As noted earlier, the idea that taxation should be aligned with value creating activities might initially seem straightforward; the aim is to tax profits in that jurisdiction, where actual business activities take place.127 Still, the precise meaning of the principle of value creation and potential consequences that would follow its application in international taxation remains ambiguous.128 Similarly, it is not perfectly clear whether the idea of value creation
121 Ibid.
122 M. Scherleitner, Addressing Tax Arbitrage with Hybrid Financial Instruments (IBFD Doctoral Publications 2019) Ch. 3.2.1 ‘Equity’.
123 Pistone et al. supra n. 105, at 11.
124 The term was first coined in 1972. See, R. A. Musgrave and P.B. Musgrave, ‘Inter-nation equity’ in R. M.
Bird and J. G. Head (eds), Modern Fiscal Issues: Essays in Honor of Carl S. Shoup (University of Toronto Press 1972) 68.
125 Pistone et al., supra n. 109, at 13.
126 Ibid.
127 Morse, supra n. 110, at 196. In contrast, Johanna Hey has pointed out that ‘… the location of real economic activity and that of the creation of value do not necessarily coincide.’ See, J. Hey, ‘”Taxation Where Value is Created” and the OECD/G20 Base Erosion and Profit Shifting Initiative’ (2018) Bulletin for International Taxation 203.
128 On the discussion of what is value and how is it created, from an economic angle, see M. E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (Free Press 1985); and M.
Mazzucato, The Value of Everything: Making and Taking in the Global Economy (Penguin Books 2019). For
29 has been a guiding international tax regime in the past.129 Yet, brought together by OECD’s work on BEPS, the international tax community now seems to agree, that value creation should guide the allocation of taxing rights.130 However, determinate and unified definition on the concept itself remains yet to be found.
It has been argued, that from an economic perspective both the customer and the business create value.131 While it is undeniable that besides the producer or service provider, the customer is of key relevance in the chain of events that enables economy to function, the customer does not, as such, contribute to value creation itself. This results directly from the distinction between value and income: sales and revenue are merely the outcome of (successful) value creation – of value realisation.132
The idea of value creation as a legal principle may be grasped through references to negative and positive rules for income sourcing, ‘source rules’; the former indicating what activities cannot be regarded as creating value, and the latter trying to capture activities that do create value.133 Of course, countries have their own fiscal interests that influence their stances when the ‘correct’ meaning of value creation is contested.134 For the time being, analysis on the meaning of value creation as a positive source rule is merely able to capture the ongoing competition between countries to promote their national interests; with reference to negative source rules, common ground is easier to find, and certainly this has already been greatly advanced through the work done over BEPS actions 8-10 on transfer pricing.135
Value creation as a negative source rule seeks to define activities that cannot be deemed to create value, indicating where income should not be allocated.136 Functionally empty, highly capitalised ‘cash box’ entity in a low tax jurisdiction that provides financing for other group
interdisciplinary reading, see B. Townley, P. Roscoe and N. Searle, ‘Constructing Value’ in Roscoe and Searle (eds), Creating Economy: Enterprise, Intellectual Property, and the Valuation of Goods (Oxford University Press 2019).
129 W. Schön, supra n. 11, at 5; Cf. S. Postler, ‘The OECDS’s Work on Profit Allocation and Nexus Rules for a Digitalised Economy – A Potential Improvement of the International Taxation Framework?’ (2020) Bulletin for International Taxation 76, at 79.
130 Schön, supra n. 11, at 5.
131 Kysar, supra n. 1, at 217 and references therein.
132 WU Transfer Pricing Centre, supra n. 89, at 4.
133 A. J. M. Jiménez, ‘Value Creation: A Guiding Light for the Interpretation of Tax Treaties?’ (2020) Bulletin for International Taxation 197 et seq.
134 Morse, supra n. 110, at 202.
135 OECD, Final Report on BEPS Actions 8-10, supra n. 111.
136 Jiménez, supra n. 133, at 200.
30 entities in high tax jurisdictions would most likely not be considered to contribute significantly to the value creation of the group as a whole and therefore be entitled to its residual profits. Especially the introduction of a substance over form principle137 in transfer pricing should prove useful in defining more clearly, where income cannot not be allocated.
In contrast to value creation as a negative source rule, the concept of a positive source rule aims to identify what are the specific value creating activities that indicate, how the income of multinationals should be allocated.138 Here, too, the work on risk under BEPS project,139 and more broadly, the increased emphasis of functionality analysis, on relevant business functions of associated enterprises helps in conceiving the idea of the functions that are relevant in allocating income.
Still, when discussing the creation of value in the framework of taxation and acknowledging that income is the proxy through which taxes are often imposed, the question on the actual extent to which income is a result of value creation should not be ignored.140 Many valuable goods do not have a price that would directly result in revenue.141 Moreover, income can be generated by capturing value through passive investment.142 Evidently, the question on the interplay between income and value is not a simple one, and a definitive or objectively sound answer may never unfold. But this obscurity is precisely what should be borne in mind when contemplating the potentiality of value creation as a principle to guide the allocation of taxing rights.
Jiménez has identified two biases concerning value creation as a positive source rule. These relate to significant people functions and ‘knowledge-based assets’;143 the analysis of which seems to imply of an understanding of value creation through the post-BEPS interpretation of the arm’s length principle. Firstly, Jiménez sees the concept of control over risk inherently linked with the ‘human element’ of risk controlling, to significant people functions. As people tend to be physically present in some relevant jurisdiction of an MNE, this human
137 This concept will be discussed in more detail in chapter 4.
138 Jiménez, supra n. 133.
139 See in detail below.
140 See, W. Haslehner, ‘Taxing where value is created in a post-BEPS (digitalized) world?’ (2018) Kluwer Intl. Tax Blog, available at http://kluwertaxblog.com/2018/05/30/taxing-value-created-post-beps-digitalized-world; Kysar, supra n. 1, at 217.
141 J. Becker and J. Englisch, ‘Taxing Where Value is Created: What’s ‘User Involvement’ Got to Do With It?’ 47 Intertax 161 (2019) Ch. II. 2.
142 Kysar, supra n. 1, at 217.
143 Jiménez, supra n. 133, at 200.
31 feature of risks and the relevance of risk to profit allocation under post-BEPS interpretation of the arm’s length principle may contradict the objective to eradicate the necessity of physical presence with regard to profit allocation.144 Secondly, Jiménez argues that the focus on intangibles, or knowledge-based assets, leads to over allocation of profit to mobile functions.145 People are a significant component of the development of intangibles and thus highly relevant in determining where the profits arising from intangibles are taxed. While Jiménez acknowledges that, as for now, people are often located in developed countries, he regards the mobility of people as potentially problematic for the future of tax systems, since using mobile assets as proxy to determine tax base allows shifting these assets to low tax countries.146
The notion on significant people functions may very well be correct in its criticism toward the requirement of physical presence, especially in contrast with the objectives of modernising the nexus concept and profit allocation rules for digitalised economy. Still, this argument seems limited in assessing the soundness of thought in granting people functions significance in profit allocation, at least beyond these very objectives.147 With regard to the second bias identified by Jiménez, the author considers the core underlying premise to be flawed; it is not per se problematic to have actual business functions in low tax jurisdictions.148 Instead, issues on tax fairness arise when insufficient nexus rules allow profit to be shifted into countries where the actual business activities are not.149 As such, here the issue lies in having taxable presence in a low tax jurisdiction without real economic presence and reporting profits in this jurisdiction and not in the jurisdiction where relevant economic activities are located.
As we can see from above, value creation is an inherently ambiguous concept, easily subjected to the differing interests of sovereign states and broad enough to facilitate the
gift-144 Ibid.
145 Ibid, at 201.
146 Ibid. Shaviro has further questioned the rationality in using value creation as denominator for tax base.
See, D. N. Shaviro, ‘Digital Services Taxes and the Broader Shift from Determining the Source of Income to Taxing Location-Specific Rents’ (2020) N.Y.U. Law & Econ. Research Paper No. 19-36 (working draft) 16, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3448070.
147 This is of course circular argumentation in the big picture, but the argument made by Jiménez may be useful in analysing the success of BEPS Action 1 against the objectives bestowed upon it.
148 The issues with jurisdictions having low effective tax rates and harmful tax competition that follows, are better addressed through global minimum taxation. See, OECD, Pillar Two Blueprint, supra n. 23.
149 OECD¸ Action Plan, supra n. 36, para 10.
32 wrapping of international consensus on direct taxation under a single principle.150 This reflects the fact that, to date, it has not been conceived possible to determinatively identify the exact components which contribute to value creation and to what extent.151 Indeed, value creation may be rightly criticised for being empty in substance: differing views on value creation and the significance of supply or demand side activities are equally justifiable under the notion of value creation, since there is no coherent economic theory backing the principle.
One feasible way to arrive at an outcome that reasonably well reflects value adding components, should this be the preferred policy approach, might be to deploy case-specific value contribution analysis.152 Then, through a detailed functional analysis that relies on the value contribution analysis and by applying the residual profit split method, it could be possible to identify the key factors in individual business models that result in value being created, or at least factors that can politically be agreed as fair proxies of value adding components, which are ultimately realised as sales revenue. However, in order to achieve sufficient level of tax certainty, this kind of contribution analysis would most likely have to be agreed under advance pricing agreements with relevant local tax authorities.
As mentioned above, any reference to the concept of value creation has been omitted from the wording of the Blueprint on Pillar One. This decision might very well be trivial in nature, resulting in the omission of the concept as unexpectedly as it originally emerged into political discussion.153 But it may well be that the OECD has come to realise that linking taxing rights with indeterminate concepts will not easily result in the level of endorsement that would be required to achieve a sustainable, consensus-based solution. It has been suggested outright that OECD erred in introducing the principle of value creation with reference to BEPS outcomes.154 Still, even if it was a mistake to introduce such a principle in this context, in the sense that the principle is currently too vague to effectively guide the allocation of taxing rights, as it can be used to justify virtually any position on the matter, the idea of aligning taxation with economic activity (that creates value) is not mistaken.
150 Becker and Englisch, supra n. 135, at chapter II;.Shaviro, supra n. 146, 15 et seq.
151 Ault and Bradford, supra, n. 2.
152 Value contribution analysis refers here to the most appropriate analytic framework available to identify the relevant business functions. Contribution analysis could draw from the concepts of value chain analysis, value network and value shop, discussed above in chapter 2.1.1.
153 See, Hey, supra n. 127.
154 Jiménez, supra n. 133.
33 And with reference to the idea of aligning taxation with real economic activities, common understanding seems to be strongly prevalent among the G20 and members of the Inclusive Framework.155 Indeed, when the right to tax corporate income is conjoined with actual business activities, this creates incentives to countries to provide such a business environment, that is appealing and competitive. This approach might advance global development that nurtures economic opportunities for businesses and individuals by ensuring legal certainty, efficient administrative procedures, protection of property rights as well as access to independent courts and to justice. Although neutrality is most certainly an important objective of tax law, taxation is an effective tool to purposely support certain broader objectives and phenomena, such as social responsibility of corporations or innovative research and development. Conversely, attaching corporate income taxation to the consumption of individuals provides for less opportunities to incentivise sustainable and institutional or structural development through CIT regimes.