SO we are back to digital economy and sharing of taxing rights again. It all began in 2013 with the OECD launching its Base Erosion and Profit Shifting project with much fanfare. OECD (the club of the rich) put addressing the challenges of digital economy at number one of its priorities and we got excited that finally some of the blatant inequalities of the current international tax system will get addressed. Under pressure from the USA on whose largesse the OECD depends, the OECD immediately clarified that its efforts are not for changing the basic rules of allocation of taxing rights and profit allocation. OECD submitted its final report in 2015 but without any agreement on the crucial issue of digital economy where a task force from selected countries continued to struggle to find a solution to the vexed issue. The only area of agreement amongst all was the MNCs should be taxed where the value is created. Soon, everybody got bogged down to finding the meaning of value creation and clever technocrats from the developed world succeeded in derailing the discussion into a quagmire. What is the value and where value is created- Is it where the intellectual property is developed or is it where some low level labour takes place or is it the place where the marketing activities take place or is it the country where the market is. Unlike much of the industrial goods, in the digital space, the market share of the developing countries (or at least some of them) is quite large and it was difficult to ignore their demand for greater allocation of profits. In the meantime, in search of its legitimacy, the OECD formed the so called Inclusive Framework where developing countries having very limited material and manpower resources were included to basically rubber stamp what the big boys will decide. But the charade of inclusiveness on the oft-quoted "equal footing" has to continue.

We have discussed the digital economy and Indian response to the same on a number of occasions. Just to recapitulate very briefly, there were 4 main proposals from the members of the Task Force on Digital Economy, which the OECD divided into 2 pillars - one pillar containing 3 proposals dealing with expansion of taxing rights to varying degrees and another from the USA that essentially is a modified GILTI (Global Intangible low-taxed Income) proposal and propounds the theory of a minimum tax, (which in the USA varies from 10.5 to 13.125% of the foreign income of the MNC). It is not clear whether the two proposals (Pillar 1 and Pillar 2) run concurrently or parallel to each other. A stand alone minimum tax proposal is unlikely to enthuse most of the developing countries and work on the same is still ongoing.

The commonality of the three main proposals on the table in so far as pillar one is concerned is the modification of the nexus rules and the concomitant modification of the existing rules of profit allocation. While one of these proposals dealt with nexus and profit allocation in the case of highly digitalised business and would take into account the active user contribution that had emerged as one of the main ideological input from the BEPS project (favoured by the UK) , the other one favoured by the USA would ignore the concept of user value creation and would establish a nexus by reference to marketing intangibles and would apply to both digital and traditional businesse s though emphasis is given to the intangibles for claiming greater taxing right for market jurisdictions. The third proposal emanating from India, faithfully followed the OECD 2015 final report on Action 1 and proposed the significant economic presence in the digitalised environment as a nexus and profit is to be allocated by a simple formula based approach that is easy to implement at least by the developing countries.

Thereafter, discussions continued amongst the TFDE members but obviously there was no consensus and discussions went round and round along the entrenched positions represented by the different groups representing diverse interests. It may be noted that the Indian proposal was the preferred approach for the G-24 representing the interests of the developing countries. In the meantime, the timeline for delivering a report to the G-20 ministers was approaching and the OECD, a group so far representing the homogenous interests of the developed countries, perhaps got fed up and came up with an OECD secretariat proposal on the 8th of October, 2019, calling it a unified approach for pillar one and presented the same to G20 Finance Ministers

This is rather extraordinary way of functioning and apparently, has been justified by Pascal Saint Amans, the OECD tax chief in a meeting arranged jointly with IMF and World bank on 20th October, 2019 on the ground that the "OECD Secretariat's proposal for a unified approach to pillar one was meant to break a deadlock among countries that were going "round and round" in their discussion about how to best update the international tax rules." (As reported by Julie Martin of MNE Tax). According to the same report, apparently he also said that while he understands complaints that the process is moving too rapidly, especially for developing countries that lack capacity, it is not wise to slow it down.

It is in this context that one needs to examine the so-called unified approach that the OECD is trying to ram drown the throat of the developing countries. Of course, the proposal is not final and OECD has sought suggestions from the stakeholders by 12th November, but there is hardly anytime for developing countries to properly digest the proposal and come up with coherent solutions. So what are the essentials of this approach?

According to the Secretariat paper, its approach covers not only highly digital business models like platforms but covers all consumer -facing business. What then exactly is a consumer facing business? Seems like all businesses that have consumers would be covered. The work relating to the scope of the proposal and carve out is yet to be finalised. Perhaps OECD will come out with another clarification in time to come. But, at the outset, it has been made clear that this approach will not affect extractive industries presumably on the ground that the taxing rights in respect of such industries are with the source countries. While the taxing right may already exist, but there are services rendered to such industries that are often a way to salt away most of the source country profits. In fact, the UN committee of experts had been working on the extractive for quite some time now.

The selling pitch of the OECD Secretariat for its proposal is that under the present system (that it had designed and defended), in the digitalised mode of doing business, unless there is a fixed place of business, no source taxation occurs in the absence of a nexus. In case there is a physical presence either in the form of a PE or subsidiary, then the current (OECD) rules will continue to play.

Therefore the OECD will give a concession to source countries in the form of a new nexus not dependent on physical presence but largely based on sales. "The new nexus could have thresholds including country specific sales thresholds calibrated to ensure that jurisdictions with smaller economies can also benefit. It would be designed as a new self-standing treaty provision." The threshold of sales in a country that will constitute a nexus will thus vary from country to country. The question is who will do the calibration. Is the OECD the right forum for such an exercise? Or will the amount be left to be negotiated bilaterally? In that event the country with lesser negotiating power will lose.

Having conceded a nexus the next question is how profit of an MNC will be allocated to that nexus. Under the current OECD Model, that amount is dependent on the application of arm's length standard both in the PE and subsidiary situation. The OECD proposal presumes that all the countries follow the current OECD rules in this regard. Some countries like Brazil, India and China do not exactly follow the OECD rules of profit allocation and for valid reasons. Therefore, effort is on to bring them on board.

For the new nexus, the OECD is ready to concede that the profit allocation rules that it is proposing will go beyond the arm's length standard. And these rules are for taxpayers that come within the new scope "and irrespective of whether they have an in-country marketing or distribution presence (permanent establishment or separate subsidiary) or sell via unrelated distributors." But the OECD does not ditch the arm's length principle. In its own words, the approach largely retains the current transfer pricing rules based on the arm's length principle but complements them with formula based solutions in areas where tensions in the current system are the highest. In other words, where disputes occur. Having failed in its attempt to force compulsory binding arbitration on the developing countries, OECD is now dangling the carrot of an ephemeral increased profit allocation to bring back its proposal of binding arbitration through the back door. India should be particularly worried considering the recent peer review of India's MAP process, a mechanism which (in my view) was unwisely agreed to by India.

And what is the amount that will be allowed to be taxed if there exists a new nexus? It is here that the Secretariat proposal rather than being a unified approach becomes the US approach. The language is involved and profit to be allocated will be the sum of amounts A, B and C.

Amount A - A new taxing right for market jurisdictions over a portion of within the scope MNE groups ' deemed residual profit calculated on a business line basis. The deemed residual profit would be the profit that remains after allocating what would be regarded as a deemed routine profit on activities to the countries where the activities are performed.

So first one has to determine the total profits of the MNC group (to be determined according to the rules of the country of Headquarters) and then determine the still undefined routine profits of the group and deducting the same from the total profits, one gets the deemed residual profits and only a portion of the same (percentage yet to be determined) that will then be allocated to particular markets meeting the new nexus rule through a formula based on sales. If one goes by what transpired at the IFA meeting in London, according to the US representatives, this will only be a very very tiny portion.

Amount B - According to the Secretariat paper, activities in market jurisdictions, and in particular distribution functions, would remain taxable according to existing rules. However, given the large number of tax disputes related to distribution functions , the possibility of using fixed remunerations would be explored, reflecting an assumed baseline activity. So, this amount will be added to a particular country's tax kitty where distribution activities take place. It may be noted that Amount B is available only when there is physical presence in a country outside the parent company's headquarters.

Amount C - "Any dispute between the market jurisdiction and the taxpayer over any element of the proposal should be subject to legally binding and effective dispute prevention and resolution mechanisms. This would include those cases where there are more functions in the market jurisdiction than have been accounted for by reference to the local entity's assumed baseline activity (which is subject to the fixed return in B above), and that jurisdiction seeks to tax an additional profit on those extra functions in accordance with the existing transfer pricing rules."

The OECD Secretariat paper helpfully gives an example for determination of Amount A that make one's head spin. Sample this. Assume that the profit margin of an MNC group is z%. A portion of that will be routine profits. (What is routine profit, nobody knows). If that portion is x%, then only (z%-x %) = y % would be regarded as representing the group's deemed non-routine or residual profits. And this y% would then be allocated between the profits attributable to market jurisdictions (assumed to be w %) and the profits attributable to other factors such as trade intangibles (assumed to be v %). The method of determining the said w% and whether the same will vary by industries would have to be finalised by the Inclusive Framework.

While it will require a number of readings for the proper understanding the proposal, developing countries should not be shy of saying- We don't understand. Such countries should not agree to whatever the OECD Secretariat is saying as a price for sitting at the high table for a few days and should try to understand whether this is a new way of continuing the old colonial policies in a different way.