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Taxing the digital economy update – release of the OECD consultation document

Taxing the digital economy update

The OECD has released its consultation on taxing the digital economy. We will be hosting a webinar looking at the consultation in more detail on 25 February 2019.

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On 13 February 2019 the OECD published its much-anticipated consultation paper on taxing the digital economy. The publication marks the start of a four week consultation process – written comments from interested parties are to be submitted by 1 March, and there will then be a public consultation in Paris on 13 and 14 March. The paper follows the general structure of the OECD’s high-level policy note published on 29 January, but includes more detail on the various proposals being explored by the Inclusive Framework. The OECD is still aiming for a consensus proposal by 2020. We are also hosting a webinar on 25 February 2019 where we will discuss our initial insights on the public consultation – sign up at the end of this article.

Content of the consultation paper

The consultation paper is broken down into three sections:

  • Section 1 gives an overview of the journey since BEPS Action 1, and restates many of the common themes that the OECD has returned to throughout the evolving debate in this space, including:
    • The conclusion that it is not possible to ring-fence the digital economy; and
    • The assertion that highly digitalised businesses often display ‘scale without mass’, rely heavily on intangibles, and generate value from data and user participation in a manner that is not captured by the existing international tax architecture.
  • Section 2 sets out three proposals that the Inclusive Framework is discussing in the context of re-examining the existing rules on nexus and profit allocation, namely:
    • The ‘user participation’ proposal;
    • The ‘marketing intangibles’ proposal; and 
    • The ‘significant economic presence’ proposal.

Section 2 compares the three proposals, then looks at a series of important design considerations, including scoping, the determination (and allocation) of profits, and the elimination of double taxation. Whilst the paper does expand on the information contained in the 29 January policy note, the three proposals are still somewhat embryonic and will need further analysis and fleshing out by the OECD (in particular, the ‘significant economic presence’ proposal, which is where the OECD’s thinking seems to be the least advanced).

  • Section 3 sets out a ‘global anti base erosion’ proposal, which is intended to address the perceived risk of diversion of profits to low (or no) tax jurisdictions. This proposal comprises two elements:
    • An income inclusion rule; and
    • A tax on base eroding payments.

The paper makes it clear that both sets of proposed new rules would operate broadly – i.e., they would apply not only to intangible property returns, but also to other mobile forms of income (such as cross-border financing), and perhaps even more broadly. The paper also includes high-level options on coordination rules that would ensure the Section 3 proposals interact as intended and do not overlap in a way that creates double taxation.

As with Section 2, the proposals in Section 3 are positioned as needing significant work around design and implementation.

Further detail on Section 2

The three proposals under Section 2 all have the same over-arching objective, which is to recognise, from different perspectives, value created by a business’s activity or participation in user/market jurisdictions that is not recognised in the current BEPS framework for allocating profits.

The ‘user participation’ proposal

  • Soliciting the sustained engagement and active participation of users is considered to be a critical component for some highly digitalised businesses. The existing tax framework is perceived to ignore (and as such not tax) the value that certain business models derive from user participation. The business models identified by the Inclusive Framework are the same as those highlighted in the UK digital services tax (DST) consultation paper; and
  • This proposal seeks to revise profit allocation rules to accommodate the value creating activities of an active and engaged user base and crucially dismisses the idea that the application of the arm’s length principle would be sufficient. Instead a more formulary approach would be applied using the profit split method. For instance, a pre-determined percentage may be applied to the non-routine profits of a group which would carve out a proportion to be allocated and taxed between jurisdictions where users are resident regardless of physical nexus.

The ‘marketing intangibles’ proposal

  • This proposal is similar to the user participation proposal but rather than focusing on highly digitalised business models it is broader in scope. This proposal considers that the BEPS Actions 8-10 did not go far enough in addressing the shifting of income that may still be accomplished by exercising a degree of decision making outside of the market jurisdiction; and
  • In other words this proposal targets limited risk distribution models. It links marketing intangibles with the market jurisdiction, and emphasises that a proportion of the non-routine profits generated by an MNE group should be attributed to marketing intangibles, thereby ensuring that an element of non-routine profit is taxed in every market jurisdiction. The allocation of some or all non-routine returns from marketing intangibles would apply regardless of legal ownership or Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) analysis of the functions relating to those intangibles.

The ‘significant economic presence’ proposal

  • This proposal considers that a taxable presence in a jurisdiction would arise when a non-resident enterprise has a significant economic presence on the basis of factors that evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means. Revenue generated on a sustained basis combined with other factors would establish nexus in the form of a significant economic presence in the country concerned. These additional factors (six were identified) may include the existence of a user base and the associated data input, the volume of digital content derived from the jurisdiction, and the maintenance of a website in a local language.

Therefore whilst all three proposals have a global approach to the determination of profit, the first two proposals have more in common, and as mentioned above are fleshed out more in the paper. Commentators’ views are requested on the policy, technical and administrability issues raised by each of the three proposals described above.

Further detail on section 3

Income inclusion rule

The income inclusion rule would supplement (rather than replace) existing CFC rules, and would operate as a minimum tax. It would apply in the context of overseas subsidiaries and overseas permanent establishments.

In the case of overseas subsidiaries, the rule would require a shareholder in a corporation to bring into account a proportionate share of the income of that corporation if the income has not been subjected to an effective tax rate of a minimum specified rate (to be agreed as part of the design process). In the case of overseas permanent establishments, the rule would switch off the benefit of existing income exemption rules in the head office, replacing them with credit systems.

The paper indicates that the income inclusion rule will apply both to domestic and to overseas subsidiaries (presumably in order to address considerations around discrimination and (in an EU context) freedom of establishment and free movement of capital), and mentions that it will draw from certain aspects of the new US tax regime for taxing ‘Global Intangible Low-Taxed Income’.

Tax on base eroding payments 

This proposal comprises a rule to tackle so-called ‘undertaxed payments’, and a rule to address situations where the recipient of a payment is not ‘subject to tax’.

The undertaxed payments rule will deny deductions for certain defined categories of payments (to be determined), where the recipient of the payment is not subject to a minimum effective tax rate in its jurisdiction. The rate will be determined as part of the consultation process, and will take into account withholding taxes suffered in connection with the payment in question. The paper also proposes that the undertaxed payments rule will cover ‘conduit’ and ‘imported’ arrangements (which have become familiar in the context of the BEPS Action 2 implementation around hybrids), and seems to position the rule as a complementary measure to the income inclusion rule.

The subject to tax rule would operate to disallow treaty benefits in situations where undertaxed payments would otherwise be eligible for relief under a double tax treaty. The paper proposes that this would apply to the following provisions of a double tax treaty (using the OECD model treaty numbering convention):

  • Article 7 (Business profits); 
  • Article 9 (Associated enterprises);
  • Article 10 (Dividends); 
  • Articles 11 – 13 (Interest, Royalties, and Capital Gains); and 
  • Article 21 (Other income).

Conclusion and summary

The content of the paper is largely as anticipated, and it is helpful to see some further information around how the OECD’s thinking is starting to evolve in relation to the various moving parts in play. However, a significant amount of information is still needed – not least of all in relation to the potential administration and compliance burdens of these new rules, and the way in which disputes will be resolved in a cross-border context. Interested parties should submit their observations directly to the OECD by 1 March, and taxpayers should continue to monitor developments closely over the coming weeks.

KPMG Webinar

Join us on Monday 25 February 2019 at 1:30 pm (GMT) for the second webinar in the series on taxing the digital economy hosted by Melissa Geiger, KPMG in the UK’s Head of International Tax and Tax Policy.

This time, Matthew Herrington, Kirsty Rockall and Jennifer Cooper from KPMG in the UK, Kara Boatman from KPMG in the US, and Robert Van der Jagt from KPMG's EU Tax Centre will provide their insights on the public consultation document, and will discuss whether it could mean we are any closer to achieving multilateral consensus on how to tax the digital economy.

Register here today to ensure you have the latest insights. You can also listen back to the first webinar, ‘Taxing the digital economy – the journey so far from BEPS Action 1’ here.

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