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Taxation of the digital economy is on the horizon – OECD proposal for a unified approach

The OECD has responded to the new business models that have arisen in the course of the digital transformation and, on 9.10.2019, it presented a proposal for the allocation of taxing rights. A key aspect of this ‘unified approach’ is establishing a connection with sales irrespective of any physical presence. This concept will radically change the international tax system that has traditionally been based on subsidiaries and permanent establishments.

Unified Approach – Three become one and a new nexus

At the beginning of 2019, the Task Force on the Digital Economy deployed by the OECD presented three proposals as follows.

The user participation model – According to this, the users create value and the states where these users are based do not participate in the value creation (proposal for profit sharing via a residual profit split).

The marketing intangibles model – According to this approach, so-called marketing intangibles are developed in the state where the users are based.

Significant economic presence – This approach assumes that a digital permanent establishment is created that profits from its local presence through its digital activities.

All three approaches are aimed at extending the taxing rights for states where customers or users of the digital business models are located. On the basis of these three approaches the OECD has now developed a ‘unified approach’. This is supposed to form the so-called Pillar One, which addresses the assignment of taxing rights to market states. Here, the nexus for taxpayers would be based on sales irrespective of any physical presence.

Sequence of steps according to the unified approach

The approach provides for profits to be allocated irrespective of whether or not there is a subsidiary or a permanent establishment in the country where the digital sales are realised. A marketing or distribution presence or an independent sales partner would thus no longer be the prerequisites. Current transfer pricing rules would be retained but complemented with formula-based solutions. The OECD profit allocation approach consists of a three tier mechanism, which is however still quite abstract. For a better understanding of this approach, in the next section we provide a description of the sequence of steps that is clearer than the one in the OECD proposal:

  • (1) Calculation of the overall profit to be allocated (e.g. group EBIT).
  • (2) Calculation of the residual profit for the state where the head office is located and for the market states by deducting routine remunerations from the overall profit.
  • (3) All the parties involved in marketing and distribution functions would receive routine remunerations from the residual profit.
  • (4) The remaining profit would be divided up as follows. First of all, the state where the head office is located would receive a minimum return. If the remaining profit exceeds this minimum return then the market states would once again receive a portion of the residual profit and the other portion would remain in the state where the head office is located.
  • (5) For special cases – for example, if a (market) state claims a greater share of the profit – a compulsory mutual agreement procedure would apply.

Uncertainties with regard to the application of the unified approach

The unified approach constitutes an intervention in current transfer price formation practice. If, up to now, prices have been formed on the basis of the arm’s length principle then the unified approach would require a rethink. After the Federal Fiscal Court (Bundesfinanzhof, BFH), in its ruling from 26.2.2019, overturned free transfer pricing by associated enterprises (Art. 9 OECD MTC) and decided on a substantive adjustment in accordance with the national standard (Section 1 of the German External Tax Relations Act), now it is the OECD itself that is making an intervention. Other uncertainties have arisen because, up to now, the scope of application has not been clarified. The proposal admittedly discusses consumer-related companies. This would certainly cover the ‘B2C’ area, but probably also B2B business models.

Outlook: The OECD proposal for Pillar 1 was released to the public for written comments until 12.11.2019 and this will now be followed by a public consultation meeting, which will take place on 21./22.11.2019. The draft for Pillar Two, which will focus on the issue of minimum taxation, is likewise expected in November.

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