Editor: Greg A. Fairbanks, J.D., LL.M.
Over the course of 2019, the Organisation for Economic Co-operation and Development (OECD) continued to advance proposals to address the tax challenges of the digitalization of the economy. The secretariat for the OECD issued two consultation documents in October and November of 2019 that further build upon the initial consultation issued by the OECD under its May 31, 2019, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising From the Digitalisation of the Economy (work plan). These proposals go far beyond just digital tax and apply in a much broader context.
The work plan presented a two-pillar approach. Pillar 1 addressed taxable nexus and the allocation of taxing rights among jurisdictions. Pillar 2 addressed the global anti-base erosion (GloBE) issue and presented an approach to implement a global minimum tax through a coordinated set of global tax rules that contain both income inclusions and base-erosion payments.
The "Unified Approach" consultation released Oct. 9 focuses on pillar 1, while the GloBE consultation released Nov. 8 centers on pillar 2. The OECD issued both of these consultation documents to allow external stakeholders to provide input on the OECD's ongoing work. The hope is to achieve a consensus approach that will discourage unilateral responses to these issues. The OECD held consultative meetings Nov. 21 and 22 for stakeholders to present their comments and responses on pillar 1. On Dec. 3, U.S. Treasury Secretary Steven Mnuchin expressed reservations about pillar 1's potential departure from the arm's-length and nexus standards and called for the proposal to be a "safe-harbor" regime. The consultative meeting on pillar 2 was held on Dec. 9, and most of the comments related to the mechanics and operation of the GloBE income inclusion.
Implementation of both pillars 1 and 2 will significantly affect countries' taxing rights and how they assert taxing jurisdiction and allocate the taxable profit of multinational enterprises. The Unified Approach would depart from long-standing tax norms regarding respect of corporate organizational structures and permanent establishment and also go beyond the arm's-length principle. Global consensus will be critical to avoid meaningful double taxation. These proposals are meant to be implemented by the end of 2020, and the issues created by unilateral efforts like those in France and Italy (which are more focused on digital tax matters) will have to be addressed.
Background: The work plan
Under the OECD's work plan issued in May 2019, pillar 1 would determine the amount of profit or loss allocated to a jurisdiction under a new taxing regime. The work plan suggested possible methods of allocation, including a modified residual profit split, fractional apportionment, and distribution-based simplified methods. A new tax nexus rule would create a remote nonphysical presence through an expanded definition of permanent establishment (PE) under the OECD model income tax convention and changes to local law.
Key in this analysis is that an enterprise without assets or personnel in a country can be participating in the economy of that country and taxable based on an allocation of its share of global income. Double-taxation issues created by the new nexus and allocation approaches would need to be addressed. Finally, pillar 1 would affect all multinational enterprises, subject to certain important limitations to be discussed later, and would not be limited to the digital economy.
Under pillar 2 of the work plan, a new GloBE proposal would enact a global minimum tax similar to the U.S. global intangible low-taxed income (GILTI) provisions from a policy perspective, and a tax on base-erosion payments similar to the U.S. base-erosion and anti-abuse tax (BEAT) provisions. Pillar 2 addressed a concern that, regardless of an individual country's efforts, multinational enterprises could still locate profits in a low-tax jurisdiction. To ensure that such income is taxed at a minimum tax rate, pillar 2 creates a mechanism whereby a country would need to determine whether subsidiaries under its taxing jurisdiction are subject to a minimum effective tax rate and apply a tax to the extent of the difference in tax rates.
Pillar 2 also proposes a tax on base-eroding payments, where deductions would be disallowed or withholding tax applied if the related-party recipient was not subject to a minimum tax on the payment. Additionally, tax treaty benefits would be disallowed where the recipient was not subject to a minimum level of tax.
New pillar 1 proposal (Unified Approach)
Departing from the work plan, the OECD's Unified Approach proposal narrows the scope of application to large, consumer-facing businesses. In addition, it introduces a plan to allocate three types of taxable profit to market jurisdictions.
The definition of "consumer-facing business" is one of the more significant open questions. Consumer-facing business could include both direct and indirect sales to consumers. Some businesses have both consumer-facing and non-consumer-facing segments. Certain business sectors such as extractive industries and financial services might be excluded. The proposal also suggests a scope limited to businesses with combined revenues in the group of €750 million ($826 million) or more. There would be country-specific sales thresholds, too. Since it is not clear how the thresholds would be determined for particular markets, some small jurisdictions might set the threshold at just a few million dollars or even less to ensure they do not miss out on additional tax revenues. This could create a burden to register for taxes in multiple additional jurisdictions to meet the requirements proposed under the Unified Approach.
The Unified Approach attempts to retain some elements of the arm's-length principle, albeit with modifications. The allocation of income to market jurisdictions would consist of three types of income (Amounts A, B, and C). Amount A (the new taxing right) is a portion of a covered multinational enterprise's profit and is not dependent on physical presence. It utilizes a residual-profit-split approach, with fractional apportionment of the deemed residual profits remaining after benchmarked returns are designated for routine functions. The deemed residual profits would be allocated between market jurisdictions and others based upon an internationally agreed convention that rewards marketing contributions and other factors such as trade intangibles, capital, and risk. Amount B provides a fixed return for certain baseline or routine marketing activities taking place in a market jurisdiction. Lastly, Amount C arises when a market jurisdiction shows that the market activities exceed the baseline level and should be allocated more profit, for instance.
The Unified Approach also proposes the development of nexus thresholds through changes to local tax legislation, as well as the introduction of a new treaty provision to make sure the arrangements would work. Certain activities might be outside the scope, including extractive industries, financial services, commodities, and likely some business-to-business scenarios.
New pillar 2 proposal (GloBE)
The OECD's new GloBE (global anti-base erosion) consultative document primarily highlights design concerns related to the income inclusion. Although the work plan under pillar 2 includes four components — an income-inclusion rule, an undertaxed-payments rule, a switch-over rule, and a subject-to-tax rule — the GloBE consultative document is focused on the income-inclusion rule and describes broad principles as to how the rule might operate. The document fails to discuss how the income-inclusion rule would be harmonized with the other rules under consideration.
Specifically, the GloBE consultative document focuses on design elements that would enable ascertaining a tax base through the use of financial accounts as a starting point, adjustments that might be necessary for purposes of blending, and carve-outs and thresholds that may be considered. The document includes no discussion of the exact minimum tax rate that might be applied, but the examples in "Annex A" of the document apply a rate of 15%.
While comments are welcome on all aspects of pillar 2, and notwithstanding the focus on the income-inclusion rule, the GloBE consultative document seeks comments with respect to three technical design aspects:
- The use of financial accounts as a starting point for determining the tax base, as well as different mechanisms to address timing differences. The secretariat recognizes in the proposal that there is a clear challenge in determining what financial accounts and rules should be used for the tax base determination, because of notable differences between accounting standards and bases. It also suggests ways to tackle temporary and permanent differences and requests comments from the public.
- The extent to which multinational enterprises can combine high-tax and low-tax income from different sources in determining the effective tax rate on that income, also referred to as "blending." Since the proposal is based on a test of the effective tax rate resulting from the inclusion of a mix of high- and low-tax income, a method must be established to correctly apply this test. The secretariat suggests three methods that can accomplish this: a worldwide blending approach, a jurisdictional blending approach, and an entity blending approach. All three approaches face challenges, and several factors with each method, such as profit allocation under transfer-pricing rules as well as cost of compliance, need to be considered.
- Stakeholders' experience with, and views on, carve-outs required to fairly tax the global income at a minimum rate without creating inappropriate and unreasonable tax burdens to taxpayers. Taxpayers may be subject to certain regulatory obligations in their local jurisdictions, and it would be necessary to adjust the tax base accordingly in order to align the policy with the taxpayer's local obligations. Although the proposal does not specifically mention the U.S. GILTI regime, GILTI would seem to be a likely carve-out, as including GILTI income in the tax bases would potentially apply the minimum tax of both regimes to the same income.
The GloBE consultative document recognizes that simultaneous implementation and an effective dispute resolution mechanism are needed to make this pillar viable. Both in turn require a high level of agreement among jurisdictions that may have different and even competing priorities and different formulas.
The state tax analogy
Issues raised in pillars 1 and 2 of the OECD consultation documents resemble issues being addressed at the state and local tax level in the United States. For example, the potential adoption of nexus thresholds (like pillar 1) based on market sales rather than physical presence was the central topic addressed by the U.S. Supreme Court in South Dakota v. Wayfair, Inc.,138 S. Ct. 2080 (2018). The Court upheld the constitutionality of a South Dakota statute requiring remote sellers to register, collect, and remit sales taxes if they met at least one of two economic thresholds ($100,000 in South Dakota sales or 200 transactions with South Dakota customers), overturning a physical presence rule that the Court had previously endorsed.
In response to Wayfair, nearly all the states have adopted their own sets of economic thresholds for purposes of their sales taxes, requiring remote sellers from within and even outside the United States to consider how much economic presence they have in each of the states. The Wayfair decision also has emboldened states to begin to apply economic presence tests for purposes of corporate income tax nexus as well. The increased compliance and burden for midsize and smaller businesses that could occur with the adoption of pillar 1 is already happening in the states as a result ofWayfair.
With respect to pillar 2's focus on requiring a company to effectively pay a minimum worldwide tax, states historically have struggled with a similar problem in the area of corporate income taxes. One example occurs when a corporation incurs a related-party expense in a high-tax jurisdiction, an affiliate recognizes the associated income in a low- or no-tax jurisdiction, and the related entities are not required to file together on the same tax return in the high-tax jurisdiction. Many states that allow such separate filings have responded to this practice by either requiring addbacks of otherwise deductible related-party interest and intangible expenses unless certain exceptions are met, or ultimately requiring the entities to file on a combined unitary basis.
A second example of attempting to source a portion of income to each of the states where a company is doing business is the concept of allocation and apportionment. Due to a lack of conformity among the states, however, this concept often results in an aggregate state corporation income tax rate that is substantially above or below the rate that would apply if all the income were earned in one state.
Key points and takeaways
The OECD drafts as proposed present the real potential for increased administrative burden, cost, and double taxation. Midmarket and low-margin businesses would face significant challenges if these proposals prevailed as they currently stand.
The new approach departs from the principles of simplicity and certainty and may lead to unforeseen results that could change from year to year. In addition, the departure from some aspects of the arm's-length principle represents a significant change in tax policy and could be difficult to administer unless there is global consensus on the approach.
Such proposals can only work if there is consistent agreement and a commitment by the individual countries. There would need to be a consensus on the mechanisms applied to routine returns/residual profit allocation of income, financial income measures, and the formulaic approach. There also would need to be detailed rules that can be implemented with a minimum of ambiguity, including clear definitions and binding dispute resolution procedures.
Tax reform (including the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and other global tax reform efforts) has changed the landscape of risks and opportunities and its impact on the value chain. Pre-TCJA base-erosion and profit-shifting planning is no longer optimal in the post-reform world, and it becomes imperative to perform quantitative and modeling analysis and to pay special consideration to each jurisdiction's tax rates and regimes in order to arrive at a structure that provides both operational and global tax advantages. Layering the additional compliance and tax burden of the OECD proposals on top of the existing demands takes the difficulty and complexity to an entirely new level.
Significant work will need to be done in order to arrive at a unified approach (especially given the United States's remarks) that is fair and equitable to both countries and taxpayers, and finalizing it by the end of 2020. This will be a significant challenge. Unilateral initiatives must also be addressed. While change is coming, this is only the beginning of the end of a tax era.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.