1. Background
Despite the OECD's Pillar 1 agreement on 8 October, a number of policy issues still remain to be resolved. By far the most sensitive one concerns which national taxes must be abolished as a consequence of the agreement.
The accompanying press release briefly notes that the parties have undertaken to phase out "all Digital Services Taxes and other relevant similar measures with respect to all companies, and to commit not to introduce such measures in the future." The term "other relevant similar measures" will be defined in the forthcoming multilateral convention.
Accordingly, the OECD decides what digital taxes countries may or may not retain or adopt at the national level.
We who have participated in previous OECD procedures where tax regimes have been examined know how difficult it is to persuade countries to accept OECD requirements. Unless the OECD is prepared to act with some “determination” (which happened in the 1990s), the process invariably leads to results based on the least common denominator, i.e., to virtually no results at all.
2. Generally about the review process under Pillar 1
The category of tax regimes to be examined under Pillar 1 is totally different from those examined in other OECD processes.
The violation of countries' tax sovereignty becomes much more difficult to justify in the Pillar 1 context
The OECD's ongoing review of potentially harmful regimes targets, amongst others, patentbox regimes and various regimes in tax havens. The aim of these regimes is not to persuade foreign MNEs to locate real activities in the regime country, but to transfer income to the regime, which is then taxed only nominally. The tax revenue derived under the regime actually belongs to other countries.
The tax regimes to be examined under Pillar 1 have been established for opposite reasons. The goal of digital taxes is to prevent foreign MNEs from avoiding taxation on activities conducted within the country. Digital taxes are thus perfectly legitimate and aim to counter tax avoidance and to ensure competition neutrality between different actors in the domestic market. The revenue derived and taxed here belongs to the country imposing the digital tax regime.
If the OECD has problems getting countries to accept the requirements imposed in relation to harmful tax regimes, the organization will encounter even greater problems now when countries will be required to abolish legitimately adopted taxes. The violation of countries' tax sovereignty simply becomes much more difficult to justify in the Pillar 1 context.
So what regimes are to be abolished and on the basis of what process? What criteria will govern the review process? And, finally, what will happen to countries that refuse to dismantle their regimes? Let's address these issues in turn.
2.1 The Process
The OECD's Director of the CTP, Pascal Saint-Amans, noted this spring that the reviews will take place within the framework of a per review process comparable to those conducted in the area of potentially harmful tax regimes and exchange of information.
The review process will not only focus on already adopted or planned digital taxes, but also on comparable regimes that may be adopted in the future.
2.2 The Criteria
The only thing we know for sure about the criteria is that they target all digital services taxes designed according to the Commission's 2018 proposal. As stated above, however, the criteria will also target "other relevant similar measures". We do not yet know what taxes are referred to here, only that this will be clarified when the multilateral convention is finalized by the end of November.
Last spring, the US Treasury proposed that the criteria should target digital taxes that:
apply outside the framework of tax treaties;
are de jure or de facto discriminatory;
establish an alternative nexus standard that deviates from pillar 1. (1)
Even if we assume that these criteria will be governing, many questions remain. Some of them are listed below.
If the criteria end up targeting also indirect taxes, the number of taxes that must be abolished will be significantly higher
Is it enough for the digital tax to satisfy one criterion or must all criteria be satisfied?
What discrimination rules should govern the review process? Those that apply under trade rules or tax treaties or both? If the discrimination rules applicable in the trade context govern, should the review then be carried out by the US, the OECD or the WTO? To date, the United States has, on quite discretionary grounds, threatened about a dozen countries that have adopted digital taxes with trade sanctions, without making any attempt to anchor those assessments in the WTO.
Can digital taxes or similar measures continue to apply to MNEs that are outside the scope of Pillar 1? May countries keep digital taxes that apply primarily to domestic companies?
May countries extend the domestic definition of permanent establishment to include the concept of "substantial economic presence" (2), if the provision applies only in regard to MNEs based in countries with which they have no tax treaty? May countries agree in a tax treaty to extend the definition of permanent establishment to include the concept of "substantial economic presence"?
Are countries allowed to adopt withholding taxes in domestic law on payments for digital services if they apply only to MNEs based in countries with which they have no tax treaty? What happens to countries that include the UN's new Article 12B in new or renegotiated tax treaties (see previous blog post on Article 12B here)?
Should countries that have adopted digital taxes, but refuse to support Pillar 1, still be forced to abolish them? This issue is particularly relevant to countries such as Kenya and Nigeria.
When must digital taxes “blacklisted” by the OECD be abolished? Immediately or when the Convention enters into force or when all countries with “blacklisted” digital taxes have acceded to the Convention?
These are just some questions that require a response. How these questions are answered determine both the manner in which digital taxes are abolished as well as the number of categories of taxes to be phased out.
The OECD may decide to target only digital services taxes based on the 2018 Commission proposal or also other categories of digital taxes, such as the Indian Equalization Levies (3), digital withholding taxes, substantial economic presence rules as well as British, New Zealand and Australian variants of the Diverted Profits Tax (4).
In principle, Pillar 1 should not affect VAT or sales-based digital taxes. However, the Commission has (at least for the time being) been pressured to withdraw its proposal for a Digital Levy, which apparently is intended to be designed as a sales-based indirect tax. (5) If the criteria end up targeting also indirect taxes, the number of taxes that must be abolished will be significantly higher.
Note that approximately seventy countries have (so far) adopted or planned to adopt some type of direct or indirect digital tax.
2.3 What happens to countries that do not accept the outcome of the review process?
Countries that will be required to abolish digital services taxes and "other relevant similar measures" may be divided into two categories - the winners and the losers.
The winners
The winners are those who will be compensated by or maybe even gain from pillar 1. These countries will be fairly easy to deal with.
The United States has already reached agreements with some of them, including the UK, France, Spain, Italy and Austria. These countries may continue to apply their digital services taxes until the entry into force of the Multilateral Convention. In return, they have agreed - under certain conditions - to offset digital services tax revenues against future Pillar 1 income. (6)
Other likely winners may be more difficult to deal with. India, for example, will probably abolish their Equalization Levies if the loss of revenue is fully offset by Pillar 1 income. But is India also prepared to sacrifice already collected tax revenue or revenue it will derive until the entry into force of the Convention? Hardly. India has also extended its domestic permanent establishment rules to include the concept of ‘substantial economic presence’. Would India agree to abolish these rules as well? I doubt it. Note that the Equalization Levy and ‘substantial economic presence’ were two of the digital taxes “approved” by the OECD in the BEPS Final Report under Action 1. (7)
The losers
What about the losers? That is, those countries that have to abolish their digital taxes without being compensated by Pillar 1 income? Should these countries - many of them developing countries - be forced to sacrifice important tax revenues to ensure the OECD's new world order in the field of taxation is not undermined? Are the countries themselves ready to make such a sacrifice for the greater good? Hardly.
Such action would in fact be comparable to British gunboat diplomacy of the 19th century
The Biden administration is in fact in a tight corner. It is already today unlikely that the Senate Republicans will agree to adopt the Pillar 1 Multilateral Convention (see previous blog posts on this issue here and here). In principle, the Democrats need Republican support, since international conventions are adopted by the Senate by two-thirds majority. However, the chances of getting Republican support would be zero if the Biden administration fails to persuade countries worldwide to abolish "blacklisted" digital taxes that target American GAFAM companies. And, if the US fails to implement the OECD Convention, the entire Pillar 1 agreement falls apart.
The Biden administration may therefore be forced to bring the losers to their knees, i.e., to continue to pressure countries to abolish their digital taxes under the threat of trade sanctions. Such action would in fact be comparable to the British gunboat diplomacy of the 19th century.
The question is, however, how far the United States dares to pursue such gunboat diplomacy and also what conflicts such hostile action would trigger in both the shorter and longer term. Forcing a country to abolish legislation designed to tax commercial activities undertaken within its own territory constitutes a clear-cut violation of countries' internationally recognized sovereignty in the field of tax.
Pascal Saint-Amans stresses repeatably that “global chaos” will follow unless Pillar 1 is implemented. However, such “chaos” is more likely to ensue if the United States and the OECD force countries to abolish legitimate and democratically adopted digital taxes against their will.
Hopefully, the process will crumble long before these questions arise. Pillar 1 may metaphorically be compared to a tank rolling on wheels of a Fiat 500. It is only a matter of time before the wheels collapse.
(1) See, “Treasury Must Make Good on Pledge to Eliminate Digital Services Taxes”, Tax Notes Today International, September 2, 2021. (2) Significant economic presence rules target companies able to derive substantial sales revenue in a source country without establishing a physical presence. (3) India has adopted two types of Equalization Levies. One works in practice as a withholding tax on "business-to-business payments" made for certain digital services. The other taxes foreign digital companies' “business-to-consumer revenues” derived from services provided to Indian IP addresses. Both types of Levies ultimately aim to persuade foreign MNEs to establish a PE in India and to link relevant revenues to that PE. (4) The Diverted Profits Tax taxes income derived by foreign groups at a higher corporate rate than the headline rate, if the groups have misapplied applicable PE rules. The rules aim to persuade foreign groups to establish a PE in the UK and link relevant revenues to that PE. (5) The sales tax differs from the VAT in that it is only levied at the last stage of the production process when the finished product is sold. (6) See, “U.S. Treasury Notes Joint Statement on DST Agreement ”, Tax Notes Today International, October 21, 2021. (7) See, OECD/G20 BEPS Project, Action Point 1, “Addressing the Tax Challenges of the Digital Economy”, p. 13 (October, 2015).
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