Tax challenges of the digitalisation of the economy

​published on March 25, 2019

On the 13th of February the OECD published a public consultation discussion paper within the framework of the OECD/G20 ”Base Erosion and Profit Shifting” (BEPS) project during the 13th and 14th of March in Paris, which constituted the foundation for the public consultation.

The aim of this consultation was to explore, how it could be possible to modernize the fundamental architecture of international taxation, which stands under substantial pressure due to the increasing digitalization of the economy. The underlying challenges can primarily be traced back to three characteristics of highly digitalized companies, which put the efficiency of the existing profit allocation and nexus rules at risk: scale without mass, heavy reliance on intangible assets, as well as data and user participation. These characteristics render possible scenarios, where businesses create value within a market jurisdiction, according to the existing profit allocation and nexus rules. This is not an adequate taxation, because the company either has no local physical entity or it operates a local entity, which has a strongly limited functional profile. In light of these challenges it is the OECD's objective to reach a consensus about common, simple and holistic solutions for the coherent revision of the existing profit allocation and nexus rules by 2020. The starting point for this undertaking is constituted by the following 3 approaches:

The first approach, called ”user participation approach”, refers to highly digitalized businesses that develop an active and engaged user base, from which they solicit data and content contributions. The value creation resulting from this activity cannot be taxed in the jurisdiction, in which it takes place, if the business has no local physical presence. The proposed solution to this challenge is to first determine the profit related to the value created by the user base, which can be achieved with a revised residual profit split approach, and then to allocate these profits to the user jurisdictions based on an agreed allocation metric.

The second approach, which is referred to as ”marketing intangibles approach”, addresses the situation, in which a MNE group reaches into a jurisdiction remotely or through a limited risk distributor to develop a user- or customer-base, as well as other marketing intangibles, which cannot be adequately taxed. Similarly to the first approach, the proposed solution is the application of a revised profit split analysis, which enables the determination of the profit related to the marketing intangibles by using mechanical approximations. In a second step these profits are then allocated to the jurisdictions in which the marketing intangibles were generated by using an agreed allocation metric.

According to the third approach, which is called ”significant economic presence approach”, a taxable presence in a jurisdiction would arise when a non-resident enterprise has a significant economic presence in the form of purposeful and sustained interaction with a jurisdiction (via digital technologies). The proposal for the determination of the tax base is to apply the global profit rate of the MNE group to the revenue (sales) generated within the respective jurisdiction and to subsequently apportion the tax base by taking into account certain factors such as sales, assets, employees or in some cases also the user base. The profit allocation could be based on a fractioned appointment method, with which the previously determined profit would be allocated to the respective jurisdictions based on a weighted allocation key.

For all three approaches it would be necessary to change the existing nexus concept, so that the jurisdictions obtain the right to tax the additional income deriving from value creation within their country. This could be achieved by either amending or supplementing the existing definition of a ”permanent establishment” or by introducing a new nexus through a standalone rule, which allocates taxing rights over the additional income.

It is especially the common aspects of these three approaches that illustrate how the future prospects of international taxation look: the detachment of taxation rights from the condition of physical presence and the utilization of global approaches for the determination of profits.

The main objective of the public consultation, as well as of the further work being done by the OECD ”Task Force on the Digital Economy” (TFDE), is now to explore the practicability of these approaches (and possibly of a unified approach) and to reach a consensus about well-founded proposals for the future of international taxation. We will gladly keep you informed about further developments and news.