Transfer pricing and digital taxation

Published on September 10, 2019

Tax leaders can help prepare their companies to manage the impact of digital disruption.

The arm’s length principle has been a mainstay of international tax policy for decades, but its future is uncertain. As part of its work on taxation and the digital economy, the Organisation for Economic Co-operation and Development (OECD) is consulting on revisions to the profit allocation and nexus rules. With businesses in all sectors becoming increasingly digital, the OECD’s work could dramatically affect current transfer pricing arrangements.Under the arm’s length principle, group companies aim to set their intercompany transfer prices at the same levels as unrelated parties. The arm’s length principle considers the functions, assets and risks of the parties to the transaction in determining arm’s length pricing. Before the OECD initiated its Action Plan on Base Erosion and Profit Shifting, many countries were concerned that companies were able to apply the arm’s length principle in a way that allowed them to move profits to no or low tax jurisdictions based largely on legal ownership, contractual rights and funding, particularly for intangible property (IP).However, when the issue was debated during the first round of BEPS talks, the OECD concluded that the arm’s length standard itself was not a problem. Rather, the problem was with how the standard was interpreted and implemented in highly complex international arrangements.

From contract rights to substance

The OECD’s BEPS report on Actions 8 to 10 on transfer pricing and value creation — issued in 2015 — set out a new approach to IP ownership and the allocation of associated profits among group companies. This approach considered intangibles in terms of their development, enhancement, maintenance, protection and exploitation (DEMPE). This approach dovetailed with revisions to the OECD’s transfer pricing guidelines on risk allocation, which looked to control over risk in addition to contractual allocations of risk in the determination of risk allocation.

In the wake of these changes, companies reviewed their structures, often moving their IP into countries where they have decision-making substance over their IP development, and also moving people to increase headcounts and therefore substance in tax-efficient locations. Business substance, headcounts and DEMPE were central to the wave of state aid cases that swept Europe shortly after.

As work progressed on the other actions, the OECD delayed work on Action 1 on taxing the digital economy. By the time the OECD was ready to tackle these issues under “BEPS 2.0”, questions about taxing economic activity conducted electronically, with no physical presence, no longer only applied to purely digital companies. Today, digitalization has advanced to the point where most businesses can be considered digital businesses, and the work on taxing the digitalized economy will have much broader impact than originally expected under Action 1. Any notion that the digital economy could be ring-fenced for international tax purposes has been largely abandoned.

In the meantime, some countries believe they are missing out on their share of tax from rapidly expanding digital economic activity, such as from profits generated by social media users within their borders. With no way to tax revenues from users contributing content (e.g. posting photos, product reviews) or viewing ads, some countries have moved ahead with digital services taxes on digital transactions, such as online advertising and sales of user data.

As these unilateral measures continue to spread, the global tax environment stands to become more fragmented and uncertain. This is putting the OECD and members of the Inclusive Framework under more pressure to forge an international consensus on a coordinated approach for the taxation of a digitalized economy.

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