OECD Pillar One Proposal:
Fragmentation of the Profit Allocation Rules – A Level Playing Field?
University of Helsinki Faculty of Law Master’s Thesis International Tax Law Author: Linda Sydänmaanlakka Supervisor: Prof. Marjaana Helminen February 2021
ii
Tiedekunta/Osasto – Fakultet/Sektion – Faculty Faculty of Law
Laitos – Institution – Department Tax Law
Tekijä – Författare – Author Linda Sydänmaanlakka
Työn nimi – Arbetets titel – Title
OECD Pillar One Proposal – Fragmentation of the Profit Allocation Rules – A Level Playing Field?
Oppiaine – Läroämne – Subject International Tax Law
Työn laji – Arbetets art – Level
Master’s Thesis
Aika – Datum – Month and year
February, 2021
Sivumäärä – Sidoantal – Number of pages
xv + 61 Tiivistelmä – Referat – Abstract
Significant tax challenges are claimed to arise from the digitalisation of the economy. The Organisation for Economic Co-operation and Development (OECD) has been working towards an international consensus-based solution for these tax challenges that predominantly relate to the international tax rules on permanent establishments (nexus) and profit allocation.
Under heated political discussion, many are questioning the fairness of the century old compromise on the allocation of taxing rights between source and residence countries, arguing that digitalisation renders the rules outdated that were designed in the era of ‘brick and mortar’ businesses with limited global dimension. Driven by this policy issue, the OECD has released Blueprint reports for Pillar One and Two Proposals for public consultation on 12 October 2020, which seek to reform fundamental elements of the international tax system, and to introduce a global minimum taxation for multinational enterprises.
The Blueprint on Pillar One Proposal is analysed in this thesis, albeit the core focus will be i.) on the scope of the proposal, which seeks to amend the profit allocation rules of businesses that engage with activities that fall under the definitions of Automated Digital
Services or Consumer Facing Business; and ii.) on the profit allocation rules, which seek to introduce a formula-based approach
for the allocation of a limited portion of the global residual profits arising from the provision of automated digital services or consumer facing businesses.
The research question of this thesis is whether the conveyed profit allocation formula, as compared to the arm’s length principle, is better suited to allocate the residual profits of companies engaging in the provision of automated digital services and consumer facing businesses, and whether it does so in such a manner that justifies the partial dismissal of the long-standing rules of international tax law and the ensuing fragmentation of this legal framework. International tax law principles, namely fairness, neutrality and efficiency, underpinned by the requirement of coherence of law, provide for a qualitative measure against which both these approaches to profit allocation are evaluated.
The discussion of this thesis concludes that, in the light of the international tax principles, there is no justification to enact a fragmented rule framework for profit allocation, by introducing a profit allocation formula to reallocate a limited portion of the residual profits of businesses engaging in the provision of automated digital services or consumer facing business. A hybrid system in profit allocation would increase complexity and welfare losses, that arise from distortions in economic behaviour, as well as decrease the overall efficiency and certainty of the international tax system. Ultimately, the more preferable solution to the modern issues of taxing business profit (digital or not) is to build a coherent rule framework under tax theory, which draws from a unified set of principles on fairness, redistribution, socially sustainable tax incentives and efficiency.
This theory may well stem from the familiar concepts of arm’s length principle or formulary apportionment, or it might introduce a completely novel approach to the global allocation of taxing rights and MNE profits. But it must be agreeable for sufficiently many jurisdictions, so as to truly benefit from the regime on a global level, promote international trade and the optimal allocation of resources. Until such comprehensive solution can be globally agreed upon, the most sensible way forward is to modernise the international tax framework on the basis of the existing system that relies on the post-BEPS interpretation of the arm’s length principle.
Avainsanat – Nyckelord – Keywords
BEPS, Unified Approach, Pillar One, International Tax Law, Profit Allocation, Arm’s Length Principle, Formulary Apportionment, Digital Taxation, Tax Policy, Coherence of Law
Säilytyspaikka – Förvaringställe – Where deposited University of Helsinki, Main Library
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Table of Contents
References ... v
Abbreviations ... xv
1 Introduction ... 1
2 Policy Issue of Digital and Consumer Facing Businesses ... 10
2.1 Description of the issue ... 10
2.1.1 Digitalisation and economies of scale ... 10
2.1.2 Overview of Pillar One ... 17
2.2 Definitions ... 19
2.2.1 Automated digital services ... 22
2.2.2 Consumer facing businesses ... 23
3 Principles for Sound International Tax System ... 25
3.1 Tax certainty ... 26
3.2 Fairness ... 27
3.3 Value creation ... 28
3.4 Efficiency... 33
4 Arm’s Length Principle ... 35
4.1 Definition ... 35
4.2 Application of the Arm’s Length Principle ... 37
4.2.1 Traditional transfer pricing methods ... 37
4.2.2 Transactional transfer pricing methods ... 39
4.3 Evolution under BEPS ... 40
4.4 Critique ... 44
4.4.1 Complexity: theory and practise ... 44
4.4.2 Easy to manipulate: abusive transfer pricing and profit shifting ... 46
4.4.3 Developing countries and structural inequality ... 48
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5.1 Definition ... 50
5.2 Addressing the failures of the Arm’s Length Principle ... 51
5.3 Comparison of the two methods ... 53
5.3.1 Against the principles of a sound international tax regime ... 53
5.3.2 Comparing the Formula with the Arm’s Length Principle ... 55
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Comments on BP
Netflix comment 14 Dec. 2020 on the Public Consultation Document on the Reports on the Pillar One and Pillar Two Blueprints
WU Transfer Pricing Centre comment 14 Dec. 2020 on the Public Consultation Document on the Reports on the Pillar One and Pillar Two Blueprints
International Bar Association comment 14 Dec. 2020 on the Public Consultation Document on the Reports on the Pillar One and Pillar Two Blueprints
PricewaterhouseCoopers comment 14 Dec. 2020 on the Public Consultation Document on the Reports on the Pillar One and Pillar Two Blueprints
National case law
KHO 2020:34 KHO 2018:173 KHO 2017:146 KHO 2014:119 KHO 2013:36
xiv
Table of Statues
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The Vienna Convention on Law of Treaties, 22 May 1969, United Nations, Treaty Series, vol 1155, p. 331
The Finnish Tax Assessment Procedure Act (1558/1995, as amended) The 1935 U.S. Treasury Regulations, Tax Code Sec. 45-1(b)
The United States War Revenue Act of 1917, Regulation 41 The Finance (No. 2) Act of 1915 (United Kingdom)
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Abbreviations
ADS Automated Digital Services
APA Advance Pricing Agreement
BEPS Base Erosion and Profit Shifting
CFB Consumer Facing Business
CPM Cost Plus Method
CUP Comparable Uncontrolled Price
Method
EU European Union
FTA Finnish Tax Administration
G20 Group of Twenty
GAAP Generally Accepted Accounting
Principles
GST Goods and Services Tax
IBFD International Bureau of Fiscal
Documentation
IMF International Monetary Fund
IT Information Technology
MNE Multinational Enterprise
OECD Organisation for Economic
Co-operation and Development
PBT Profit Before Tax
PSM Transactional Profit Split Method
RPM Resale Price Method
SAC Supreme Administrative Court
TBD To be decided
TNMM Transactional Net Margin Method
TP Transfer Pricing
1
1 Introduction
Taxation should be aligned with value creation – a seemingly natural objective within the area of international tax law, which has over the past decade brought an unforeseeable magnitude of global cooperation over corporate income taxation. Regrettably, even fairly simple objectives can be found extremely difficult to put into practise. Taxation, being inherently a matter of national sovereignty and of national policies and economic interests, is not effortlessly merged with the current reality of a globalised economy and multinational enterprises. Along with cross-border trade, digitalisation and evolving business models that seem unattached to physical presence, the traditional division between source and residence taxation has become increasingly obscure.
Previously the debate has been predominantly focused on how to balance the taxing rights of source and residence countries. Although the current discussion is reflective of the historic decisions made over this question, today we find ourselves lacking international consensus on where, or what, the source actually is. The flagrantly differing stances to defining the source of profit and value that vary from a consumption-based to a production-based approach reflect the highly political nature of this discussion. The existing compromise in the allocation of taxing rights between the country of source and country of residence is, even now, more reflective of international power and politics than being a precise encapsulation of economics and nexus.1 Moreover, value creation as a concept is not
economically robust, and to date it has not been possible to identify a causal link between profit and the distinct components of that profit.2 The very fact that the precise source of income is, at best, an educated guess, enables global governance to try loosely rein in international consensus even over such complex questions as the global balance of taxing rights and fair profit allocation. But it is exactly the ambiguity of the concept, that should work as glue in bringing countries together over a coordinated outcome, that allows countries to justify virtually any view on how to allocate taxing rights as aligned with value creation.
1 R. M. Kysar, ’Value Creation: A Dimming Lodestar for International Taxation?’ (2020) 74 Bulletin for International Taxation 4/5, 216.
2 H. J. Ault and D. F. Bradford, ’Taxing International Income: an Analysis of the U.S. System and its Economic Premises’ (1989) NBER Working Paper No. w3056; Schreiber et al. ’Why the Arm’s Length Principle Should be Maintained’ (2020) 27 International Transfer Pricing Journal 6. Value adding components are even more difficult to identify with regard to services (and compared to product manufacture): see, e.g., Engblom et al. Elinkeinoverotus (Edita 2020), ch. 13.
2 ***
In the beginning of 20th century, when companies first started to conduct business on a large
scale outside the country in which they were situated (hereinafter ‘country of residence’), international consensus was remarkably achieved over the question of how national taxation should account international businesses. In 1920s the concept of economic allegiance was introduced by a technical expert committee of four economists, which was nominated by the League of Nations in 1921 , and that concept was to serve as a basis for the allocation of taxing rights and as means to avoid juridical double taxation within the international tax framework.3 Aside from the country of residence, it was then agreed that the country in which the company operates, and conducts significant business activities therein, should be awarded the right to tax profits arising from that country (hereinafter ‘country of source’). As a compromise between the country of residence and the country of source, it was further decided, that the residence country should have the primary right to tax the profits of companies residing within its jurisdiction.4 The only exception to this general taxing right would be a permanent establishment (hereinafter ‘PE’) – a taxable nexus, which is constituted through sufficient degree of economic allegiance with another country. The country of permanent establishment would have the right to tax the profits of a company that was a resident of another country. The country of residence would have to eliminate double taxation domestically. The source country’s right to tax would cover any and all income of the permanent establishment, but only to the extent this income would be attributable to the PE situated therein.5
With regard to PEs, a two-step analysis is required to determine the correct amount of taxable profit in residence and source countries, respectively. First it should be examined whether a company that is a resident in one country, has sufficient amount of activity in another, meets the requirements of economic allegiance, thereby creating a tax nexus. Then, since the PE is functionally and legally part of the company itself, an appropriate amount of profit must be allocated to the source country i.e., the country where the PE is located. This
3 Bruins et al., Report on Double Taxation: Document E.F.S.73.F.19 (5 April 1923). Economic allegiance was based on the factors of the place of origin [of wealth]; the location of wealth; place of enforcement of the rights to the wealth; place of consumption or disposition, measuring the existence and extent of the economic relationship between a particular country and the company (income). See, OECD, BEPS Action 1 – Final Report on Tax Challenges Arising from Digitalisation (2015), ch 2.
4 Bruins et al. supra n 3.
3 profit allocation is based on the separate entity approach, which means, that the PE is hypothesised, for tax purposes, as separate from the company. The PE should be allocated profit and loss as if it were an independent company operating in the source country on its own, under normal market pressure, performing business functions, using assets and assuming risks solely in its own economic interest.6
***
Approximately half of world trade7 is conducted within multinational enterprises (hereinafter ‘MNE’).8 Due to fiscal sovereignty of jurisdictions, diverging corporate income
tax rates (hereinafter ‘CIT’), cost deduction rules and so forth, it is certainly not irrelevant for the effective tax rate of the MNE, where it operates and makes profit (and loss). When companies that, ultimately, are concerned with a shared economic interest, conduct business with each other, there may be incentives to price internal transactions differently to that what independent parties would have agreed on.9 Associated enterprises that are parts of the same MNE group, may even undertake transactions that independent parties would not have agreed to at all.
The separate entity approach is enforced through the arm’s length principle (hereinafter ‘ALP’), which aims to ensure that associated enterprises, in internal transactions, use conditions that would have been agreed between independent enterprises under comparable circumstances.10 Essentially this means, that associated enterprises should not be able to
artificially undertake transactions or agree on terms through which they could shift profit to jurisdictions with low or no taxation, which would minimise the effective tax rate of the MNE as a whole.
Transfer pricing is the subdivision of international tax law which is concerned with related party transactions. At the heart of transfer pricing is the arm’s length principle, which is used to establish an appropriate transfer price, the price used in a related party transaction. By
6 OECD, Model Tax Convention on Income and on Capital: Condensed Version 2017 (OECD Publishing 2017) Art. 7, <http://dx.doi.org/10.1787/mtc_cond-2017-en>
7 Estimates vary between 40 and 70 percent. OECD has estimated that approximately half of world trade takes place within multinationals. See, <www.oecd.org/sdd/its/measuring-multinational-enterprises.htm> last accessed 15 January 2021.
8 OECD, Model Tax Convention 2017, supra n. 6, Art. 9 (‘Associated Enterprises’).
9 Although it has to be reckoned, that companies within an MNE may also compete with each other ferociously, driven by company or business-line specific sales targets and other performance indicators. 10 The definition of arm’s length principle is examined more thoroughly in ch 3.
4 preparing transfer pricing documentation, conducting comparable uncontrolled transaction analyses and making price adjustments when necessary, companies that engage in intra-group transactions seek to ensure their compliance with the arm’s length principle and avoid adverse transfer pricing audit outcomes, often accompanied with bad press and punitive tax increases.
Transfer pricing itself is about tax compliance – multinationals cannot decide not to do it; it is an indispensable part of conducting business globally as a multinational. Yet, transfer pricing can also be used as a tool for minimising tax burden, both legally and illegally. In the past, transfer pricing has mainly been under public discussion due to extensive tax planning schemes. Even though transfer pricing builds on the relatively simple idea of companies conducting business as if they were separate entities having their individual economic interests, the compliance with this key principle is often short of simple. Tax authorities conducting transfer pricing audits, too, may experience difficulties in assessing the set transfer price and other relevant conditions. This kind of dual complexity invites aggressive tax planning.11
The Project on Base Erosion and Profit Shifting (hereinafter ‘BEPS’) took place in 2013 when the G20 entrusted the OECD with the task of redesigning international tax rules aimed to prevent artificial profit shifting to low or zero tax jurisdictions that results in the erosion of national tax bases.12 BEPS is not a transfer pricing project per se, but many of the action
points concluded by the OECD do focus directly or indirectly on transfer pricing issues.13 Under the Final Report on BEPS Action 1 – Tax Challenges Arising from Digitalisation14
the OECD stated that digitalisation and evolving business models, especially the growing importance of intangible property, exacerbates many issues identified in the project as pressure points to profit shifting and aggressive tax planning.15
11 W. Schön, ‘Ten Questions on Why and How Tax the Digitalised Economy’ (2018) 72 Bulletin for International Taxation 4/5.
12 OECD, Action Plan on Base Erosion and Profit Shifting (OECD Publishing 2013).
http://dx.doi.org/10.1787/9789264202719-en. Profit shifting has not been defined by OECD, but for the purposes of this thesis, a following definition is adopted: “the extent to which corporations systematically report lower profits when they face higher taxes”. See, N. Johanssen, infra n. 223, at 791.
13 See also, J. Andrus and P. Oosterhuis, ‘Transfer Pricing After BEPS: Where Are We and Where should We Be Going’ (2017) Taxes: The Tax Magazine; On the origins of BEPS, see A. Christians and S. Shay, General Report, in 102A Cahiers de Droit Fiscal International: Assessing BEPS: Origins, Standards, and Responses (International Fiscal Association 2017) 17.
14 OECD, Final Report, supra n. 3. 15 Ibid.
5 ***
Technological advancement in late 20th and especially 21st century has certainly influenced
daily routines across the globe and scattered both business and personal life into various social media platforms. Digitalisation has been claimed to both enable and intensify globalisation.16 New business models have emerged, and trade has gone further online. Due to the Covid-19 pandemic, which has forced governments across the world to impose social distancing measures and travel restrictions, many have started working and studying from home, or at least find themselves spending majority of their time indoors, bound to their home countries. Demand for IT and platforms that allow people to connect from afar has surged. The pandemic will certainly have lasting effects on businesses and further empower the trend of digitalisation.
According to the OECD, the tax policy issue concerning digitalisation is, that certain businesses are able to participate in a sustained and significant manner in the economic life of a market jurisdiction, without necessarily having physical presence there.17,18 This creates disparities in the operational environment of digital companies compared to traditional ones. In these situations, due to the lack of physical presence, no taxable nexus is deemed to exist in the market jurisdiction. And even if a PE would be deemed to exist, it is argued that current profit allocation rules would not allocate any meaningful profit to it.19 As such, the
current legislative framework is perceived to lead to a mismatch between economic activity and taxation and to fail in delivering a level playing field, the equity between market actors. As a response to these tax challenges arising from digitalisation, the OECD and G20 member countries along with the Inclusive Framework on BEPS,20 have composed a twofold unified approach, which proposes to level the playing field for digitalised and traditional businesses alike, by fundamentally changing the way in which global profits of multinationals have been allocated for over a century, as well as further discourage the international profit 16 Ibid.
17 OECD, Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint: Inclusive
Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, (OECD Publishing, Paris 2020) https://doi.org/10.1787/beba0634-en.
18 The term ‘market jurisdiction’ is used here to refer to jurisdictions in which an MNE group sells its products, or in the case of digital businesses, provides services to users or collects data or content contributions from users. See, ibid.
19 OECD, Final Report, supra n. 3, at para 486.
20 The Inclusive Framework contains members from over 135 jurisdictions. In the following, ‘OECD’ with regard to BEPS is used to refer to OECD member countries, G20 countries and the members of the Inclusive Framework.
6 shifting of multinationals companies. Unified approach consists of two proposals with diverging yet interrelated objectives. Pillar One Proposal (hereinafter the ‘Proposal’ or ‘Pillar One’)21 seeks to create a new taxable nexus and profit allocation rules, that aim to
deliver more sustainable, fair and efficient international tax law regime reflective of modern day digitalised and global economy.22 Pillar Two Proposal has a broader objective to address remaining BEPS issues through the introduction of global minimum taxation regime and by ensuring that large MNE’s pay a minimum level of tax irrespective of their operative or headquarters location.23
Acknowledging the fact that there is no intrinsic value in maintaining status quo simply because in the current situation and immediate future it might be the most convenient thing to do, a critical analysis of this Proposal is needed.24
***
In the following, I will evaluate the coherence of the policy arguments underlying the pillar one proposal and the legal approach adopted by the OECD, which departs from the long-standing arm’s length principle as prevailing method to allocate global profits for tax purposes, and introduces a new profit allocation formula (hereinafter the ‘Formula’) to be applied alongside ALP. The general aim of this thesis is to bring about conceptual perspective into the discussion over reallocation of global profits deriving from Automated Digital Services (hereinafter ‘ADS’) or Consumer Facing Business (hereinafter ‘CFB’). The research question of this thesis is whether the profit allocation formula, as compared to the arm’s length principle, is better suited to allocate the residual profits25 of companies
21 OECD, Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint: Inclusive
Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing, Paris 2020) https://doi.org/10.1787/beba0634-en.
22 OECD, Cover Statement by the Inclusive Framework on the Reports on the Blueprints of Pillar One and
Pillar Two, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing, Paris 2020) para 5.
23 OECD, Tax Challenges Arising from Digitalisation – Report on Pillar Two Blueprint: Inclusive
Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing, Paris 2020) para 8, https://doi.org/10.1787/abb4c3d1-en.
24 Although it has to be noted, that the alternative to coordinated international approach is most likely not the status quo, but the introduction of national digital sales taxes and highly fragmented operating environment for digital businesses. Still, the following discussion won’t praise Pillar One simply for being the lesser of two evils; instead, the author believes that with time, it is possible to reach an objectively better solution for the international tax regime.
25 Here defined as “profit in excess of a certain profitability threshold percentage”. See, See, OECD, Tax
Challenges Arising from Digitalisation – Economic Impact Assessment: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing, Paris 2020) para 10.
7 engaging in the provision of ADS and CFB; and in such manner that justifies the partial dismissal of the long-standing rules of international tax law and the ensuing fragmentation of this legal framework. This analysis is underpinned by international tax law principles, which provide for the qualitative measure against which both ALP and the Formula are evaluated.
To answer these questions, the following topics are discussed in further detail below. Chapter on Policy issue of digital and consumer facing business provides the reader with fundamental understanding of the business characteristics that call for a change in the profit allocation rules. In Principles for sound international tax system, concepts of the coherence of law, tax certainty, fairness, value creation and efficiency are analysed so as to provide the reader with context and introduce some ground rules for a legal framework of taxation. This analysis facilitates the evaluation of both ALP and the Formula in contrast to these principles, underpinned by the concept of coherence of law. Third chapter on the Arm’s length principle intends to capture the nature of status quo in profit allocation, the evolution of the arm’s length principle under the BEPS project and to identify the core weaknesses of the ALP. Chapter on the Profit allocation formula examines the definition of the Formula, evaluates how the Formula could address the weak spots of the arm’s length principle and whether it should be considered better suited in allocating the residual profits derived from ADS and CFB. Finally, concluding remarks underline the challenges presented by the imperfect implementation of formula-based profit allocation rules that, ultimately, result in a hybrid regime for the allocation of taxing rights. The thesis rejects the OECD’s Proposal, which suggests that, in contrast to existing allocation rules, a formula-based approach would be better suited to allocate the global profits derived from automated digital services and consumer facing business.
***
The method to address the research question outlined above is a combination of traditional legal dogmatics, legal theory and tax policy considerations. This thesis intentionally bypasses the perhaps more obvious and traditional choice of perspective used upon nearing changes in the legislative landscape; that is, the purely legal dogmatic and comparative method to systemise and explain, what is, and what will be. Here, this perspective would be premature and partially illogical. After following the discussion on digital taxation for several years, the author does not believe that the Pillar One, as currently laid out in the
8 Blueprint released for public consultation in October 2020, will achieve sufficiently broad international consensus that would be vital for the success of the Proposal.26
For this reason, a more conceptual perspective has been adopted instead. By focusing on the underlying premises and fundamental aspects of the Pillar One, i.e., the rationale for activity-based limitations on scope and for the use of predetermined formula in profit allocation, the discussion in this thesis is more likely to hold relevance in subsequent attempts to redesign international tax rules, should the Pillar One fail to conquer.
Conceptual perspective naturally rules out many directly and indirectly related questions of relevance on this topic. As for the Pillar One Proposal, the focus is predominantly on the rules on scope and profit allocation. Critical issues that remain untouched in the following text include a detailed analysis of Pillar One and its functionality as a whole, together with existing rule framework and with Pillar Two. Predominantly economic issues regarding tax accounting and the combination of separate entity and consolidated taxation are left out of scope. Another highly important question that remains to be discussed some other time, is that of third countries, i.e., those jurisdictions that would not adopt the nexus and allocation rules proposed in Pillar One, and potential double taxation that may arise in these situations. Moreover, it should be acknowledged that the effects of BEPS on MNE tax conduct are still unfolding.27 This materially limits the accuracy of virtually any assessment on any impacts
of Pillar One, or Pillar Two for that matter, since a clear picture of the baseline is currently unavailable.
***
When searching for source material on the topic of this thesis, it has been easy to observe that journal articles on the question of digital taxation are plenty. Peer reviewed contributions have been preferred in writing this thesis where possible. Geographically, majority of the references used can be located in Europe and North America; and this innately Western perspective should be acknowledged. Conclusions of this thesis might be different, should the prevailing perspective instead be that of developing countries. To
26 This view seems to be shared by the European Commission; evidenced by the release of an initiative on digital levy for ‘A Fair and competitive digital economy’ on 14 Jan 2021 – the same day the OECD held its public consultation meeting on Pillar One Blueprint. See,
<https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12836> accessed 15 Jan 2021.
27 The economic impact assessment relies on financial figures from fiscal year 2016, which is before the adoption of most BEPS measures. See, OECD, Economic Impact Assessment, supra n. 25, chapter 1.
9 appropriately provide for symmetry, this viewpoint, too, will be thoroughly examined, and the two perspectives hopefully joined together in writing, and state practise under international agreement, in time to come.
In addition to academic literature, journals, case law and various official documents, the author has gained tremendous insight from interviews with Tatu Mäkimartti of Korpi Capital, Heikki Puomila of Supercell, Leena Aine of the Ministry of Finance (Finland), Jarno Laaksonen of PricewaterhouseCoopers and Maria Volanen of the Technology Industries of Finland. Thank you all. Regardless of the greatly inspiring nature of these discussions, respectively, no direct references have been made to these interviews, and all views expressed, as well as potential errors occurring in this thesis are on the sole responsibility of the author.
10
2 Policy Issue of Digital and Consumer Facing Businesses
2.1 Description of the issue
2.1.1 Digitalisation and economies of scale
Information technology (hereinafter ‘IT’) refers to any computing technology, i.e. hardware, software, the internet and other technical means for networking.28 Simply put, it enables
businesses to perform more efficiently, and with reference to globalisation, effective IT provides companies with the means to actually reach global markets, conduct business from multiple locations, benefit from the expertise of workers unbound of their physical domicile, as well as flexibly to relocate production and other business functions to where it is most efficient to undertake such activities.29 IT can be viewed both as a supporting act and simultaneously, in many cases, a significant component of the business itself. Often, it is the overarching business function that fully enables the core business to remain focused on making profit. Moreover, developments in IT drive digitalisation, which can be understood as the increase in the frequency and commonness of use of IT. Further, this increased usage imposes structural changes throughout societies. Digitalisation provides for efficiency gains in existing business models and creates room for completely new and novel business models to enter the market.30 In addition to the increase in operational possibilities on the supply side, the expansion of IT and digitalisation has significantly affected the demand side of business.31
The emergence of social media, e-commerce, sharing economy, internet of things, virtual currencies, and artificial intelligence – to name only few, has made large parts of humankind more connected and less bound by national borders than ever before. The needs of ordinary
28 See, e.g., J. Recker, Scientific Research in Information Systems: A Beginners Guide (Springer 2012). 29 Naturally, IT is also highly important for the efficiency of businesses that operate solely domestically. 30 This definition is roughly translated from a definition formed by Anita Isomaa, originally in Finnish: “… käsite, jolla tarkoitetaan tieto- ja viestintäteknologioiden lisääntyvää hyödyntämistä ja siitä johtuvaa yhteiskunnallista muutosta. Kysymyksessä on ilmiö, jonka vaikutus ulottuu kaikkialle yhteiskuntaan ja sen rakenteisiin… Sen avulla voidaan tehostaa jo aikaisemmin käytössä olleita liiketoimintamalleja, mutta digitalisaatio luo mahdollisuudet myös täysin uudenlaisten liiketoimintamallien käyttöönotolle.” See, A. Isomaa-Myllymäki, ’Korkean digitalisaation liiketoiminnan lisääntyvä sääntely ja verotus Euroopan unionissa’ in Penttilä, Nykänen and Nieminen (eds) Parempaan yritysverotukseen (Edita 2020) 85. 31 OECD, Pillar One Blueprint, supra n. 21.
11 people as well as businesses are becoming increasingly sophisticated and this necessitates intensifying specialisation in the realm of service providers and product suppliers.32
Digitalisation is believed to bring considerable productivity and efficiency gains to market actors.33 According to widely accepted economic theories, these cost efficiencies should in turn translate into consumer welfare and add to the overall wealth of a society. Any in-depth analysis of this argument is regrettably out of scope of this thesis and beyond the expertise of the author. However, for the purposes of this thesis, based on a rather large body of economic literature, the accuracy of the economic presumption in relation to increased productivity and ensuing welfare of a society is assumed robust and well rounded.34 Notwithstanding the positive corollaries of digitalisation, the ‘breadth and speed’ of change in business environment delivered through advancing digitalisation is seen as a challenge to the level playing field or the equity between more digitalised businesses against traditional ones.35 International tax rules are considered outdated for modern, digitalised and globalised economy. Large multinational companies reaping colossal profits through their highly digitalised business models are often condemned in the public discourse for not paying their fair share of taxes. When launching the BEPS project in 2013, it was grandiosely stated by the OECD, that at the stake with the project would be the integrity of the corporate income tax system as a whole.36
Spanning from year 2015, the OECD has been working to better identify the tax challenges related to digitalisation and design a consensus-based solution to these challenges, which could eventually be implemented via multilateral instrument, ultimately affecting thousands of bilateral tax treaties, so as to facilitate stability and coherence throughout the international tax system. The challenges identified by OECD were initially allocated into two categories;
32 P. Collier, The Future of Capitalism: Facing the New Anxieties (HarperCollins 2018) 125 et seq.
33 OECD, Tax Challenges Arising from Digitalisation – Interim Report 2018, Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing, Paris 2018) 13.
34 See e.g., R. Whish and D. Bailey, Competition Law (Oxford University Press 2012), Ch 1.3 ‘The Theory of Competition’ and references therein.
35 OECD, Pillar One Blueprint, supra n. 21; see also, European Commission, A Fair and Efficient Tax
System in the European Union for the Digital Single Market, Brussels 21. Sept 2017, COM (2017) 547 final, 2.
36 OECD, Action Plan on Base Erosion and Profit Shifting (OECD Publishing 2013), p. 8. http://dx.doi.org/10.1787/9789264202719-en.
12 one which consists of BEPS issues exacerbated by digitalisation; and the other which composes tax challenges concerning more fundamental aspects of international tax law.37
The first category, BEPS issues exacerbated by digitalisation, is not examined further in the following text, as these issues are well discussed in the respective final reports of the BEPS project and academic literature. Naturally, this limitation should not be understood as an understatement of the fact that digitalisation very well might further enable certain kinds of profit shifting, especially with regards to intangible assets. But for the purposes of this thesis, this aspect is considered out of scope, and a reference is simply made to the final reports covering these exacerbation issues.38
***
In the Final Report of 2015 on Tax Challenges Arising from Digitalisation, the OECD was unable to recommend a single course of action to address these tax challenges. It was then agreed that G20/OECD countries, together with the members of Inclusive Framework would carry on efforts to find a unitary solution for those challenges. Notwithstanding the differing viewpoints of the participating countries and the indeterminate final report that ensued, an understanding was reached over some key features of the digital economy. These are listed as follows:
- mobility of intangibles, users and business functions; - reliance on data;
- importance of network effects; - multi-sided business models;
- tendency towards monopoly or oligopoly; and - volatility of the market.39
On the basis of these key features, the most pressing policy challenges for direct taxation were identified as nexus, data and characterisation. These topics are briefly discussed below. Nexus
Evolving business models as well as the growth of digital infrastructure has provided businesses with the ability carry out activities remotely, increasing the options available for MNEs to choose where the relevant business activities, as defined under current tax rules, 37 OECD, Final Report, supra n. 3.
38 See the final reports on the OECD/G20 BEPS project, actions 2-15. Available at <www.oecd.org/tax/beps/>
13 take place.40 This may result in previously locally performed business activities to move
outside that jurisdiction, e.g., into the residence country of an MNE, or any other country. Still, even with the fact that business activities have been relocated out of the relevant jurisdiction, it is considered that if a company is able to be ‘heavily involved with the economic life’ of another country,41 that country should have a legitimate tax claim to the profits of that company. This resonates with the principle of economic allegiance as the basis of taxing rights. Yet, the content and meaning of the concept involvement with the economic life [of another country] seems to depart from the meaning given to the concept of economic allegiance – and defy the general objective of preventing double taxation; profits of a company should be appropriately taxed in the country where the actual business functions reside.42
In the Final Report, it is acknowledged that information about customers and markets has always been valuable for businesses and that also pre-digitalisation economy has benefited from network effects, which are characteristic to highly digitalised business models of today. However, it is suggested that changes in tax policy with regard to nexus rules may be justified due to ‘…lower marginal costs in digital businesses coupled with increased network effects generated by higher levels of user participation’.43 If mere operational efficiency is to establish tax nexus into jurisdictions where businesses have locally operated in the past, we have come a long way from the principles underlying the concept of economic allegiance, which is based on identifiable factors that are used as proxies to measure the existence and extent of economic relationship between a country and income.44
Data and Characterisation
Taxes are commonly imposed on different stages of wealth, the most common ones being the creation; holding; transfer and consumption of wealth.45 By reference to these stages, payments are used as proxies to define the tax base.46 Data and the accurate characterisation
40 Ibid, paras 253-254. 41 Ibid, para 256.
42 Schön, supra n. 11. It is important to keep in mind, that ‘market country’ does not necessarily equal to ‘source country’.
43 OECD, Final Report, supra n. 3, para 259. 44 Ibid, Ch. 2. Bruins et al., supra n. 3, at 22.
45 P. Harris and D. Oliver, ‘Fundamentals and sources of international tax law’ in International Commercial
Tax (Cambridge Tax Law Series, Cambridge University Press 2010) 8-42.
14 of certain data-related actions for tax purposes are considered challenging for the traditional means of imposing tax: the collection and eventual monetisation of data, as well as user contributions, are not captured as payments under current tax rules. Of course, the added value reflected in the value of the business itself may be traditionally monetised and taxed as a payment upon the transfer of wealth.47 Still, in practise, questions on data and its accurate characterisation would undoubtedly prove rather testing with regards to tax enforcement and administration – which might be why the issue has not been discussed beyond the Action 1 – Final Report by the OECD. Nevertheless, the question whether cross-border transfer of data and user contributions in multi-sided business models48 should be taxed as transactions remains, at least in theory, an intriguing question.
***
In March 2018, the OECD published an Interim Report, in which the work on defining ‘highly digitalised business models’ was advanced and the characteristics of cross-jurisdictional scale without mass; heavy reliance on intangible assets; and the importance of data, user participation and their synergies with intellectual property that are linked with digital businesses, elaborated further.49 Other defining characteristics were identified as
well, but these could not be said to be exclusive to digital markets.50
Value creation processes can be roughly described through the concepts of i.) value chain; ii.) value network; and iii.) value shop.51 Value chain is illustrating the creation of value
within a business through five primary activities and four support activities.52 Here, value
creation is conceived as the conversion of inputs into outputs through different business activities that ultimately leads to a final deliverable that is sold to customers with a profit margin, which in turn is determined by the effectiveness of the activities in the value chain.53 If value chain is most suitable to understanding value creation in traditional businesses that
47 OECD, Final Report, supra n. 3, paras 262-267.
48 Multi-sided business model refers to business models where “the key feature is that the ability of a company to attract one group of customers often depends on the company’s ability to attract a second group of customers or users”. See, ibid, para 266.
49 OECD, Interim Report, supra n. 33. 50 Ibid, paras 42-43.
51 Ibid, para 65.
52 Ibid, para 75. Primary activities of a value chain are listed as: inbound logistics, operations, outbound logistics and sales, service. Support activities (common to all value creation processes) are listed as: infrastructure, human resource management, technology development and procurement.
15 produce physical or tangible products, then value network illustrates how value is created in the era of technology and service providers. The value network is comprised of three primary activities and four support activities, underpinned by the notion of connectivity.54 In a network, value is created by connecting users, which can be individual customers or larger organisations, driven by their customised needs to provide, sell, use or buy.55 Finally, the value shop encapsulates the process of value creation related to solving unique problems of customers with technology intensive solutions.56 The value shop consists of five primary activities and four support activities. Here, value creation results from, and ultimately, the profit margin is determined by, the accuracy and effectiveness of interplay between these activities, that delivers the solution to a specific problem of the customer.57
Although the report provides rather substantive insight on different value creation models illustrated by various digitalised businesses,58 the main policy issue seemingly lies, not within the stated differences in the methods of value creation itself, but namely within the ability of highly digitalised businesses to conduct business without a physical presence in a country where it has customers and to benefit from cross-jurisdictional scale without mass. The decision to equate business characteristics with policy issues of regulation can be subject to justified criticism on its own right, but more interesting here is the wording for the phenomenon ‘scale without mass’. Scale without mass effectively relates to the mathematically proven and well-established principle of microeconomics, the economies of scale. Economies of scale, or scale benefits, occur when the average cost per unit output decreases with the increase of the outputs produced.59
With reference to traditional businesses, economies of scale means that it is more cost efficient to produce multiple products together rather than separately. In principle, this applies to digitalised businesses as well; although with digitalised businesses, whose products or services are often intangible and provided non-physically over an internet connection or through other networks, the marginal cost to serve additional customers may
54 Ibid, paras 75, 80-84. Primary activities of a value network are listed as: network promotion and contract management, service provisioning and infrastructure operation. Support activities are listed in supra n. 50. 55 Ibid, paras 80-84.
56 Ibid, para 89. 57 Ibid, paras 89-94. 58 OECD 2018 ch. 2.
59 See e.g., Whish and Bailey, supra n. 34, at 10; and more generally, B. Supple (ed), Essays in British
16 be remarkably low or even zero, and this is what is considered problematic from the perspective of ‘sufficient’ and fair taxation.60 Yet, there is no rationale justifying different
tax treatment on the basis of economies of scale, because these synergies present themselves in virtually all multinational enterprises.61 The mere fact that the quantity of these benefits may vary according to the quality of the product or service provided, should not result in more aggressive taxation; or at least this approach cannot be defended by the established tax virtue of neutrality and subsequently, the optimal allocation of resources.62
Nonetheless, OECD has adopted the term scale without mass, although it has no basis in microeconomic theory. Of course, the rationale behind this approach may relate to a need to somehow differentiate the phenomenon of economies of scale with reference to ADS and CFB, compared to these scale benefits retained in other business models. In the following text, scale without mass is used to refer to economies of scale, or scale benefits, group synergies, that occur in digitalised businesses.63
The OECD argues, that under the current legislative framework, the phenomenon of cross-jurisdictional scale without mass will affect business models in such a way that the number of jurisdictions with a right to tax business profit is likely to decrease remarkably in the future.64 It follows, that rules which combine significant economic presence, and
correspondingly, taxing rights as regards to the proceeds of the said economic activity, to significant people functions are conceived as inherently flawed when applied to digital businesses.65
The change of tone here is quite blunt; first, the OECD spends years analysing the economic substance of highly digitalised business, aiming to provide fiscally level playing field for digitalised and traditional businesses alike. It then goes on to state that one of the main issues with regard to digitalisation and direct taxation is the fact that digitalised businesses have discovered efficient and productive ways of conducting business, or, the ability to benefit 60 See, OECD, Cover Statement, supra n. 22; and also European Commission, Communication on Tax
Fairness, supra n. 35.
61 See below chapter 4.4. 62 See below, chapter 3.
63 Scale without mass as a concept is mentioned in one scientific draft article but has not been widely recognised. See, Brynjolfsson et al., ‘Preliminary Draft: Scale Without Mass: Business Process Replication and Industry Dynamics’ (2006) Harvard Business School. Available under www.hbs.edu/research/pdf/07-016.pdf. With reference to consumer facing business, scale benefits are naturally referred to as economies of scale.
64 OECD, Interim Report, supra n. 33, para 384. 65 Ibid.
17 from cross-jurisdictional scale without mass; and that due to this operational efficiency, taxing rights to corporate profits should be increasingly allocated to the country of the market, instead of the country of the business functions.66
To address the policy issue as conceived above, in May 2019, OECD introduced the concepts of Pillar One and Pillar Two to the international community as a solution for remaining BEPS issues.67 Less than a year later, in late January 2020, the Inclusive Framework welcomed the Unified Approach as the foundation to reach a consensus-based solution with regard to nexus and income allocation as well as global minimum taxation. The Unified Approach is composed of proposals on Pillar One and Pillar Two, which are intended to complement each other’s policy objectives. The general objective of pillar two has been briefly described above and will not be examined further.
2.1.2 Overview of Pillar One
The objective of Pillar One is to present a sustainable response to the challenges of international tax framework, by extending the taxing rights of jurisdictions in which consumers are located, and create nexus rules fit for digital economy, where businesses can participate in an active and sustained manner in the economic life of a market jurisdiction, through engagement extending beyond the mere conclusion of sales, in order to increase the value of their products, their sales and thus their profits.68 The proposal seeks to welcome more fair and efficient allocation of taxing rights, reflective of the modern digitalising economy.69
Pillar One presents a three-fold response to global tax issues brought by certain digitalised and consumer facing business models, which are discussed in detail below.70 The key elements of Pillar One are Amount A, Amount B and Tax certainty. Amount A introduces a new taxing right for market jurisdictions which, through profit allocation formula, seeks to allocate a share of residual profit to countries where multinationals sell their products or
66 See also Netflix comment 14 Dec. 2020 on the Public Consultation Document on the Reports on the Pillar One and Pillar Two Blueprints.
67 OECD, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the
Digitalisation of the Economy, OECD/G20 Inclusive Framework on BEPS (OECD, Paris 2019), available under <www.oecd.org/tax/beps/programme-of-work-to-develop-aconsensus-solution-to-the-tax-challenges-arising-from-the-digitalisation-of-the-economy.htm>
68 OECD, Pillar One Blueprint, supra n. 21, para 22. 69 OECD, Cover Statement, supra n. 22.
