Diverging approaches to taxing multinational companies with digital business models are taking shape on the global stage—potentially leading to more complexity and a bumpy ride for multinationals.
The OECD and the UN are each working on separate approaches to taxing the digital economy. But having two models for a digital services tax regime will present overlap depending on the countries in which a multinational operates, dual compliance systems, and increased instances of double taxation.
The Organization for Economic Cooperation and Development’s model, known as Pillar One, inherits complexity due to its intended breadth of taxation, while trying to achieve a majority consensus among nearly 140 countries having far-ranging differences in thoughts and implementation.
The UN’s focus is developing countries, which have many similar attributes and challenges for implementing a new taxing regime. This targeted focus makes it easier to craft a potential solution that fulfills many needs.
The two different approaches to digital taxation, though, coupled with unilateral digital tax regimes, could represent a perfect storm.
As a follow-up to the prior deep dive on digital services taxes, let’s explore some of the reasons why the UN decided to pursue a draft proposal apart from the OECD and what the diverging approaches mean for multinationals.
The OECD began addressing challenges of the digital economy in 2015 as part of its base erosion and profit shifting project with the G20.
The OECD did not recommend a withholding tax on digital transactions, or a new nexus standard with an economic presence foundation, which led the UN to pursue a separate draft proposal.
As a result, the United Nations Committee of Experts identified income from automated digital services as a priority in developing Article 12B, a new article under the UN Model Convention.
Absent article 12B, automated digital services were only subject to tax in the state of residence, or through a permanent establishment (PE) or fixed base in the other source state.
Other articles of the UN Model Convention, including Article 5 on PE, Article 7 on business profits, and Article 14 on independent personal services, had limitations to tax such income.
As a result, there was an inherent advantage for non-resident service providers based in a low- or no-tax jurisdiction versus a domestic service provider where this income would have been subject to a higher domestic tax.
The UN envisaged that a gross basis digital services tax would result in excessive or double taxation, and set forth potential solutions to eliminate or minimize this tax burden:
- Article 23 provides for an exemption or credit method;
- Paragraph 2 of Article 12B provides for a modest tax rate pursuant to bilateral negotiations; and
- Paragraph 3 of Article 12B allows the non-resident service provider to adopt a net basis of tax approach (which should generally be governed within a double tax treaty as a tax based on income).
Thus, the UN has taken a forward-looking and practical approach to double taxation.
What Is At Stake?
On the other hand, the OECD aims to increase tax certainty for multinationals by introducing innovative dispute prevention and dispute resolution mechanisms to address significant changes in the way taxing rights are allocated among jurisdictions in Pillar One.
But the OECD proposal, which seeks to apply a new taxing right to multinationals by allocating global residual profit to market countries, lacks a structure that can be implemented easily and regulated efficiently.
The OECD, in an October public consultation document, requested comments by Dec. 14 for potential solutions to eliminate double taxation in a multi-step approach. The first complex hurdle to overcome is identifying which entity must pay the tax. That approach results in imperfect allocations, after which an exemption or credit mechanism would be used.
The OECD Secretariat issued an economic assessment report in October which estimated global tax revenue gains from Pillar One to be $5 billion to $12 billion dollars (0.2% - 0.5% of global corporate income tax revenues), partially due to higher tax rates in jurisdictions where residual profits would be allocated.
Jurisdiction-specific results of the OECD’s revenue estimates, for Pillar One and Pillar Two, were shared with over 125 countries and jurisdictions part of the Inclusive Framework on a confidential basis to estimate the impact on their fisc.
The OECD noted the report does not represent consensus views of the Inclusive Framework members.
Pillar One and Unilateral Measures
Several countries, including France and the U.K., have legislated or enacted unilateral digital services tax legislation. The hope by many, including the OECD, is that such legislation would be rescinded as the OECD DST regime takes effect.
However, a country may find its legislation preferable to the OECD’s final recommendation and maintain its own regime in the near future. That could lead to increased tax disputes over double, or even triple, taxation for multinational enterprises.
Developing countries also have stakes in the digital services tax debate. They have a high probability of successfully adopting the UN DST proposal due to its relative simplification, which would result in a win-win for such countries and the UN.
Meanwhile, developed countries that are members of the Inclusive Framework have a significant headwind towards successful adoption of the OECD proposal. Pillar One is unduly complex, while creating more uncertainty regarding timing, regulations, and governance. The transfer pricing aspects of this initiative are also very challenging, which may take years to resolve efficiently.
The OECD is not relying on a Plan B, such as mirroring the UN proposal to guarantee success. As a result, legislation is expected to be enacted for which the timeline may be accommodated although the rules may not be well understood or clearly interpreted.
The OECD’s complex plans are then added to the layers of tax work piling around the world.
Almost all countries are currently facing backlogs to resolve transfer pricing cases, analyze
The EU Member States are also still working diligently to adopt DAC6 provisions, interpretations, and systems for automatically receiving and distributing information regarding arrangements identified as potentially aggressive tax planning items. Additionally, they have proactively announced their intention to adopt a DST regime, with or without a timely Pillar One plan.
Double or Triple Taxation
The adoption of any digital services tax would significantly impact major U.S. multinationals in the DST realm.
In prior years, double taxation generally occurred between two jurisdictions. However, international tax legislation in recent years result in allocation provisions that extend beyond the two-country scenario. Thus, triple taxation may become more the norm.
Under the U.S. 2017 tax law, known as the Tax Cuts and Jobs Act, the global intangible low-taxed income (GILTI) legislation presumably captures the foreign income being reported. Currently, the net tax is 10.5% (after a 50% tax code Section 250 deduction applied to the 21% corporate tax rate), although it may be less if there are limits.
The GILTI tax may capture a slice of income relating to the digital services tax, in addition to the resident country and other countries where a DST allocation is in place.
The characterization of the DST makes a difference for multinationals who want to avoid such a triple tax scenario. If the DST is based on income, which may be the result for the UN alternative methodology, a U.S. foreign tax credit is generally available for the foreign taxes paid. However, the credit is haircut by allocation and other provisions, resulting in taxes only partially creditable.
A gross basis DST, applied to turnover, is not creditable for U.S. income taxes, and is also recognized as a part of operating income. This income is not eligible for U.S. foreign tax credits and thereby becomes an additional expense that reduces global revenue, if it is not charged back to the user.
U.S. President-elect Joe Biden starts his term on Jan. 20, 2021, and has said he would raise the corporate tax rate to 28%, from 21%, which would automatically raise the GILTI net tax rate and affect its interaction with the OECD’s digital tax plans.
But obviously any new U.S. legislation will need to be passed by Congress.
Overall, the complexities of Pillar One and the consultation document are still being studied by multinationals to understand the breadth, and magnitude, of its impact and related transfer pricing effects. The OECD’s proposal follows in the footsteps of the BEPS Action Plan, and has a high probability of success, notwithstanding many unknowns as to its final verbiage.
The UN draft proposal is clear and concise, enabling quantification and availability of an alternative methodology that would provide additional flexibility. This model minimizes uncertainty and regulations that will evolve into final legislation, and may indeed be preferable, however it will likely be specific to developing countries as a subset of global DST implementation.
In summary, the DST regime has a rocky road ahead, which promises more complexity and additional tax compliance burdens for multinationals.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Keith Brockman is a CPA, CGMA, and authors a Best Practices international tax blog at strategizingtaxrisks.com. He is a frequent presenter at international tax conferences, having over 30 years of experience as a corporate tax executive. He has served on tax committees in the U.S. and Europe with Tax Executives Institute and Manufacturers Alliance for Productivity and Innovation.