By Mayur B. Nayak | Tarunkumar G. Singhal | Anil D. Doshi
Chartered Accountants
With the advent of computers and internet,
the modes of business transactions have undergone significant changes. The
distinction between doing business ‘with’ a country and ‘in’ a country is
increasingly becoming blurred. Virtual presence has overtaken physical
presence. Naturally, under the changed circumstances, traditional concepts of
PE and taxing rules are just not sufficient to tax cross-border transactions.
OECD identified these challenges arising out of the digitalisation of the
economy as one of the main areas of focus in its 2015 BEPS Action Plan 1.
However, taxing transactions in the
digitised economy is fraught with many challenges, as traditional source vs.
residence principles and globally accepted and settled transfer pricing
regulations (especially, the principle of ‘arm’s length price’) are being
challenged and need to be tweaked or revisited. At the same time, not
addressing these issues is leaving gaps in taxation to the advantage of
Multi-National Enterprises (MNEs), who are able to save / avoid considerable
tax through Base Erosion and Profit Shifting (BEPS). Not merely that, many
countries have introduced unilateral measures (for example, India introduced
Equalisation Levy to tax online advertisements) which are resulting in double
taxation and hampering global trade and economy. Therefore, OECD has set the
deadline of end-2020 to come out with a consensus-based solution to taxation of
cross-border transactions driven by digitalisation.
OECD has published two public consultation
documents, namely, (i) a ‘Unified Approach under Pillar One’ dealing with reallocation
of profit and revised nexus rules, and (ii) ‘Global Anti-Base Erosion
Proposal (GloBE) – Pillar Two’. It is important to understand these documents,
because once accepted, they will change the global landscape of international
taxation.
This article discusses the first document
dealing with ‘Unified Approach under Pillar One’.
1.0 Background
Tax challenges of the digitalisation of
economy was identified as one of the main areas of focus in the BEPS Action
Plan 1 in 2015; however, no consensus could be reached on a methodology for
taxation. The Action Plan 1 suggested the development of a consensus-based
solution to the taxation of digitalised economy by the end of 2020 after due
consultation with all stakeholders and undertaking further work on this dynamic
subject. In the meanwhile, however, based on the options analysed by the Task
Force on the Digital Economy (TFDE), the BEPS Action Plan 1 recommended three
options for countries to incorporate in their domestic tax laws to address the
challenges of BEPS. However, countries were well advised to ensure that any of
the measures adopted did not in any way vitiate their obligation under a tax
treaty or any bilateral treaty obligation. It also provided that these options
may be calibrated or adapted in such a way as to ensure existing international
legal commitments.
Three options to
tax digitised transactions, as mentioned in BEPS Action Plan 1, are as follows:
(i) New nexus in the form of Significant
Economic Presence;
(ii) A withholding tax on certain types of digital
transactions; and
(iii) Equalisation Levy.
Pending implementation of the BEPS Action
Plan till the end of 2020, India chose to introduce unilateral measures as recommended
above. Accordingly, section 9 of the Income-tax Act, 1961 was amended to expand
the scope of deemed income to include income based on Significant Presence of a
non-resident in India.
The new Explanation 2A was added to
section 9(1) vide the Finance Act, 2018 and provides as follows:
Significant Economic Presence shall
mean
(a) Any transaction in respect of any
goods, services or property carried out by a non-resident in India including
provision of download of data or software in India if the aggregate of payments
arising from such transaction or transactions during the previous year exceeds
the amount as may be prescribed; or
(b)
Systematic and continuous soliciting of its business activities or engaging in
interaction with such number of users as may be prescribed, in India through
digital means.
Provided that the transactions or activities shall constitute Significant
Economic Presence in India, whether or not
(i) the agreement for such transactions or
activities is entered in India; or
(ii) the non-resident has a residence or place of
business in India; or
(iii) the non-resident renders services in India.
Provided, further, that only so much of income as is attributable to the
transactions or activities referred to in clause (a) or clause (b) shall be
deemed to accrue or arise in India.
However, it may be noted that in the absence
of rules and prescription of transaction threshold, the provision has remained
infructuous.
Equalisation Levy (EL) was introduced in
India vide the Finance Act, 2016 whereby certain specified transactions
or payments in respect of online advertisements are subject to a levy of 6% on
a gross basis. However, EL was introduced as a separate levy and not as part of
the Income-tax Act, and hence there are issues in claiming its credit in
overseas jurisdictions.
OECD continued further work on this aspect
and that led to an interim report in March, 2018 analysing the impact of
digitalisation of various business models and the relevance of the same to the
international income tax system. In January, 2019, the Inclusive Framework (it
refers to the expanded group of 137 countries involved in the BEPS project
which was originally started by G20 nations) issued a short Policy Note which
grouped the proposals for addressing the challenges of digitised economy into
two pillars as mentioned below.
Pillar 1 Reallocation of profit and revised nexus rules
It was felt that the traditional nexus of
physical presence is not sufficient to tax the profits arising in market
jurisdiction (source state) and therefore new nexus rules are essential. This
pillar will explore potential solutions for determining new nexus-based profits
taxation and attribution based on clients or user base or both. In other words,
this Pillar deals with two significant aspects of the taxation of the
digitalised transactions, namely, nexus rules and profit allocation. Thus,
Pillar One comprises ‘User Participation’, ‘Marketing Intangibles’ and
‘Significant Economic Presence’ proposals.
Pillar 2 Global Anti-base Erosion Mechanism
Proposals under this Pillar go beyond
digitised economy, as it proposes to tax MNEs at a minimum level of tax. Thus,
it in its true sense addresses the BEPS challenge. It has proposed four broad
rules to ensure minimum level of taxation by MNEs. These are discussed at
length subsequently.
Let us look at proposals under Pillar One in
more detail.
2.0 Pillar One – Unified Approach towards
reallocation of profit and revised nexus rules
The public consultation document has
recognised the need to evolve new nexus rules to allocate profits arising in
digitalised economy. According to the document ‘the need to revise the rules
on profit allocation (arises) as the traditional income allocation rules would
today allocate zero profit to any nexus not based on physical presence, thus
rendering changes to nexus pointless and invalidating the policy intent. That
in turn requires a change to the nexus and profit allocation rules not just for
situations where there is no physical presence, but also for those where there
is’.
Thus, we can see that the new nexus approach
would recognise the contribution of the market jurisdiction or a consumer base
without a physical presence. Broadly, the Unified Approach aims to have a
solution based on the following key features:
(a) Wider Scope: It not only aims to cover highly digitalised
businesses, but also to cover other businesses that are more consumer focussed.
Consumer-facing businesses are broadly defined as businesses that generate
revenue from supplying consumer products or providing digital services that
have a consumer facing element.
The following carve-outs are expected from
the scope of new nexus:
(i) Extractive industries
(ii) Commodities
(iii) Financial services
(iv) Sales below specified revenue threshold [e.g.,
Euro 750 million threshold for Country by Country Reporting (CbCR)].
(b) New Nexus: The new nexus of taxation would be largely based on sales, rather
than physical presence. The thresholds of sales may even be country-specific
such that even the smaller economies benefit (for example, it could be a lower
sales threshold for small and developing countries, a higher threshold for
developed countries).
(c) New Profit Allocation Rules: For the first time, profit allocation rules contemplate attribution
of profits even in a scenario of sales via unrelated distributors. To this
extent these rules will go beyond the arm’s length principle (ALP). ALP will
continue to apply for in-country marketing or distribution presence (through a
Permanent Establishment or a separate subsidiary), but for attribution of
profits in another scenario, a formula-based solution may be developed.
(d) Tax certainty via a three-tier
mechanism for profit allocation
The Unified Approach aims at tax certainty
for both taxpayers and tax administrations and proposes a three-tier profit
allocation mechanism as follows:
Amount A:
Profit allocated to market jurisdiction in absence of physical presence.
Amount B:
Fixed returns varying by industry or region for certain ‘baseline’ or ‘routine’
marketing and distributing activities taking place (by a PE or a subsidiary) in
a market jurisdiction.
Amount C: Profit in excess of fixed return
contemplated under Amount B, which is attributable to marketing and
distribution activities taking place in marketing jurisdiction or any other
activities. Example: Expenses on brand building or advertising, marketing and
promotions (beyond routine in nature).
It is suggested to divide the total profit
of an MNE group into the above mentioned three amounts A, B, and C.
2.1 Amount
A:
New taxing right – Under this method, a share of deemed residual profit will be
allocated to market jurisdictions using a formula-based approach. The ‘Deemed
Residual Profit’ for an MNE group would be the profit that remains after
allocating what would be regarded as ‘Deemed Routine Profit’ for activities, to
the countries where activities are performed. Deemed residual profit thus
calculated will be allocated to the market jurisdiction under the new nexus
rules based on sales.
The document on Unified Approach provides
that ‘the simplest way of operating the new rule would be to define a
revenue threshold in the market (the amount of which could be adapted to the
size of the market) as the primary indicator of a sustained and significant
involvement in that jurisdiction. The revenue threshold would also take into
account certain activities, such as online advertising services, which are
directed at non-paying users in locations that are different from those in
which the relevant revenues are booked. This new nexus would be introduced
through a standalone rule – on top of the permanent establishment rule – to
limit any unintended spill-over effect on other existing rules. The intention
is that a revenue threshold would not only create nexus for business models
involving remote selling to consumers, but would also apply to groups that sell
in a market through a distributor (whether a related or non-related local
entity). This would be important to ensure neutrality between different
business models and capture all forms of remote involvement in the economy of a
market jurisdiction’.
The steps involved in computing profits
allocation to market jurisdictions under the New Nexus Approach are as follows:
Step 1: Determine
the MNE group’s profits from the consolidated financials from CbCR prepared as
per Generally Accepted Accounting Principles (GAAP) or International Financial
Reporting Standards (IFRS).
Step 2: Approximate
the profits attributable to routine activities based on an agreed level of
profitability. The level of profitability deemed to represent such ‘routine’
profits could be determined by way of a predetermined fixed percentage(s) which
may vary by industry. Thus, as the name suggests, routine profits are computed
based on some deeming percentage.
Step 3:
Arrive at the deemed non-routine profits (reducing deemed routine profits from
total profits of the MNE group).
Split these deemed non-routine profits into
two parts: (a) Profits attributable to the market jurisdiction, and (b) Profits
attributable to other factors such as trade intangibles, capital and risk, etc.
The rationale of attributing deemed
non-routine profits to other factors is that many activities that may be
conducted in non-market jurisdiction may give rise to non-routine profits. For
example, a social media business may generate excess profits (non-routine) not
only from the database of its customers, but also from powerful algorithms and
software.
Step 4: Allocate
the deemed non-routine profits to the eligible market jurisdictions based on
the internationally-agreed allocation key using variables such as sales (a
fixed percentage of allocation key may vary as per industry or a business
line).
Let us consider an example:
Net Profit to Revenue – 10%
Deemed Routine Profit – 8%
————
Non-Routine Profit – 2%
=======
2.2 Amount
B:
This type of profit would seek to allocate
profits for certain baseline or routine marketing and distribution functions in
a market jurisdiction, usually undertaken by a PE or a subsidiary of the MNE
group / parent. Traditional methods of transfer pricing rules may not be
sufficient or may result in disputes, therefore in order to simplify the
allocation, a fixed return varying by industry or region is proposed.
2.3 Amount
C:
Under this part profit is attributed to
activities in the market jurisdiction which are beyond baseline function. There
could also be some activities which are unrelated to market and distribution.
However, the Unified Approach does not prescribe any formulae or fixed
percentage-based allocation here but leaves the allocation based on the
traditional arm’s length principle. It only suggests a robust dispute
prevention and resolution mechanism to ensure avoidance of litigation and
double taxation.
Summary
of Amount C
- Allocation of additional
profits to market jurisdiction for activities beyond baseline level marketing
and distribution activities (e.g., brand-building).
- Other business activities
unrelated to marketing and distribution.
- Amount to be determined by
applying existing arm’s length principles.
Let us understand
this with the help of an illustration given in the document on Unified
Approach.
Illustration
The facts are as follows:
- Group X is an MNE group
that provides streaming services. It has no other business lines. The group is
highly profitable, earning non-routine profits, significantly above both the
market average and those of its competitors.
- P Co (resident in Country
1) is the parent company of Group X. P Co owns all the intangible assets
exploited in the group’s streaming services business. Hence, P Co is entitled
to all the non-routine profit earned by Group X.
- Q Co, a subsidiary of P Co,
resident in Country 2, is responsible for marketing and distributing Group X’s
streaming services.
- Q Co sells streaming
services directly to customers in Country 2. Q Co has also recently started
selling streaming services remotely to customers in Country 3, where it does
not have any form of taxable presence under current rules.
Proposed Taxability
Taxability
in Country 2
- Group X already has taxable
presence in Country 2 in the form of Q Co. This subsidiary is already
contracting with and making sales to local customers.
- Assuming that Q Co makes
sufficient sale in Country 2 to trigger the application of new nexus, this
would give Country 2 the right to tax on a portion of deemed non-routine
profits of Group X (Amount A).
- The deemed non-routine profits
of Group X in Country 2 will be attributable to P Co as it is owning the
intangibles. P Co would be taxed on a portion of deemed non-routine profits,
along with Q Co (as its PE to facilitate administration – similar to
representative assessee under the Income-tax Act, 1961). P Co can claim relief
under a tax treaty by claiming exemption or foreign tax credit of taxes
withheld / paid in Country 2.
- Q Co would be taxed on the
fixed return for baseline marketing and distribution (Amount B) which may be
arrived at by applying transfer pricing adjustments to the transactions between
P Co and Q Co to eliminate double taxation.
- Q Co may also be taxed on Amount C if Country
2 considers that its activities go beyond the baseline activities. However, for
this Country 2 must place a robust measure to resolve disputes and prevent double
taxation.
Taxability in Country 3
- In Country 3, Group X does
not have any direct presence under the existing rules. However, Q Co is making
remote sales in Country 3.
- Assuming that Group X makes
sufficient sales in Country 3 to meet the revenue threshold to trigger new
nexus, Country 3 will get the right to tax a portion of the deemed non-routine
profits of Group X of Amount A. Country 3 may tax that income directly from the
entity that is treated as owning the non-routine profit (i.e. P Co), with P Co
being held to have a taxable presence in Country 3 under the new nexus rules.
- Since Group X does not have
an in-country presence in Country 3 by way of a branch or subsidiary, under
current rules, Amount B will not be allocated.
3.0 Open
issues
There are several open issues in the
proposed document, some of which are listed below:
3.1
Determination of routine profit
The first step in
Amount A is to determine routine profit based on a fixed percentage. As
different industries have different profitability, business cycles, regional
disparities and so on, it is going to be a huge challenge in arriving at a
globally-accepted fixed percentage.
3.2 Determination of residual (non-routine) profit
What percentages
will be attributed to which market jurisdiction and what allocation keys are to
be used for this purpose? These will be difficult to arrive at and make the
entire exercise very complex.
3.3 Other pending issues
The document on
Unified Approach has identified several areas in which further work would be
required, such as regional segmentation, issues and options in connection with
the treatment of losses and challenges associated with the determination of the
location of sales, compliance and administrative burden, enforcement and
collection of taxes where the tax liability is fastened on the non-resident of
a jurisdiction and so on.
CONCLUSION
While OECD had
asked for public comments on its document on Unified Approach for New Nexus,
there are several grey areas; reaching a consensus within the stipulated time
of December, 2020 appears to be quite optimistic. However, it is also a fact
that more and more countries are resorting to unilateral measures to tax MNEs
operating in their jurisdictions through digitised means. In fact, introduction
of SEP in Indian tax laws is also perceived as a measure to convey to the world
the urgency of consensus on new nexus favouring marketing jurisdiction or a
source state taxation.
Bifurcation of MNEs’ profits in three parts and within three parts,
routine and non-routine profits would create huge complications. Again, both
routine and non-routine parts are determined on an approximation basis.
Consensus on a fixed percentage or allocation keys could be a huge challenge.
India has already expressed its dissent on bifurcation of routine and
non-routine profits. Such a bifurcation has the potential of shifting more
revenue in favour of developed countries. It remains to be seen how the world
reacts to the proposed new nexus rules.
