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.