Changing Rules in Taxation of Digitalization of the Economy

On May 31, the Organization for Economic Co-operation and Development (“OECD”) issued a proposed approach to addressing challenges arising from the digitalization of the economy (the “Program of Work”).  If it reaches consensus, the Program of Work could change “how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries.” The new approach would govern taxation of all multinational entities (“MNEs”), instead of a set of highly digitalized business.

The Program of Work groups the proposals into two pillars to form the basis for consensus:

Pillar 1: Revised nexus and profit allocation rules (Program of Work proposes three potential methods)

  1. Modified residual profit split method: allocate an MNE group’s non-routine profit to market jurisdictions, where market jurisdiction refers to the location of sales or where the customers/users live or where the services/intangible assets exist. Such an allocation of non-routine profit reflects the value created in markets (that is not recognized under the existing profit allocation rules).
  2. Fractional apportionment method: allocate an MNE group’s profit to market jurisdiction(s) using an allocation key such as sales, employees, users, etc. This approach would not distinguish between routine and non-routine profit to determine the amount of profits each jurisdiction may tax.
  3. Distribution-based method: possibly specifies a baseline profit (either minimum or maximum) that an MNE group should attribute to marketing, distribution and user-based activities, reflecting the OECD’s consideration of a simplified approach.

To enact/implement the profit allocation proposed above, the Program of Work will revise the nexus rules by developing a concept of remote taxable presence and a new set of standards for identifying when such a remote taxable presence exists.  This taxing right would generally not be constrained by traditional physical presence requirements.

Pillar 2: Global anti-base erosion (“GLoBE”) proposal

The GLoBeE proposal seeks to develop two inter-related rules:

  1. An income inclusion rule that would tax the income of a foreign branch or a controlled entity if that income was subject to tax, at an effective rate that is below a minimum rate; and,
  2. A tax on base eroding payments that would operate by way of a denial of a deduction or imposition of source-based taxation, together with any necessary changes to double tax treaties, for certain payments unless that payment was subject to a tax at or above a minimum rate.

OECD aims to settle on one of the three proposed profit allocation methods under Pillar One by the end of 2019 and the OECD working parties will continue to work on technical issues and related policy with an extremely ambitious goal of releasing a final report by the end of 2020.  In addition to consensus on a unified approach in the economic context, reaching political agreement is another challenge.  The political issues lie in whether certain countries will be impacted favorably or unfavorably based on their respective economy characteristics (e.g., developing vs. developed countries; export-oriented vs. direct investment-oriented economies, etc.) and their existing tax rules (and tax incentives).  On the other hand, countries should have incentives to reach a consensus sooner rather than later to avoid a “proliferation of uncoordinated and unilateral actions” as explained in the Program of Work.  As an example, the French government has passed new legislation on a digital services tax on July, 11, 2019 that imposes a three percent tax on the gross revenues derived from digital activities of which French “users” are deemed to play a major role in value creation.  Both Spain and Italy have followed suit, approving new taxes of three percent on digital services revenue effective in January 2019 and the U.K. government confirmed a proposal on a new digital services tax that will come in to effect in April 2020.

As of August 2019, the U.S. has not announced any proposal on such digital services tax.  In addition, the U.S. Treasury Secretary Steven T. Mnuchin has expressed that the U.S. is concerned of and against any unilateral and unfair actions in the form of a gross sales tax on digital services.[1],[2]  The U.S. further expressed that it is actively engaging at the OECD to settle on a long-term, multilateral solution. More importantly, the U.S. believes that the subject issue is much broader than the digital economy – the problem is intangible assets generally.[3]  The U.S.’s focus on intangible assets has been reflected in the new provisions of the Tax Cuts and Jobs Act (e.g., GILTI and BEAT provisions).[4]  Although the U.S. has not proposed a gross sales tax on revenue from digital businesses like the countries mentioned above, it is revising other tax rules that may indirectly impact certain aspects of taxation of the digital businesses.  For example, the U.S. Department of Treasury has released proposed Digital Content Regulations and Cloud Regulations.[5]  These proposals, if finalized, will impact the determination of source of income, which ties to international discussions regarding the taxation of the digital economy.

Most countries are waiting on the consensus-based approach that is still in process by the OECD.  Such a unified approach, if released timely as projected, appears to be the key to lead to a multilateral approach and to minimize any disputes related to discrimination, double taxation, etc. caused by unilateral actions of certain countries.

Learn More

For more information regarding these updated regulations, please contact Ben Miller by calling 770.396.2200.

________________________________________________________________________________________________________

[1] See U.S. Treasury’s website regarding U.S. Treasury Secretary Steven T. Mnuchin’s statement on Oct. 25, 2018 regarding digital tax proposals. https://home.treasury.gov/news/press-releases/sm0316

[2] See U.S. Treasury’s website regarding U.S. Treasury Secretary Steven T. Mnuchin’s statement regarding the OECD report on taxation of the digital economy. https://home.treasury.gov/news/press-releases/sm534

[3] See “Keynote Address by Deputy Secretary Justin Muzinich to the German-American Conference in Berlin: Strengthening Transatlantic Resilience in Turbulent Times” on June 12, 2019  https://home.treasury.gov/news/press-releases/sm707.

[4] https://www.whitehouse.gov/wp-content/uploads/2018/02/WH_CuttingTaxesForAmericanWorkers_Feb2018.pdf

[5] The IRS proposed regulations (REG-130700-14) to clarify how to classify transactions involving digital content and cloud computing.