The moot question that arises is whether the international tax laws are aligned to the fast-changing business models, as most of the tax regimes were built around the traditional ‘brick and mortar’ business models.
To address this issue, the Organisation for Economic Cooperation and Development (OECD), while laying down its Base Erosion and Profit Shifting (BEPS) Action Plans considered tax challenges arising from digitalisation as part of its Action 1. Under the Action Plan, OECD agreed to develop, by the end of 2020, a consensus-based solution for tackling the issue through revised profit allocation and revised nexus rules. This is a significant shift from the current established tax norms where physical presence of an entity in a particular jurisdiction is considered as a pre-requisite for levy of tax on such entity.
As part of the action plan, the OECD framed following two complementary pillars to address the issue:
1: Re-allocation of profit and revised nexus rules: intended to develop new nexus rules based on economic activity and profits there from, jurisdiction where tax should be paid, the basis for payment of tax and the profit allocation rules for such jurisdiction. This contemplates a framework where portion of profits should be taxed in a jurisdiction where clients or users are located.
2: Global anti-base erosion mechanism: intended to identify and tackle remaining issues identified by OECD under the BEPS framework.
Under Pillar 1, to develop a new nexus and profit allocation rule, OECD explored three proposals: i) user participation, (ii) marketing intangibles, and (iii) significant economic presence.
Given the commonality in the three proposals under Pillar 1, OECD has developed a ‘unified approach’, which has recently been released for public comments.
The key objective of this approach is to provide simplicity, stabilization of tax system and tax certainty to businesses. It also goes beyond the accepted norms of arm’s length price advocated by the age-old transfer pricing regulations. Further, the proposal not only covers digital business models but also focusses on consumer-facing businesses, as specified.
New nexus rule to be based on sales and not on physical presence
The new nexus rule proposes to define a sales revenue threshold in a market as the primary indicator of a sustained and significant economic involvement of an enterprise in that jurisdiction. Setting up a revenue threshold would ensure that tax laws are made applicable to businesses having significant customer base in a country. The new nexus rules would apply even where goods are sold remotely or through distributors.
For instance, an enterprise selling products in India though independent re-sellers/ distributors could theoretically have sufficient ‘nexus’, to trigger profit allocation rules and hence, taxability in India.
New profit allocation rules to increase tax certainty
The traditional method for allocating profits to an enterprise were based on three key parameters namely functions performed, assets used and risk assumed by an organization in a country (popularly known as FAR analysis). However, this method failed to allocate sufficient profit in case of digital businesses due to absence of physical presence. Accordingly, the policy document proposes a new profit allocation rule for such cases.
This new profit allocation rule would be applicable to organization having ‘nexus’ in a jurisdiction. Further, the rule not only seeks to allocate profit to baseline marketing and distribution functions, it also addresses situations where a jurisdiction seeks to tax additional profits for extra functions over the baseline activity undertaken in a jurisdiction.
The rule recommends a three-tier profit allocation mechanism as follows:
• Amount A: The amount represents the deemed residual profit of an enterprise allocated to a country in which the nexus is established. To arrive at this amount, the routine profits for the enterprise’s traditional functions are to be determined preferably using a fixed percentage. The difference between the total profits of an enterprise and profits attributable to routine functions is the residual profits. Such residual profits would then be attributed to a particular jurisdiction based on internally agreed fixed percentages. This amount would typically be attributed to non-resident entities operating in market jurisdictions without a physical presence in such jurisdictions.
• Amount B: This amount represents a fixed percentage of return to be allocated to functional activities, like marketing and distribution, carried out in a jurisdiction. However, the proposal does not prescribe as to what would constitute baseline functional activities. This attribution would typically be carried out particularly in cases where marketing entities/ distributors are physically located in a jurisdiction.
• Amount C: Attribution under Amount C would be in cases where, for instance, a distributor performs additional activities, beyond the baseline activity for which Amount B has been allocated in a jurisdiction.
Let’s say a US-based company X has global sales of US $1,000 and global profitability of 30% (of sales) with the contribution to profit split as under:
• From Manufacturing activities (carried out in US) at 10%;
• From Marketing and distribution activities (carried out by Indian subsidiary) at 12%; and
• Residual profits 8%.
Profit attribution would be as follows:
Amount A If Company X has global sales of $1000, $80 (ie. 8% of $1000) would be deemed residual profit. This $80 would be allocated to different countries based on market jurisdiction and other factors such as trade intangibles, capital and risk.
If India accounts for 60% of the global sales, the residual profit of $80 would be allocated to India at an agreed fixed percentage.
Amount B In the above example, since Indian subsidiary undertakes marketing and distribution functions, 12% of $1000 i.e. $120 would be allocated to India.
Amount C If, later on, it comes to the notice of the Indian revenue authorities that the Indian subsidiary was performing activities over and above the marketing and distribution functions, further profit allocation related to such additional activities can be made. However, in such cases, mutual agreement procedures may be initiated between India and US governments in order to avoid double taxation due to overlap of Amount A into Amount C
Given the proliferation of unilateral actions by many countries (including India) in tackling the tax challenges around digital economy, the proposal is a step in the right direction as it aims to promote cooperation among OECD members and non-member countries for reaching a consensus.
The proposal also seeks to support stable and predictable transfer pricing laws. The proposal would lead to a paradigm shift in transfer pricing approach as this is a move away from the arm’s length principle which has governed transfer pricing concepts for so long. Therefore, it is imperative for businesses to remain cognizant of these developments and take necessary action, as required.
Vaishali Mane and Shubham Jain contributed to this article.
Vikas Vasal is national leader-tax at Grant Thornton India. You can send your queries to firstname.lastname@example.org