On October 9, the Organisation for Economic Cooperation and Development (OECD) released a public consultation document for a ‘unified approach’ under Pillar One to address the tax challenges of the digitalisation of the economy. This proposal is, arguably, the most transformative of all the ones that have come out of the ongoing base erosion and profit shifting (BEPS) initiative by the OECD covering highly digitalised business models as well as ‘consumerfacing’ non-digitalised businesses.
The digital economy has given rise to a number of new business models that include ecommerce, app stores, online advertising and cloud computing.
The OECD proposal includes a new ‘nexus’ concept not dependent on physical presence and is largely based on sales. It is separate from the existing ‘fixed place of business’ concept, or ‘permanent establishment’ (PE), and would operate regardless of whether taxpayers have an in-country marketing or distribution presence, or sell through related or unrelated distributors.
This would ensure that a business that has a sustained, and significant, involvement in the economy of a market jurisdiction, is taxable there, even if such a business is not physically present at the location.
Under the proposed profit allocation rule, these steps are contemplated:
*Amount A: First, the total profit at the multinational enterprise (MNE) level is taken from global consolidated financial statements. Second, exclude ‘deemed’ residual routine profit — say, as a percentage of revenue — to account for profits for performing routine functions. Third, allocate a portion of the ‘deemed’ residual profits to market jurisdictions, using a fixed percentage of profits considered attributable to factors such as trade intangibles, capital and risk. Fourth, the remaining residual profits are allocated to market jurisdictions based on a pre-agreed formulaic approach.
*Amounts B & C: While Amount A applies to cases where there is a new taxing right, Amounts B and C would only apply where there is already a nexus in the market jurisdiction under existing rules. Amount B essentially provides a fixed return for certain ‘baseline’ or routine marketing and distribution activities in a jurisdiction. And Amount C provides for activities beyond the baseline — beyond marketing and distribution — to be remunerated with profits in excess of the fixed return under Amount B.
Based on a preliminary assessment, it is expected that the combined effect of Pillar One and Two would be a significant increase in global tax revenues, as well as a redistribution of taxing rights to market jurisdictions.
Under this preliminary assessment, on average, low and middle-income economies would be expected to gain from Pillar One, experiencing a higher rate of increase in revenues than high-income economies even though larger market jurisdictions would be expected to gain more revenue in absolute terms.
Investment hubs, where current levels of residual profit seem to be high, would be expected to experience significant losses in the tax base. The proposals are also expected to significantly impact MNEs operating in digital-oriented and intangible intensive sectors, as these proposals could lead to significant changes to the overall international tax rules.
*Revenue threshold of transaction in respect of physical goods or services carried out by a non-resident in India.
*Revenue threshold of transaction in respect of digital goods or services or property, including provision of download of data or software carried out by a non-resident in India.
*Threshold for number of ‘users’ with whom a non-resident engages in interaction, or carries out systematic and continuous soliciting of business activities in India through digital means. The threshold reportedly under consideration is Rs 20 crore of revenue and/or 0.5 million users.
India seems keen to extend SEP to all the businesses. It also seems that SEP under the income-tax law is subject to treaty obligation. So, it’s unlikely to trigger taxable nexus for the foreign enterprise that enjoys treaty protection, and doesn’t trigger tax in respect of business profits in absence of PE, or of attribution of profits to PE.
Further, the proposal is unlikely to impact the procurement function or shared services operations in India, which may be undertaken by MNEs making use of technology on remote basis. Accordingly, business models that derive value from operations where, say, India serves as a service provider — rather than a consumer base or market jurisdiction — may continue to be governed by the conventional taxable nexus rules and conventional transfer pricing-based profit attribution principles.
The writer is national tax leader, EY India. Views are personal.