Digital transformation of the world’s economy is changing the way businesses are operating globally. The business models and value creation processes of the digitalized enterprises typically have the following features –
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- cross-jurisdictional scale without physical presence;
- heavy reliance on intangible assets;
- the importance is given to data and user participation, and their synergies with intangible assets;
Currently, the tax regimes of most jurisdictions attribute profits to activities in a particular jurisdiction, based on the tangible presence of the respective enterprise(s) in the source state. With the increasing digitalisation of the economy, businesses can no longer be circumscribed by reference to their tangible presence and hence most countries agree that the current rules are not sufficient to ensure a fair allocation of taxing rights amongst the various jurisdictions a Multinational Enterprise (MNE) operates in.
In order to address the above tax challenges, Organisation for Economic Co-operation and Development (OECD) /G20 Base Erosion and Profit Shifting (BEPS) Project, came up with the 2015 BEPS Action 1 Report “Addressing the Tax Challenges of the Digital Economy” which analysed various options to tax such digital business without providing any specific recommendation. As one may be aware India has in a limited way, adopted one of these recommendations by a limited ‘equalisation levy’ om certain specified transactions. More work, however, is continuously being done to find a way that most countries should find acceptable
Supplementing the Action 1 Report, on 9th October 2019, the OECD released a public consultation document outlining a proposal from the OECD Secretariat for a “Unified Approach”. It provides high-level suggestions on the approach to the new nexus concept (where tax should be paid), and an approach for new and revised profit allocation rules (on what portion of proﬁts they should be taxed). The new nexus concept shall be a standalone rule, operating on top of the permanent establishment rule to limit any unintended spill-over effects on other existing rules. It is intended to facilitate negotiations among the countries, with the aim of achieving the objective of a political agreement of inclusive framework on BEPS by 2020.
The Unified Approach seeks to address the following –
- Reallocation of taxing rights in favour of user/market jurisdiction;
- New nexus rule that would not depend on physical presence in the user/market jurisdiction;
- Going beyond the arm’s length principle and depart from the separate entity principle and;
- Search for simplicity, stabilisation of the tax system, and increased tax certainty
The Unified Approach seeks to cover highly digitalized business models and also non-digitalized businesses that are consumer-facing. It consists of the following three-tier profit allocation mechanism:
Amount A – Portion (%) of deemed residual profit
This captures a share of deemed residual profit allocated to market jurisdictions using a formula based and residual profit split approach and moves beyond arm’s length price. The new profit allocation rules would apply to profit as well as losses.
- Identification of the MNE group’s profits which can be derived from the consolidated financial statements. Profits may need to be determined on a business line and/or regional/market basis. (z%)
- Compute/attribute the remuneration of the routine activities based on an agreed level of profitability. The simplified approach to determine the routine profits would agree a fixed percentage possibly with variances by industry. (x%)
- The non-routine profits to be reallocated to the market jurisdictions would be the profit that remains after allocating profit on routine activities (y%= z% – x%).
- Determine the split of non-routine profits between the portion that is attributable to the market jurisdiction (w%) and the portion that is attributable to other factors such as trade intangibles, capital and risk, etc (v%).
- The final step would be to allocate the relevant portion of the non-routine profit (w%) among the eligible market jurisdictions. This allocation should be based on a previously agreed allocation key, using variables (such as sales) which would seek to approximate the appropriate profit due to the new taxing right.
Amount A applies to cases where there is a new taxing right (as well as to cases with nexus under existing rules) and Amounts B & C would only apply where there is already a nexus in the market jurisdiction under the existing rules (a subsidiary or permanent establishment).
Amounts B – Fixed return for distribution functions
The second type of profit would seek to establish fixed returns based on industry or region for certain “baseline” or routine marketing and distribution activities taking place in a market jurisdiction. The intention is to reduce the disputes in the application of the transfer pricing rules.
The quantum of fixed return could be determined in a variety of ways including the single fixed percentage or fixed percentages that vary by industry and/or region or some other agreed method.
Amount C – Additional return based on TP analysis
The third type of profit is in excess of the fixed return contemplated in Amount B where the marketing and distribution activities taking place in a market jurisdiction go beyond the baseline level of functionality or where the MNE group perform other business activities in the jurisdiction unrelated to marketing and distribution.
This may lead to disputes between the taxpayers and the tax administrations which should be subject to legally binding and effective dispute prevention and resolution mechanisms to ensure the elimination of protracted disputes and double taxation.
The interplay of new nexus rule and profit allocation rules with provisions of Indian tax law
The new nexus concept proposed by the Unified Approach is in principle similar to India’s SEP as nexus will be established where an MNE group has a sustained and significant involvement in the economy of a market jurisdiction such as through consumer interaction and engagement, irrespective of its level of physical presence in that jurisdiction.
However, the key difference between SEP and Unified Approach is that while under India’s SEP threshold for determining economic nexus is based on revenue generated from India and also based on interactions with users in India, the Unified Approach seems to consider only revenue threshold as a proxy for nexus determination.
While the Unified Approach outlines the key principles for allocation of group profits, the following points merit appropriate consideration when the document is finalised by OECD:
- how a digital business or a consumer-facing business might be defined – whether a negative definition with certain exclusions or a positive list of covered businesses;
- define the sectors covered as well as excluded under the Unified Approach (e.g. financial services);
- threshold limits for exclusions – smaller businesses should be excluded where the burden of compliance/administration will be disproportionate to the profits allocated;
- the interplay of Unified Approach with other digital tax measures (such as equalization levy)
- applicable accounting standards for measuring group profits – multi-year or annual profits?
- periodicity of review of allocation basis and routine returns
Several large MNEs and 300+ stakeholders have provided comments on the OECD’s Unified Approach under Pillar One and a few have backed it as a potential solution to the issue of digital economy taxation.
Although the Unified Approach has provided the methodology to compute attributable profits for respective jurisdictions, implementation of the above approach is going to be a challenge considering the fact that all countries have to come to a consensus for computing step by step allocations. The countries that may get adversely affected because of the new approach, may not want to include the new methodology in its local tax laws, which might lead to double taxation in those countries. OECD has expressed concern over the US proposing to treat the Unified Approach as a safe harbour i.e. being optional to avoid controversy and not being mandatory in nature.
It is hoped that the above issues will be addressed in the forthcoming drafts and the countries will come to a mutual consensus and the recommended formulary approach will become the new way of taxing global enterprises not having a tangible presence in the tax net.
Courtesy, The Chamber of Tax Consultants (CTC). Written by a young member CA Harshita Pincha and vetted by CA Anish M Thacker, Vice President, CTC (2019-20)