Transfer pricing and digital taxation

The arm’s length principle has been a mainstay of international tax policy for decades, but its future is uncertain. As part of its work on taxation and the digital economy, the Organisation for Economic Co-operation and Development (OECD) is consulting on revisions to the profit allocation and nexus rules. With businesses in all sectors becoming increasingly digital, the OECD’s work could dramatically affect current transfer pricing arrangements.

Under the arm’s length principle, group companies aim to set their intercompany transfer prices at the same levels as unrelated parties. The arm’s length principle considers the functions, assets and risks of the parties to the transaction in determining arm’s length pricing. Before the OECD initiated its Action Plan on Base Erosion and Profit Shifting, many countries were concerned that companies were able to apply the arm’s length principle in a way that allowed them to move profits to no or low tax jurisdictions based largely on legal ownership, contractual rights and funding, particularly for intangible property (IP).

However, when the issue was debated during the first round of BEPS talks, the OECD concluded that the arm's length standard itself was not a problem. Rather, the problem was with how the standard was interpreted and implemented in highly complex international arrangements.

The OECD’s BEPS report on Actions 8 to 10 on transfer pricing and value creation — issued in 2015 — set out a new approach to IP ownership and the allocation of associated profits among group companies. This approach considered intangibles in terms of their development, enhancement, maintenance, protection and exploitation (DEMPE). This approach dovetailed with revisions to the OECD’s transfer pricing guidelines on risk allocation, which looked to control over risk in addition to contractual allocations of risk in the determination of risk allocation.

In the wake of these changes, companies reviewed their structures, often moving their IP into countries where they have decision-making substance over their IP development, and also moving people to increase headcounts and therefore substance in tax-efficient locations. Business substance, headcounts and DEMPE were central to the wave of state aid cases that swept Europe shortly after.

As work progressed on the other actions, the OECD delayed work on Action 1 on taxing the digital economy. By the time the OECD was ready to tackle these issues under “BEPS 2.0”, questions about taxing economic activity conducted electronically, with no physical presence, no longer only applied to purely digital companies. Today, digitalization has advanced to the point where most businesses can be considered digital businesses, and the work on taxing the digitalized economy will have much broader impact than originally expected under Action 1. Any notion that the digital economy could be ring-fenced for international tax purposes has been largely abandoned.

In the meantime, some countries believe they are missing out on their share of tax from rapidly expanding digital economic activity, such as from profits generated by social media users within their borders. With no way to tax revenues from users contributing content (e.g. posting photos, product reviews) or viewing ads, some countries have moved ahead with digital services taxes on digital transactions, such as online advertising and sales of user data.

As these unilateral measures continue to spread, the global tax environment stands to become more fragmented and uncertain. This is putting the OECD and members of the Inclusive Framework under more pressure to forge an international consensus on a coordinated approach for the taxation of a digitalized economy.

In January 2019, the OECD issued a policy note proposing to approach these issues through two pillars. The first pillar goes beyond the arm’s length principle to address nexus and profit allocation issues in the context of digital business activity. The second pillar (which is outside this article’s scope) addresses broader BEPS issues and may result in an international minimum taxation framework of some form.

Allocating profits is the key focus of the first pillar. Before the BEPS Action Plan, it was not uncommon for a substantial amount of a group’s profit to be taxable in no or low tax jurisdictions based on contracts and IP ownership. Then, under the concepts developed in the BEPS Action Plan — now commonly called BEPS 1.0 — profit allocations came to be increasingly aligned with DEMPE, with more earnings taxed in countries with more decision-making substance.

BEPS 2.0 will likely attribute more value from remote business activity to the markets involved, allocating a larger share of profits based on the customer base in various locations. Countries such as the United Kingdom have argued that the value created in local markets has grown with the rise of business models that rely heavily on user content and participation. Other countries such as China have long argued that existing rules undervalue contributions of markets to the MNE group’s business more generally and the issue is not restricted to digital activities.

Exactly how profits will be allocated under BEPS 2.0 is still a work in progress. The OECD’s May 2019 program of work sets out three possible options for consideration:

Profits allocated under each of these options would be subject to a new taxing right that captures “business presence” in a jurisdiction that is not constrained by “physical presence”. The nexus workplan is largely focused on implementation of required treaty changes, with nexus determined as a remote taxable presence based on sustained local revenue.

In weighing the three options for profit allocation, many Inclusive Framework members, especially those from developing countries, wanted rules that are administratively simple, using formulas, allocation keys and safe harbors that are easy for taxpayers to follow and tax authorities to verify. However, there are a host of tax, accounting and business issues, such as the allocation of tax losses, that greatly complicate the accurate determination and allocation of profit.

The OECD is therefore conscious of the need for solutions that balance precision against administrability.

On October 9, 2019, the OECD released a new, single proposal for allocating taxing rights for digital economy transactions. This “unified approach” brings together common elements of the three working proposals under Pillar One outlined above. In particular, the OECD recognizes that each of the proposals in Pillar One would grant greater taxing rights over the profits of businesses to the user/market jurisdiction and would therefore require a new nexus rule that would not be based on physical presence in the user/market jurisdiction.

In seeking to reallocate taxing rights, the unified approach would go beyond the arm’s length principle while aiming for simplicity and increased tax certainty.

In announcing the unified approach, the OECD recognizes that existing profit attribution rules work well for most routine transactions. The OECD therefore recommends that current transfer pricing rules be retained but complemented with formula-based solutions to allow for greater taxation in market jurisdictions.

The OECD’s unified approach would therefore:

• reallocate some profits and corresponding taxing rights to countries and jurisdictions where international companies have their markets
• provide that international companies conducting significant business in places where they do not have a physical presence would be taxed in those jurisdictions, through the creation of new rules providing:
  • nexus rules that govern where tax is to be paid
  • rules for allocating what portion of profits are to be taxed.

The OECD will conducted a further public consultation in November 2019 and plans to release an outline of the final architecture for the proposals in January 2020. The OECD’s goal is to finalize its recommendations by the end of 2020.

The initial BEPS discussions focused on profits that were not being taxed anywhere and determining where they should be taxed. But the current discussions involve taking profits that are already being taxed in one place and reallocating them so they’re taxed somewhere else.

For example, consider a company with entities in 100 countries that also sells in an additional 60 countries. Under the unified approach, profits currently allocated among the 100 companies would instead be allocated across 160 countries. This not only changes the company’s tax situation and compliance burden, it also splits the share of profits into smaller pieces, opening the door to potential double taxation and tax disputes.

Achieving consensus on the final recommendations is therefore crucial. The work program acknowledges the need to tackle complex issues regarding the elimination of double taxation and dispute resolution under any newly developed rules.

There’s much work for policy makers to do to develop new transfer pricing principles that will stand the test of time in the digital age. Based on the OECD’s timetable for the work under BEPS 2.0, global businesses will likely need to manage some form of fundamental change to global transfer pricing rules and principles for allocating profit in the next few years.

Tax leaders can make help prepare their companies to manage the impact of digital disruption on global tax policy and chart their best course forward by:

• engaging directly in the OECD’s policy development work to influence solutions and ensure issues specific to their company’s business models and industry are addressed
• engaging with governments, peer companies and industry associations to understand the effects of the OECD’s proposals and contribute to the development of consensus positions
• engaging with their company’s senior management and strategy and business development teams to model and predict the effects of various scenarios on effective tax rates, cash flows and business models
• elevating the profile of global tax issues across the company so all functions take tax into account early in the design and launch of new products, services and business models
• doubling down on the quality and accessibility of the detailed transactional data that may be needed to comply with a new global tax regime.