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Making Waves: OECD Navigates Debate on Tax Rules for Digital Age

Posted on Mar. 20, 2019

They don’t call it the City of Light for nothing. Tucked away inside a former 19th-century iron foundry on Rue Saint-Maur in the 11th arrondissement is Paris’s first digital art museum, L’Atelier des Lumières. There, fine art comes to life through sumptuous short films set to music and projected onto the foundry’s massive walls and concrete floors, giving awestruck visitors a truly immersive experience.

One of those films is Japon rêvé, images du monde flottant (Dreamed Japan, images of the floating world), which draws inspiration from Japan’s Edo period, including Katsushika Hokusai’s iconic print, “The Great Wave off Kanagawa.” As giant blue swells rise and fall to dramatic music while ocean waters swirl at viewers’ feet, it’s easy to get swept away by how well traditional art has adapted to the 21st century.

Meanwhile, on the other side of town at Rue André Pascal in the 16th arrondissement, some 400 representatives from government, business, academia, civil society, tax advisory firms, and other organizations gathered at OECD headquarters March 13-14 to discuss adapting something else for the digital age: the international tax system.

At the center of the OECD’s hotly anticipated public consultation on the best approach to address the long-term tax challenges of digitalization were four proposals, organized under two pillars.

Under pillar 1, which focuses on profit allocation and nexus issues, one proposal would give more taxing rights to user jurisdictions based on active user contribution; another option would give more taxing rights to market jurisdictions based on marketing intangibles; and yet another calls for the reconsideration of nexus concepts, such as “significant economic presence.”

The proposal under pillar 2, focused on remaining base erosion and profit-shifting issues, comprises an income inclusion rule that would function as a minimum tax and a tax on base-eroding payments (TBEP). The former is loosely based on the U.S. global intangible low-taxed income provision of the Tax Cuts and Jobs Act, while the latter is similar to the TCJA's base erosion and antiabuse tax.

Visitors enjoy traditional art adapted to the digital age at L'Atelier des Lumières in Paris. On the other side of town, tax luminaries gathered to discuss updating the tax rules for the 21st century. (Culturespaces / E. Spiller.)
Visitors enjoy traditional art adapted to the digital age at L'Atelier des Lumières in Paris. On the other side of town, tax luminaries gathered to discuss updating the tax rules for the 21st century. (Culturespaces / E. Spiller.)

The goal for the Task Force on the Digital Economy, which is leading the OECD’s work in the area, is to facilitate consensus among the 129 members of the BEPS inclusive framework on a global solution to tax the digital economy by 2020.

Despite the relatively short public consultation window, which began February 13 with the release of a discussion draft outlining the four options and ended March 6, the OECD was inundated with more than 200 submissions from a wide range of stakeholders, of which 120 were filed within the last hour of the consultation. The OECD is navigating uncharted territory in many ways, as all four proposals may form the basis of a globally agreed-upon approach that could lead to fundamental changes to the international tax system.

Brian Jenn, Treasury deputy international tax counsel and co-chair of the task force, emphasized that the OECD is still in the early stages of designing a work plan, similar to what happened when the BEPS project action plan was still being developed.

The OECD is keen to get input from a range of stakeholders, including the business sector, civil society, and tax practitioners, “because the questions which are on the table . . . are quite fundamental questions,” said Pascal Saint-Amans, director of the OECD's Centre for Tax Policy and Administration.

Changing Tides: Pillar 1

If there were any doubts about the business sector’s commitment to the debate on taxing digitalization, Will Morris, chair of the Business and Industry Advisory Committee to the OECD’s Committee on Taxation and Fiscal Policy, seemed keen on dispelling them. According to Morris, his committee will engage in the ongoing debate using a “three Cs” approach: understanding that change is coming; expressing concerns about technical, legal, and accounting issues; and engaging in discussions constructively. “There is not going to be a return to a golden age of tax,” he declared. “This is about change.” However, Morris acknowledged the challenges in the long road ahead. For consensus to be reached, a solution must not only be broad but also deep, and that requires a clear explanation and acceptance of the principled reasons for the debate, he said.

The heart of the pillar 1 proposals is the reallocation of taxing rights, Morris noted. “If one country wins, then another country has to lose,” he said. For international consensus, the countries that lose have to agree on whatever solution comes out of the process, and any pragmatic approach that isn’t underpinned by principles won’t survive, Morris added.

Stakeholders should also consider more specific questions, such as the justification for the allocation of more profit to a specific market jurisdiction, as well as practical questions, such as how to work through the complex issues related to the four proposals, he added. “The only thing that worries me more about this project succeeding is this project failing,” Morris said. “That cannot happen.”

Businesses are certainly concerned about where the debate is going, according to Elselien Zelle of accommodations reservations giant Booking.com. “We as a company don’t really mind where we pay our tax, as long as it’s clear what the rules are and as long as we don’t pay twice,” she said. Booking.com is in favor of a global solution and prefers the marketing intangibles proposal under pillar 1 because it applies to all companies, not just digital ones, and would fit into existing transfer pricing rules, Zelle said.

Francois Chadwick of ride-hailing app Uber also expressed his company’s preference for the marketing intangibles proposal, arguing that the user participation option will create economic distortions and won’t withstand the test of time. Likewise, the significant economic presence option has its problems and is unlikely to garner consensus, he added. “Change is needed,” Chadwick said, adding that that change will lead to additional tax for Uber. “We need to find common ground as quickly as possible.” However, proposals should also avoid hindering growth and earning potential, he said.

“One idea we’d love to discuss more is some form of global notional pooling of losses for any form of marketing intangible,” Chadwick said. While the proposal may represent a slight move away from the arm’s-length principle, some safe harbors could be implemented to avoid major disruption in the existing system, he said.

Uber would also take a closer look at a proposal that Katherine Amos of Johnson & Johnson had discussed that would serve as an alternative to the residual profit-split method suggested as part of the marketing intangibles approach.

Catherine Harlow of pharmaceutical company AstraZeneca also said her company doesn’t mind where it pays tax, as long as it’s only paid once, echoing Zelle and other company representatives who spoke during the consultation. “We still strongly believe in the arm’s-length principle and it’s effective for our business, but we do recognize there is a desire for change,” she said. The debate should take into account businesses that aren’t as active in the digital sphere and that derive more value from research and development instead of marketing intangibles, Harlow added. The OECD should therefore take an industry-specific approach to carry out impact assessments before settling on a proposal, she said.

However, companies also want simplicity when it comes to proposal design, according to Janine Juggins of Unilever. “If you are going to regain public trust in a tax system . . . it’s got to be something that you can explain and that the public can understand,” she said. That in turn would help companies better explain why they pay tax in some countries, Juggins added.

Stakeholders must also avoid choosing an approach that will have to be revised again in the short term and must not “throw out the baby with the bathwater,” said Manal Corwin of KPMG. “I don’t think we should take for granted the long-standing international principles on which consensus was reached,” she said, noting that those principles led to stability in the tax system for many years. Change may be happening, and solutions may be necessary to address that change, but it’s important to consider what components of the internationally agreed system can be preserved in the process, she added.

Whatever proposal is developed should indeed be based on sound policy rationale and stay within the value creation framework, said Robert Danon of the University of Lausanne. Neutrality and simplicity, ease of administration, and tax certainty should also play a part in developing a solution, he said, adding that the proposal should not only be linked to dispute resolution but also dispute prevention mechanisms. “We have a chance to address something that’s extremely important for the future of the international tax system,” Danon added. “We just should not take it lightly and rush in but be consistent in doing so.”

Sol Picciotto of Lancaster University and the BEPS Monitoring Group called for clarity about timeline and process for ongoing discussions.

According to Picciotto, some good first steps include adopting a single enterprise principle for a unitary profit allocation approach that takes into account three factors that generate profit: people and labor, capital, and sales, which are essential for the realization of profit. Allocation factors should be generic to allow for flexibility and changing business models, he said. “Finally, when considering allocation factors, you do need to look at the impact on investment as much as on tax revenues,” Picciotto added.

“We are in a period of change. Change is going to happen, but we need to know the direction,” Picciotto said. Although some have said that the debate should look ahead to five or 10 years into the future, “we need to plan really . . . for the next 80 years,” he said. “We need a clear direction of travel.”

Rocking the Boat: Pillar 2

The global anti-base-erosion proposal under pillar 2 seemed to make a splash, eliciting divergent stakeholder views.

It certainly took business by surprise, according to Georg Geberth of Siemens, representing the International Chamber of Commerce. What’s perhaps most unexpected is that the proposal has nothing to do with taxing value creation, a departure from the BEPS project's fundamentals, Geberth said.

The proposal would also apply to legitimate business activities instead of targeting artificial profit shifting, which was a key focus for the BEPS project as well, he added. Design simplicity would be essential, especially because the pillar 2 proposal could be technically complex and therefore quite burdensome on companies, Geberth said.

Barbara Angus of EY urged the OECD to proceed carefully and slowly and wait to see how the rest of the BEPS project plays out. She noted that it also seems like the OECD is going beyond the BEPS project with pillar 2 and is directly targeting incidents of low or no taxation. Should the OECD now focus on tax rates alone, it would be advocating measures that would affect real economic activity that lack the characteristics of harmful tax practices, so any one-size-fits-all rule would violate countries’ tax sovereignty and could lead to distortions on real economic activity, Angus added.

For simplicity’s sake, the income inclusion rule should apply on a foreign consolidated basis using the parent’s financials so that the tax would be imposed on the ultimate parent company, according to Carol Doran Klein of the U.S. Council for International Business. There should also be an agreed-upon single minimum tax rate that applies in all countries that end up adopting the pillar 2 approach, she added.

The council and its members support a global computation of the minimum tax rate over a per-country computation because while the latter may be more precise, “there is a trade-off between precision and simplicity,” Klein said. The income inclusion rule should also take priority over the TBEP, and foreign income taxes should be fully creditable against the minimum tax as well, she added.

Joachim Englisch of Muenster University speculated that one possible behavioral impact of the income inclusion rule would be a risk of inversions in the absence of global implementation. “We could see that also in [controlled foreign corporation] regimes already,” he said.

Jonathan Leigh Pemberton of the World Bank agreed, adding that there is an effectiveness issue with additional CFC rules. “From the perspective of developing countries, they’re of limited relevance if you’re a capital importer,” he said. “Unless there is absolutely universal adoption of CFC rules elsewhere, you’re not going to benefit.” Pemberton noted that he and his colleague, Jan Loeprick, published a paper March 12 that explores the possibility of an anti-diversion rule that would enable developing countries to tax profits diverted into offshore structures in low-tax jurisdictions.

With the TBEP, the tax world gets a new acronym Stephen Shay of Harvard Law School proclaimed. According to the OECD discussion draft, the TBEP would include an undertaxed payments rule that calls for the denial of a deduction for payments made to a related party if they aren’t subject to minimum taxation and a subject-to-tax rule in tax treaties that would allow some treaty benefits as long as an income item is taxed enough in the other jurisdiction.

Some design considerations include determining how related a party should be for the rule to apply and what kinds of payments should be included, Shay said, adding that the rule should apply to deductible interest and royalties. He also pointed out that it’s unclear from the OECD consultation document whether the subject-to-tax rule should be limited to related parties.

Having a minimum tax is desirable from a developing country perspective, according to Joy Ndubai of Tax Justice Network Africa and Action Aid. However, the TBEP falls short in many ways for developing countries, Ndubai said, noting that it is complex to implement and relies heavily on administrative capacity and cooperation. But those challenges could be overcome if there is a full denial of deductions on outbound payments to related parties, she said.

For the income inclusion rule to work, transparency is crucial, Ndubai said, calling for country-by-country reporting to be public and for removing the restriction on using that information for adjusting profits.

Johan Langerock of Oxfam pushed back on the idea that minimum taxation comes as a surprise, pointing out that the concept had been effectively discussed since the OECD’s publication of a key harmful tax competition report in 1998. Harmful tax competition has yet to be addressed effectively, so a minimum tax would correct what’s gone wrong since that report was published, he argued. “So let’s open our eyes again and really take this proposal seriously . . . because it’s developing countries that have been suffering from base-eroding payments,” Langerock said.

Setting Sail

Certainly, the OECD must contend with a “trilemma,” as Martin Hearson, fellow in international political economy at the London School of Economics and Political Science, put it. First, there’s a desire for a deep and broad consensus, as well as agreement on what everyone wants to accomplish and on the technical basis on which the work should be carried out. Second, a solution should be binding and universal for all 129 countries in the BEPS inclusive framework, and third, the entire project should be done within two years, according to Hearson.

“There is a need to consider the trade-off between those three objectives,” Hearson said. The issue is particularly pronounced because discussions about the international tax system's principles are not only taking place within the OECD but within the inclusive framework, most of whose members were not involved in crafting those principles to begin with, he said.

“It seems to me [that] the process of forming a consensus, and states being willing to be bound by that consensus, is going to be a lengthy one,” Hearson added.

Grace Perez-Navarro, deputy director of the Centre for Tax Policy and Administration, outlined the immediate next steps, which will culminate in a work program that will be presented to the inclusive framework at its meeting at the end of May, so that specific technical work can be delegated to the various OECD working parties. The OECD will present the work plan to G-20 finance ministers during their June 8-9 meeting in Fukuoka, Japan; then to G-20 leaders during their June 28-29 summit in Osaka, Japan —both under the G-20 Japanese presidency. “Following June is when the really hard technical work will be carried out,” she said. The OECD is also working on assessing the potential economic impacts of potential options.

Indeed, the OECD will start working immediately, given the tight time frame, Saint-Amans said. To that end, the OECD plans on releasing more detail-oriented discussion drafts for the next round of public consultation by the end of 2019 and throughout 2020, he added.

But the debate is off to a good start, according to Saint-Amans. “We are extremely happy with how constructive the conversation has been,” he said. “If I look back at the time of development of the BEPS project, we didn’t feel that the contributions were as constructive as they have been for the past day and a half.”

Morris expressed confidence that OECD, G-20, and the inclusive framework will pull all the stakeholders into the ongoing debate. “But in turn, we the stakeholders have to give back and have to give back freely,” he urged.

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