Regular readers of CBT blogs may have noticed the lack of recent contributions. Apologies. One reason is a lack of time, partly due to completing a book with the Oxford International Tax Group – watch this space for further news on that. But a more important reason is that Richard Collier – the driving force behind the blogs – has been otherwise engaged running the OECD Pillar One project. We are looking forward to his return some time in 2020.
The OECD’s “Secretariat Proposal” is the latest instalment of a series of documents charting progress, and evidence of Richard’s productivity while away from Oxford. But while the Secretariat may accept responsibility for the proposal, it is clearly designed to be a compromise that might be acceptable to the 134 members of the Inclusive Framework.
Some readers may also recall that I wrote a blog earlier in the year about a proposal of the Oxford International Tax Group to introduce a “Residual Profit Allocation by Income” (RPAI).
The Secretariat’s Pillar One proposals certainly share some important features with the RPAI.
The key innovation in the OECD proposal is to allocate a share of deemed residual profit to market jurisdictions, or what the academic literature refers to as “destination” countries. As someone who has long advocated a shift to a destination basis I see this proposal as a step in the right direction. The RPAI would allocate all residual profit on a destination basis, and I will return to this distinction from the OECD proposal below. But in both cases, the direction of travel is to allocate “routine” profits roughly on the basis of the existing system but to allocate some - or all, in the case of the RPAI - residual profit to destination countries.
The two proposals differ in the practicalities of how to achieve that aim.
The OECD propose to identify residual profit from global consolidated accounts – the residual is what is left after deducting a “deemed” routine rate of return. Then part of the residual would be allocated to destination countries on the basis of sales. That is overlaid on top of the existing system, and that causes two problems.
First, the proposal would result in double taxation unless the profit allocated to the destination countries is deducted from taxable profit in some other countries. It is not clear how that other countries will be identified, but it seems reasonable in principle to deduct it from countries where the residual profit is currently allocated. That would imply identifying the routine and residual profit in every country in which the multinational operates, so that the residual could be reduced by an allocation of the amount that has been given to the destination countries.
The RPAI aims to achieve just that outcome by a bottom-up approach based on a routine mark-up on costs. But it looks like the OECD is heading towards a much more arbitrary adjustment. That may be hard to sell to countries that believe they will lose out. On the other hand, it seems plausible that ultimately taxable profit will be taken, somewhat arbitrarily, from jurisdictions with low tax rates (and high residual profit) – and that may be perfectly acceptable to most OECD members.
Second, since the proposal is overlaid on top of the existing system, everything else is left largely unreformed. It can surely only be the case that complexity and uncertainty will become even greater.
But let us return to the important difference of principle as to whether some, or all, residual profit should be allocated to destination countries. It is not clear why the Secretariat (or members of the Inclusive Framework) believe a partial move towards destination is a good idea. In my view, such a move is justified by the relative immobility of a third party purchaser of goods and services (especially individual consumers). That reduces economic inefficiencies created by tax-induced distortions to real location decisions and also reduces options for shifting profit. But that view apparently remains controversial.
The proposal instead seems to be based more closely on the BEPS concept of taxing profit where value is created. The idea here seems to be that some value is created in the market - for example, through the existence of “marketing intangibles” located there. So one interpretation is that the proposal is simply trying to identify approximately where value is created. That has two implications.
First, that only part of residual profit is likely to have been created in the market, or destination, country.
Second, it implies that the scope of the project may be limited to consumer-facing businesses, where it appears to be thought that there is more chance that value might be created – though that is questionable. The OECD project started by trying to fix the problem of taxing profit earned by large digital companies. But it evolved into more fundamental reform which would apply more generally for a good reason: the difficulties in defining which type of businesses are caught by the new arrangements, the tax planning opportunities that will inevitably arise, and also the economic inefficiencies created. But similar problems will arise if the scope is limited to “consumer-facing” businesses. What is a consumer-facing business? What about businesses that sell to both other businesses and to consumers? Expect an additional layer of complexity.
I have argued against the “value creation” view on many occasions, and I won’t repeat the arguments here. Instead, I would simply note the view expressed by Pascal Saint-Amans at the recent London IFA Congress. He rejected this concept as justifying a general allocation of taxing rights, suggesting instead that it was useful only in identifying that profit did not arise in havens that had little or no real activity.
It is simply not credible to believe that we need fundamental reform of the system because we have just discovered that there is some “value” is being created in “markets”.
What is credible is that governments have understood that the immobility of the consumer – or the user in the case of some digitalised services – gives them an opportunity to tax the very large profits of some multinationals. That is why there are unilateral proposals for digital services taxes, in the UK and elsewhere. Acknowledging that would be a first step to a more comprehensive and stable system.
But in any case, the opportunity presented by relatively immobile consumers and users will remain attractive to governments. And that suggests that the current proposal may be just a step in the direction of a what will ultimately become a more fundamental shift of taxing rights to destination countries.
Research from the Centre for Business Taxation relevant to this blog includes:
Alan Auerbach, Michael P. Devereux, Michael Keen, and John Vella, “Destination-based cash flow taxation”, 2017.
Michael P. Devereux, Alan Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella, “Residual Profit Allocation by Income”, 2019
A much shorter version of this blog appeared in the Tax Journal on October 18: Pillar one: first step towards a destination-based tax?