The Challenges of Consensus in the Digital Economy on the International Tax Treaty System

June 25, 2019

The OECD has already released the program of work to develop a consensus solution to the Tax Challenges Arising from the Digitalization of the Economy. Right now, the OECD is working on the design of the possible solutions that can be suitable for giving new taxing rights to market countries. The implementation of this plan will depend on how effective the OECD members and the Inclusive Framework (IF) consider the proposed solutions. Even with this project still going on there are some skeptics on the possibility of global consensus around the world. This is the case of some countries that are already discussing enacting unilateral measures on digital companies.

Because of the political importance of the OECD project, the organization decided to do things in the fast lane, with the goal of global consensus by 2020. Since 2017, the OECD has been conducting discussions to find a solution to the tax challenges of the digital economy. A few weeks ago, the organization released the work plan to get the final work done. The plan is mainly focused on finding solutions to tackle the problems that were identified as part of BEPS Action 1 (2015) and some other BEPS problems with ideas including a new global minimum tax and other base erosion rules.

This initiative, known as BEPS 2.0, not only includes the OECD members, but also incorporates the IF, which is a group of countries that are not OECD members but are willing to work with the organization to improve and adapt their tax systems to a more unified international tax framework.

In this discussion for a new international tax framework, experts have mentioned their concerns about the project, and the challenges to its implementation. An important set of challenges will be identifying how the final recommendations will affect the tax treaty framework. Those challenges will come when negotiation of new treaties or modification of the existing ones arise.

In the search for consensus, the starting point lays in the coordination that nations can reach over the taxation of international transactions. Consensus on that point will easily impact the tax treaty network. There are around 2,000 bilateral double tax treaties in the world that are the basis of international taxation of businesses.

Different treaty models

When thinking about the effective application of the new OECD proposal, it is necessary to think that the existing treaties in effect were created based on any of three templates that will need to be modified to make the application of the new OECD project effective.

The three templates are the OECD treaty model (first released in 1977), the UN model treaty (released in 1979), and the United States model. Each model is slightly different and designed for different circumstances. Additionally, the OECD has the multilateral instrument (MLI), which is a tool designed to incorporate base erosion and profit shifting measures into tax treaties.

Managing changes to tax treaties resulting from the OECD project will need to consider how the differences among the treaty models will shape implementation.

The implications of the OECD proposal to revised nexus rule and treaty issues

The actual OECD proposal has two pillars: the first to revise the nexus and profit allocation rules, and the second with a global anti-base erosion proposal. In general, the proposal is based on the existing OECD treaty model.

From the perspective of Pillar 1, Chapter II of the OECD program suggests to explore the design of a remote taxable presence concept. With this new approach, taxable income derived from a jurisdiction will not necessarily be limited in cases where multinationals do not have physical presence in a country but still do business by digital means.

The development of the new concepts will require the modification of existing tax treaties. The OECD suggests that the new permanent establishment (PE) concept has to be redesigned to include digital business models in cases where multinational companies have a remote, sustained, and significant involvement in the economy of a jurisdiction. Also necessary will be to define how to allocate profits derived from those activities, which will be taxed in that jurisdiction.

Another treaty provision that will need modification is the article referring to taxation of business profits. The modification of article 9, referring to associated enterprises, would be required to allow market jurisdictions to exercise taxing rights over the measure of profits allocated to them. Finally, to facilitate the implementation of any of these methods, it is also necessary to think about the ways to ensure tax certainty, administrability, the effective dispute prevention, and resolution.

In its work plan (paragraphs 42 and 43), the OECD considers the possibility of giving a multilateral authority the ability to provide guidance on any of these matters. The competent authority according to the work plan will be able to explore the effectiveness of the existing treaty and domestic law provisions, such as the current dispute prevention and resolution procedures in the context of the new rules. The OECD work plan discusses multilateral agreements between competent authorities, the inclusion of arbitration, and multilaterally coordinated risk assessments to make recommendations to the parties involved in transactions.

The work plan also mentions the necessity of modifying existing tax treaties and adapting them to the new rules in the case of the allocation of taxing rights, the absence of physical presence, and the inclusion of the new nexus rule, to address the possible challenges to eliminate double taxation, and the resolution of associated disputes. It suggests that a good practice would be to have all the parties committing to the plan implement changes at the same time.

Even the OECD has not figured out yet a way to address the problem of how to include the new features to treaties and considers that the options can include modifying the MLI or the creation of a multilateral convention.

Pillar 2 on its own will affect treaties with a switch-over rule which could apply a credit method instead of an exemption method, where the profits attributable to a PE or derived from immovable property are subject to tax at an effective rate below the minimum rate.

Pillar 2 also includes the design of a tax on base-eroding payments as a measure to protect a source jurisdiction from the risk of those payments. The proposal suggests exploring a subject to tax rule in tax treaties to limit certain benefits if an item of income were subject to tax at a minimum rate. The same consequences are explored in the proposal in cases where there is evidence of undertaxed payments.  

Conclusion

There are many challenges arising from the OECD project to find a solution to the taxation of the digital economy and related issues. One of them involves the creation of a document with clear recommendations to address those problems. Once these recommendations are published another challenge is the necessity to reach consensus on the modification of valid tax treaties and the enactment of new ones. This represents a highly complex task that needs to be addressed if the real objective out of the whole work is to find a solution to change the international tax system.

The new set of rules will add complexity to the system and create an additional burden because it will require the renegotiation of existing tax treaties. It is difficult to believe that all the countries are willing to accept exactly what the OECD would recommend in the new standards.

The idea of enhancing the international tax system to avoid the effects of BEPS, and to give market jurisdictions the right to tax part of the revenues that are derived from these jurisdictions, is not new but it requires careful consideration of the various challenges it presents. The OECD should not simply create a set of rules that just adds new layers of complexity; however, even a simple approach will involve many complex changes to current laws and treaties.

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