OECD proposes new profit allocation rule

"It is encouraging that the OECD has been able to come up with this proposal which suggests that international consensus on the thorny problem of reforming the international tax system to deal with the digitalisation of business could just be achievable," said Eloise Walker a corporate tax expert at Pinsent Masons, the law firm behind Out-law.com.

"Multinationals are already facing the challenges of a raft of new taxes being introduced unilaterally by countries keen to get their hands on a share of the tax revenues from tech companies operating in their jurisdictions," she said. "A global solution should reduce uncertainty and minimise double tax in the long term, although achieving that result will very much be dependent on the introduction of a dispute resolution procedure that has some bite. Let's hope that these signs of progress on international agreement will mean that countries like the UK will think again about proceeding with their interim digital services taxes."

The OECD proposal is that countries where multinationals operate (market jurisdictions) would have a new taxing right over a portion of the 'residual profit' of certain multinational enterprises. The residual profit would be the profit that remains after allocating what would be regarded as a deemed routine profit on activities to the countries where the activities are performed. This deemed routine profit could be a fixed percentage with industry variances.

The new profit allocation rule would apply irrespective of whether multinationals have an in-country marketing or distribution presence or sell via unrelated distributors. Activities in market jurisdictions, particularly distribution functions, would remain taxable according to existing rules such as transfer pricing under the arm’s length principle and permanent establishment rules. Although an assumed  return for distribution activities is being considered.

The OECD proposes that any dispute between the market jurisdiction and the taxpayer over any element of the proposal would be subject to "legally binding and effective" dispute prevention and resolution mechanisms.

"The proposal will not just catch tech companies – it is aimed more broadly at customer-facing businesses, so extraction industries are excluded, although there is a suggestion that financial services could also be carved out," Eloise Walker said.

It would apply only to large businesses, possibly using the £750 million revenue threshold used for country-by-country reporting, which have a 'sustained and significant involvement in the economy of a market jurisdiction', probably tested by a revenue threshold in relation to the market jurisdiction in question.

Under current rules a non-resident company is taxable on its profits from a jurisdiction only if it has a permanent establishment (PE) there. A PE requires a physical presence but digitalisation means that companies can do business with customers in a country without having a physical presence there. It is widely accepted that this concept, devised in the 1920s, does not work well in an increasingly digitalised world where a business can derive significant profits from a territory where it has no physical presence.    

The OECD is aiming to have an internationally agreed solution to the challenges of taxing the digitalised economy by the end of 2020. It published a public consultation document in February which set out three different proposals for changing the profit allocation and nexus rules. These alternative proposals were to allocate taxing rights on the basis of user participation, marketing intangibles or significant economic presence.

The current proposal is an attempt to bring together common elements from the three competing proposals. A programme of work published by the OECD in March emphasised the necessity of agreeing the outline of the architecture of an agreed approach by January 2020 including whittling down the three competing proposals for profit allocation.

While the OECD has been considering how the international tax system should be changed, a number of countries have proposed interim taxes on turnover of certain digital businesses. The UK's proposed digital services tax (DST) coming into force in April 2020 will tax search engines, social media platforms and online market places, subjecting them to a 2% tax on revenues linked to UK 'user participation'.

France has introduced a 3% digital services tax from 1 January 2019 on revenues deemed to have been generated in France by digital companies.

The OECD admits that in reaching agreement on changes to the international tax system, "the stakes are very high".

"Although much of the detail of the proposals remains to be considered, groups which may be affected have an opportunity to feed into the consultation and to point out any obvious issues with the proposals for their industry," Eloise Walker said. "One assumption that underlies the OECD's proposals is that international groups can - at the mere touch of a button – have at their fingertips detailed breakdowns of things like revenue by jurisdiction or business line, whilst the reality is usually not that simple. By proposing a tax which impacts all groups and sectors, apart from a minority to be carved out, not just the obvious digital giants, the OECD runs the risk of imposing a huge compliance burden on the majority of businesses."

The public consultation on the proposals closes at noon, Paris time, on 12 November.

A second pillar of the OECD's work aims to resolve remaining base erosion and profit shifting (BEPS) issues, ensuring a minimum corporate income tax on the profits of multinationals. This will be discussed in a public consultation that is expected to take place in December 2019.