The principles underpinning our current international tax rules, which allocate taxing rights over a company’s global profits, date back over 100 years. They are about as compatible with digital business models as dinosaurs with smartphones.

As part of the ongoing effort to nudge the tax world into the modern era, the tax officials at the Organisation for Economic Co-operation and Development (OECD) have released their latest proposal to address the tax challenges stemming from the digitalisation of the economy and globalisation.

It lays the platform for further discussion and negotiation by more than 130 countries that are part of the OECD’s Inclusive Framework on Base Erosion and Profit Shifting, early next year, to reach an agreed way forward by the end of 2020.

The proposal aims to answer the question that has been puzzling tax administrators, Governments and multinational businesses for years now: What is a fair and appropriate basis for allocating global profits in the modern, increasingly digital, business environment, when physical presence in a country (the traditional profit allocation basis for tax) is no longer relevant for many businesses?

The key components of this latest proposal are all subject to considerable further development, consultation and negotiation, but if a way forward is agreed, will result in material changes to how global profits are split and taxed between countries. 

• Under the current rules, a company operating in a foreign jurisdiction must typically have “physical presence” (usually “bricks and mortar” or in-country sales staff) in order for its business profits to be taxable there. The new approach will be applicable in any situation where a business has “sustained and significant involvement” in the economy of the jurisdiction. Sustained and significant involvement can be achieved through consumer interaction or certain other activities such as advertising or data collection. This, in effect, provides a return for market, rather than just physical presence.
• It follows that this new approach will catch not only businesses with highly digitalised models, but potentially any consumer facing organisation with international operations. This means that the scope of the proposal is broad and the new rules will impact more businesses than initially expected.
• Sales based threshold tests, measured at both a global and local level, are likely to apply before a multinational group is caught by the new rules.  These thresholds have yet to be set, but are aimed at avoiding smaller multinational operations from being caught. Carve-outs for certain sectors (such as mining and commodities) are also proposed, but their exact scope will need to be developed and agreed.
• If a multinational group’s operations are caught under the proposal, new profit allocation rules will determine how much of its profits will be subject to tax in each country.
• The proposal introduces a formula based approach, which include a base level of remuneration for marketing and distribution functions (where they exist in a country) with the residual profit considered to relate to market presence. This deemed residual profit is the heart of the change. It is this limb that potentially increases taxable income for some countries (and reduces it for others). 

Although simple on the surface, as one delves deeper, the complexities become apparent. Modern business models are complex, varied and multi-layered. The challenges with definitions and thresholds alone are numerous, and questions around what to do with loss making groups, or companies with multiple business lines with different profiles, will need to be addressed. 

For New Zealand, the exclusion of our primary industries (commodities) from the scope of these rules may well determine whether “NZ Inc” is a net fiscal winner or loser from the changes.

This is incredibly important work and the political drivers for change are strong, with civil society concerns about multinationals not paying their ‘fair share’ of tax and frustration around the time being taken for reform.  

A successful outcome, however, depends finding a final set of rules which are satisfactory for 134 countries, each with different economic and political drivers. There will necessarily be “winners” and “losers”. It makes an orderly Brexit seem easy.

However, failure to reach agreement could undermine the credibility of the OECD and multilateral approaches to addressing global issues. It will encourage more countries to enact local tax measures. Ultimately, this could result in large-scale double taxation for multinationals and huge complexity in, and barriers to, international trade.

With the stakes high, and the subject matter hugely complex, progress is going to require compromise on all sides. This is likely to be the tax battle of our generation.

For further information, please contact Kim Jarrett or Nadia Fediaeva.