OECD PROPOSED RULES ON TAXATION OF DIGITALIZING ECONOMIES
By: Euney Marie J. Mata-Perez on November 14,2019
NEW rules on taxation of digitalized transactions are being proposed by OECD (Organization for Economic Co-operation and Development), and these rules will be game changing in international taxation.
The power of taxation is exercised by each state. It is generally exercised over territories, activities and subjects within the state’s jurisdiction. Stated differently, there has to be some connection or so-called “nexus” between a state and the taxpayer before the state can impose taxes on the income or transaction of the taxpayer. If a nexus is established or present, the taxpayer generally must pay taxes on income generated from that state.
With respect to foreign entities that are not registered taxpayers in a state, a nexus will arise if it derives income within the other state or it undertakes transactions that takes place within the taxing jurisdiction of the state. In this regard, our Tax Code imposes income tax only on Philippine-sourced income of foreign corporations and alien individuals. To determine what is Philippine-sourced income, our Tax Code provides for ”source rules.” For instances, service income is deemed Philippine-sourced if the services are performed in the Philippines. For sale transactions, if the sales take place here.
Domestic tax rules, however, may be modified by income tax treaties entered into between contracting states. Under existing tax treaties, even if a foreign entity from a treaty state derives business income from the Philippines, it will not be subject to income tax and thus be exempt if the income is not attributable to a permanent establishment (PE) of the entity in the Philippines. A PE under the traditional treaty model is generally a fixed place of business, such an office, branch or warehouse. This concept includes the designation of an agent that is not independent and in certain treaties, has evolved to include the provision of services in a state for a certain period, which is usually six months.
In summary, under the present regime, physical presence in a country or the lack of it would be key in taxing income.
But in our digital age, substantial economic activity can be conducted by a foreign entity in another country remotely with no or minimal physical presence. Businesses can project themselves to consumers and create consumer values in various jurisdictions without traditional physical presence in the market. Thus, it is now the view that for these transactions, the allocation of right to tax can no longer be based on physical presence alone.
Is has then been recognized worldwide that there is a need to redefine what is the nexus or tax rules for the digitalizing economy. But such rules should be commonly agreed by the various taxing jurisdictions. Without such agreement, each country could promulgate their own local rules on how to tax such digital transactions. Countries could claim nexus on the same income arising from the same taxable transaction. With this unilateral approach, the risk that income from digital transactions becomes subject to double taxation then becomes high.
In this regard, OECD is seeking to address the taxation challenges of the digitalizing economy by proposing a unified approach or set of rules to define acceptable elements of business models of taxation. The first proposals are under a so-called Pillar One. The first draft of the proposals was released by the OECD in early October and is still being subject of public consultations to spur discussion among countries. OECD aims to finalize the proposals by the end of 2020.
The Global Tax Advisers Platform (GTAP), which was the subject of my article last week, together with other international tax bodies, such as CFE Tax Advisers Europe and the Asia-Oceania Tax Consultants’ Association (AOTCA), has submitted to OECD its comments and position on the draft proposals.
New nexus and allocation rules
So, what are the new OECD-proposed rules?
OECD proposes that the nexus should be determined by the taxpayer’s sustained and significant involvement in the market economy, such as through consumer involvement or engagement, without regard to physical presence. It believes that this rule can be implemented by setting a ”revenue threshold,” which can be based on the size of the market. The revenue threshold can take into account certain activities such as online advertising.
New profit allocation rules
OECD is also proposing profit allocation rules, where a share of the deemed residual profits of the ”consumer-facing” multinational companies will be reallocated to market jurisdictions, partly through formulary apportionment and use of proxies such as sales. The OECD proposals definitely target companies that are engaged with or directly selling to consumers.
The novel application of a market jurisdictions approach will result in the recognition of new taxation rights for market jurisdictions. It is a departure from the present international tax rules where zero profit could be allocated to any nexus not based on physical presence.
These proposed rules or approach will be a welcome to some countries, especially the market economies. The Philippines, with its huge consuming public, will definitely benefit, since profits of big digital-selling companies, like Amazon and Alibaba, may be allocated here and thus be taxed in the Philippines.
However, the implementation of the new rules will give rise to a host of issues and compliance costs especially to multinational entitles or MNEs. How the new rules will interplay with existing rules will also have to be addressed. Adoption or agreement to the new rules is another. Many countries, especially the developing ones including the Philippines, are not members of the OECD. For these countries, adoption of the OECD proposals is just an option. As mentioned, without a global consensus, the risk of double taxation could be high.
In any case though, the international tax scene is abuzz and waiting as to how the OECD proposals will progress. AOTCA and other international tax platforms such as the GTAP and CFE Tax Advisers Europe, are taking the opportunity to be heard and contribute to the shaping of the new rules.