It all comes down to money: Corporate income tax reform and the need for more information

The OECD’s Inclusive Framework on base erosion and profit shifting (BEPS), which includes over 125 countries, is debating four proposals for corporate tax reform, to update the global tax system to the digitalizing economy. Over 2000 pages of public comments have been filed with the OECD and livestreamed, public meetings were recently held in Paris. The “first pillar” of options require significant reforms to legal rules to allocate more taxable profits to market countries, irrespective of corporate physical presence. The debate is interesting, but these negotiations were born out of public outrage regarding fairness—the sense that the pie of corporate profits is not divided equitably between shareholders and governments, or between nations. It’s the financial (and administrative) implications that we need to talk about.

With the internet, physical presence has become a vestige of the past for many lines of business. Global corporate taxing rights are based on the residence of the company, so if a company sells goods and/or services in a jurisdiction but has no physical presence, it is not subject to tax. Alternatively, even if a company does have a physical presence, it can minimize its tax liability in that country by legally shifting profits out. Often, large outbound payments are justified based on intangible assets such as intellectual property, which are owned by foreign parents.

Reform proposals under the “first pillar” all amend legal nexus rules to give market jurisdictions taxing rights over multinational profits associated with their country, irrespective of physical presence. But each option proposes a different type of “presence”, based on user participation, marketing intangibles, or significant economic presence. The outcomes under each would be very different:

• The user participation proposal (see our previous blog), advanced principally by the United Kingdom, targets highly digitalised businesses that generate profits from user participation and data. The location of users alone would be enough to establish a company-country nexus. Minimum thresholds regarding the size of the business (in terms of revenues or users) would be likely. Colloquially referred to as a “GAFA” tax (Google, Apple, Facebook, and Amazon), this approach mimics the UK’s proposed Digital Services Tax.
• The marketing intangibles proposal, advanced by the United States, goes further, allowing countries with an “intrinsic functional link” to a company’s marketing intangibles—assets such as market research, user data, and brands/trademarks—to tax the associated profits. Those rights would exist no matter which affiliate in the multinational corporate structure owns the marketing intangibles, carries out the marketing functions for that country, or bears the risk. So, in addition to the Facebooks and YouTubes of the world, which among other things use marketing intangibles (user data, brands) to sell targeted digital advertising space, the Coca Colas and Teslas would be caught too. This approach makes sense because traditional consumer product businesses also use the internet to build a customer base or maintain their brands, with or without a (limited) physical presence.
• The significant economic presence proposal, advanced by a group of developing countries, represents the most significant overhaul to nexus rules, although it is the least developed of the options in the Consultations Document. A country-company nexus would exist based on “a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means.” First, the company would have to generate revenues in that jurisdiction, plus have some other kind of revenue-generating activity there, such as a user base and user data; digital content generated by that jurisdiction; billing and collection in the local currency; a website in a local language; responsibility for shipment, fulfilment and after-sales services in that jurisdiction; or sustained marketing and sales promotion activities (online or otherwise). In this scenario, international investment funds that generate profits on the investments of clients in a country, and maintain a website in the local language, could be implicated. Israel, India and the Slovak Republic have already extended their domestic corporate tax frameworks along similar lines.  

Negotiators and commentators are debating these proposals (separately, or a combination thereof) extensively—just how irrelevant is physical presence for different kinds of business today? In that spirit, the Consultations Document explains that exclusions for certain products, industries, or business lines could be adopted, as well as business size thresholds based on costs or the user base. Representatives from the financial services and banking sectors, for example, have submitted strong statements requesting that their activities are exempted from nexus rules along these lines.

The United States has also suggested that new nexus rules should be limited to business-to-consumer (B2C) ecommerce, because “marketing intangibles are most relevant in that context”, as compared to business-to-business (B2B) transactions. This distinction does not appear to make much theoretical sense, given that marketing strategies between B2B and B2C ecommerce are converging: one report suggests that social media advertising (driven by user data) is just as important in each. But it does make financial sense. In 2018, global B2B ecommerce was 5 times larger than the B2C market, so a lot of profit is at stake.

There will be significant distributional consequences depending on how nexus rules are amended. The same goes for any new rules on profit allocation—different formulas for profit determination and allocation have different effects on revenues. For example, the residual profit split method is complex and discretionary, involving the valuation of intangible assets over other forms of value creation. Some kind of metric, such as sales, revenues, users, or expenditures, has to be selected to divide profits between jurisdictions. Alternatively, formulary apportionment may be relatively simple and transparent, but tax competition could worsen unless sales is selected as the only metric to divide global corporate profits between jurisdictions. Reaching agreement on such details, given the diverse range of countries involved, will be a challenge.

The IMF recently released an analysis of the various corporate tax reform options and this provides some insight regarding revenue effects. Overall, the study finds that allocating taxing rights to marketing jurisdictions is the most effective way to address tax competition and profit shifting in the global economy. Lower income countries may also end up with greater corporate tax revenues, but it all depends on the precise form those taxes take. The IMF estimates are also made trickier by the lack of data on corporate residual profits.
With revenue implications being so obscure, governments are also concerned about administrability. The residual profit split method is considered more complex than the current system, although it would be easily navigated by those with the deepest pockets. While mechanical formulas could help, meaningful oversight is still beyond the capacity of many tax administrations.

This is where the World Bank needs to get involved. An in-depth assessment of the administrability of the proposed reforms for lower income countries, using in-country knowledge and experience, could facilitate consensus building within the Inclusive Framework. In addition, the World Bank could convene developing countries and engage them actively on this topic.