Tax Notes reporters Stephanie Johnston and Ryan Finley provide an update on the OECD’s work to find a multilateral solution on the taxation of the digital economy.
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This episode is sponsored by University of California, Irvine Law School’s Graduate Tax Program. For more information, visit law.uci.edu/gradtax.
David Stewart: 0:00
Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: BEPS 2.0 update. Now that the OECD has held consultations on both pillars of its digital economy project, we figured it would be a good time to check in again and see where things stand. Here to update us on the latest from the OECD are Tax Notes reporters Stephanie Johnston and Ryan Finley. Stephanie, Ryan, welcome back.
Ryan Finley: 0:29
Stephanie Johnston: 0:29
Thanks. Good to be here.
David Stewart: 0:31
So a lot has happened since the last time we had both of you on the podcast. Could you give us a brief refresher on what the OECD is working on and what's the big deal here?
Stephanie Johnston: 0:40
So one thing I've learned this year about tax nerds who have been following the OECD's work in this space. They love the Beatles and Beatles references, so this one's for them: You say you want a revolution / Well, you know / We all want to change the tax world / You tell me that it's evolution / Well, you know / We all want to change the tax world. At the G-20's request, the OECD is working on leading more than 130 countries toward a common approach to adapt international tax rules for the 21st century so that companies without physical presence in a given jurisdiction pays corporation tax. And some countries want this solution to be revolutionary so that it results in the reallocation of taxing rights to market jurisdictions. Other countries really want companies to pay a minimum level of tax in their countries, and others still don't really seem that keen on changing things up too much. But some kind of change is on the horizon, whether it's revolutionary or evolutionary is yet to be determined. This year, there's been a lot happening in this space and it's all culminated into what is now on the table at the OECD. It's a two pillar proposal. Pillar 1 in broad terms is about the revision of nexus and profit allocation rules to give more taxing rights to market jurisdictions, where a pillar 2 is about minimum taxation, ensuring that corporations pay at least some tax in the jurisdictions which they operate. And the OECD has had several consultations on these two pillars. And, as Ryan will discuss, there are still plenty of outstanding questions to be answered by the end of 2020, which is when the OECD is aiming to have consensus on a solution.
David Stewart: 2:06
All right. So, Ryan, in the last few months we've had consultations. One was on pillar 1, the other on pillar 2 in December. What did we learn from those consultations?
Ryan Finley: 2:14
Well, for pillar 1, the consultation focused on kind of the specifics in the unified approach that the OECD secretariat released in October. It's based on a variant of the residual profit split that uses kind of fixed percentages instead of a case-by-case transfer pricing analysis. Specifically, they termed the amounts amounts A, B, and C. Amount A is really where the residual profit split part comes in. Again, the main difference between a traditional profit split is that you don't apply another method. Usually the transactional net margin method to figure out what a routine return is you just stipulated by rule. So the next step in the unified approach for this Amount A is to allocate some chunk of that residual profit to all market jurisdictions. That also would be based on just some fixed percentage, rather than a kind of a case-by-case analysis. And then the last step for Amount A would be to have some allocation formula agreed by everybody, probably based on sales, that allocates the bits of that part of the residual profit to each country. Then the Amount B is kind of similar to the way things work now. You determine some sort of routine return for any distribution activities that a subsidiary or branch performs. But it would also use kind of like stipulated percentages instead of case-by-case transfer pricing analysis. And then Amount C, which to some extent it is the most likely cause of disputes, or at least that's what they say in the unified approach consultation document, would be any kind of additional functions that a subsidiary or branch performs beyond what's reflected in that routine return in Amount B and it would be a compensation for those additional activities. So basically, in the second consultation, they had all these kind of concepts out there to talk about. The recurring themes in terms of what people said were a couple things. One of them really focused on dispute resolution mechanisms, particularly mandatory binding arbitration. Taxpayers and business groups representatives were very concerned that countries will apply this differently and lead to double taxation as a result. Another issue basically had to do with what these percentages will be, none of which are specified in the consultation document. Practitioners generally said at the consultation meeting that whatever the rules are chosen, they should basically approximate what you would have gotten under the traditional arm's length principle based transfer pricing system. So those are the big things with pillar 1. Pillar 2 is a little more narrow and specific. The second consultation, picking up on the consultation document on pillar 2, was really focused on this issue of blending. Basically the part of the pillar 2 proposal that the consultation document is focusing on has to do with this income inclusion rule or basically some subsidiaries in subject to a level effective tax that's below some minimum threshold. The idea is you'd have an income inclusion rule, most likely in the parent company's jurisdiction, to top them up to that minimum rate. Now, companies for the sake of administrative simplicity and perhaps other reasons as well, would like to be able to blend the financial results of all their subsidiaries all over the world and come up with one percentage and then test that percentage relative to the minimum tax floor.
David Stewart: 5:20
So this would be as opposed to applying this minimum rate for each jurisdiction where they operate or for each entity —
Ryan Finley: 5:27
Yes, yes. Both are possibilities and, as you might expect, representatives from business groups were very opposed to that. There are a lot of practical issues. Apparently not all entities in all countries have any obligation to prepare separate accounts. So it would be this whole exercise of creating separate accounts if you were to do it on an entity by entity basis. But then, on the other hand, you representatives from NGOs said blending wouldn't work because it would not stop a company from still parking a significant amount of money in artificially in a low tax jurisdiction. Just as long as they're average rate is above the threshold, there's nothing you can do about that. The other thing had to do with basically the numbers that you take for these calculations. The consultation document talked a lot about how basically the preferred approach, for now, is to take figures for financial accounting purposes, whether under U.S. gap or another country's gap or IFRS. But then you'd have to make adjustments to reflect any timing differences, things with a depreciation, things to do with revenue recognition losses. You need various adjustments to kind of make sure everything's on the same page. So the number and the complexity of the adjustments was also a concern for taxpayers.
Stephanie Johnston: 6:39
Another interesting thing that came up during the pillar 1 consultation was this idea of: what are we calling all this? We call it BEPS 2.0. We've sort of established that, that's a good shorthand for this work.
David Stewart: 6:51
It fits in headlines.
Stephanie Johnston: 6:52
It does. Yes, it's very convenient. But Will Morris — he was saying during the public consultation that really this work should not be called BEPS 2.0 because we're talking about a new taxing right in pillar 1 and it's not really picking up on what the BEPS project actually set out to accomplish, which is really what's happening in pillar 2. So there's sort of an ongoing debate between various factions. The NGOs love BEPS 2.0 as well. We reporters like it because it's convenient, but there's an ongoing discussion about what to call this. And on the sidelines of the consultation, I had heard people saying, 'You know, we should just call it the new tax world order or a new tax deal.' I don't really know what to call it. All I know is that it's keeping us super busy, and there's plenty more to come in 2020.
David Stewart: 0:00
Now, while these negotiations and consultations are continuing on both pillars, have countries continued to support that work? Or are they moving ahead with their own measures, like the digital services tax?
Stephanie Johnston: 8:55
So countries have publicly said that they are still supportive of the OECD's work, and they'll continue to be engaged in negotiations. But yet we still see countries still moving forward with their digital services taxes and digital advertising taxes. They don't seem to be waiting around too much longer for the OECD's solution, and I guess I could see why that is because we don't really know what the timeline is going to be. Even if the OECD does manage to get everyone to agree on something by the end of the year of 2020, then there's still going to be a period of implementation. And in meantime, these governments are still under pressure to do something to tax multinationals. So, yes. Countries are still going ahead with their digital services taxes. And this has led to some friction between countries and the U.S., in particular the U.S. and France. You might recall that's the U.S. Trade Representative in July opened an investigation into France's digital services tax, which is a 3 percent revenue base tax that applies to turnover from online advertising, the sale of data for advertising purposes, and fees derived from linking users to online sales platforms. The tax applies to large companies that have digital activities in France and took effect in January. And this tax has really ruffled the U.S.'s feathers in many ways. So they started this investigation in July, and they recently published their findings earlier this month, and they did find to nobody's surprise that this tax was discriminatory against U.S. companies. Now the U.S. wants to impose tariffs of up to 100 percent on French goods, including champagne, leather goods, cheeses. I mean, literally everything that I love. So that was an interesting development that happened in this space. So what is going to happen now is that the USTR is going to have a public hearing on January 7, 2020 to discuss these tariffs further and they're also indicating that they might open similar investigations into the digital services taxes and digital advertising taxes of Austria, Italy, and Turkey. So you'd think that this investigation would have scared them a little, but Austria, Italy, and Turkey have all said, 'We're still going ahead with these plans. We're not scared.' So, we'll see what happens. It seems that this OECD work was meant to curb the proliferation of these measures. But in the absence of any real solution on the horizon, countries I think are still going to keep going on with these.
David Stewart: 11:12
Now on December 3rd, we saw this letter come out from Treasury Secretary Steve Mnuchin. It was to the OECD secretary general and expressed reservations about the pillar 1 work. What was this letter about and how was it received?
Ryan Finley: 11:25
Well, the letter, after stating a bunch of courtesies about how the U.S. is committed to the process of coming up with a solution, basically it said two things that were noteworthy to say at least. The first was that the U.S. supports a pillar 2-like solution, but he uses the term 'GILTI-like pillar 2 solution.' Whether pillar 2 is specifically modeled on the U.S. GILTI regime is definitely something that's controversial. But with the pillar 1 proposal, he said that the U.S. has substantial concerns that pillar 1 departs from the established nexus and transfer pricing principles, but that the U.S. believes that the goals of pillar 1 could be achieved using sort of an elective safe harbor regime. This sort of came in at the eleventh hour and took a lot of people by surprise. In the letter responding from the OECD secretary general, he specifically mentioned that in the months and months that we've been having these negotiations, nobody's once brought this up. This has never been proposed, and there's some confusion as the how exactly safe harbors were kind of perform the goal that the people at least think that pillar 1 was supposed to achieve.
David Stewart: 12:32
What does Secretary Mnuchin mean by safe harbors in this context?
Ryan Finley: 12:35
So safe harbors in the transfer pricing context usually refer to some sort of fixed margin or return that whether it's a markup on costs or a margin on operating profit that if you set your transfer pricing arrangements in compliance with that, then that tax administration agrees not to bother you. They're completely elective and taxpayers under safe harbor approach would always have the option to do what they would've done anyway and to support that basically under the same kind of transfer pricing analysis that we've already had. It's a little bit unclear how safe harbors would really work politically as well as technically, because to the extent that they're trying to reallocate taxing right, safe harbors don't necessarily achieve that to the extent that it's up to taxpayers whether to opt in or not. The other thing is whether this would actually, just in monetary amounts, transfer enough revenue to market countries to appease them and get them to agree to pull back their DSTs and other controversial unilateral measures is not clear. So we're still waiting to see how this proposal kind of flies with the rest of the OECD.
David Stewart: 13:41
What did this letter exchange mean for the current OECD negotiations?
Stephanie Johnston: 13:46
Well, like Ryan said, it sort of remains to be seen. We haven't really heard much else from the U.S. in the wake of the letter. A lot of observers have said that this is going to blow up the negotiations because if the U.S. isn't going to support pillar 1, that would mean a collapse in negotiations, which I can't really say either way because I don't have all the information at hand the moment. But it is safe to say that it represents a wrinkle in the negotiations, so we'll have to wait and see how everything plays out. But going back to Ryan's point about how this might all affect countries, so the OECD is still continuing work on impact assessments and the impact assessments are meant to give countries and idea of how are these options under pillar 1 and pillar 2 going to affect them. Is it worth it for them to sign on? So I understand from David Bradbury, who heads up this work at the OECD, that the OECD plans on releasing some of the results of the impact assessments in early 2020 and a lot more by mid 2020. So that should shed some more light on who the winners and losers might be notwithstanding any possible changes to the proposals. We don't know yet whether they'll be rejiggering some of the stuff already on the table, but we understand that is likely be another consultation in March 2020.
David Stewart: 14:56
All right, so we're closing out the OECD's work of 2019 and we're heading into 2020 when all of this is expected to be delivered. What can we expect in 2020?
Stephanie Johnston: 15:05
Well, so OECD's tax chief Pascal Saint-Amans had said that they were aiming for getting political agreement on the solution by June 2020. So that is the timeline that stands now. I haven't heard anything to the contrary yet. I would imagine that we'll see a lot more action in the digital taxation space as far as unilateral measures. Because as you might recall, Canada's Liberal Party had proposed a digital services tax in their platform and now that they've been reelected, it seems that they're going ahead with their plans. So we'll probably see some more proliferation of unilateral measures and probably have a public consultation, another one, in March. We'll see more impact assessment results by mid 2020. All I know is that we're going to be super busy and I cannot wait to cover it all.
David Stewart: 15:50
And we will have you back to talk about it as we learn more. Ryan, Stephanie, thanks for being here.
Ryan Finley: 15:56
Stephanie Johnston: 15:56
David Stewart: 15:59
And now, coming attractions. Each week we preview commentary that'll be appearing in the Tax Notes magazines. I'm joined by Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?
Jasper Smith: 16:09
Thanks, Dave. In Tax Notes Federal, Jesus Mijangos Castro explains how examining foreign income on a transaction-by-transaction basis can help companies make the most out of their FDII deductions. Eugene Seago and Edward Schnee argue that the rules when accounting for NOL carryforwards are not always neutral but may result in neutrality. In Tax Notes State, David Cassidy discusses Louisiana's recent steps to make its tax laws more intelligible. Leah Robinson and Samuel Fowler provide an updated appendix summarizing advisory opinions addressing state taxation of online services. And in Tax Notes International, Vidushi Gupta evaluates the OECD's unified approach to determine whether consensus is a realistic goal, while Heikki Wahlroos and Sampo Viding discuss the Finnish tax administration's new procedures to facilitate more predictable outcomes for taxpayers. And finally in the Tax Notes Opinions page, Roxanne Bland looks at California's income tax regulation on space launches, while Joe Thorndike writes that the wealth tax should continue to be a discussion topic.
Ryan Finley: 17:13
You can read all that and a lot more in the December 23rd editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me online at @TaxStew, that's S-T-E-W. If have any comments, questions, or suggestions for a future episode, you can email us a firstname.lastname@example.org. And as always, if you like what we're doing here, please leave a rating a review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.