OECD tax overhaul would see profits taxed by jurisdiction

The OECD is consulting on plans for a major change to the international rules on taxing multinationals (MNEs), including digital companies, so that they pay tax wherever they have significant consumer-facing activities and generate their profits

The proposal, which will be put to the meeting of G20 Finance Ministers and Central Bank Governors in Washington DC next week, is based on work from OECD’s base erosion and profit shifting (BEPS) network, and seeks to bring together common elements of three competing proposals from member countries.

The OECD’s consultation document states: ‘In a digital age, the allocation of taxing rights can no longer be exclusively circumscribed by reference to physical presence. The current rules dating back to the 1920s are no longer sufficient to ensure a fair allocation of taxing rights in an increasingly globalised world.’

The proposal creates a new taxing right and includes a new nexus.

The OECD says this decision also means there is a requirement to revise the rules on profit allocation as the traditional income allocation rules today allocate zero profit to any nexus not based on physical presence, thus rendering changes to nexus pointless and invalidating the policy intent.

That in turn requires a change to the nexus and profit allocation rules not just for situations where there is no physical presence, but also for those where there is.

Otherwise, the OECD says, taxpayers could simply side step the new rules by using alternative forms of an in-country presence (whether a local branch or related entity), making the new taxing right elective for taxpayers and creating what it calls ‘an open invitation for tax planning’.

Paul Miller, tax partner at law firm Ashurst, said: ‘These proposals are expressly designed to increase the tax actually paid by larger cross-border businesses in "market jurisdictions", so there is a question as to whether there is sufficient international political will to finalise and implement these proposals.

‘If not, such businesses will instead probably have to cope with a range of fragmented domestic approaches in those jurisdictions where they do business. However, if these OECD proposals are actually implemented by governments, they would represent the most seminal changes in any tax practitioner's lifetime to the way in which larger cross-border businesses are taxed, dwarfing even the recent BEPS changes.’

OECD proposals

The OECD proposal covers highly digital business models but goes wider – broadly focusing on consumer-facing businesses with further work to be carried out on scope and carve-outs. Extractive industries are assumed to be out of the scope.

For businesses within the scope, it creates a new nexus, not dependent on physical presence but largely based on sales. The new nexus could have thresholds including country specific sales thresholds calibrated to ensure that jurisdictions with smaller economies can also benefit. It would be designed as a new self-standing treaty provision.

 It creates a new profit allocation rule applicable to taxpayers within the scope, and irrespective of whether they have an in-country marketing or distribution presence (permanent establishment or separate subsidiary) or sell via unrelated distributors.

At the same time, the approach largely retains the current transfer pricing rules based on the arm’s length principle but complements them with formula-based solutions in areas where tensions in the current system are the highest.

The OECD plans are also designed to increase tax certainty for taxpayers and tax administrations, with the introduction of a three-tier profit allocation mechanism.

This is made up of ‘amount A’, which is a share of deemed residual profit allocated to market jurisdictions using a formulaic approach, ie, the new taxing right.  ‘Amount B’ is a fixed remuneration for baseline marketing and distribution functions that take place in the market jurisdiction.

Finally, ‘amount C’ refers to binding and effective dispute prevention and resolution mechanisms relating to all elements of the proposal, including any additional profit where in-country functions exceed the baseline activity compensated under amount B.

Angel Gurría, OECD secretary-general, said: ‘We’re making real progress to address the tax challenges arising from digitalisation of the economy, and to continue advancing toward a consensus-based solution to overhaul the rules-based international tax system by 2020.

‘This plan brings together common elements of existing competing proposals, involving over 130 countries, with input from governments, business, civil society, academia and the general public. It brings us closer to our ultimate goal: ensuring all MNEs pay their fair share.’

The proposals for a so-called ‘unified approach’ under pillar one of the OECD’s work is open for consultation until 12 November.

Beyond the specific elements on reallocating taxing rights, a second pillar of the work aims to resolve remaining BEPS issues, ensuring a minimum corporate income tax on MNE profits. This will be discussed in a public consultation which is expected to take place in December 2019.

OECD Proposal for a Unified Approach under Pillar One

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