. One reason for that is how countries are dealing with the fiscal fallout from the pandemic, which could scramble everything in terms of tax policy, he added.
The bottom line? “The project is at a perilous moment,” Stack said.