Game changers in the digital economy’s taxation landscape

Generally, the power of taxation extends only as far as the territorial jurisdiction of a state. However, digitalization of the economy defies these boundaries as the goods and services of digital enterprises become accessible anywhere around the globe. Digitalization likewise reduces, if not eliminates, the need to maintain bricks-and-mortar shops in a specific market jurisdiction since the customers can easily conclude a transaction with just one click. This new normal in our way of doing business makes it harder for countries, including the Philippines, to impose the appropriate taxes on digital transactions, especially on those that do not have a physical presence in the archipelago.

The challenges brought about by digitalization were acknowledged as early as 2015, which resulted in the creation of the Base Erosion and Profit Shifting Action Plans by the Organization for Economic Co-operation and Development (OECD). More recently, the OECD/Group of Twenty (G20) Inclusive Framework was mandated to address these challenges by the end of 2020. Although the Philippines is not yet a member of this Inclusive Framework, it will be beneficial to know what is happening in the global setting, especially since the Bureau of Internal Revenue generally recognizes international practices and subscribes to OECD interpretations.

In June 2019, the G20 Finance Ministers and Leaders endorsed the Programme of Work, which lays down a two-pillar approach in an attempt to solve this challenge. Pillar 1 aims to create a new nexus and profit allocation rules, while Pillar 2 will provide the formation of a global base erosion mechanism.

To fast-track things, the OECD Secretariat developed the “Unified Approach” under Pillar 1, which was published in October for comment. This Unified Approach harmonized the commonalities of the three proposals submitted regarding the new nexus of taxation and profit allocation rules.

Under the Unified Approach, the new nexus rule will apply to all cases where a digital business is significantly involved in a certain country’s economy, even if it has no or limited physical presence in that territory. This approach gives the market jurisdiction a new taxing right on the transactions of an online income earner despite not having a bricks-and-mortar set-up. The new profit allocation rule also goes beyond the current transfer pricing rules, which are based on the arm’s length principle, by complementing it with a formula-based solution. This solution uses a three-tier profit allocation mechanism in determining the following amounts:

1. Amount A is the share of deemed residual profit allocated to market jurisdictions using a formulaic approach, (i.e., the new taxing right);

2. Amount B is a fixed remuneration for baseline marketing and distribution functions that take place in the market jurisdiction; and

3. Amount C is an additional profit that may be agreed upon when in-country functions exceed the baseline activity (marketing and distribution) compensated under Amount B.

Under the allocation mechanism, the computation of Amount A begins from the Multinational Enterprise (MNE) group’s profits, which can be sourced from its consolidated financial statements. For instance, if ABC Group’s profit margin is 20%, some of that profit margin will pertain to routine profits of about, let’s say 8%. This 8% will be not be included in the profits to be reallocated to the market jurisdiction.

At this point, the remaining 12% representing non-routine profits will be divided between the market jurisdiction and the other factors (e.g., trade intangibles, capital, and risk, etc.). For example, a social media business may generate non-routine profit not just from its customers’ data and valuable brand, but also from its innovative algorithms and software. Considering the practical difficulties of using conventional transfer pricing rules, the Unified Approach recommends that the deemed non-routine profit attributable to the market jurisdiction may be allocated using an internationally-agreed fixed percentage, which may differ across different industries or business lines. So, for this step, let’s assume that 50% is the agreed fixed percentage of the non-routine profits that will be reallocated to the market jurisdiction. The final step of this proposed approach would be to allocate the relevant portion of the deemed non-routine profit (6% in our example) among the eligible market jurisdictions to arrive at Amount A.

Amount B and Amount C are somehow interrelated. Since the taxpayers and tax administrations may argue that the marketing and distribution activities taking place in the market jurisdiction go beyond the baseline level of functionality, and therefore warrant a profit in excess of the fixed return contemplated under Amount B, or that the MNE group performs other business activities in a jurisdiction other than marketing and distribution, this additional profit pertains to Amount C.

The Unified Approach still has to address pending questions and issues, such as the differentiation for business models and the elimination of double taxation. It also needs to balance the cost of compliance and tax administration while ensuring that taxpayers fulfill their new obligations. The mechanism to address the complexity in the enforcement and collection of the proper tax from non-resident MNEs must also be developed. To address these questions and implementation issues, the Secretariat held public consultation meetings last month.

Since the Philippines is an emerging market for digital businesses, the government should consider our membership in the Inclusive Framework taking into account this game changer in the taxation of the digital economy. Meanwhile, our MNE groups in the Philippines should assess the impact of this Unified Approach, monitor its development, and prepare for its implementation once it is adopted by the end of 2020.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.

Mac Kerwin P. Visda is a Senior Tax Consultant at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network. Readers may call +63 (2) 8845-2728 or e-mail the author at mac.kerwin.visda@pwc.com for questions or feedback.