Sydney and Kuala Lumpur — The OECD Secretariat published its proposed 'unified approach' to reform international tax rules to address tax challenges posed by digitalization on 9 October 2019.
Under current rules, there is little chance of a company being taxed without its physical presence in the country concerned. But digitalization enables many businesses to remotely conduct economic activities affecting a national economy without a direct physical presence.
The OECD proposal aims to ensure that highly profitable large transnational enterprises (TNEs), including digital companies, pay tax wherever they generate profits from significant 'consumer-facing activities'.
'Consumer-facing' refers to any role, service, technology or information directed at customers, including sales and marketing. Hence, the proposal is principally about allocating taxing rights to countries and jurisdictions where TNEs have their markets and not only to countries where products or services are produced or where the TNEs are physically present.
The proposal -- open for public consultation until 12 November -- is in response to the G20 request to the OECD to find consensus solutions to tackle under-taxation of TNEs in an increasingly digitalized economy. The OECD is seeking agreement in principle from the G20 by the end of January 2020 before proposing more detailed rules.
The OECD proposal includes a new formula for 'residual profits', involving taxing rights for countries when revenues arise from sales in countries exceeding a certain level yet to be determined.
Pascal Saint-Amans, Director of the OECD Centre for Tax Policy and Administration, has explained the proposed tax rules using the following example. If a company has a worldwide profit rate of 35%, of which, say, 10% is 'normal' or 'routine' profit, then 25% will be deemed 'residual' profit.
An agreed percentage -- say 20% of the 25%, or 5% of global profit in the example -- will be reallocated to market jurisdictions according to their sales' shares or market size. So, if a country accounts for 10% of a company's sales, it would get taxing rights on 0.5% of the total profits of the company.
These shares are open to negotiation. But what is clear is that it would have to be a formula-based solution to prevent haggling over what counts as routine and residual profit respectively. If agreed, this would mark a key first step in establishing one of the most significant shifts in international taxation since the 1920s.
Shifting from production to consumption
Although billed as the most dramatic change to existing century-old international tax rules, the OECD proposal has been criticised for only tinkering at the margins, "doing little to redistribute profits from tax havens, and even less for the lower-income countries that lose the most to corporate tax abuse", according to the Tax Justice Network (TJN).
TJN's analysis shows that the OECD reforms could end up reducing their tax bases by 3%, while about four-fifths of the taxes obtained will likely go to high income countries.
The biggest winners will be large economies such as the US, UK, Germany, France, Italy and large developing economies like China and India. Small economies, particularly the small developing economies where the TNEs locate their production, will lose out. Small developing countries would benefit more from a focus on employees rather than market size.
The OECD's Trade Union Advisory Committee (TUAC) sees the proposal as heading in the right direction by recognizing unitary taxation as unavoidable in an increasingly digitalized world economy. But the TUAC considers the proposed changes too timid, falling short of what is needed to achieve fair and sustainable taxation.
After all, the proposal is limited to 'consumer-facing' businesses with some carve-outs yet to be decided, excluding pure 'business to business' (B2B) transactions and extractive industries. Its impact on finance is also unclear as while some may be largely B2B, 'business to consumer' (B2C) transactions invariably figure to some extent.
The Independent Commission for the Reform of International Corporate Taxation (ICRICT) recognizes that the OECD proposal moves beyond the restrictive arm's length principle (ALP). It also appreciates the intention to stem the 'race to the bottom' due to tax competition by providing a floor with a global minimum corporate tax.
But the ICRICT laments that the proposal falls short of adopting the unitary enterprise principle for all TNE profits, also advocated by many developing countries (led by the Washington-based G24 caucus of developing countries in the Bretton Woods institutions) and civil society. The ICRICT also recommends a global minimum corporate tax rate of 25%.
Long live transfer pricing
The ICRICT is also concerned about the proposal to separate 'routine' from 'residual' profits, with only the latter subject to formulary apportionment, and that the proposal relies only on sales to determine the distribution of taxable profits.
The proposal to only allocate a small fraction of residual profits based on formulary apportionment will mean that the ALP will still guide allocation of the vast bulk of a company's profits. Thus, the OECD proposal will not stop transfer pricing as TNEs can still shift 'routine' or normal profit, as has long happened.
Meanwhile, concerns remain about the scope and extent of the current reform process and whether it will be watered down by pressures from TNEs and some influential governments. Key issues will include how much profits will be drawn from sales and the threshold for routine profits.
Greater tax transparency is needed for informed discussion of such reforms. Currently publicly available data on TNEs' country-by-country reporting fall short of what is needed by countries to be able to assess the likely impacts of the proposal.
While the process has become more inclusive, the credibility of the OECD as the appropriate body leading such work remains moot, and much still needs to be done to ensure more effective participation and representation of developing countries.
Worryingly, before its announcement, the proposal was discussed on 1 October behind closed doors by OECD Member States participating in the OECD Task Force on the Digital Economy. A French economic ministry official also revealed that the principles of the unified approach were decided by G7 ministers in Chantilly in July. Such G7 and OECD influence gives cause for concern about biases inherent in the proposal.
Creating a fairer international tax architecture requires multilateral discussions well beyond current processes, and should be led by the United Nations system, the only forum where all countries are represented equally.