Making sense of the OECD’s three proposals for revising profit allocation and nexus rules

This is in the backdrop of the OECD’s latest step to issue a consultation paper on the same and seeking public comments.  

QUESTIONS: 

1. What do the OECD’s recent proposals for revising profit allocation and nexus rules simply state? Please illustrate with the modern day examples?

*User participation proposal 

This proposal seeks to allocate the taxing right of multinational enterprise on the basis of “user base” instead of local physical presence, which is a traditional criterion. It is based on the idea that active participation of users is a critical factor of value creation for certain highly digitalised businesses.

It recognizes that the traditional model does not include the value generated by user participation in user jurisdictions where profits should be allocated and taxed. Therefore, the proposal seeks to revise profit allocation rules to include the value-creating activities of an active and engaged user base. This proposal is most significant to the highly digitized business models such as social media platforms, search engines and online marketplace.

*Marketing Intangibles proposal

Marketing intangible refers to an intangible that relates to marketing activities which aid in the commercial exploitation of a product/ service having an important promotional value for the product concerned. Marketing intangibles may include trademarks, trade names, customer lists, customer relationships, proprietary market and customer data that is used or aids in marketing and selling goods or services to customers.

The proposal seeks to revise profit and nexus rules to incorporate marketing intangibles as a base of allocating the taxing rights recognizing that such intangibles facilitate the sale by creating favourable attitudes in the minds of customers and helps in devising the marketing strategies as per the demand and expectation of the consumer. Therefore, the proposal addresses the situation where a multinational group can essentially reach into a jurisdiction, either remotely or through a limited local presence for developing a user/customer base and other marketing intangibles.

The proposal would require that the non-routine or residual income of the multinational group attributable to marketing intangibles and their attendant risks be allocated to the market jurisdiction.

For eg., marketing intangibles such as microdata on customers/ potential customers, including their interests and preferences, customer lists, proprietary market etc, acquired in exchange for free services, such as free search functions, free emails etc helps company to enhance its sale by enabling it to understand the demands, customer behavior, expectation and type of market.  

*Significant Economic Presence 

Significant Economic Presence is the presence of a non-resident in another country owing to its significant economic interests without having any physical presence. It encompasses any transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India if the aggregate of payments arising from such transactions during the previous year exceeds the prescribed threshold; or systematic and continuous soliciting of its business activities or engaging in interaction with prescribed number of users in India through digital means.

As per this proposal, a non-resident enterprise would have a taxable presence in a jurisdiction if it has a significant economic presence determined on the basis of purposeful and sustained interaction with the jurisdiction via digital technology and other automated means.

It is based on the view that the digitalization of the economy and other technological advances have involved business enterprises heavily in the economic life of jurisdiction without having any significant physical presence. Provision of services of streaming of e-content (audio/video), interaction with customers such as for troubleshooting, etc, and provision of online training/gaming services could be few examples.

2. What is your broad sense of such proposals? How do they look like for countries like India?

All three proposals identify the inherent consideration in the digital business models and are accordingly designed to reframe the basis of allocating taxing rights. Though the proposals are well-thought ideas driven by a thorough analysis of the structure of digital business models, its application would require concrete basis such as identification of user-base, presence of marketing intangibles etc. Such proposals depend on different factors for their successful implementation. Both proposals, “user participation model” and “marketing intangibles model” would have the effect of increasing the share of business profit allocated to countries in which users or customers are located. The user participation proposal emphasizes the value that digital businesses generate from the engagement, interaction and contributions of users, including content, data and powerful network effects. However, the marketing intangible proposal emphasizes the intrinsic factual link between a market jurisdiction and marketing intangibles related to that jurisdiction, while suggesting that loyalty of an active and engaged user itself could be considered a type of marketing intangible. Significant economic presence (SEP) proposal has already been applied in India by widening the definition of Business Connection of a non-resident under the domestic law. However, any proposal of OECD will have to be applied multilaterally in order to become effective. Like in India, the proposal of SEP does not impact the non-residents of countries with which India has a tax treaty.

3. What are the pros and cons of each one proposal prescribed? Please substantiate the responses with day-to-day instances? 

User participation model

Under the user participation proposal, it could be argued that the value created through users does not constitute value created by the business but by third-parties, that are more akin to suppliers than employees. Furthermore, if the conceptual motivation behind the user participation proposal is accepted, there arises another question as to whether it has relevance beyond the digital-centric businesses, and whether the narrow scope proposed would prove sustainable over time as digitalization impacts other traditional businesses.

Marketing Intangible proposal

The intrinsic link between marketing intangibles and a market jurisdiction could be questioned, particularly where marketing activities are undertaken outside of that jurisdiction and not significantly tailored to local customer habits and preferences. Also, whether such proposal would apply to a business that sells business-to-business, having substantial marketing expenditure and valuable trademarks, brands, or goodwill but does not leverage digital technology and customer data in delivering highly targeted/personalised marketing in the same way as consumer-facing businesses.

Significant Economic Presence

Determining SEP of an entity in another jurisdiction shall be a subjective exercise since the same is based on certain thresholds viz., user base, revenue base etc. Further, thresholds for each jurisdiction shall have to be unique and dependent on its demography, demand etc.  This proposal would tend to increase compliance obligation and include administrative and practical challenges on implementation.

4. Do you have any suggestions for the tax collectors in the world with regards above?

The principles enshrined would provide ease to the tax authorities in identifying the relation of income generated through digital businesses with the jurisdiction. Earlier, the conduct of litigations was more cumbersome as there were no guidelines for tax authorities to deal with digital revenue. Where on one side, complexity would reduce, the tax authorities have to be more vigilant for details while scrutinizing the cases in order to substantiate the presence of key indicators governing the taxation of digital businesses. Unlike physical presence, the cases would be investigated considering the virtual presence, detailed information and its thorough analysis would be required to govern the taxation of income flowing through the digital business.

5. Public comments are sought on the consultation paper after which the G20 meeting will happen. What should the CFOs of the world watch out from this mega event? 

The Task Force on Digital Economy (TFDE) is yet to issue its final report on addressing the tax challenges on the digitalized economy. The report would include all the conclusive methods for taxing the income of digitalized businesses. The consultation document gives a flavour of what the TFDE can bring in its report. Public comments on the proposals laid down by TFDE may bring certainty in the type of business model impacted by these proposals and the factors that may be relevant for framing the new nexus rules. It would enable a business to evaluate the merits of using the different profit allocation methods including residual profit split method and fractional apportionment method.

6. Lastly, what do you think of the overall progress made so far in the context of tackling tax challenges of the digitalised economy or Simply Action 1 of the BEPS Package? 

BEPS Action plan -1 gave certain suggestions viz. Equalization Levy, SEP and VAT, that could be incorporated in the domestic law by the countries to tax the digital economy. Many countries have adopted unilateral measures to deal with the tax challenges of the digital economy individually, without waiting for the consensus bases solution of OECD due in 2020. Amongst the different measures taken worldwide, India adopted the concept of equalization levy and SEP in its domestic tax laws, EU proposed to introduced interim tax, US proposed to tax MNC’s profit from marketing activities. Aforesaid are only a few actions, many other countries have also taken such steps unilaterally. However, the unilateral measures may increase the complexities in the governance of the taxation system and conduct of global businesses. The ideal situation would be to have a consensus-based solution to be applied multilaterally.

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Contributing Advisors