OECD's Inclusive Framework, the Paris-based multilateral forum comprising over 135 countries brought together on an equal footing, has been under the spotlight for nearly five years ever since it took on the baton to develop a new age tax policy for a rapidly digitalising global economy. Significant milestones have been reached in the journey, thus far.
A comprehensive package to address Base Erosion and Profit Shifting (BEPS) was published in 2016, later endorsed and adopted by finance ministers from the G20 group of nations, targeted to modify over 1500 bilateral tax treaties through 15 Action Plans (APs). The BEPS package delivered three minimum standards and a set of compelling proposals for amendments to bilateral and multilateral treaties, with the view to clampdown on global base erosion and profit shifting behaviour among large multinational enterprises (MNE) taxpayers.
These changes, albeit still in the policy deliberation phase, are quite radical. It challenges the fundamental edifice of the international tax system. Newer businesses led by the technology revolution are posing new and more complex tax challenges that are not limited to digital economy alone. That said, finding a consensus led solution for these challenges has been identified as one of the main areas of focus for the Inclusive Framework. This has led to BEPS Action Plan-One, provoking further discussion on these challenges as an important part of the international tax policy agenda.
On the back of the G20 endorsement, the Inclusive Framework came up with an interim report in March 2018, followed by a set of alternate proposals, on 'without prejudice' basis. The Programme of Work (PoW) comprising two pillars was adopted by the Inclusive Framework in May 2019, which was later endorsed by G20 finance ministers in June in Tokyo. PoW is a critical milestone towards responding to the request of the G20 to arrive at a consensus-led solution on taxation in the digitalised economy.
PoW consists of two pillars. Pillar One addresses the allocation of taxing rights between jurisdictions and considers proposals for new profit allocation rules and nexus rules. Pillar Two calls for development of a co-ordinated set of rules to address ongoing risks from structures that allow MNEs to shift profit to low or no tax jurisdictions. A closer look reveals that Pillar One outcomes are deeply rooted in BEPS AP-One that deals with challenges of digital economy taxation. On the other hand, Pillar two traverses beyond OECD's BEPS package solution and seeks to bring about global tax equilibrium through what has come to be christened as 'global anti-base erosion' proposals (GloBE). Pillar Two is thus intended to address the remaining aspects of BEPS concerns through a consensus-led global minimum tax framework. It is premised on the belief that such global 'min-tax' could evolve as an effective deterrent against unhealthy tax competition among jurisdictions seeking to 'race to bottom'.
In October this year, the OECD released the output of Pillar One work under PoW, titled 'Unified Approach'. Although the consultation document released by the OECD Secretariat does not represent the consensus of the Inclusive Framework, it seeks to combine significant commonalities among three alternate proposals presented in the PoW released in May this year - user participation, intangibles and Significant Economic Presence. The end goal for the Inclusive Framework is to garner political consensus towards delivering a global solution by the end of 2020, which is as simple and implementable as possible.
At the principle level, Pillar One seeks to present a new nexus rule and a formulaic profit allocation framework. At the basic level, the new nexus rule seeks to amend the historical definition and interpretation of the Permanent Establishment, a test sacrosanct under international tax treaties for taxing active business income from source or market countries. Such change will seek to obviate the requirement of physical mass/presence for an MNE to create a PE, if it otherwise derives substantial sales revenues from the source country. The proposal is sought to be applied to 'consumer facing' highly digitalised business. It is at the very core of the debate surrounding the scope of Pillar One on whether such narrow ring fencing is called for. The debate has been triggered considering that businesses across sectors and industries are leveraging new technologies and no longer exclusively rely on physical presence for serving customers. The dichotomy between 'consumer-facing' versus B2B business model is confusing. The final consensus should address this aspect and the scope of nexus rule should evolve with consensus.
The second part to Unified Approach under Pillar One is setting out a profit allocation rule (A + B + C) - a formula-based rule that introduces a new element in the form of 'global residual profit' (that is, A), and modifies prevailing arm's length price (ALP) test in order to allocate returns to routine functions (baseline activities) by way of a fixed percentage /safe harbour range (that is, B). In addition to the B in formula, if the market country seeks to tax more than what has been attributed under traditional transfer pricing rules, C comes into play to determine such excess, subject to the source country agreeing to a legally binding and effective dispute resolution mechanism.
While the attempt to simplify nexus rules by linking it to a non-physical threshold (revenues, users etc) and the profit allocation rule by introducing a formulaic approach is noble, the larger debate should be on whether we should bring about these radical changes all at once. If yes, then we need to discuss how to pace the implementation to allow smooth transition to the new regime. The answer to the first question is more philosophical than objective, that is, any change intended to be brought to the existing fabric must achieve an incremental degree of certainty for taxpayers, while it must yield more revenues for the states in play. Curiously, an overwhelming feedback thus far is that we are moving into a direction where businesses would pay more taxes for less (or absolutely no) tax certainty. The concern is not only genuine, but quite worrying, unless the proposed changes are calibrated adequately. For instance, there could be a way out to implement Pillar One on a standalone basis while Pillar Two is postponed. This approach could turn out to be better to test the policy changes and refine new rules than seeking to evolve a consensus-based (at least in the theory, if not necessarily in practice) solution under both pillars. The logic is fairly simple. The solutions or proposals under two pillars are definitely revolutionary in their nature and given the uncertainty around their shapes, outcomes could be different than what we have anticipated, if administered all at once. So, it is but prudent to test what we will live with for decades to come.
(Sumit Singhania is Partner and Anuj Agarwal is Senior Manager at Deloitte India)