The OECD’s digital tax proposal: untangling the impact of ‘Pillar One’ on developing countries

Last week the OECD secretariat published its proposed ‘unified approach’ to update corporate tax rules for the digital era, or at least for one of the project’s two pillars. The proposal is designed to be “the basis for a negotiation that could result in a political agreement by mid-2020.” This agreement is to be made via the G20/OECD Inclusive Framework, which has 134 country members, including 24 from Africa (at the last count – it’s hard to keep up). I previously wrote about Africa’s response to this project, based on my participation at a conference organized by the African Tax Administration Forum. So, now that the OECD’s proposal is out, what can we say about its potential impacts on developing countries?

The new OECD proposal

The explicit purpose of Pillar 1 is to reallocate a share of multinational companies’ taxable profits to ‘market jurisdictions’. It includes three ‘amounts’:

  • Amount A’ gets all the attention. The top line of the whole project is often reduced to a point about how digitalization allows companies to have a significant participation in the economic life of a country without being physically present there. Amount A overcomes this by means of a ‘new taxing right’ that does not require a physical presence. It also gets tax nerds very excited because it allocates profits by means of a formula, which until recently was anathema to the OECD. But as I discuss below, it may not be where the biggest impact on developing countries is to be found.
  • The Pillar 1 proposal would also allocate some profits (‘Amount B’) to companies’ marketing and distribution functions, and says that “the possibility of using fixed remunerations would be explored.” This only applies where there is a physical presence, so it might not seem as radical as Amount A. However, it is interesting for developing countries, for a couple reasons. First, they often complain that multinationals manipulate the profits of their distribution companies downwards as a tax planning technique, and that existing tax rules do not capture the value creation of localized marketing functions. Second, the use of a simplified approach here – something that ICTD research has pointed towards – also sets an interesting precedent.
  • Let’s not forget ‘Amount C’. This allows a country to challenge the amount that it has received via amounts A and B, adjusting the total upwards by using traditional transfer pricing methods if it considers that appropriate. Even so, the language of Amount C in the secretariat proposal actually shifts the focus onto something else. It opens as follows: “Any dispute between the market jurisdiction and the taxpayer over any element of the proposal should be subject to legally binding and effective dispute prevention and resolution mechanisms,” something of a vexed topic for developing countries.

Here are some further questions, concerns and observations about the proposal:

We do not know how much, if anything, low-income countries will gain from the different permutations

There are a lot of reasons for this: many moving parts that might affect the proposal significantly; the lack of good quality data for developing countries; the need to model the dynamic effects of the proposals, that is how companies’ behavior might change. The OECD’s report to the G20 states its preliminary finding that “Overall, on average, low and middle-income economies would gain from Pillar One, experiencing a higher rate of increase in revenues than high-income economies even though, larger market jurisdictions will benefit more in absolute.”

It will be important to look at the winners and losers producing that average result when the OECD work is published. There’s a variety of ongoing work to model the impact of formulary approaches to allocating the tax base, but the reported findings – including those published by Alex Cobham, Tommaso Faccio, and Valpy FitzGerald this week –  suggest that a sales-only approach, as proposed under Pillar 1, produces more losers among developing countries than one that incorporates sales and labour. By the key decision point of January 2020, we may still not be able to say with any confidence how low-income countries will be affected.

Carve-outs and thresholds could reduce the utility of Pillar 1 for low-income countries

While the scope of Pillar 1 is now greater than just the highly-digitalised companies whose tax affairs triggered discussions, it is likely to be limited in a number of important ways:

  • The company threshold. In discussions at the International Fiscal Association (IFA) conference last month, it was suggested that the turnover threshold at which Amount A would apply could be more than €750m. Only the world’s largest companies will be affected. To take one example, Jumia, which is perhaps Africa’s best known e-commerce firm, turned over just €130m last year.
  • The revenue threshold. Amount A will only kick in once sales and/or users exceed a certain amount. This can work against less wealthy countries, where sales are naturally lower in absolute terms. The proposal helpfully leaves open the possibility of adapting this threshold to the size of the market, as well as somehow including non-paying users.
  • The residual profit threshold. Amount A only applies to a company’s ‘residual’ profits, which cannot be easily tied to specific parts of the business and are particularly high for digital companies. The residual profit would essentially be any profit above a fixed rate deemed to be the ‘routine’ profit rate, which will be negotiated within the Inclusive Framework. The higher that rate, the smaller the amount of profits that will be redistributed under Amount A. Chip Hartner, the US representative speaking at IFA, said his country’s position was that the residual profit threshold should be set high enough to isolate only the most important cases.
  • Carve-outs. As expected, the proposal states clearly that the new approach is not suitable for oil, gas and mining companies, but it suggests that it may exclude commodities and financial services, and that it will apply to consumer-facing businesses. What does this mean for developing countries? They may benefit from the exclusion of sectors where their position is primarily within value chains, and where they do not have large consumer markets, but sectoral carve-outs could also limit the application of the ‘new taxing right’ significantly.

Put this all together, and under Amount A we have a redistribution of the tax base that low-income countries may gain from. Their gains will be limited to companies larger than a certain overall threshold, which have a presence in their market above a certain threshold, only in certain sectors, and only to their profits above a certain amount. And all of those ‘certain’ elements are still under negotiation!

What difference will segmentation make?

The proposal suggests at various points that each of its elements might not apply uniformly, but might apply differently between and within companies, according to different segments, business lines, sectors and/or regions. What will this mean for low-income countries? If any fixed return under Amount B were to vary by sector, the value of the return in sectors of relevance to developing countries would be a critical matter for negotiation. Meanwhile, the possibility of a regional segmentation under Amount A needs careful consideration, given that Africa is commonly described as the continent with the highest return on investment.

The potential costs of participation

In addition to the potential gains for lower-income countries, there are a few costs from participation that merit consideration. For example, some larger developing countries currently tweak international tax rules to give themselves a larger share of the tax base.  Wilson Prichard and I have written about how China adds to international tax rules to give itself a ‘market premium’, which is now covered by Amount B. Others have implemented, or are considering, unilateral measures to help them tax digital companies, such as India’s equalization levy. The eventual package proposal from the Inclusive Framework is likely to include a moratorium on these kinds of measures, which may limit lower-income countries’ ability to innovate or to emulate. The text of the secretariat proposal makes clear that they will also be subject to mandatory and binding dispute settlement procedures. This could mean that, regardless of how well the eventual settlement works for them, lower-income countries that join may be unable to deviate from it.  A final point is that, while this is a simplification, it is also a whole new set of tax rules that will need to be applied domestically, creating an opportunity cost for countries that are often still getting the legislative and administrative basics in place.

The OECD secretariat responded robustly to the Tax Justice Network’s claims that developing countries would not gain from its proposal, by pointing out that developing countries are now at the table. As the head of the BEPS project Pascal Saint-Amans said “We now serve all these countries and a compromise will have to be found among all of them.” We may gain some indications of the politics of negotiations between developed and developing countries inside the Inclusive Framework as we see how the issues outlined above are worked through in the months ahead.

First published by ICTD.

Response to the OECD consultation on taxation of the digital economy: taking the politics seriously

Yesterday I was part of a group of political scientists who made a submission to the OECD’s consultation on taxation of the digital economy. The text of our submission, also available as a PDF document, is below, first published on Rasmus Christensen’s website.

The undersigned are a group of political science academics working on issues of international taxation. Such a coalition has rarely involved itself in the OECD’s technical consultations. This submission reflects two compelling factors. First, the global tax system and its governance stand at a critical junction. The current debate on solutions to the tax challenges of digitalisation has the potential to shape global tax policy and its outcomes for countries and citizens across the world for decades to come – and this has motivated us to prepare this submission. Second, our research offers important insights that can help the global tax policy community pursue sustainable reforms. Below, we offer some general comments before moving to specific responses to the consultation questions.

Vincent Arel-Bundock, Université de Montréal; Rasmus Corlin Christensen, Copenhagen Business School; Lukas Hakelberg, University of Bamberg; Martin Hearson, London School of Economics and Political Science; Wouter Lips, Ghent University; Thomas Rixen, University of Bamberg; Indra Römgens, Roskilde University and Radboud University; Leonard Seabrooke, Copenhagen Business School; Laura Seelkopf, Ludwig-Maximilians-Universität München; Saila Stausholm, Copenhagen Business School; Duncan Wigan, Copenhagen Business School

General comments

We wish to highlight three key considerations for effective and sustainable action on the tax challenges of digitalisation.

  1. The objectives of the consultation and the taxation of the digital economy policy discussion more broadly are as much political as they are technical. By ‘political’ we mean that the drivers of this consultation are rooted in the popular politics of taxation, and that the political implications of policy solutions are not incidental or secondary considerations. This includes the consequences for inter- and intra-national (re)distribution, for citizens’ experiences of fiscal systems, for the viability of global tax governance, and for the wider economic transformations occurring as a result of digitalisation, where tax policy will help determine winners and losers. Historically, the relative isolation of international tax policy-making from popular politics helped produce a remarkably stable cross-border tax system. However, isolation challenges responsiveness to political demands for change. In today’s context, international tax politics has become both more mainstream and highly politicized. The risks of not engaging proactively with diverse political stakeholder interests – including ordinary citizens, civil society, business groups (large and small), academia, etc. – are significant. For instance, one reason for the recent struggles of multilateral trade cooperation is that the trade agenda extended into areas where social and environmental concerns implicated new political actors. Yet, the multilateral regime continued to treat these issues through a narrow trade lens. Technical approaches to taxing the digital economy are unlikely to be sustainable unless their substance and the process by which they were produced are perceived as fair by a broad range of stakeholders.
  • The recent expansion of the OECD’s tax policy-making institutions to include non-OECD members brings important dilemmas. While this expansion represents an important step towards global inclusiveness and accountability, it also calls into question the balance between inclusiveness and the coherence of the global tax system itself. Global economic shifts are raising the profile and influence of historically marginalised countries in global economic governance. In some cases, incrementalism has been enough to satisfy ‘rising powers’; in others, dissatisfaction with the status quo has led to the pursuit of outside options or to stalemate over wholesale reforms. The balance between building on the work undertaken over decades and responding to these new challenges is critical for achieving effective and coherent global action on the tax challenges of digitalisation. Institutional expansion at the OECD challenges the historical division of labour between the OECD and other bodies for international tax cooperation (such as the United Nations), which allowed one group of like-minded countries to move quickly while the process of global consensus-building could take place at a necessarily slower pace. We believe that the success of institutional expansion is contingent on a serious reconsideration of policies and processes that were not historically designed to accommodate the interests of emerging and developing countries. To turn again to the example of international trade cooperation, developed countries’ unwillingness to respond to developing countries’ longstanding concerns about agricultural protectionism was a major contributor to the breakdown of the talks.
  • The move towards binding, global cooperation on taxation creates costs as well as benefits. The reluctance of governments to enter into binding cooperation has shaped the global tax system for a century, at times hindering effective action and enabling harmful tax competition. Commitments to strong cooperation on international taxation are a key prerequisite for governments’ abilities to make and enforce fiscal policies in their own interests. Moreover, given the significance of the tax challenges of digitalisation, and the increasing willingness of states to act unilaterally, the risks of furthering cross-national mismatches and unintended externalities (in the form of double taxation or double non-taxation) in the international corporate tax system are high. Nonetheless, setting the bar too high creates a risk of short-term failure, as the OECD experienced in the past with the Multilateral Investment Agreement, or long-term instability as countries defect from binding agreements. In this context, the sustainability of any policy option depends on managing effective cooperation that prevents harmful tax competition while recognising that it is contingent on meeting the interests and expectations of all its members, and limiting incursions into the design of national tax systems when such a balance is not feasible. Moreover, it is important that each government is open and transparent with its domestic stakeholders about the likely costs and benefits of entering such cooperation

Specific comments

What is your general view on the proposals? In answering this question please consider   the   objectives,   policy   rationale,   and   economic   and   behavioural implications.

  • Distributional considerations should be foregrounded. Discussing the three suggestions on revised profit allocation and nexus rules, the consultation document usefully acknowledges that while they all have the objective of recognising value created in market jurisdictions, their implications for shifts of taxing rights are different. These differences, which we take to be highly significant, have implications for the considerations on effective action outlined above. Of the three proposals, the ‘significant economic presence’ idea, given its greater sectoral scope, seems to offer the potential to shift taxing rights covering most profit, although this would naturally be contingent on the final design of the mechanics.
  • The emerging differences between taxation on the basis of source and residence vs. market/destination merit further consideration. The Inclusive Framework is committed to considering solutions that reallocate the tax base. In today’s economy, the distinction between source and residence taxation is indeed increasingly unhelpful; yet, there is a risk that a singular emphasis on ‘market jurisdictions’ may unduly disadvantage traditional source jurisdictions without sizeable markets and limited purchasing power. The interests of these jurisdictions – often less powerful and underrepresented at the OECD – should receive significant attention.

How would you suggest that the rules should best be co-ordinated?

  • Coordination design is contingent on meeting stakeholder expectations. A number of implementation measures are available to the Inclusive Framework, including standard-setting, peer review, blacklisting and sanctioning, which have proven effective to varying degrees. These measures differ in their balancing of binding ‘lock-in’, national flexibility to pursue government policy choices (especially as regards raising effective capital taxation), and international redistribution. All of these critical considerations are interrelated and must be taken into account together in coordination design. For instance, the reopening of the distributional debate on allocation issues has become necessary because of the challenges faced by the current international tax system in enforcing effective capital taxation. Thus, on the one hand, should a workable and commonly agreeable solution that matches all members’ distributional interests and national policy choices be found, strong and binding cooperation is preferable. If, however, and we see a real risk of this, the envisaged solution is unfavourable to emerging/developing countries (see previous paragraph), then strong and binding cooperation is undesirable.

What could be the best approaches to reduce complexity, ensure early tax certainty and to avoid or resolve multi-jurisdictional disputes?

  • The consultation should seek to refocus public debate away from ex post criticism of the outcomes of tax rules once they are implemented, and towards ex ante debate over rules as they develop. A core component of tax certainty is political stability – the certainty of a tax position given the likelihood of future political action affecting that position. Such action may be in the form of legislative initiatives that change tax results, changed administrative practice, or public pressure on companies to alter approaches to tax planning. The stability of any policy solution(s) on the tax challenge of digitalisation developed by the Inclusive Framework depends critically on engaging with the voices and objectives of a broad range of stakeholders, and on a reconsideration of entrenched interests. In this context, the limitations of the consultation to primarily consider ostensibly technical questions on ‘aligning value creation’ may hinder positive engagement with a broader range of stakeholders. Such consultation design erects barriers of language and expertise that limit diverse engagement, closing off stakeholder engagement. In turn, this may negatively affect the likelihood that its policy outcomes will be broadly seen as fair.
  • Deeper and broader stakeholder engagement. In this context, we encourage the OECD and the Inclusive Framework to pursue more proactive engagement with non-traditional and diverse stakeholders in relation to the tax challenges of digitalisation. At the national level, this should mean an active approach to education and consultation with stakeholders around national negotiating positions, and parliamentary debate over the adoption of new rules that moves beyond the rubber-stamping that has thus far characterised the adoption of BEPS outcomes by most countries. At the multilateral level, this would go beyond the currently institutionalised TUAC and BIAC partnerships and the few substantive consultation letters received from non-expert interests, and would include sustained interactions on questions of the political implications of the tax challenges of digitalisation, including the inter- and intra-national distributional implications. Inspiration could, for instance, be drawn from other policy domains of the OECD where non-state actors have been successfully integrated through increased voice and access channels, implementation partnerships, institutionalised reviews, etc. More generally, we suggest the Inclusive Framework could – at a minimum – set out its formal ambitions for the involvement and diversity of stakeholders in global tax policy-making, and specific initiatives to achieve these ambitions.