Toward an International Agreement to Tax the Digitalized Economy: Deciphering the BEPS Policy Note
After years of inaction on the growing problem of tax avoidance by multinational tech giants, the OECD recently announced important progress ahead of the June G20 summit hosted and chaired by Japan. International tax expert Naoki Oka comments on the BEPS Policy Note and its significance.
* * *
On January 29, 2019, the Organization for Economic Cooperation and Development announced that the international community had made “important progress toward addressing the tax challenges arising from digitalization of the economy.” The announcement concerned the Policy Note unanimously endorsed by the participants of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) at their January 23–24 meeting. The Inclusive Framework is an international deliberative body comprising 127 countries and jurisdictions—accounting for 95% of the world’s GDP—each participating on an equal footing.
While the Policy Note does not constitute an agreement on specific measures, it does represent a consensus on the basic goals of reform and present a limited number of policy options for achieving those goals, drawing on the opinions and proposals submitted by the framework’s members over many months of deliberation. I agree with Pascal Saint-Amans, director of the OECD Center for Tax Policy and Administration, that “the international community has taken a significant step forward toward resolving the tax challenges arising from digitalization.” In the following, I would like to review and assess the Policy Note as a framework for meeting one of the biggest tax issues of our time: fair taxation of corporate income in the digital age.
The BEPS Project was launched by the OECD and the Group of 20 in 2013 to tackle the problem of tax avoidance by multinational corporations, including the special challenges raised by the digitalization of the economy. China and other non-OECD countries were engaged in the decision-making process from the outset, and the project enjoyed political support at the highest levels. After agreeing on 15 BEPS “actions,” or objectives, the project issued a “final report” on each action in 2015. Many of the recommendations included in those reports are already being implemented by countries at the national level.
Topping the list of objectives was Action 1, “addressing the tax challenges of the digital economy.” Unfortunately, while the “final report” on Action 1 offered recommendations for taxation of digital transactions, such as a sales or consumption tax on online content (which Japan and many other countries have since implemented), the participants were unable to agree on new rules governing the direct taxation of corporate income. Instead, the report pledged that work would continue under the Inclusive Framework with the aim of reaching an agreement on concrete measures by 2020. In the meantime, countries would be free to address the problem within the framework of their own tax laws, providing those measures did not conflict with the rules of the World Trade Organization or existing tax treaties.
It was not until recently, however, that the international community showed any signs of progress toward a consensus on Action 1. What precipitated this forward movement? A key factor was the threat of unilateral action in several jurisdictions, including Britain, France, and the EU.
Milestones in Taxation of the Digital Economy
|Year||Month||OECD (BEPS Action 1)||Individual jurisdictions|
|2015||10||BEPS Project releases final reports (recommendations on corporate taxes deferred)|
|2018||1||US: BEAT and GILTI go into effect|
|3||BEPS interim report||EU: European Commission proposes digital sales tax|
|10||UK: Announces digital services tax beginning in 2020|
|12||France: Announces digital tax beginning in Jan. 2019|
|2019||1||BEPS Policy Note: Agreement on a way forward under the Inclusive Framework|
|2||Public Consultation Document released||EU: Will ECOFIN discuss the DST?|
India: New tax using “significant economic presence” nexus rule to go into effect
UK: New tax on offshore receipts in respect of intangible property to go into effect
|5||Meeting of Inclusive Framework||EU: European Parliament election|
G20 meeting of finance ministers (Fukuoka, Japan) to hear progress report
|2020||Report on Action 1 measures|
According to the European Commission, “only 50% of the affiliates of digital multinationals are foreign-based, compared to 80% for traditional multinationals”. Therefore, among the most urgent challenges of taxation in the digital economy is reform of the international rules governing tax “nexus,” that is, a business’s tax presence in a given country or jurisdiction. Under current tax treaties, drawn up under international guidelines, a country may only tax the business income of a foreign-based company if the business has a “permanent establishment”—a registered subsidiary or other significant physical presence of some sort—in that country. But digital companies have much less need to be physically present than traditional businesses. Such multinational tech businesses as Facebook, Google, and Amazon have taken full advantage of that to avoid taxation in the overseas markets where they do a large portion of their business.
Unilateral Action and International Progress
Because such tax avoidance hits some countries (i.e., user or market jurisdictions) much harder than others (namely, homelands of the tech companies such as the United States and various tax havens), BEPS talks on Action 1 had stalled. Frustrated by this inaction, market jurisdictions, including Britain and France, began to take unilateral action by legislating national digital sales taxes targeting big multinational tech firms. These new levies (indirect taxes), which are possible under existing tax treaties, may be largely symbolic, but they raised serious concerns that, in the absence of significant progress at the international level, more and more countries might start taking matters into their own hands, potentially sowing chaos in the global economy. The OECD (which, by Saint-Amans’s own admission, opened the door to such unilateral action with the 2015 BEPS report) was anxious to accelerate progress on international negotiations in advance of the G20 summit scheduled for June 2019, which will be chaired by Japan.
Under the Inclusive Framework, all 127 participating countries and jurisdictions have an equal voice, and each is committed to implementing the recommendations formally adopted through the BEPS process. For this reason, the understanding reached early this year, as articulated by the Policy Note, represents an important step forward, particularly given the rapid expansion of the digitalization of the economy.
The Policy Note identifies two fundamental objectives, or “pillars,” of a comprehensive agreement and references a number of specific options (proposals) that the participants in the Inclusive Framework agreed to explore. The first pillar targets profit allocation and nexus rules, with the aim of augmenting the taxing rights of market or user jurisdictions vis-à-vis platform companies and other big tech firms. The Policy Note references three options for achieving this objective. The second pillar takes aim at tax havens through rules that would give jurisdictions the right to “tax back” profits that have escaped (an agreed) minimum effective tax rate. In the following, I summarize the policy options now under consideration, as set forth in the Public Consultation Document on Addressing the Challenges of the Digitalization of the Economy, released in February 2019.
Pillar 1: Three Options for Augmenting User Countries’ Taxing Rights
The “user participation” proposal, which is generally identified with Britain, specifically targets businesses that create value with the active participation/ contribution of users and would give taxation rights to jurisdictions where those users are located. According to the Public Consultation Document, taxable profits attributable to the users in a particular jurisdiction would be calculated by applying a residual profit-split approach. The proportion of the non-routine profits attributable to user activities could be determined either through the quantity and quality of information about user contribution or through a pre-agreed percentage. To some degree, the system would rely on formulas that approximate the value of users to the business in each country. If the proposed British digital services tax is any indication, the location of users might be determined using the IP addresses of devices used to access a platform.
The “marketing intangibles” proposal (associated with the United States) would have broad application, instead of being limited to a certain subset of highly digitalized businesses. This proposal seeks to allocate a greater share of the profits earned by multinational corporate groups to market countries by changing the rules governing transfer pricing, incorporating “marketing intangibles” in the calculation. In the context of platform businesses, marketing intangibles might include value generated from free digital services, such as search engines, email, and storage (see paragraph 40 of the Public Consultation Document). Either cost-based methods or fixed percentages might be used to calculate the value of marketing intangibles (paragraph 47).
The “significant economic presence” proposal would use the concept of SEP, previously introduced in the 2015 BEPS report on Action 1, to determine tax nexus and taxation rights. According the Public Consultation Document, SEP in a given jurisdiction would be determined by a combination of factors, including the existence of a user base in that jurisdiction, the volume of digital content derived from the jurisdiction, settlement of transactions using the local currency, maintenance of a website in a local language, after-sales service, and sustained marketing geared to customers in that market (paragraph 51). The proposed system would use the principles of unitary taxation and formulary apportionment to allocate the total taxable revenues of a multinational corporate group among jurisdictions where it has an SEP on the basis of their share of the group’s global sales or profits (paragraphs 52–53).
Thus far, the last proposal seems to be gaining momentum, especially among developing countries (including India) that favor a simpler solution . Beginning in April 2019, India will begin levying a digital tax that incorporates the SEP concept. The tax will apply only to the revenues of companies that have an SEP in India (as determined by such factors as the number of local users and sales to local consumers) and that are based in countries with which India has no tax treaty.
Here I would like to offer a brief critique of the three proposals from the standpoint of their potential efficacy vis-à-vis the goal of expanding the taxing rights of user and market jurisdictions.
One of the fundamental problems BEPS was set up to address is the shifting of profits away from market countries to avoid taxation. Multinational corporations have a number of established routes and schemes for accomplishing this, often through large payments to affiliates registered in tax havens. How do the proposals summarized above compare in terms of cracking down on such tax avoidance schemes?
The “user participation” proposal should, in theory, prevent companies from shifting the revenues generated by user participation, since the system would allocate taxable revenue by identifying the geographical location of users. The “significant economic presence” proposal, likewise, theoretically guards against such profit shifting. These systems do raise some technical issues, such as the definition of active participation and the method for calculating the allocation of revenue among SEPs. However, they are fairly tough on identifying the location of users.
Now let us turn to the “marketing intangibles” proposal. As explained in the Public Consultation Document, such marketing intangibles as customer relationships are derived from activities in specific market jurisdictions, making them difficult to shift away from the jurisdiction where the market is located. However, the measurement of “users” or “customers” is indirect. The system described might not prevent companies from assigning the costs of creating such intangibles to subsidiaries registered in tax havens and compensating them accordingly, thus effectively siphoning off profits generated in market countries. This is not an insurmountable obstacle, however, particularly if the system is combined with the proposal (discussed below) for stemming the erosion of the tax base.
Finding a fair method of allocating profits among jurisdictions is going to be a key challenge under any of the three options. Current international tax rules attempt to prevent the systematic shifting of profits by requiring that transactions among affiliates be priced on a market-value basis, according to the “arm’s length principle”—as if they were conducted between independent, unrelated entities. However, the intangible assets that account for so much of the value created in our global economy, especially by multinational tech firms, can be hard to value, making it difficult to calculate the amount of profit that should be allocated to a user jurisdiction. The Policy Note makes it clear that the Inclusive Framework will be looking beyond the arm’s-length standard—a bedrock principle of international taxation—for new approaches to the allocation of nonroutine profits (that is, profit deriving from nonroutine activities contributing to high profitability). Viewed from the perspective of an expert in the field, this is a stunning development. Of course, the devil is in the details, but assuming that the technical challenges and compliance costs can be adequately addressed, this strikes me as a very welcome trend.
Pillar 2: Global Anti–Base Erosion Proposal
The second “pillar,” simply put, is aimed at stamping out tax havens (or more accurately, stamping out tax avoidance schemes using havens). The Policy Note outlines a multipronged proposal to this end, reportedly submitted by Germany and France. Under the proposed reform, jurisdictions would be able to “tax back” profits that had been spirited away to low-tax jurisdictions to ensure that multinationals pay a minimum effective rate .
Where previously international tax agreements focused on the elimination of double taxation with a view to promoting economic growth, the BEPS Project and Inclusive Framework have shifted the emphasis to fighting “double nontaxation.” The new focus is epitomized in the second policy pillar.
The proposal outlined in the Public Consultation Document calls for the adoption of two interrelated measures: an income inclusion rule and a tax on base-eroding payments. The income inclusion rule would allow a jurisdiction to tax the profits earned locally by a foreign subsidiary if the effective tax rate paid on that income fell below a designated minimum—thus functioning as a minimum tax on the profits earned by multinational corporations. The tax on base-eroding payments would allow a jurisdiction to deny companies tax deductions or other forms of relief for payments made to affiliates in tax havens. While helping countries secure tax revenue, these measures could effectively shut down the world’s tax havens by destroying their raison d’être.
Both of these rules are modeled on measures already incorporated into tax law at the national level. The income inclusion rule draws on aspects of the US system for taxing Global Intangible Low-Taxed Income (GILTI), which went into effect for the tax year beginning in January 2018. GILTI requires major US shareholders of multinationals to pay a minimum tax rate of 10.5% on the earnings of the low-taxed foreign subsidiaries.
The United States also offers an example of a tax on base-eroding payments in the form of the Base Erosion and Anti-Abuse Tax (BEAT). This system targets large multinational firms (with gross receipts of more than $500 million) and imposes a tax on certain deductible payments made to foreign subsidiaries (such as interest payments, payments for services rendered, licensing fees, and reinsurance premiums) when such payments amount to more than 3% of total deductions. (Japan’s rule limiting the deductibility of interest paid to affiliates, which was strengthened under reforms that go into effect in April 2019, functions similarly.)
Although it is not mentioned in the OECD notes, an existing example of a “tax on base-eroding payments” option might include the new British tax on “offshore receipts in respect of intangible property,” which will go into effect in April 2019.
Such minimum-tax provisions are potent weapons with the power to prevent as well as penalize the shifting of profits to tax havens. I hope I am not being overly optimistic in suggesting that such rules, if properly enforced, could virtually wipe out corporate tax havens. The OECD estimated the revenue losses from base erosion and profit shifting at between 4% and 10% of global corporate tax revenues ($100 billion to $240 billion annually) as of 2014. The minimum tax would allow governments to recover that lost revenue. A comprehensive international agreement on such provisions would also serve to harmonize the world’s tax regimes and prevent double taxation.
The impact on national tax policy could be far-reaching as well. By removing the incentive for profit shifting, a minimum tax would reduce pressure on national governments to lower their corporate tax rates to compete with low-tax jurisdictions.
All nations have equal rights in international society, and taxation rights are integral to national sovereignty. However, unilateral action, far from solving the problems arising from conflicts in the international tax system, is likely to have negative consequences, such as double taxation. The fact that the 127 countries and jurisdictions of the Inclusive Framework were able to agree on a way forward for BEPS talks, as set forth in the Policy Note, is no small matter. With such unanimity, one can reasonably look forward to an efficacious agreement that includes concrete recommendations for changes in bilateral tax treaties and national tax laws.
Japan, which hosted the first meeting of the Inclusive Framework in the summer of 2016 in Kyoto, has been strongly committed to the BEPS Project since its inception. As G20 chair in 2019, Japan has a golden opportunity to facilitate progress toward an international agreement at the June meeting of G20 finance ministers and central bank governors in Fukuoka. Japan should take the opportunity to share its own experience, positive and negative.
The conditions are ripe for a breakthrough in international tax reform for the twenty-first century. Preparations for the G20 meeting are proceeding apace. There are high hopes that Japanese leadership will help pave the way for an accord that will greatly profit the global community. Japan has the experience and the know-how to meet those expectations.