Policy discussions on the digital economy remain an important part of the international agenda. Taxing the elusive profits of multinational digital giants has become a serious concern for developed and developing countries alike.
So far, discussions on the issue have given rise to two groups of proposals, often called "pillars." Pillar One focuses on the allocation of taxing rights, which necessitates a coherent and concurrent review of profit allocation and nexus rules. Pillar Two concentrates on measures to achieve minimum effective tax rates. The latter explores the design of a tax system to ensure that multinational enterprises in the digital economy and beyond pay a minimum level of tax.
Pillar One converges three proposals for allocating taxing rights based on user participation, marketing intangibles and significant economic presence. But it is never an easy task for any country to choose the most suitable scheme.
The Organization for Economic Cooperation and Development (OECD) recently published a public consultation document titled "Unified Approach," filled with comments from the public on several policy issues and technical aspects related to its latest proposal to tax digital business models and consumer-facing businesses.
The comments are supposed to assist members of the Inclusive Framework on Base Erosion and Profit Shifting – a collaboration of 130 countries to stem tax avoidance – in developing a solution for its final report to the Group of 20 next year.
The Unified Approach was established because there were gaps in the Pillar One proposals. For instance, the user participation proposal makes specific reference to digital businesses, while the marketing intangibles proposal focuses more broadly on conventional businesses.
The nature of the reallocation of taxing rights also differs between the Pillar One proposals. The marketing intangibles and user participation proposals reallocate a portion of non-routine profits to the user or market jurisdiction, whereas the significant economic presence proposal looks at all profit – routine and non-routine – as a starting point.
As things stood, a solution was unlikely to be reached by choosing one proposal over another. That would just encourage more jurisdictions to adopt uncoordinated, unilateral tax measures that could damage global investment and growth.
The Unified Approach was developed as a new approach based on what the three proposals had in common and took into account their ultimate aim.
Public consultations on this unified proposal confirmed that any solution must be as simple as possible. The approach broadly covers digital business models and consumer-facing business in particular.
The Unified Approach also creates a new nexus that rather than depends on physical presence, primarily focuses on sales. It is possible for the new nexus to have a threshold, including country-specific sales thresholds calibrated to ensure that countries or jurisdictions with smaller economies can also benefit from implementing this approach. The nexus will be designed as a provision in a new self-standing treaty.
The approach creates a new profit allocation rule applicable to taxpayers. It consists of a three-tier profit allocation mechanism described as follows:
First, "Amount A" is a share of deemed residual profit allocated to market jurisdictions using a formulaic approach. Second, "Amount B" is a fixed remuneration served as a baseline to determine how to distribute marketing functions in such jurisdiction. Lastly, "Amount C" is a binding and effective dispute prevention and resolution mechanism relating to all elements in the proposal.
Amount C also includes an arrangement on additional profit where in-country functions exceed the baseline activity compensated under Amount B.
The OECD has said this unified approach proposal is made on a relatively general level, with certain aspects still requiring further work. Consequently, there is a lack of certainty on the Unified Approach proposal.
Overall, the critical point in the proposal is Amount A, since it represents the remaining profit after designating a deemed routine profit on activities of the group or business line.
The fixed percentage of the deemed residual profit has not been decided, and the numbers are open to negotiation.
To make it clear about Amount A, here is an example: Company X has a consolidated worldwide profit of 35 percent. Let us assume a fixed percentage for profit reallocation of 10 percent. This means Company X has a 25 percent deemed residual profit (35 percent minus 10 percent). Now, Company X must reallocate a portion of that residual profit to the user or market jurisdiction – presumably around 20 percent.
The five percent left (of the company's global profit) would go to the market jurisdiction depending on its size – relative to Company X's global sales. If a country has 10 percent of the company's sales, the country would get taxing rights at 0.5 percent of the company's total profit.
By using the Unified Approach, the user or market jurisdiction would have taxing rights without having to have the taxpayer to be physically present in the country. And the fixed percentage is simple.
However, the following issues should be noted:
First, the threshold should not be relatively high. A user or market jurisdiction, such as Indonesia, might end up not having any taxing right if sales of the multinational enterprises to be regulated do not reach the threshold, or if the routine profit is the same, or less, than the rate of fixed percentage.
This proposal also requires a country to have an effective and binding dispute resolution mechanism in place. It does not have to be arbitration, but must be equivalent to it.
Even if this proposal is accepted, the OECD would need to do more work before implementing it. Multilateral agreements will be required to change provisions in existing treaties.
Indonesia would be considered late to the party, since there is already so much revenue forgone for not taking any interim measures as some other countries had done.
Indonesia is an enormous market for the digital economy and could very well take advantage of the Unified Approach. The country must at least make diligent efforts to seek the most reasonable taxing rights. In terms of taxing the digital economy, it is about the only thing that Indonesia can do presently.
Pungki Yunita Chandrasari and M. Rifqy Nurfauzan Abdillah are analysts in the Fiscal Policy Office at the Finance Ministry. This article is their personal opinion and does not represent the views of the institution.