In Brief
BEPS & the OECD: Taxation of the Digital Economy
IN THIS ARTICLE
What is base erosion and profit shifting (BEPS)?
What is the OECD’s Inclusive Framework on BEPS, and what is the timeline?
How will Pillar One be implemented, and what is the likely timing?
How will Pillar Two be implemented, and what is the likely timing?
How can businesses prepare for implementation?
[Download our report on the OECD’s Pillar Two plan and track developments that impact you.]
The digital economy has changed the landscape for businesses that operate in foreign markets. As a result, both businesses and governments must adapt new tax regulations.
Digitization has undermined traditional tax structure. Because e-commerce enables goods and services to be sold around the world, businesses are no longer required to have a permanent establishment, or a physical presence, which means that revenue generated by businesses may not enter a jurisdiction’s financial system. A lack of physical presence thereby removes a connection that would otherwise allow monitoring of transactions and enforcement.
Intangible assets, mainly intellectual property, have become a factor in the income generation process. This heavy intangible input has opened the opportunity for companies to use accounting techniques and differences in national rates to manage their tax liability in a manner that works against tax collecting authorities.
What is base erosion and profit shifting (BEPS)?
As digitization expands, multinational companies are able to implement a tax planning strategy called base erosion and profit shifting. This strategy involves exploiting gaps and mismatches in tax rules to avoid paying tax, such as moving profits to low or no-tax locations where there is little or no economic activity. BEPS lessens tax bases through deductible payments, like interest or royalties.
While some of these practices are illegal, most are not. But the use of these practices can mean that countries – including developing countries, which rely more on corporate taxes – do not receive support they would have received otherwise. In fact, BEPS actions cost countries between $100 billion to $240 billion in tax revenue each year, according to the Organisation for Economic Co-operation and Development (OECD).
As countries continue to navigate these digital taxation issues, some have levied digital services taxes (DSTs) to protect their tax base and tax income arising from certain digital activities derived within their jurisdiction. These DSTs can then lead to a risk of double taxation.
Martin Kreienbaum, director general of international taxation at Germany’s Finance Ministry speaking to Michael Rapoport, Bloomberg Tax senior reporter, on Dec. 19, 2022. While acknowledging the enormous task ahead and tough timelines to achieve various steps, Kreienbaum seems cautiously optimistic that the world leaders will be able to come together to end the race to the bottom on corporate taxation that has been dominating the international tax system for many years. [24:04]
What is the OECD’s Inclusive Framework on BEPS, and what is the timeline?
The governmental response to the rise of the digital economy, mainly (though not entirely), through the auspices of the OECD, has taken on a scope that reflects how dramatically the operating environment has changed. The process has been underway since 2013, when the OECD promulgated its BEPS initiative, but has since evolved.
Currently, the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting has agreed upon a solution to address the tax challenges arising from the digitalization of the economy through the Pillar One and Pillar Two proposals. As the OECD notes, the BEPS package “equips governments with the domestic and international instruments needed to tackle tax avoidance” in addition to giving businesses “greater certainty by reducing disputes over the application of international tax rules” and standardizing compliance requirements.
On July 1, 2021, the OECD/G20 Inclusive Framework issued a statement providing that broad agreement had been reached on the two-pillar approach. An updated statement was issued in October 2021. On December 20, 2021, the OECD published model Global Anti-Base Erosion (GloBE) Rules for the global minimum tax under Pillar Two. Two days later, the EU released a Proposed Directive based on the model rules. On March 14, 2022, the OECD published commentary to the GloBE Model Rules.
For Pillar One, the OECD published Draft Rules on nexus and revenue sourcing, and on determining the tax base in February 2022. As of November 4, 2021, the OECD noted 137 member countries of the Inclusive Framework had agreed to the Two- Pillar Solution, including both OECD and G20 countries as well as developing countries.
The new rules were supposed to come into effect in 2023 – with Pillar Two at a more advanced stage with regard to potential implementation and compliance – but sometime in 2024 is now more likely. (The detailed implementation plan is available in the Annex of the OECD’s October 2021 statement.)
What is Pillar One?
Pillar One of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting reallocates the profits of about 100 of the world’s largest and most profitable multinational enterprises to market jurisdictions. It achieves this by establishing new nexus and profit allocation rules that expand the taxing rights of market jurisdictions – regardless of physical presence.
This Pillar uses revenue sourcing rules to determine whether revenue derives from a market jurisdiction and profit allocation rules to allocate profits to those market jurisdictions. It also eliminates double taxation and clarifies filing and payment requirements.
Key points:
- Companies within the scope of Pillar One must have global revenue exceeding 20 billion euros and a profit-to-revenue ratio of more than 10%.
- To be subject to tax in a market jurisdiction, a company must have a nexus with that jurisdiction – this means deriving at least 1 million euros in revenue from a market jurisdiction. For smaller jurisdictions with a GDP lower than 40 billion euros, the nexus is set at 250,000 euros.
- The entity or entities that will bear the tax liability will be drawn from those that earn residual profit.
- To avoid double taxation, there will be either an exemption for the portion of profits allocated to market jurisdictions or a credit for tax paid.
- A separate element of Pillar One provides for a simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities.
How will Pillar One be implemented, and what is the likely timing?
Pillar One will require changes to both domestic law and double tax treaties. In mid-September of 2022, the OECD reported in its sixth progress report on the BEPS framework that “good progress” has been made. A Multilateral Convention (MLC) will be implemented to supersede existing tax treaties and allow market jurisdictions to tax the allocated profits.
Model rules for amendments to domestic legislation to give effect to the taxing right under Pillar One continued to be developed in 2022, with provisions related to baseline marketing and distribution activities expected to be finalized by the end of 2022. Peer reviews also continued in 2022.
In its September 2022 report, the OECD noted that work on the detailed provisions of the MLC and its Explanatory Statement are expected to be completed to allow for an MLC signing ceremony to be held in the first half of 2023. It also noted a 2024 objective for entry into force, after a “critical mass” of jurisdictions (as defined by the MLC) have ratified it.
What is Pillar Two?
Pillar Two ensures that multinational enterprises pay a minimum level of tax, regardless of where the headquarters are located or the jurisdictions in which the company operates. This Pillar targets around 2,000 multinational corporations and is expected to bring in about $150 billion in additional global tax revenues annually. Other expected benefits are the stabilization of the international tax system and increased tax certainty for taxpayers and tax administrations.
Key points:
- Establishes a global minimum effective tax rate of 15%, ensuring that large multinational companies pay a minimum level of tax.
- Pillar Two applies to multinational groups with consolidated group revenue equal to or exceeding 750 million euros.
- Governments can still set their own corporate tax rates, but if companies try to shift profits to low- or no-tax jurisdictions, their country of residence has the right to “top up” taxes to the 15% global minimum rate.
- Imposes a minimum level of tax on certain base-eroding payments between related parties.
How will Pillar Two be implemented, and what is the likely timing?
Model rules to implement the global minimum tax were issued on December 20, 2021, with key aspects planned to be implemented into domestic law in 2022, to be effective in 2023. On March 14, 2022, the OECD published Commentary to the GloBE Model Rules which provides tax administrations and taxpayers with guidance on the interpretation and application of the Model Rules. At the same time, a public consultation on a detailed implementation framework was announced.
The European Commission published a draft directive for Pillar Two on December 22, 2021, that required EU Member States to transpose the final version of the directive into domestic law. However, in May 2022, the OECD Secretary-General acknowledged that practical implementation is more likely from 2024 onward.
How can businesses prepare for implementation?
Though the exact timeline for the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting Two-Pillar Solution is in flux, there are actions that multinational businesses can take to have a head start when this massive framework goes into effect.
First, companies can track the progress of countries in their relevant jurisdictions and confirm which countries are relevant to their operations. Then companies can confirm answers to the following questions. Have those relevant countries already adopted the framework? And, if a relevant country has not adopted the framework, how might this affect the business’s operations and taxation?
Second, though the final action steps are not yet confirmed, companies may want to consider undertaking high-level calculations to determine the additional taxes that may be due upon the framework’s implementation.
Third, multinational companies can consider their internal plans for gathering information on taxation and related requirements. This consideration may require establishing a multifunctional team that goes beyond the taxation department and includes department representatives from both financial accounting and information technology.
As peer review continues and the process moves forward, Bloomberg Tax also continues to provide up-to-the-minute information on potential tax changes in the digital services sphere. Learn more about avoiding unexpected tax burdens from your current or potential digital operations via the related Bloomberg report: Digital Service Taxes and Other Unilateral Measures Roadmap.