In Brief

OECD and Taxation of the Digital Economy

April 4, 2022
OECD and Taxation of the Digital Economy

IN THIS ARTICLE

How have the OECD countries and other governments responded?


Pillar One

  • What is the impact of Pillar One?
  • How will Pillar One be implemented?


Pillar Two

  • What is the impact of Pillar Two?
  • How will Pillar Two be implemented?


Digital Service Taxes (DSTs)

  • What will happen to DSTs?
  • What is the Unilateral Measures Compromise?


Indirect tax and the digital economy


The digital economy has weakened governments’ ability to tax business income from foreign activities. Digitalization has undermined the traditional structure, in which businesses normally had some sort of physical presence – referred to as a permanent establishment – in a given jurisdiction that gave authorities a tangible basis against which to secure tax compliance.

E-commerce now enables entities to sell goods and many services to customers located anywhere in the world without a local physical presence. It also means the revenue they generate may not touch the jurisdiction’s financial system, removing a connection that would otherwise allow monitoring of transactions and enforcement.

The expansion of e-commerce has also raised the importance of intangible assets – mainly intellectual property – as a factor in the income generation process. The 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.

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How have the OECD countries and other governments responded?

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 Base Erosion and Profit Shifting (BEPS) initiative, and has since morphed through many iterations. The OECD/G20 Inclusive Framework on BEPS addresses the tax challenges arising from the digitalization of the economy through the Pillar One and Pillar Two proposals.

Pillar One establishes new nexus and profit allocation rules for large multinational enterprises that meet certain revenue and profitability thresholds and expands the taxing rights of countries to tax activity carried on there regardless of physical presence (“market jurisdictions”). Pillar Two establishes mechanisms to ensure large multinationals pay a 15% minimum level of tax regardless of where they are headquartered or the jurisdictions they operate in.

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.

137 member countries of the Inclusive Framework have agreed to the Two Pillar solution. The new rules are generally planned to be implemented by 2023.


VIDEO: Will the Global Minimum Tax End the Race to the Bottom?


Pillar One

What is the impact of Pillar One?

Pillar One 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. The Pillar uses revenue sourcing rules to determine whether revenue derives from a market jurisdiction and profit allocation rules to allocate profits to 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?

Pillar One will require changes to both domestic law and double tax treaties. A Multilateral Convention (MLC) will be implemented to supersede existing tax treaties and allow market jurisdictions to tax the allocated profits. This is expected to be developed and finalized in early 2022

There will be a “high-level” signing ceremony by mid-2022, after which jurisdictions are expected to ratify the MLC as soon as possible, so it can it to enter into force in 2023.

Model rules for amendments to domestic legislation to give effect to the taxing right under Pillar One are to be developed in 2022 with it being effective in 2023. The provisions related to baseline marketing and distribution activities are expected to be finalized by the end of 2022.


Pillar Two 

What is the impact of Pillar Two?

Pillar Two ensures that multinational enterprises pay a minimum level of tax, regardless of where the headquarters are located or which jurisdictions the company operates in. The 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.

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How will Pillar Two be implemented?

Model rules to implement the global minimum tax were issued on December 20, 2021, with the key aspects of it generally 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 implementing Pillar Two on December 22, 2021, with EU Member States being required to transpose the final version of the directive into domestic law, to be implemented as of 2023. However, a revised text that has been issued suggests a possible delay to 2024.


Digital Service Taxes (DSTs)

The difficulties the OECD has faced in achieving a global consensus have led to numerous countries implementing unilateral measures, in particular DSTs, to protect their tax base and tax income arising from certain digital activities derived within their jurisdiction. DSTs generally apply as a tax on gross revenue derived from various digitally provided services.

What will happen to DSTs? 

To implement Pillar One, the MLC will require the removal of DSTs and other relevant similar measures for all companies.

The October 8, 2021, statement provides that no newly enacted DSTs or other relevant similar measures are to be imposed from October 8, 2021, until the earlier of December 31, 2023, or the coming into force of the multilateral convention to give effect to Pillar One.

However, this did not address the treatment of existing DSTs.

A number of countries have reached an agreement with the U.S. as to the treatment of their existing DSTs pending the implementation of Pillar One. This is known as the Unilateral Measures Compromise.

What is the Unilateral Measures Compromise?

The Unilateral Measures Compromise is a solution – agreed upon by the U.S. and Austria, France, Italy, Spain, the United Kingdom, Turkey, and India – that covers the interim period between January 2022 (April 2022 for India) and the earlier of the date Pillar One formally takes effect or December 31, 2023 (March 2024 for India).​

Under the compromise, these countries can keep their existing DSTs in place until the implementation of Pillar One of the OECD agreement. However, corporations that are subject to DSTs may receive a tax credit against future tax liabilities.

In return, the U.S. agrees to terminate proposed punitive trade actions under Section 301 of Trade Act of 1974 and to refrain from imposing further trade actions against these countries.


Indirect tax and the digital economy

Digitalization of the economy creates challenges from an indirect tax perspective. Businesses that provide electronic services or goods through e-commerce may structure their affairs to pay little or no VAT on remotely delivered services and intangibles, or to avoid import VAT on inbound supplies of low value goods ordered via e-commerce.

The European Commission has implemented two Council Directives with implementing regulations on B2C digital services (so-called “electronically supplied services”) and e-commerce in goods.

Broadly, the EU aims to impose destination-based VAT on the digital economy, simplify cross-border trade in the EU and reduce the administrative costs of VAT compliance. The EU also aims to enable EU businesses to compete on an equal footing with non-EU businesses by eliminating certain advantages that non-EU businesses previously enjoyed, such as import VAT exemptions for low-value imports. EU Member States were required to transpose the Council Directives into domestic law in stages, between January 1, 2010, and July 1, 2021

The OECD delivered guidance on how to collect VAT on cross-border sales, beginning with the International VAT Guidelines, released in 2015 and updated in 2017. These guidelines set nonbinding international standards for the treatment of international trade in services and intangibles. Their aim is to simplify the administration of the VAT regime, increase tax certainty for compliant businesses, and reduce double taxation and opportunities for VAT fraud.

The guidelines support the application of the destination principle as a mechanism for allocating the taxing right and advise that business-to-consumer (B2C) transactions, like their business-to-business counterparts, should be taxed in the jurisdiction where the customer resides.

The OECD recommends that foreign B2C service providers register and account for VAT in the jurisdiction where the customer is located, generally via a form of simplified registration process.

The OECD has also issued reports on Mechanisms for the Effective Collection of VAT/ GST When the Supplier Is Not Located in the Jurisdiction of Taxation (2017) and on The Role of Digital Platforms in the Collection of VAT/GST on Online Sales (2019). The report on the role of digital platforms advocates making digital platforms liable for the VAT/GST on sales they facilitate.

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