Digital Tax: Taking a step ahead and expanding the footprint!

vishal_rai_in_ey_com_LThumbThe Organisation for Economic Co-operation and Development (OECD), in the process of providing an answer on taxation of digital economy, issued a public consultation document titled “Addressing the Tax Challenges of the Digitalisation of the Economy” on 13 February 2019. The consultation document provides an opportunity to the interested parties for putting down their views on the listed proposals.

A thoughtful read of the title clearly indicates that the proposals covered herein go beyond the so-called “digital economy” and “highly-digitalized businesses” and cover “consumer product business” as well. Thus, the impact of these proposals are not restricted to digital business models only, hence, this should be on top of the “to-review” list of all multi-national enterprises (MNEs) utilizing intangible assets.

As discussed in our earlier blog, various countries have proposed/ are contemplating unilateral measures to tax digital economy. Given the unique characteristics of digital businesses, tax administrations believe that the challenge before them revolves around nexus and profit allocation rules. Thereby, new nexus rules are required to deal with the highly digitalized businesses that are able to create value by performing activities closely linked with a jurisdiction without establishing a physical presence. Any solution that seeks to address the nexus must also address the closely related issue of profit allocation. Accordingly, the proposals focus on nexus as well as profit allocation issues simultaneously.

Starting with a summary on the meetings/ developments taken so far on this topic, the document identifies the three possible long-term proposals. The first two proposals, i.e., “user participation” and “marketing intangibles” have been debated more recently and described in much detail. The third “significant economic presence” proposal is similar to what was proposed in Action Plan 1 earlier.

The first proposal, “user participation proposal” is based on the theory that participation of active users contribute to creation of the brand, generation of valuable data and development of a critical mass of users that helps to establish market power. Therefore, soliciting the sustained engagement of users is a critical component of value creation for digital business models. As per this proposal, such value creation is most significant for social media platforms, search engines and online marketplaces. To allocate profit to the jurisdiction where the user is located (user jurisdiction), the proposal seeks to apply a residual profit split approach. This entails calculating the non-routine profit and then attributing a certain proportion of those profits to value creation by user activities basis quantitative/qualitative information or pre-agreed basis. Such profits would then be allocated amongst the user jurisdictions basis agreed allocation metric. Further, user jurisdictions would be given a right to tax such profits irrespective of taxable presence of business as per current nexus rules.

The second proposal of “marketing intangibles” recognizes that there is an intrinsic functional link between marketing intangibles and the market jurisdiction. It broadens the scope of first proposal to apply to all MNEs utilizing marketing intangibles such as trade names, customer data, customer relationship. It addresses a situation where an MNE group can essentially “reach into” a jurisdiction to develop a user/customer base and other marketing intangibles. This proposal applies equally to highly digitalized business models irrespective of their non-presence or presence as limited risk distributors (LRDs) in a jurisdiction. Further, this proposal applies to consumer product businesses not traditionally thought of as highly-digitalized businesses, making it the differentiating factor between itself and the user participation proposal discussed above. The proposal provides that the market jurisdiction would have the taxing right for all or an allocated share of the non-routine profit associated with such marketing intangibles. It clarifies that such profit allocation to market jurisdiction would apply irrespective of which entity owns the legal title to and performs DEMPE functions in relation to marketing intangibles and regardless of how risks and incomes are allocated under current transfer pricing provisions. The proposal provides for various approaches to compute such profit attributable to marketing intangibles.

The third proposal, “significant economic presence” focuses on creating a taxable presence for a non-resident enterprise with a purposeful and sustained interaction via digital technology and other automated means. The fractional apportionment method proposed would involve defining the tax base to be divided (such as global profit rate on sales in a jurisdiction), allocation keys to divide the tax base (sales, assets, employees, users) and assigning weights to such keys. The proposal also offers a modified deemed profits method for the profit allocation which could involve applying a ratio of presumed expenses to arrive at the profit or apply an industry profit percentage.

The first two proposals are based on the same premise, i.e., countries contributing to value creation either through users or customers should get additional taxing rights. Also, profit allocation is to be done using residual profit split approach in both the proposals. However, the user participation proposal is restricted to digitalized business only.

Both proposals clearly express that further work would need to be done to implement and clarify the proposals. Some such areas include application of the proposal to separate business segments rather than entity-wide, determination and allocation of profit. Further, tax treaties would need to be amended to eliminate double taxation arising from revised profit allocation. Provision of taxing rights to user / market jurisdiction may require amending treaties or introduction of new nexus through standalone rule.

The consultation document also discussed the global anti-base erosion proposal. It addresses the continued risk of profit shifting to entities subject to low or no tax jurisdictions through a set of two inter-related rules: an income inclusion rule and a tax on base eroding payments. These provisions are not limited to digitalized business models and will apply to all MNEs.

To discuss the above and public comments sent, a public consultation meeting will be held at the OECD Conference Centre in Paris on 13-14 March 2019.

All three proposals represent a significant departure from current international tax and transfer pricing provisions and thus if implemented would impact a very wide range of businesses. The OECD have set a target of 2020 to finalize their proposals in this regard. While achieving consensus may not be easy and implementation may be fraught with procedural hurdles, global businesses should follow the developments closely.

Continue to watch this space!

The author of this blog is Vishal Rai, Tax Partner, EY india

The blog is co-authored by Himanshu Gupta, Tax Manager, EY India