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Dr. Han's Comments on the OECD's Unified Approach Proposal
bepress (2019)
  • Sung-Soo Han
Abstract
The OECD publicly requested the comments for the Secretariat Proposal for a "Unified Approach" under Pillar One for the resolution of digital service tax problems. For the Unified Approach, the OECD classified MNEs’ digital service business’ profit into 3 types of taxable profit: i) Amount A, ii) Amount B and iii) Amount C. Current digital service tax problems mostly occur due to i) the permanent establishment (“PE”) rule, ii) the intellectual property immigration practice between related parties and iii) the character of remote control business. Accordingly, we need to exactly understand the current situation in order to make out an exact solution to these problems. Otherwise, we might make issues more complex and exacerbate the current situation.  

The first cause of digital service problems in terms of taxation is the location of a server. 

Commentary 125 of Article 5 of 2017 OECD Model Tax Convention provides “Computer equipment at a given location may only constitute a permanent establishment if it meets the requirement of being fixed. In the case of a server, what is relevant is not the possibility of the server being moved, but whether it is in fact moved. In order to constitute a fixed place of business, a server will need to be located at a certain place for a sufficient period of time so as to become fixed within the meaning of paragraph 1.”  

A digital service company can shift its server easily from one place to another place. Also, as a server can be operated by remote control, it is possible not to have a server manager in the country where a server is located. Thus, it is not reasonable to determine a PE only based on the location of a server from the standpoint of business functions and risk burdens. Accordingly the current Commentaries shall be revised. 

The second cause of digital service problems is IP immigration.  

R&D activities are very important to MNEs. MNEs which require a technology for their business cannot survive in the market without R&D activities. Thus, most of MNEs actively get involved in R&D activities. A patent is an output of R&D activities. MNEs often shift their patent into tax heaven areas in order to save related taxes. For that purpose, they conclude a contract between related parties for migration of a patent. Thus, it would be desirable for the international community to prevent this kind of transaction between related parties unless there is a justifiable reason.  

The third cause of digital service problems is remote business activity.  

A remote business enterprise has no business entity in a State in which sales activities occur and thus it looks like having no physical nexus with that State. Nevertheless, sales activities are taking place in a remote sales way in a State in which users (or customers) receive a digital service. So we could say that it has nexus with that State in terms of taxation. The tax law has priority over the general law in terms of taxation. Accordingly, it would be possible to treat the remote business enterprise as having a deemed PE in that State and tax the related profit case by case according to the existing principle of transfer pricing (including intra-group service charge principle).  

The OECD's Unified Approach does not provide the exact solutions to current issues and thus can cause problems as follows:  

First, the OECD’s unified approach does not make any comment concerning the existing PE rule. If the OECD leaves the current e-commerce PE rule alone, it can conflict with the OECD’s unified approach. Thus, the OECD should carefully handle this matter.

Second, the OECD intends to use a kind of residual profit split method. If a MNE wants to use the residual profit split method, firs of all it should prepare a segmented financial statement per business line and type of transaction. Thus, it is necessary for a MNE to divide its Group financial statement per business line or type of transaction for the purpose of applying the residual profit split method. It would require a lot of time and money. What is more, in case where the OECD requires MNEs to insert a detailed segmented financial statement in their annual report, they must pay much more audit consulting fee to accounting firms. Thus, the OECD should introduce a cost-effective method for MNEs.  

Third, for the purpose of residual profit split method, a MNE should divide its Group financial statement into several business lines such as “distribution activity”, “marketing activity” (sales support activity) and “administrative activity” (intra-group service). And then it determines the routine profit of each entity by using an allocation key such as cost-plus 5% or 10% markup. By doing so, it can minimize the “routine profit” that is allocated to the countries in which its subsidiaries are located.  

Under the OECD’s unified approach, the quantum of the fixed return could be determined in a variety of ways: it could be i) a single fixed percentage; ii) a fixed percentage that varies by industry and/or region; or iii) some other agreed method. However, it would be very difficult for every related tax authority to agree upon such an allocation key. For example, let’s assume that a digital service MNE has 80 subsidiaries in 50 countries. In that case, would it be possible for 50 tax authorities to agree upon a fixed percentage? Perhaps it is not.  

If that is the case, we cannot understand why the OECD tries to use this kind of inefficient and unreasonable approach. If there is no possibility of compromise between related tax authorities, this kind of approach should be discarded. If the OECD continues to insist upon this kind of approach, it would just substantially increase tax disputes between related tax authorities.  

Fourth, under the OECD’s unified approach, only in case where a MNE meets a certain revenue threshold in a specific country, may the tax authority of that country have taxing right over “Amount A” or “Amount B” relating to the revenue in issue. Is it reasonable from the standpoint of equity? Of course it is not. Under the principle of taxation equity, if there is income, there must be tax on it. Thus, the OECD’s unified approach is not reasonable from the standpoint of equity.  

Fifth, in case where there is a traditional nexus in the market jurisdiction under the OECD’s unified approach, first of all, taxpayers and tax authorities should determine the applicable fixed return (“Amount B”). And then in case where tax authorities consider that a MNE performs activities exceeding the fixed return arrangement, taxpayers and tax authorities should once again determine an additional taxing right (“Amount C”).  

Further in case where a MNE is making remote sales and thus has no in-country physical presence, taxpayers and tax authorities should determine a portion of the deemed non-routine profits (“Amount A”) of MNE Group. But the OECD does not explain how to calculate that portion of the deemed non-routine profit. Is this process efficient? Of course it is not. Thus, the OECD should adopt a more efficient approach in order to minimize the tax disputes and MNEs' compliance expense.  

The OECD does exist for the development of the international community. Accordingly the OECD should handle the pending issues in a way which can promote a peaceful relationship between states. The current OECD's proposed "Unified Approach" does not provide the exact solutions to current issues and as a result there is a high possibility that international taxation disputes between states increase substantially. Accordingly, the OECD should propose the tailor-made and feasible solutions to the causes of problems.

Keywords
  • OECD Unified Approach
Disciplines
Publication Date
Fall October 21, 2019
Citation Information
Sung-Soo Han. "Dr. Han's Comments on the OECD's Unified Approach Proposal" bepress (2019)
Available at: http://works.bepress.com/sung_soo_han/95/