The OECD’s plan to tax the digital economy

| 11/11/2021
The OECD’s plan to tax the digital economy

On Oct. 8, the Organization for Economic Cooperation and Development (OECD) announced agreement on a plan to overhaul the way taxes are determined on a global basis. The purpose of the agreement is to address the challenges of taxing large multinational enterprises (MNEs) in a digital world. OECD countries have been working on this framework since the OECD began its base erosion and profit shifting (BEPS) initiative in 2015. The project started out with 15 major work streams or actions and finally reached tentative agreement on BEPS and how to tax the digital economy.

Of the six countries that previously had refused to sign on to the plan, Ireland, Hungary, and Estonia changed their positions and joined the group. Kenya, Nigeria, and Sri Lanka are the remaining holdouts. Pakistan reversed its prior position and no longer supports the agreement. Many developing countries continue to have concerns with the current plan but have not bowed out. On Oct. 31, the plan was adopted by the G-20, the intergovernmental group of the 19 largest world economies and the European Union.

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The plan

The plan addresses two major points or “pillars” for taxing multinational corporations. Pillar 1 will revise the way certain MNEs (those with revenue more than 20 billion euros and profits greater than 10% of revenue) are taxed. Essentially, the rule will require an MNE subject to the rules to allocate an amount of income (Amount A) to the market jurisdiction if its revenue from the jurisdiction exceeds 1 million euros, regardless of physical presence. For reference, the market jurisdiction is the location in which the ultimate consumers are located. The amount of residual profit, or Amount A, to be allocated currently is 25% of the profit in excess of a 10% return on revenue. In addition, jurisdictions that have implemented unilateral digital service taxes (such as France, the U.K., and Italy) will be required to withdraw them. Even with these developments, a significant amount of work on Pillar 1 still is needed before jurisdictions will be implementing these changes. The methodology to prevent double taxation has yet to be determined, as has the safe harbor for routine marketing and distribution activities.

The second pillar, or Pillar 2, is designed to address tax base erosion by requiring large MNEs to pay a minimum level of tax through certain rules intended to mitigate base erosion and an additional tax on MNE income that is taxed at a rate that is below a 15% effective rate. Under the plan, MNEs will not be allowed to deduct payments that are subject to tax in the payee jurisdiction at a rate below the proposed minimum rate (15%). In addition, source jurisdictions will be allowed to impose a withholding tax on payments made to related parties in other countries if the tax imposed on the income received by the related party is below a minimum rate, currently set at 9%.

Next steps

Pillar 1 will be enacted through a multilateral agreement that automatically will adjust the treaty provisions among the countries that adopt the plan. This agreement is important as it will determine how the taxing rights are divided among the participants. The plan calls for the agreement to be signed in 2022 and implemented in 2023. While the U.S. has agreed to implement the OECD plan, it has not signed on to the multilateral agreement. Currently, any adjustment to the U.S. bilateral tax treaties such as the Pillar 1 multilateral agreement will require a supermajority approval in the Senate because the Senate must ratify all U.S. tax treaties. If the Senate cannot get the required votes, then implementation of the plan will stall.

The OECD has indicated that it plans to release rules for Pillar 2 in November. Unlike Pillar 1, adoption will require countries to adopt domestic rules to implement Pillar 2. One common unanswered question is how to address timing differences, as the minimum tax determination will be based on profits as reported in the audited financial statements of the in-scope MNEs.

While the OECD continues to work through its agenda, the U.S. could enact legislation affecting MNEs. Given all of these changes, companies should work with their tax advisers to analyze how their businesses might be affected.

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Brent Felten
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John Kelleher
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