A Reform Option for the OECD: Residual Profit Allocation by Income

The recent OECD consultation, notionally on the tax challenges brought by the digitalisation of the economy, has resulted in over 230 responses, from ACCA to Zalando. If it were just about new rules for a handful of large digital companies, that would be surprising. But it is not. The changes afoot go right to the heart of the international tax system, and the tax community is right to believe that what is being considered is radical reform that could affect all businesses.

Regular readers will know that I and colleagues have long argued for radical reform of the international tax system. It is failing us in many ways – it distorts economic decisions, it encourages competition between governments, it is amazingly complex and it is still prone to profit shifting.

The direction of the thinking in the OECD’s documents is to move some of the tax base on profit to the market country. And this is also what I and colleagues have been arguing for years. Our basic rationale is that the consumers are relatively immobile, and so taxing profit in the location of consumers brings significant advantages; it would not affect the location of economic activity, it would remove tax competition, it could be considerably less complex, and much less prone to profit shifting.

OECD members cannot quite (yet) bring themselves to shift the tax base on these grounds. But they have another rationale: they may be able to persuade themselves that the market country is actually also a source country (where “value is created”), which allows them to allocate taxing rights there, in an attempt to align the allocation to the destination country with arm’s length pricing.

The same applies to countries hosting users of digital services – users are similarly relatively immobile, and this also gives an opportunity to tax digital companies there. But again, in OECD eyes, this can only be if we can identify the user as a source of profit.

The basic approach of the OECD is to identify the return to a marketing intangible and allocate the taxing rights to that return to the destination country, instead of where the functions and activities that generate the intangible are located. That could be immensely difficult and complex. It could be justified if it was based on a clear conceptual framework. But I find it difficult to see any conceptual basis here, other than an attempt to shift some taxing rights into the market or destination country.

For the last few years, I have chaired the Oxford International Tax Group of economists and lawyers, which has aimed to develop proposals for sensible reform of the international tax system.[1] .We have developed two proposal in detail. One is the destination-based cash flow tax (DBCFT),[2] which was hotly debated in the United States in 2017, and which Martin Wolf strongly advocated recently.[3] That would certainly be a radical change, moving the entire system to a destination (market) basis.

The second proposal, which we have just published, is for a profit split roughly along the lines considered in the OECD’s Consultation Document. We call it Residual Profit Allocation by Income (RPA-I).[4] Unlike the DBCFT it is based on concepts and mechanisms employed by the existing system. It allocates taxing rights to routine profits to countries in which functions and activities take place, as under the existing system. It allocates the right to tax residual profit to the market, or destination, country where sales are made to third parties.

More specifically, under the RPA-I, the residual profit of a multinational can be calculated in two ways. The first, bottom-up approach, identifies the residual gross income (RGI) earned in each destination country. This is measured as the value of sales to third parties in that jurisdiction, less the costs of goods sold, including expenses incurred in that country plus the transfer value of goods and services purchased from other parts of the multinational group. The transfer value is based on the costs incurred in the relevant functions and activities of the selling party together with any routine profit associated with those costs. Costs that cannot be directly allocated to specific sales would be apportioned to each destination country based on that country’s share of the group’s total RGI, and the apportioned costs would be deducted to determine the residual profit in each destination country.

This approach yields identical results to a top-down approach by which the group’s total residual income – calculated simply as total profit less total routine profit - is apportioned directly by RGI. Residual profit would be allocated to destination countries irrespective of the nature of the presence of the business there - whether there is a subsidiary, branch, or simply a remote sale.

The RPA-I has the appeal of a hybrid: it uses familiar transfer pricing methods to achieve what they are generally thought to (or could) do relatively simply and effectively (to calculate routine profits), and it reaps the benefits of a unitary approach where they do not (in allocating the residual profit). Even in the latter case, however, it partly uses well-known transfer pricing methods and concepts.

The RPA-I does not allocate taxing rights exclusively on a destination basis, as the DBCFT or a sales-based formulary apportionment system would. Nevertheless, it would harness many of the benefits brought by a move to a destination basis of taxation described above, whilst remaining recognisably in line with the existing system.

Whilst the OECD appears to be moving in a similar direction, it seems hampered (conceptually at least) by its attempt to align the taxing rights given to the destination country to the value of intangible assets. The difficulties in doing so should be a strong hint that more practical solutions are required. The RPA-I can be seen as just such a practical solution.

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

[1]See the Oxford International Tax Group  webpage.

[2]Alan Auerbach, Michael P. Devereux, Michael Keen, and John Vella, ““Destination-based cash flow taxation”, 2017.

[3]Martin Wolf, The world needs to change the way it taxes companies,  Financial Times, March 7.

[4] Michael P. Devereux, Alan Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella, “Residual Profit Allocation by Income”, 2019