HomeInsightsTwo supporting pillars – the OECD’s project on the tax challenges of the digital economy

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This article was first published in Taxation Magazine on 26 November 2019, and is republished here. 

There’s a loud and clear consensus across the tax profession that digitalisation performs a stress test on the international taxation system. Increased public criticism of the low effective tax rates of highly profitable, highly digitalised businesses and business models that create value through interaction with consumers has led to mounting political pressure for change. We are now playing catch up. The challenge for politicians and tax professionals alike is to create a tax system that is better suited to these new business models and the digital economy – a new system that not only relieves the current pressure points, but which is robust enough to provide a stable foundation for those future businesses and business models that at present we have only a glimpse of.

The Organisation for Economic Co-operation and Development (OECD) has placed itself at the centre of the policy debate. Its project on the Tax Challenges of the Digitalisation of the Economy (tinyurl.com/yyzmghqt) seeks to rework fundamentally the existing tax rules. Its task to date has culminated in the present proposals of:

  • pillar one, which provides new nexus and profit allocation rules; and
  • pillar two, which provides a global anti-base erosion mechanism.

The immediate question for public consultation is which strand of these proposals could be worked up to provide both the technical accuracy and the political consensus required for successful implementation. The more fundamental question is whether the current proposals will provide a strong and certain enough foundation to support even the present digital models, never mind those on the horizon.

High stakes and simple principles

Without doubt, the stakes are high. For businesses, the solution must first restore stability to the existing system and then provide the simplicity and certainty needed for economic growth and fiscal compliance. For governments, the prize is their share of tax revenue from cross-border flows and profits.

Two core principles underpin both the existing and any future international tax system. Getting these right is the key to achieving an enduring technical and political consensus of any breadth and depth.

First is ‘nexus’. When should a jurisdiction have taxing rights over the profits of an entity from another jurisdiction; in other words, when does a company have a sufficient economic relationship with a jurisdiction for that jurisdiction to have  the right to tax that particular entity?

Second is ‘profit allocation’. If there is nexus, what is the correct amount of profits attributable to any one jurisdiction?

Under existing rules, the answer to the ‘nexus’ question has traditionally been based on the presence of ‘boots-on-the- ground’ or ‘bricks and mortar’ giving rise to a physical permanent establishment in the jurisdiction in question. As businesses shift increasingly to virtual presence, often with little or no physical presence in the jurisdiction of their customers or users, the traditional approach seems outdated and irrelevant.

Similarly, existing methods of profit allocation are based predominantly on allocating profits where value is created rather than where customers or users are based. The transfer pricing rules apportion profits between affiliated entities on the basis of ‘arm’s length’ pricing for the services provided in each jurisdiction. The transfer pricing principles are already criticised for being too subjective and cultivating certain distortions; for example, the manipulation of risk allocation in a supply chain. Digital businesses have produced a seismic shift in where value is perceived as created – one that is not reflected in the traditional rules.

Noble ambition

The OECD is seeking to forge a ‘unified approach’ to these core questions and thereby drive through reform of the international tax system. Certainly, it seems the best placed to do so. With an ‘inclusive framework’ of 130 member states (from both within and outside of the OECD and G20) and a track record of recommending widely adopted changes to the global tax system through its base erosion profit shifting (BEPS) project, it has wide reach and a proven track record for fiscal reform.

However, the OECD’s reputation for addressing digital challenges is arguably less shiny. As for many policy makers and influencers, it has arguably been guilty of inertia and its BEPS project is open to criticism for failing to sufficiently recognise and address the fiscal challenges of digitalisation.    To meet these challenges now, the OECD and G20 adopted a programme of work, approved by finance ministers and   leaders in June 2019, which provides for the two pillars to develop, on a without prejudice basis, a consensus solution to be agreed by the end of 2020 (tinyurl.com/y366w6co).

The ‘two pillar’ solution aims to address the issues of nexus and profit allocation. In doing so, it also seeks to provide a platform for future multilateral tax co-operation and to prevent aggressive unilateral measures.

Key features of pillar one

Pillar one provides a package that reallocates taxing rights to market jurisdictions in specific circumstances by offering a fresh approach to the two key principles. The stated intention of the OECD is that the ‘unified approach’ would apply primarily to large businesses, in particular those that interact with users or which market products remotely to consumers in market jurisdictions with limited or no physical presence there.

First, it proposes a new overarching nexus principle, distinct from the existing concept of a physical permanent establishment. This proposes that a company is taxable in a jurisdiction if its sales exceed a specific threshold (for example, the €750m revenue used for country-by country reporting), even if it has no physical presence in the market jurisdiction.

Second, since the existing profit allocation rules are considered unworkable in the context of the new nexus, pillar one provides three alternatives for the allocation of profits:

  • user participation, whereby profits are allocated where there is an active and engaged user base;
  • marketing intangibles, whereby profits are attributed to intangibles such as brands, trade names and customer data; and
  • significant economic presence, whereby profits are allocated where there is found to be revenue generation, a user base or sustained marketing
  • To be workable, the alternatives need to be refined and some
  • The three alternatives set out under pillar one have some significant commonalities.
  • To the extent that highly digitalised businesses operate remotely, all proposals reallocate taxing rights to the user/ market
  • All proposals envisage a new nexus rule that would not depend on physical presence in the user/market jurisdiction.
  • All go beyond the arm’s length principle and depart from the separate entity
  • All search for simplicity, stabilisation of the tax system, and increased tax certainty in

The intention is that new rules would allow for the taxation at an appropriate level of business activities in a market jurisdiction, while retaining transfer pricing rules if they work relatively well there. Ultimately, this overlay of new rules over existing rules is extremely complex. It will require the new proposals to be reconciled with existing rules and broadly applied, to both profits and losses.

The OECD’s high level recognition that effective dispute prevention and binding dispute resolution between member jurisdictions would be needed to limit disputes and improve tax certainty seems to recognise the problem rather than present a solution.

Key features of pillar two

The second pillar is the global anti-base erosion (GloBE) proposal. This seeks to address the risk of digital businesses shifting profits to entities in no or low-tax jurisdictions, on the basis that some jurisdictions do not think that the BEPS measures to date go far enough. The profit shifting targeted here is often related to intangibles, but can also occur in the context of financing or similar activities.

Under GloBE, countries would be able to decide whether to have a corporate income tax and their own tax rates, but this would be balanced by the ability of other countries to apply new rules if income is taxed below a minimum effective rate.

In substance, GloBE proposes two inter-related rules:

  • an income inclusion rule to tax the income of a foreign branch or controlled entity if that income was subject to tax at an effective rate below a minimum rate; and
  • a tax on base eroding payments that would either deny a deduction or else impose a withholding

Impact assessment

The OECD has set out its preliminary impact assessment of the proposals. This concludes that the overall impact of pillars one and two would be a significant increase in global tax revenues and the redistribution of taxing rights to market jurisdictions.

An examination of the detail reveals that pillar one is predicted to result in only modest increases in global tax revenue and, primarily, this will affect multinational businesses in the digitalised and intangible intensive sectors. Pillar two is expected to have a greater impact. It is considered more likely to increase global tax revenue overall, with the greatest beneficiaries expected to be low and middle income economies.

In terms of reception among tax professionals, although the intentions and collaborative approach of the OECD are widely welcomed, enthusiasm is measured.

Glynn Fullelove, president of the Chartered Institute of Taxation (CIOT), describes pillar one as ‘a complex proposal to allocate relatively small amounts of a multinational enterprise’s tax base to market jurisdictions … [which] won’t fundamentally change how much tax any one country raises’. Certainly, it would seem that the price of international consensus could be proposals that are so complex in theory and whose impact is so watered down in practice, that serious questions are raised as to the certainty provided and the longevity of the pillar one reforms.

Generally, pillar two’s commitment to ensuring multinationals pay a minimum level of tax on all of their profits has received a warmer reception. The CIOT is supportive, but with the caveat that ‘while it may result in multinationals deriving profits from intangibles paying more tax, much of that may be at the minimum rate set, and they may still appear tax advantaged against more “traditional” industries’.

The Institute of Chartered Accountants in England and Wales (ICAEW) has welcomed both the pillar one and two proposals. The ICAEW expects that reaching a broad political consensus in these areas, however, will be fraught with difficulty given the competing interests of jurisdictions in taxing rights over the creation of value by digital means.

Frank Haskew, head of tax at the ICAEW’s Tax Faculty, comments:

‘Consensus will need to be reached not just on the detailed technical aspects of the proposals but also, and more importantly, a political consensus will need to be reached. There must be a real risk that it may not be possible to reach a consensus on the proposed approach. That being the case, we also think it is important that the OECD considers other possible approaches that might stand a better chance of achieving consensus.’

For those interested, the public views of various stakeholders who replied to the pillar one consultation are published on the consultation pages of the OECD’s website (tinyurl.com/ tbtbz5f) and will soon be joined by pillar two comments.

What’s the alternative?

While there seems to be a broad consensus that a global solution is required to fix the issues, many jurisdictions are frustrated by the pace and have initiated their own solutions, including the implementation of their own direct tax on digital. For example, France, India and Italy have already amended existing rules or enacted their own digital service taxes and some jurisdictions – including the UK, Spain, Poland, Austria, South Korea and the Czech Republic – have their own direct digital tax in the pipeline.

Other jurisdictions have favoured a digital sales tax and have introduced an extension of VAT or GST (goods and services tax) systems. For example, Australia and South Korea have extended or introduced indirect tax regimes to cover digital services. For every jurisdiction that has already implemented or announced such changes, there are many others who are or who will implement something similar.

A unilateral piecemeal approach to a global challenge can only result in an imperfect system with double taxation and lacunas. It seems highly likely that such measures will not only increase uncertainty for global businesses but also potentially distort competition – thereby achieving the exact opposite of the OECD’s stated objective of creating a fair and cohesive tax system.

At present, therefore, hope remains for a workable solution.

Indeed, some jurisdictions have gone so far as to bolster the OECD’s efforts by announcing publicly that they will wait for global consensus and will not implement their own tax on digital services in the interim.

What happens next?

First, to achieve political and technical consensus, the OECD must provide more detailed forecasts of the impact of the proposals and more detail of how the new proposals will dovetail with the existing system in practice.

Pillar one has already been the subject of a recently closed public consultation that sought comments from external stakeholders on a number of policy issues and technical aspects. The OECD hosted a public meeting on pillar one on 21 and 22 November. Meanwhile, pillar two is the subject of a second public consultation, with another separate public consultation meeting being held on 9 December.

The programme of work explicitly mandates further effort on the possible use of business line or regional segmentation, options in connection with the treatment of losses and the challenges associated with the determination of the location of sales. Other issues that still need to be agreed concern definitions and quanta, differentiation for business models, elimination of double taxation and other implementation issues. The list is long, the detail is complex, and compliance will be challenging. However, it is difficult to see how, until this has been worked through, it is possible to have any lasting political consensus.

The OECD recognises that for a solution to be delivered in 2020, the outlines of a unified approach would need to be agreed by January 2020. This outlines would need to reduce the number of options available, provide sufficient detail and bridge the remaining gaps to facilitate the task of arriving at a consensus in 2020.


Any business undertaking cross-border activities (whether overtly digitalised or not) should be cognisant of the new digital taxes on the horizon and assessing the impact on their business.

Glynn Fullelove of CIOT summarises the feeling of many that the current proposals may be the start of the solution rather than a silver bullet: ‘This is surely not the end of the story. It feels more of a precursor to a debate about what the purpose of taxing corporate entities is; and if it is primarily to tax the owners and investors, whether corporation taxes are the right vehicle, or whether we should be looking for more of a mix between taxing profits in the company and taxing distributions to owners and investors than we have today.’