To: Tax Policy and Statistics Division, OECD/CTPA Date: March 6, 2019 From: KPMG International cc: Christopher Morgan

Manal Corwin Khoonming Ho

Comments on OECD Public Consultation Document on Addressing the Tax Challenges of the Digitalized Economy

Professionals in the member firms of KPMG International1 (“KPMG”) welcome the opportunity to comment on the OECD’s public consultation document entitled “Addressing the Tax Challenges of the Digitalisation of the Economy,” released on 13 February 2019 (the “Consultation Document”).

The Consultation Document describes proposals that are being worked on through the Task Force on the Digital Economy (the “Task Force”) under the umbrella of the Inclusive Framework on BEPS (the “Inclusive Framework”) for consideration as part of the Inclusive Framework’s efforts to develop a consensus on a long-term solution to the broader tax challenges arising from the digitalization of the economy, as well as to address remaining BEPS concerns of member countries.

KPMG’s comments on the Consultation Document are presented below.

I. Introduction and Executive Summary

In their communiqué following the Hangzhou summit in September 2016, the G-20 Leaders requested that the OECD and IMF work on addressing tax certainty in recognition of the heightened concern that uncertainty in tax matters, especially in the context of international tax, would adversely impact cross–border investment and trade.2 In response to this request, the OECD and IMF issued a report in 2017 based on surveys of over 700 businesses and 25 tax jurisdictions (the “OECD/IMF Report”). This report observes that “providing greater tax certainty to taxpayers to support trade, investment and economic growth has become a shared

1 KPMG is a global network of professional services firms providing Audit, Tax and Advisory services. We

operate in 154 countries and territories and have 200,000 people working in member firms around the world. The independent member firms of the KPMG network are affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. Each KPMG firm is a legally distinct and separate entity and describes itself as such.

2 See G20 Leaders’ Communiqué: Hangzhou Summit, September 5, 2016, ¶19, available at:

http://www.g20chn.com/xwzxEnglish/sum_ann/201609/t20160906_3397.html (last checked February 28, 2019).

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priority of governments and businesses.” The surveys conducted reveal a widespread sentiment that both uncertainty and tax disputes are increasing, causing concerns for business, who need to be able to reliably understand the tax consequences of their business decisions, and for governments, who need to be able to obtain predictable streams of revenue while encouraging investment.3 The OECD/IMF Report notes further that the rise in uncertainty has been driven by factors including, in particular, the proliferation of fragmented and unilateral policy decisions (in response new business models in the context of digitalization), as well as the transition period during the implementation of the BEPS measures. Ultimately, one of the key findings emerging from the OECD/IMF Report is that both business and tax administrations agree that “legislative and tax policy design issues are a major source of tax uncertainty, mainly through complex and poorly drafted tax legislation and the frequency of legislative changes.”4

In light of these findings, it is clear that an overwhelming consensus already exists that (i) tax uncertainty is bad for business, tax administrations and the economy, and (ii) unilateral measures, complex, poorly designed laws, and frequent changes in law all contribute to uncertainty. KPMG believes that the key to achieving consensus in the current initiative will be for the work of the inclusive framework to be guided by and build upon this already existing consensus view.

As noted in the OECD/G20’s 2015 Report on Addressing the Tax Challenges of the Digital Economy (the “2015 Report”), concerns related to the digitalized economy already were taken into account in developing the relevant measures produced through the BEPS Project. Most of these measures have not yet been fully implemented by the participants in the Inclusive Framework, and ideally, the impact of those measures would be fully understood before making the decision to pursue further measures. This is particularly true given that certain of the measures being explored with respect to the tax challenges of the digitalized economy appear to be inconsistent with earlier work of the Inclusive Framework, particularly in the areas of permanent establishment, profit attribution, and transfer pricing.

Nevertheless, we recognize that tax issues related to the digitalized economy (including

both BEPS issues and more fundamental issues relate to the allocation of taxing rights) have been a source of enormous political pressure around the world. This has led to a proliferation of uncoordinated and unilateral measures being considered or enacted by members of the Inclusive Framework. While many countries have expressed a desire to forestall further uncoordinated unilateral action in the interest of reaching a global solution, an agreement on action that goes beyond the current BEPS measures appears to be needed quickly if the consensus-based international tax system is to be preserved.

Thus, to the extent that it is not possible to prevent further proliferation of uncoordinated measures and allow time for the implementation of the BEPS recommendations before proposing additional reforms, it is our belief that it will be critical to pursue an approach that effectively eliminates double taxation, reduces uncertainty to the greatest extent possible, and minimizes

3 See Tax Certainty: IMF/OECD Report for the G20 Finance Ministers, March 2017. 4 Cite to Report

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controversy. To this end, any proposal for further reform, whether it follows the proposals in the Consultation Document or takes a different direction, should be one that can obtain the broadest consensus among members of the inclusive framework, is clear and easy to administer, preserves the arms-length standard to the greatest extent possible, does not conflict, or is clearly reconciled with existing international tax rules and standards, includes robust mechanisms and expectations for relief of double taxation and timely and effective resolution of disputes, and is sustainable over time given changing business models. Our comments on the various proposals in the consultation document reflect these guiding principles and focus on key issues that we believe must be worked through with respect to each proposal in order to maximize the chance of reaching a consensus-based solution that will be administrable, provide for certainty, eliminate double taxation, and reduce and effectively resolve controversy.

In particular:

• Part II of these comments recommends that any consensus should include: (1) a high level political commitment to repeal unilateral measures in favor of the global solution reached through this work; (2) a reasonable approach and timeline for transition in recognition of differences among jurisdictions in parliamentary processes and the likely need for both legislative and treaty changes; and (3) a firm commitment to improve dispute resolution, including by committing to adopting a multilateral approach to mandatory binding arbitration of unresolved disputes.

• Part III discusses the proposals on revised profit allocation and nexus, and identifies design considerations for each, along with recommendations where possible. Broadly speaking:

• With respect to the user participation proposal, we see substantial risk that it would lead to arbitrary and distortive results, and that by focusing on specific existing business models, it risks becoming quickly outdated. We also observe that the policy objectives of the user participation proposal are largely addressed by the marketing intangibles proposal without the distortive effects and long-term viability concerns. If it were to be pursued, we note that it would be essential to be absolutely clear about which business models are covered, to agree up front and in detail on the amount of profit to be attributed under the proposal, and to provide clear and easily determinable factors for allocating that profit among jurisdictions.

• With respect to the marketing intangibles proposal, we identify a number of features that appear helpful in reaching consensus on how to address the tax challenges of the digitalized economy. We note, however, that a variety of challenging implementation issues would need to be considered carefully by the Task Force in order to avoid unintended consequences, and where possible, propose possible approaches to resolve them. These include, among others establishing simple and clear rules for determining:

1. Which MNEs are covered by the proposal.

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2. The quantum of global profit to be attributed to marketing intangibles.

3. The allocation of that quantum across taxing jurisdictions.

4. The interaction with existing nexus and legal entity accounting principles

5. Appropriate allocation rules for start-up costs and losses.

In addition, due consideration will have to be given to the practical impact of separating marketing intangibles income from other income of the enterprise, and on the application of existing transfer pricing rules to that other income.

• With respect to the significant economic presence proposal, we note that the lack of specifics about the proposal makes it difficult to comment in detail but acknowledge the need under any of the proposals currently under consideration to establish clear and administrable rules for defining scope on the basis of economic nexus or otherwise. Such rules should be informed by the agreement reached on how profit attribution is intended to work.

• Part IV discusses the global anti-base erosion proposal. In particular, it discusses a number of design challenges with respect to the undertaxed payments rule and the subject to tax rule, and suggests that many of these could be mitigated by not applying those rules with respect to payments to entities whose ultimate parent entity was subject to a regime that includes a sufficiently robust income inclusion rule. It also discusses a number of design challenges with respect to the income inclusion rule, as well as a number of questions regarding avoidance of double taxation and reducing complexity. Finally, it addresses considerations relating to the application of the global anti-base erosion proposal by Member States of the European Union.

II. General Comments

As a general matter, it should be noted that the proliferation of unilateral measures has been a significant factor driving the need for a consensus-based solution on the tax challenges of the digitalized economy. While public statements regarding those tax challenges have all generally acknowledged the need for a global consensus on a longer-term solution, many countries have enacted unilateral measures that impose tax on a gross basis, while many more are actively considering such measures. Any solution arrived at by the Inclusive Framework must address those unilateral measures if it is to achieve the goal of addressing the tax challenges of the digitalized economy without creating the risk of double or multiple taxation. It is our belief that all jurisdictions taking part in this work should make a political commitment at a high level to repeal unilateral measures in favor of implementing the global solution that is reached through the current work. A peer review process could be used to evaluate compliance with this commitment.

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In addition, it should be noted that any of the proposals contemplated will require substantial changes, both in the domestic laws of the participating jurisdictions and in the global treaty network. While the work to develop the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the MLI) will provide an important starting place in developing a mechanism for updating the global treaty network, adapting it to this purpose is likely to require substantial additional work. Recognizing the breadth of these changes, the challenge of agreeing to multilateral changes to the treaty network, and the difference among jurisdictions in parliamentary processes, the Inclusive Framework should maintain a flexible approach and agree to a reasonable timeline for transition.

Any new tax measure will increase uncertainty for taxpayers in the short term, no matter how well designed it may be. This appears particularly true of the solutions currently under consideration by the Inclusive Framework, as they are novel and untested approaches to address a new challenge. The issues raised by these proposals appear likely to go beyond clear-cut bilateral cases, and may require resort to multilateral competent authority discussions. In light of this unique situation, we believe that any global consensus to adopt a significant change to the international tax system should be accompanied by a firm commitment to improved dispute resolution, including in particular a commitment to submit disputes that are not resolved in a timely manner to mandatory binding arbitration. In this context, work would need to be done to adapt traditional bilateral arbitration procedures to the multilateral context.

While we understand the reservations that some countries have expressed about arbitration, we believe effective dispute resolution to be critical to any solution that involves a substantial departure from existing tax principles. As noted below, we believe that to the extent any solution departs from the arm’s length principle, it will make negotiation between competent authorities more challenging, further highlighting the need for a dispute resolution process that is guaranteed to reach a binding resolution. We believe that participation of emerging and developing economies in the work to develop an arbitration approach will build confidence that the agreed mandatory binding arbitration procedures would result in balanced and fair outcomes. In addition, there should be a focus on providing emerging and developing economies with training, support, and resources to ensure that they have the capacity to participate in arbitration proceedings on an equal footing with developed countries. This could include, for example, assistance from the OECD in the development of position papers for arbitration proceedings.

We note that enforcing many of the tax proposals would appear to require the use of information provided through country-by-country reporting, and may require modifications to the type of information collected in this way. One way to provide an incentive to commit to such dispute resolution would be to make access to that information contingent on agreeing to such enhanced dispute resolution. That commitment could also be monitored through a peer review process. Without such a commitment, we are concerned that tax disputes, which have already been rising worldwide, will spiral out of control.

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III. Proposals on Revised Profit Allocation and Nexus Rules

Section 2 of the Consultation Document describes three different proposals to modify the existing profit allocation and nexus rules. Each of these proposals would allocate greater taxing rights to market or user jurisdictions than the current rules, though they differ significantly in approach.

As a general matter, each of the proposals is based on a notion that the international tax system should be modified to give market jurisdictions access to a greater share of the revenue of companies (or certain companies) that actively participate in markets. The Consultation Document asks whether businesses in fact do participate without profit attribution, and if so, which businesses are able to do so under current rules, and which are expected to be able to do so in the future.

It is clear that there are some situations in which companies may participate in markets, but the existing nexus and transfer pricing rules, including the new approaches developed during the BEPS project, would not allocate taxing rights over residual profits to the market jurisdictions. As a general matter, businesses in their ordinary course take a variety of considerations into account in choosing where to locate functions, assets and risks. Transfer pricing rules reflect this flexibility, subject to certain limitations, by permitting taxpayers to allocate risk to jurisdictions in which an appropriate amount of risk-control functions take place, and to allocate returns from intangibles by contract to jurisdictions in which functions related to the development, enhancement, maintenance, protection, and exploitation of those intangibles are carried out. Residual profits associated with those items are thus in many cases not allocated to the market jurisdiction under current rules.

It should be noted, however, that the ability to have an “active presence or participation” in a market in a way that does not grant the market jurisdiction the right to tax the residual profit that may be associated with that participation is not unique to a specific sector, or to the specific business models that have been targeted in unilateral measures or in certain of the proposals in the Consultation Document. Indeed, many types of business, regardless of sector, have the ability to achieve reach and interact with customers using digital technology without establishing a taxable presence that would permit substantial taxation of residual profits in the market country.

As we discuss in more detail below, because the concern underlying the three proposals does not appear to be unique to a single sector, we believe that it will be challenging to define a “ring fenced” solution without creating further uncertainty, or causing distortive effects. We note, however, that to the extent that any proposal is intended to apply to a broad variety of businesses, careful consideration will be needed to account for potential impacts on specific industries, including industries such as financial services that may be subject to significant regulation. For example, considerations related to control of risk and the relative value of marketing intangibles or customers in a particular jurisdiction may vary significantly from industry to industry.

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A. The User Participation Proposal

1. General Views

As a general matter, in order to be effective, the consensus solution that is ultimately reached through this work should address the immediate concerns of countries about taxing rights in a digitalized economy while staying flexible enough to adapt to future changes that digitalization will bring. With this goal in mind, targeting only certain business models, while excluding others that may have similar characteristics and deliver comparable services to customers, has the potential to create market distortions. Given the pace of change in the digitalized economy, such an approach may lead to a significant ongoing burden on both tax authorities and taxpayers, due to a constant need to redefine the scope of the measures. Furthermore, unless proposals were carefully kept up to date to reflect future economic changes, there is a risk that the ongoing international consensus would weaken, resulting in a new proliferation of uncoordinated unilateral measures.

2. Policy rationale, economic and behavioral implications

The rationale for the user participation proposal is unclear from the Consultation Document. While the Consultation Document refers in some places to creation of value by businesses through development of an active and engaged user base, it also suggests in a number of places that it is the users themselves that create value for enterprises. The latter view is inconsistent with existing concepts of enterprise value creation. Users do not act on behalf of the enterprise as agents or employees. Nor do they provide their personal data or otherwise engage with businesses as a gratuitous gesture. Instead, it is better viewed as a value-for-value barter exchange that is similar to any other vendor-customer relationship.

Nevertheless, in the same way that an enterprise can effectively use its labor, capital, and risk-taking activities to build a network of suppliers that constitutes a valuable supply chain asset of the enterprise, an enterprise can use its resources to build a valuable network of users. And while traditional nexus rules would not assign nexus to tax on the basis of the location of users, the members of the Task Force are of course free to change those nexus rules.

Nevertheless, the user participation proposal does not appear well-suited as a basis for changes to the nexus and profit allocation rules. The concept of an active and engaged user base of the type intended to give rise to nexus is not something easily defined in an objective way that is susceptible to certainty, eliminates the potential for dispute, and is sustainable over the long term. In the absence of an easy way to arrive at objective, mechanical rules to define the user participation that will create nexus, the Consultation Document lists specific business models that are of a type intended to be covered by the proposal. As noted above, however, defining specific existing business models without a defining policy rationale does not promote certainty and will result in rules that are at risk of being rendered antiquated as businesses evolve, and that have the potential to create market distortions.

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3. Profit allocation

The approach of the user participation proposal is to change the profits attribution and nexus rules solely for specific covered types of business, while leaving the rules alone for businesses outside the scope of the proposal. Picking winners and losers among similarly situated businesses could result in the distortive effect outlined above.

These distortions could be reduced by ensuring that profit attribution rules are kept simple and administrable and that they make only incremental changes to the existing rules for profit attribution. As noted above, because users are external to the enterprise and do not act as dependent agents or otherwise on behalf of the enterprise, they cannot themselves create value for the enterprise. Instead, the labor, capital and risk-taking of the enterprise are better viewed as the activity that created the value that attracts the users. To the extent that this activity occurred outside the relevant market jurisdiction, determining the share of this value creation that is considered to be attributable to the new nexus created on the basis of engagement of users will be a challenging problem.

The fact that nexus would be based on factors other than physical presence makes traditional PE profit attribution rules unsuitable here, due to the lack of “significant people functions” in the market jurisdiction. While the Interim Report seemed to contemplate the possibility of treating users as carrying on such functions, this approach would not reflect economic reality.

Adoption of formulary apportionment with respect to the business models covered by the proposal is similarly unlikely to be possible as a consensus-based approach that would relieve double taxation. Whatever factors are chosen as the basis for that formulary apportionment would effectively pick winners and losers among jurisdictions, making it unlikely that a single, uniform set of factors could be agreed upon. If such a list of factors and their relative weights could be agreed upon, it appears challenging, if not impossible, to reach agreement in enough detail to ensure consistent use of the allocation keys from country to country. In addition, even if both of those initial obstacles were overcome, using formulary apportionment could eliminate double taxation while preventing less-than-single taxation only if countries were able to agree to conform the base on which the tax is imposed, which appears prohibitively difficult. Finally, to the extent that disputes arise, the use of a formula with fixed factors in place of an approach based on transfer pricing principles does not appear to give competent authority negotiators a basis for arriving at a settlement that would eliminate double taxation by determining an appropriate division of profits between jurisdictions.

Because of the foregoing considerations, we believe that a modified profit split is the least distortive path forward. Such an approach would entail determining an agreed share of total profits (which presumably could vary by line of business, by industry segment, or on some other basis) that are considered to be attributable to the market on the basis of user participation. In any case, the share of profit that is attributed to the location of active participation should be limited to a modest share of the value created by the enterprise, in recognition of the important contribution of labor, capital and risk of the enterprise to value creation. Once the share of total

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profit that is subject to the proposal is determined, its allocation among jurisdictions should be done on the basis of easily determined, objective factors (e.g. total revenues from each market), to minimize disputes.

4. Other Design features

Scope: The user participation proposal, as noted above, draws distinctions between types of business that are arbitrary in nature, and that cannot easily adjust to changes in business models over time. A scope that does not arbitrarily pick winners and losers among economically similar businesses, would reduce distortions to market place competition and will be more sustainable over the long term.

Simplifying measures: The new regime will introduce substantial complexity which can represent a barrier to growth for scaling businesses. Reducing the impact of this complexity on small and mid-sized businesses could be done by implementing minimum revenue thresholds. This should also reduce the administrative burden for tax authorities seeking to administer a dual tax regime for large numbers of taxpayers that are small or medium-sized enterprises (SMEs).

Treatment of losses and start-up costs. Any proposal that is based on allocation of a portion of net profits will need to account for the possibility that a business’s operations could result in net losses. For the user participation proposal to maintain internal consistency, a portion of those losses would need to be attributable to the markets that would be entitled to tax additional profits as a result of the proposal. Recognizing that businesses commonly incur multiple years of losses, particularly during the start-up phase, the proposal should ensure that losses incurred in one year can be carried over to offset later profits.

Indeed, the proposal seems to be based on the idea that the group is undertaking activities that give rise to value in the user jurisdiction. If the user jurisdiction is to tax the excess profits that arise from those activities, it also should provide deductions or other benefits for the expenses incurred in those activities, particularly during the startup phase. We recognize, however, that a precise matching of activities, expenses, and excess profits allocable to a particular jurisdiction in a future year is unlikely to be administratively feasible. A simpler approach may be to create a “residual loss account” when the group’s profits are less than the routine return threshold determined under the proposal. The residual loss account would be recaptured out of future year residual profits over the routine return before any residual profits are allocated to the user jurisdiction.

As noted above, the user participation proposal presents significant concerns as a standalone approach to nexus and profit allocation. If it were to be pursued, it would be essential to ensure simplicity and tax certainty, and to minimize disputes, by being absolutely clear about which business models are covered, by agreeing up front and in detail on the percentage of profit to be attributed under the proposal, and by allocating that profit among jurisdictions based on clear and easily determinable factors.

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B. The Marketing Intangibles Proposal

The marketing intangibles proposal, as described in the Consultation Document, is based on the idea that there is an “intrinsic functional link” between marketing intangibles and the market jurisdiction. To take this link into account, the marketing intangibles proposal would deviate from current nexus and transfer pricing rules by requiring marketing intangibles and risks associated with such intangibles to be allocated to the market jurisdiction. Under the proposal, the market jurisdiction would be allocated taxing rights over at least a portion of non-routine income associated with such intangibles, while all other income would be allocated among members of the group based on existing transfer pricing principles. We describe below some advantages of this proposal, as well as implementation challenges and design issues that should be considered by the Task Force in determining whether and how to further develop this proposal.

1. Advantages of the proposal

The marketing intangibles proposal as described in the Consultation Document has several features that may be helpful in achieving consensus and securing certainty on how to address the tax challenges of the digitalization of the economy.

The proposal acknowledges the concerns of stakeholders who believe that existing transfer pricing and nexus rules do not grant adequate taxing rights to a jurisdiction in which an MNE has a significant number of customers / users but limited (or no) physical presence. It addresses those concerns by providing a mechanism to attribute income to those jurisdictions based on some measure of customer / user base.

The marketing intangibles proposal avoids the issues of discrimination and distortion that are raised by proposals that treat targeted businesses differently, as discussed above and in the Interim Report on Addressing the Tax Challenges of the Digitalized Economy. In addition, such an approach, by not referencing specific business models, is more likely to be able to accommodate future changes in business models that differ from or go beyond the changes that can be anticipated today. These features may assist in achieving consensus, particularly given the stated opposition of some stakeholders to proposals that treat highly digitalized businesses differently from other business models. It thus appears to be capable of achieving the policy objectives of the user participation proposal while mitigating concerns with respect to uncertainty and long-term stability.

In addition, while the marketing intangibles proposal acknowledges that the determination and attribution of marketing intangibles income may deviate from the arm’s length standard that forms the basis of existing transfer pricing / income attribution rules, it aspires to do so in a limited way such that “all other income would be allocated among members of the group based on existing transfer pricing principles.” (para. 32). This objective, if achieved, could mitigate the disruptive impact of the modified rules on existing tax practices. As discussed in more detail below, however, it will be important to recognize that residual profit is derived from a variety of activities, and that the share attributable to marketing intangibles may be a relatively modest amount of the total residual profit.

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2. Implementation issues

The marketing intangibles proposal raises a variety of challenging implementation issues that will need to be considered carefully by the Task Force. As with the other proposals, the range and severity of potential implementation issues will be important in an overall evaluation of the relative effectiveness and administrability of the various alternatives.

Implementation issues with the marketing intangibles proposal fall into the following general categories:

1. Determining which MNEs are covered by the proposal. 2. Determining the quantum of global profit to be attributed to marketing intangibles. 3. Interaction with existing nexus and legal entity accounting principles 4. Determining the allocation of that quantum across taxing jurisdictions. 5. Determining appropriate allocation rules for start-up costs and losses. 6. Considering the impact of the separation of marketing intangibles income from other

income of the enterprise on the application of existing transfer pricing rules to that other income.5

3. MNEs covered by the proposal

As noted above and emphasized in the Consultation Document, an important feature of the marketing intangibles proposal is its broad scope with respect to impacted business models. However, the discussion in the Consultation Document is presented in the context of businesses selling directly to consumers (“B2C” businesses). The Task Force will need to consider whether and how the proposal would apply to businesses selling to other businesses (“B2B” businesses) and to MNEs with both B2C and B2B businesses.

If B2B businesses are intended to be within the scope of the proposal, there are a number of common features of B2B businesses that raise issues that do not typically arise with B2C businesses. As one example, many global B2B enterprises engage in a mix of “global contracting” and “local contracting” with their multinational business customers, with the choice often driven by customer preference. Under a global contracting model, a single entity of the business would enter into a global contract with a single legal entity of the customer (typically the headquarters entity), under which goods or services are delivered to multiple legal entities of the customer business in multiple jurisdictions. Under the “local contracting” alternative, each legal entity of the customer business enters into a separate contract with the MNE. These two models may have identical profiles with respect to the location of value creation activities (however broadly defined), yet very different footprints with respect to the jurisdiction of the contractual “customer.” If B2B businesses are within scope of the proposal, the Task Force will need to consider how marketing intangibles profit should be attributed across jurisdictions in these alternative fact patterns.

5 We note that these issues must also be addressed under the user participation proposal and the significant

economic presence proposal.

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These challenges would be avoided by excluding B2B businesses from the enterprises covered by the proposal. The simplification achieved by this approach would however, need to be weighed against the possibility that distinguishing between B2B and B2C businesses could impact the full achievement of the objectives of the proposal, the potential ambiguities in characterizing a business as B2B or B2C, and perhaps most importantly, the complexities of implementation for MNEs that engage in both B2B and B2C business. Phased implementation that delays application of the proposal to B2B business could also be considered as a way to balance these concerns.

4. Profit attributed to marketing intangibles

The Consultation Document discusses possible approaches to the determination of the portion of total global MNE profit attributed to marketing intangibles. To the extent that determination is based on profit split approaches, KPMG notes the important recent work performed by the Inclusive Framework in revising its guidance on profit split methods, on which KPMG has previously provided comments.

The Consultation Document suggests that use of a profit split method could be mandatory for determination of the quantum of profit attributed to marketing intangibles. To the extent that such methods are used in circumstances where the profit split method would not be the most appropriate method under existing transfer pricing rules, the quantum of profit so determined is likely to deviate from that which would be determined under the arm’s length principle. KPMG acknowledges that such difference may be considered desirable by some stakeholders.

KPMG would like to emphasize the importance of the tradeoff noted in the Consultation Document between determinations more closely aligned with existing transfer pricing approaches (especially the (residual) profit split method) and considerations of transparency and administrability. The Consultation Document (para. 75) states, “the more the [determinations] are based on detailed and factual determinations (e.g. conventional transfer pricing analysis), the greater is the risk of disputes and uncertainty in the outcome produced by the proposal.” As discussed below, however, we think it is important to recognize that high-level, formulaic determinations may also give rise to significant disputes.

Conventional transfer pricing analysis does indeed involve – in fact requires – analysis based on detailed inquiry into the business facts surrounding each intra-group transaction. KPMG appreciates the desire for both simplifying conventions and for extensive reliance on readily available / verifiable / auditable data (for example public filings and possibly even CbyC reports). However, the Task Force should acknowledge that the greater the reliance on such simplifying conventions and data, the greater the extent that outcomes for individual business will deviate from outcomes that are consistent with the arm’s length principle. In addition, allocation of residual profit attributable to marketing intangibles based solely on high level factors would fail to accurately reflect the actual contributions of particular markets to the MNEs profitability (as discussed below), and would ignore the impact of value creation activities with respect to marketing intangibles that may occur centrally rather than in the market jurisdiction. The greater the amount of residual marketing profit allocated in this manner, the greater this

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issue becomes. One way to reduce the extent of this deviation would therefore be to reallocate a relatively modest share of residual profit to the market jurisdiction, and to allocate the remainder using traditional transfer pricing principles under the arm’s length principle.

As the Consultation Document notes, an important aspect of this tradeoff is the level of aggregation at which the quantum of marketing intangible is determined. Particularly notable is the degree of aggregation across business lines. Different business lines within an MNE may have very different profit profiles and geographic footprints. In many cases, the data necessary to identify residual profit at the business line level will be reliably available. In other cases, the available data may not meet the desired level of simplification and availability, and the Task Force will need to take into account the availability of data when considering how to balance the goals of simplicity and accuracy. Segment reporting for public financial reporting purposes may provide a basis for many of the necessary determinations.

KPMG believes this issue has important implications for the application of existing transfer pricing principles to “all other profit,” as discussed below.

5. Interaction with existing nexus and legal entity accounting principles

As noted above and as discussed in paragraph 82 of the Document, implementing changes to nexus rules will pose significant challenges. In particular, it will be important for the Task Force to consider and clarify how the proposal is meant to interact with legal entity accounting. One potential approach would be to provide that existing transfer pricing principles would continue to determine the allocation of profit between legal entities, while new nexus and profit attribution rules would apply to the allocation of profit with respect to marketing intangibles among jurisdictions. While it is clear that the proposal contemplates that modifications to existing nexus and profit attribution rules are required, the Task Force should consider further whether changes to existing transfer pricing rules are necessary or desirable, and should carefully consider the coordination of any such changes with the nexus and attribution changes. Implementation challenges will likely differ depending on which approach is taken.

6. Allocation of marketing profit across jurisdictions

KPMG understands that, once the total quantum of profit attributed to marketing intangibles is determined, the marketing intangibles proposal would allocate that profit across jurisdictions based on some relatively simple factors such as sales / customer / users.

The apportionment of the profit allocated to marketing intangibles based on a high level factor such as sales or revenue would in many cases fail to reflect the actual contributions of the particular markets to an MNE’s profitability. In KPMG’s experience, the profit margins a business earns in various countries may differ significantly based on factors unrelated to the amount of sales or revenues. For example, using a simple apportionment approach could shift the benefits of one country’s investment in infrastructure (not only IT infrastructure, but also roads, bridges, train tracks, ports, etc.) to countries that have not made a similar investment. Similarly,

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because the regulatory burdens a country imposes on importers will affect the importer’s net profits, a simple apportionment approach could shift the economic burden imposed by countries that impose relatively high regulatory costs to countries that either have chosen to impose a lower level of regulation or have devised a more efficient regulatory scheme. Finally, an MNE may have different operating margins in different jurisdictions based on local market conditions. For example, the presence of local competitors may lower the profit associated with an MNE’s local marketing intangibles. Ultimately, members of the Task Force will need to balance the distortion caused by these factors against the value of reaching simple, agreed rules that will minimize disputes.

7. Treatment of losses and startup costs

As noted above, any proposal that is based on allocation of a portion of net profits will need to account for the possibility that a business’s operations could result in net losses and provide a way to allocate those losses. For the marketing intangibles proposal to work in a consistent manner, a portion of those losses would need to be attributable to the markets that would be entitled to tax additional residual profits as a result of the proposal. Recognizing that businesses commonly incur multiple years of losses, particularly during the start-up phase, the proposal should also provide a mechanism to ensure that losses incurred in one year can be carried over to offset later profits.

8. Impact on transfer pricing for “all other” income

The Document states that the marketing intangibles proposal would leave in place existing transfer pricing rules for “all other” income, i.e. all income that remains after attribution to marketing intangibles. KPMG considers this to be a very important feature of the proposal which, if achieved, would significantly distinguish the marketing intangibles proposal from the significant economic presence proposal and more generally from formulary apportionment approaches, and could mitigate the disruption created to tax practice and administration for MNEs and governments alike.

KPMG believes however that application of existing transfer pricing principles may be materially affected by the separate attribution of a material portion of income to marketing intangibles. The effects of the proposal on existing transfer pricing principles will need to be considered, and guidance regarding those effects will need to be developed in order to avoid increasing disputes, administrative costs, and double taxation with respect to all other income.

An important consideration in this regard is the method of determining income from marketing intangibles relative to total income, at the disaggregated level needed to apply existing transfer pricing rules. As discussed in the Consultation Document and above, to meet the needs of simplicity and administrability, marketing intangibles income may be determined at a relatively aggregate level across product lines as well as legal entities. However, existing transfer pricing methods are applied using detailed factual analysis and almost always at relatively disaggregated levels. “All other profit” will need to be determined at the disaggregated level – e.g. by product line and legal entity – at which existing transfer pricing rules are used to allocate

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it. Therefore, the use of simplifying conventions to determine marketing intangibles profit for purposes of implementing that proposal itself, does not eliminate the need for detailed determination of the sources of such profit for purposes of applying conventional transfer pricing to all other income.

The second consideration is how the separate treatment of marketing intangibles profit affects the identification and analysis of individual transactions, of which marketing intangibles may be relevant. A few examples of this follow:

• To the extent that “marketing intangibles” incorporate elements of brand value, how is transfer pricing analysis of intercompany brand royalty transactions impacted?

• To the extent that “marketing intangibles” reflect conventional customer lists and customer relationships, what is the impact of separate marketing intangibles profit to comparability analysis, where the comparables profit reflects their own ownership of such intangibles?

• To the extent that existing transfer pricing is based on profit split methods, which themselves include attribution of marketing intangibles profit, how do those methods and associated intercompany arrangements need to be modified to reflect separate attribution of marketing intangibles profit – noting per above the likely need of that separately determined marketing intangibles to be allocated to the relevant business line and legal entities for this purpose.

• To the extent that transfer pricing of goods and services across borders already include attribution of marketing intangibles profit, how do the measures interact with current approaches to pricing goods for customs and excise duties and sales tax/value added tax (VAT) purposes or cross border services for sales tax/ VAT purposes? How would adjustments to pricing affect collections and refunds of customs duties and VAT?

One alternative that might be considered is to first determine disaggregated profits under traditional transfer pricing as an initial step. Such disaggregated profits can be expected to be allocated to the group’s affiliates through its transfer pricing and accounting policies as transactions are recorded throughout the tax period. This approach allows the group to identify which group members have captured marketing intangibles profit under the traditional arm’s-length standard. As a second step, aggregated marketing intangibles profit could be determined and reported on a group-wide basis. As a final step, marketing profit taxed on a global basis could be allocated back to group members on an appropriate pro-rata basis. The allocation of a portion of the aggregate profits taxed on a group-wide basis to a particular group member would reduce the tax base of that member.

KPMG notes that determination of total marketing intangible profit to be allocated on a relatively simplified, aggregate basis does not eliminate the need for additional analysis to determine how the corresponding tax base reductions are attributed among group members. While total residual profit earned by each entity may be determined fairly easily, determination of the quantum of entity-level residual profit attributable to marketing intangibles could introduce a significant level of complexity given that under common business structures entities within the same business may earn residual profit associated with marketing intangibles, other intangibles, or simply realization of significant risks not associated with intangibles, to widely varying degrees. The inclusive framework therefore will need to consider the appropriate trade-

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offs between complexity and distortions in determining the allocation of income reductions among group members to implement the marketing intangibles proposal should be kept to a minimum.

C. The Significant Economic Presence Proposal

The Consultation Document notes that a proposal based on a “significant economic presence” of the type described in the Action 1 Report is also under consideration. This proposal would determine nexus in a jurisdiction on the basis of the amount of revenues in excess of a chosen threshold generated on a sustained basis within that jurisdiction, combined with other factors that are intended to indicate a “purposeful and sustained interaction” with a jurisdiction using digital or automated means. Once nexus is established, profits would be allocated using a multi-factor formula.

We do not fully understand the policy basis for the significant economic presence proposal. As a general matter, the approach of the proposal seems to be to arrive at factors to determine nexus, and then use that nexus as the basis for profit attribution. Ordinarily, we would expect a determination as to which profits should be attributable to which jurisdictions to be the first policy question considered, with nexus rules designed to ensure an administrable approach to achieve the desired profit attribution. This lack of a clear policy foundation appears likely to make it difficult to achieve a consensus that will provide clear answers with respect to the application of the rules to specific factual situations.

The significant economic presence proposal also shares many of the same potentially distortive effects as the user participation proposal described above. The factors described in the consultation document that may be used to determine nexus would target some businesses while leaving others subject to existing principles, based on distinctions that could appear arbitrary. Discriminating between business models in this way appears likely to create market distortions, and is likely to quickly become obsolete for the reasons described above with respect to the user participation proposal. When that happens, there is a substantial risk that there would be a new proliferation of unilateral measures of exactly the type that the current work toward global consensus should be designed to prevent.

If anything, these potential market distortions appear likely to be greater in the case of the significant economic presence proposal, as that proposal would completely replace existing transfer pricing principles with formulary apportionment in the case of covered activities, while leaving them in place with respect to non-covered activities. Maintaining two parallel tax systems seems like an inefficient approach, and likely to guarantee dispute and double taxation as countries inevitably disagree on where to draw the line between businesses subject to traditional rules and businesses subject to new rules. In addition, the scale of the departure of this proposal from existing international rules, and the need to reach a global consensus on an appropriate tax base and formulary apportionment keys is likely to significantly increase the already considerable difficulty of reaching a global consensus. As noted above, such a system also does not appear to provide an effective basis for resolving disputes over taxing rights when they arise.

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While we do not believe the significant economic presence proposal could be an effective standalone proposal in its current form, we acknowledge that under any of the proposals under consideration, it will be important to establish clear, administrable standards for nexus. Given that all of the proposals under consideration contemplate taxation that does not depend on physical presence, a “significant economic presence” concept appears highly relevant, regardless of which profit attribution approach is ultimately adopted. To develop appropriately targeted nexus rules, however, it is essential as a first step to determine how profit attribution would be intended to work. Based on that first step, a nexus rule could be constructed to keep administrative burden to a minimum by ensuring that nexus would generally not exist in situations in which no or very little profit would be attributed to that nexus, but would exist in situations intended to be caught under whatever profit attribution principle is agreed by the Inclusive Framework.

IV. Global Anti-Base Erosion Proposal

A. General Comments

While we understand that the intent is to work toward a consensus that includes both global anti-base erosion rules and revised profit allocation and nexus rules, the global anti-base erosion proposal appears less likely than the revised profit allocation and nexus rules to result in multi-jurisdictional disputes for two reasons. First, the global anti-base erosion proposal generally would not impact the arm’s length standard, as it generally implements secondary taxing rights. Second, the global anti-base erosion proposal appears capable of being implemented through relatively mechanical rules; if the rules can be agreed at a sufficient level of detail and implemented consistently across jurisdictions, disputes can be minimized. Reaching that level of consistency and clarity will be no simple task, however, and a number of design issues must be considered in order to minimize complexity and avoid creating risks of double or multiple taxation. We discuss those specific design issues for each element of the anti-base erosion proposal in more detail below. Regardless of which design features are chosen, the proposal is likely to represent a significant increase in the complexity of the international tax regimes of countries that adopt it. This complexity will be exacerbated by the need for coordination rules to avoid double or multiple taxation. Much of this complexity could be reduced, however, by not applying the tax on base eroding payments to payments to entities whose ultimate parent entity was subject to a regime that includes a sufficiently robust income inclusion rule.

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B. Design Issues

1. Undertaxed Payments Rule

As described in the consultation document, the undertaxed payments rule has the potential to be extremely complicated, depending on how it is designed. 6 In determining the optimal design features for this rule, it is important to be clear about the intended policy rationale for the proposed rule and to tailor its design to that policy rationale.

The Consultation Document states that the anti-base erosion proposal is motivated by the risks that continue to arise from the ability of companies to shift profits to low- or no-tax jurisdictions, presumably based on a concern that such payments can erode the tax base of the payor jurisdiction. The Consultation Document notes that this concern is particularly acute for intangibles and intra-group financing. If this is indeed the primary concern, then the Task Force should consider applying the rule only to the profit component of such payments, since only the profit portion of a payment can have the effect of shifting profits. Moreover, it might be further asserted that the payment of a small markup on costs does not equate to base erosion, and such a markup component should also be excluded from the application of the rule. We recognize that providing an exception for the cost component of a payment may necessitate a further requirement to trace successive payments through intervening related entities in order to ensure that the exception is only available for costs paid to unrelated parties.

A second possible justification for the base erosion payment rule would be to address competitiveness concerns that would otherwise arise if some jurisdictions did not implement the income inclusion rule. In this situation, an MNE whose ultimate parent (and any intermediate holding companies) is resident in a jurisdiction without such a rule might have a competitive advantage over an MNE whose CFCs are subject to such a rule. An MNE might even seek to change the residence of its ultimate parent (and intermediate holding companies) to a jurisdiction that did not include the rule. If this were a concern, jurisdictions that favor the implementation of an income inclusion rule might wish to have a harsh result apply when payments are made from their resident companies to entities that were not subject to the income inclusion rule because their parent jurisdiction declined to adopt the rule. Depending on the strength of those concerns, those countries may prefer that harsh rule even if it also resulted in additional complexity and double taxation by disallowing deductions for actual costs paid to unrelated parties. If this were the justification for the base erosion payment rule, it would make sense to adopt the suggestion in the Consultation Document to turn off the base erosion payment rule for payments made to MNEs that are based in a jurisdiction with a strong income inclusion rule (i.e. one that meets a minimum standard in terms of the rate and applicable tax base). This potentially would reduce the incentive for jurisdictions to engage in tax competition by not adopting the income inclusion rule and could even have the result of incentivizing jurisdiction to adopt the rule. It would also

6 Note that the subject to tax rule, discussed below, presents much of the same complexity, although it may

do so for a narrower subset of payments – namely, those that rely on treaty protection to avoid taxation in the payor’s jurisdiction.

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create a disincentive for parent companies to change their residence to avoid the application of the rule.

More fully articulating the policy justification for the rule and tailoring exceptions to the application of the rule in low-risk situations that do not implicate that purpose would go a long way to making the rule administrable.

As discussed in more detail below, calculating the effective rate of tax on a payment in another jurisdiction is difficult. In addition, as noted in the Consultation Document, to be effective, the tax on base eroding payments would have to cover “conduit” or “imported” arrangements. In some cases, those could be directly linked and tracked. In the case of intercompany financing, however, because money is fungible, all of an entity’s income is arguably supported by all of its equity and debt financing. Funding rules thus would be necessary to allocate interest deductions and other financing-related deductions to the various items of income. Moreover, the deductions allocated against the particular payment may need to be traced through multiple intercompany transactions, thereby compounding the complexity.

Many of the same issues will need to be addressed by the income inclusion rule. We believe, however, that it is more efficient to address these issues once for each MNE group based on the income inclusion rule, rather than trying to address them with respect to every payment to or within the group. Therefore, we think it would be preferable for the tax on base eroding payments to be designed primarily as a backstop to an effective income inclusion rule.

2. Scope of payments covered by the rule

As a policy matter, it appears that the scope of payments covered by the rule should be broad, to ensure as level a playing field as possible for different business models. We assume that the intent of the proposal is to cover all deductible payments.

There are meaningful questions as to what should be considered a “deductible” payment for these purposes. For example, payments that may constitute cost of goods sold for accounting purposes may give rise to concerns that are similar or identical, in many cases, to the concerns presented by deductible payments. Consideration should be given to whether payments that go beyond true deductions should or could be covered. Note, however, that trade obligations may present significant limitations on which payments can be covered. To the extent that payments likely to reflect true third party costs are within the scope of the base erosion payment rule, it would be important to have exceptions that go beyond an effective tax rate test, such as the exceptions discussed above for third party costs or for payments to a recipient whose ultimate parent is located in a jurisdiction that imposes a robust income inclusion rule.

3. Threshold for related party status

We note that companies are less likely to make base eroding payments (which by their nature shift value without due consideration) to separate entities that are primarily owned by unrelated persons. In addition, in any case in which the payor does not control the payee, the

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payor may have difficulty getting the necessary information from the payee.7 We therefore believe that the rule should apply only when there is greater than 50% (by vote or value) common ownership, by reference to direct, indirect, and constructive (e.g., family attribution) ownership through related persons. A backstop could also be provided to address arrangements used to reduce ownership below 50% without giving up practical control, when such arrangements are motivated by avoiding the application of the rule.

4. Mechanics of the effective tax rate test

A variety of options are available for measuring the effective tax rate test for purposes of either the effective tax rate test or the subject to tax test.

The simplest and most administrable option would be to simply use the statutory rate in the recipient jurisdiction. As an alternative, the effective rate for the entity in the recipient jurisdiction, calculated under the recipient jurisdiction’s tax regime, could be used instead. As noted above, however, neither of these would appear to be accurate measures of effective tax rate, because the base may be eroded by deductible payments out of the recipient jurisdiction. In addition, jurisdictions may have incentive, for reasons of competitiveness, to change their tax base to something narrower than the tax base of the payor’s country.

Another option would be to use the effective rate for the entity in the recipient jurisdiction based on the payor jurisdiction’s tax regime. While this would be more effective, it would require entities to compute their tax rate under the rules of their local jurisdiction, the jurisdiction of each parent (under the income inclusion rule), and the jurisdiction of each payor (under the undertaxed payment rule), which would impose a significant administrative burden. In addition, this approach by itself would not address conduit or imported arrangements, so additional complexity would be required to address those concerns. Consideration would also need to be given to how to smooth out the effect of timing differences between two jurisdictions that might have the effect of making a payment appear low-taxed simply because tax would be imposed in an immediately preceding or succeeding year. Similarly, the impact of net operating losses would need to be considered and addressed. The complexity of this approach appears to render it entirely unworkable.

An alternative to these first two options may be to compare tax accrued or paid against statutory income for financial statement purposes in the payee jurisdiction. Because statutory income would generally follow international financial reporting standards, it is less subject to manipulation such as intentional narrowing of the tax base. Note, however, that adjustments would still have to be made for net operating losses that may shelter current period income.

In theory, it would be possible to construct a rule that identified each payment, and allocated deductions against that payment to compute an effective rate of taxation on the net

7 That difficulty is another reason we believe that if this proposal is adopted, the income inclusion rule

should be the primary rule, because the parent has access to the most information in order to administer the rule.

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payment received. The tax paid by the entity could then be allocated to each net payment received, to compute the amount of tax on that net payment. The net payment (which would only be part of the gross payment received) could then be tested to determine whether it was subject to a sufficient level of tax. Each deduction allocated against the payment would then be tracked to determine its recipient. That secondary recipient then would undertake the same analysis to determine the net payment and amount of tax allocated to the net payment, to determine whether that portion of the payment was subject to a sufficient level of tax. Such a rule would align better with the concerns behind the proposal, but appears impossible to implement in practice.

The tracing of payments and effective tax rates required under each of the foregoing options could be avoided by a rule that focused on whether the ultimate parent entity of the recipient is subject to an effective income inclusion rule that imposes tax at a sufficient rate. This approach would ensure that the recipient entity (or the ultimate parent entity) was subject to a regime that includes the income inclusion rule and applies the rule by applying a sufficiently high effective tax rate test to a sufficiently robust tax base. Such an approach would require a peer review or other evaluation of other jurisdictions’ tax regimes, and could be based in part on country-by-country report information, which could be enhanced for this purpose.

Note that the level of substance in a jurisdiction does not seem to be related to the issue of whether the payment is subject to a sufficient level of tax. In addition, as discussed below with respect to the income inclusion rule, thresholds that rely on substance to reduce the impact of the rule will introduce complexity without appearing to meaningfully advance the goals of the provision.

5. Collective Investment Vehicles, Pensions and Government Investors

We note that a number of countries may provide for an exemption from taxation on income received by particular types of entities. This is the case, for example, for collective investment vehicles, who are often untaxed at the entity level on the basis that their income will be taxed at the level of the investors. Similarly, in the case of pension funds, where beneficiaries are subject to tax on distributions, jurisdictions often exempt the income of the fund itself. In this regard, we note the work of the OECD addressing the treaty entitlement of collective investment vehicles, and the work under the BEPS project to ensure that recognized pension funds would be entitled to treaty benefits despite frequently being exempt from taxation. We consider that the characteristics that cause such funds to be entitled to treaty benefits despite being exempt from tax would also justify an exemption from the application of the tax on base eroding payments.

Similarly, we note that many jurisdictions exempt from tax some or all of the income of government investors, including sovereign wealth funds, on the basis of limited or general sovereign immunity or similar principles. We consider that a jurisdiction that takes such an approach should also exempt such income from the tax on base eroding payments.

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6. Subject to Tax Rule

In general, many of the comments that we made above with respect to the undertaxed payments rule apply to the subject to tax rule, because the starting point for the subject to tax rule is identifying payments that are undertaxed.

The role of the subject to tax rule and its basis are less clear to us, however. We understand the proposal to be based on the notion that because bilateral tax treaties are intended primarily to avoid double taxation, a source country could be given the ability to reassert its taxing rights over payments that are not, in fact, subject to sufficient taxation in the residence jurisdiction. Applying both withholding taxation and a denial of a deduction with respect to the same item of income appears excessive. Thus, while we did not find it completely clear from the Consultation Document, our assumption is that the subject to tax rule would apply only as an alternative to the undertaxed payments rule.

If the subject to tax rule is adopted, it is worth considering whether its application should be limited to interest and royalties, which appear to present the greatest potential concerns. Application of the subject to tax test to business profits under Article 7 of tax treaties appears to raise substantial complexity. We think concerns about business profits would be better addressed by the branch mismatch recommendations under Action 2.

With respect to dividend exemption regimes, we agree that those should be excluded from scope. In fact, we believe that all dividends should be excluded from the proposals as the proposals do not seem designed to reinforce secondary rights to tax subsidiary income.

As noted above, we do not believe the proposal should apply to payments to unrelated parties. If it is intended to apply to such payments, however, we consider it unreasonable to require unrelated parties to share sensitive financial information with every payor. As a result, we believe it would be appropriate to allow a payor to rely on a certification from an unrelated payee.

C. Income inclusion rule

1. Addressing Incentives

A key consideration regarding the income inclusion rule will be addressing competitiveness concerns. As noted above, MNEs that have their parent in a jurisdiction that implements the income inclusion rule may be at a disadvantage to MNEs that do not. Although implementation of the income inclusion rule by most jurisdictions could reduce that disadvantage, some jurisdictions may have an incentive to implement the income inclusion rule, but to make it less effective or onerous by defining the base narrowly, lowering the rate of tax on the inclusion, or granting exemptions or credits. The Task Force may therefore wish to consider a peer review or similar monitoring mechanism to evaluate jurisdictions’ implementation of the income inclusion rule, particularly if the base erosion payment rule were designed not to apply when the payee is subject to an acceptable income inclusion rule.

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2. Country-by-country vs. global

Determining whether income has been subject to a low effective tax rate could be done on a country-by-country basis (i.e., by examining solely whether each branch or controlled entity is subject to tax at an appropriate rate in its country of operation or residence), or could be done on a global basis, by examining whether the global effective tax rate on CFC income exceeded a certain rate.

A country-by-country approach is likely to be significantly more complicated than an approach that is based on the global effective tax rate on CFC income, and the global approach might be preferred on that basis. However, a global approach potentially would allow high-taxed income in one jurisdiction to “shelter” low-taxed income in other jurisdictions. If a country-by-country approach were used, there would need to be rules to prevent the notional shifting of income from low-tax jurisdictions to high-taxed jurisdictions from the perspective of the jurisdiction imposing the rules. For example, the rules could disregard transactions that purport to be deductible in a low-tax jurisdiction if they are not actually includible in the tax base of the high-tax jurisdiction.

3. Balancing safe harbors for low-risk entities against need for simplicity

One stated purpose of the global anti-base erosion proposal is to address the continued risk of profit shifting to entities subject to no or very low taxation. The Consultation Document notes that this risk is particularly acute in connection with profits related to intangibles. Ideally, therefore, the regime would be designed to the extent possible not to apply to income that does not reflect a shifting of intangible returns. This would more closely focus the proposal on the stress on transfer pricing rules that is created by the increasing importance of intangibles in a digitalized economy. The benefits of any such carveout, however, will need to be weighed against the additional complexity and uncertainty that a more nuanced approach would bring.

One option to consider would be a deduction based on a deemed routine return on tangible personal property, similar to the approach taken by the U.S. global intangible low taxed income (GILTI) regime. While such an approach is conceptually straight forward, however, it raises questions about what property is or should be included in the base.

A mechanism permitting a deduction based on operating expenses will raise similar questions about what expenses should count and how jurisdictions can police abusive transactions or structures. A third option could be an exclusion based on whether transfer pricing supports the allocation of profits to the jurisdiction. Such an exclusion may be more administrable, but appears much less likely to be consistent with the idea that this proposal would serve as an effective backstop against the use of transfer pricing rules to shift income to low tax jurisdictions.

In the interest of minimizing application to low-risk taxpayers, consideration could also be given to excluding companies altogether if the global ETR reported in their audited financial statements is sufficiently high (e.g., 80% of the statutory rate of the jurisdiction that is applying the applicable rule.

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4. Appropriate rate of tax

When income is within scope of the proposal and is taxed at a rate below the minimum tax rate, the proposal will need to make clear whether the “top up” will cause the income to be taxed at the minimum rate, the full domestic rate, or some rate in between. This choice should be based on the overall design of the tax.

If the tax is intended to tax income that has been “improperly” diverted from the parent jurisdiction, then the full domestic rate seems appropriate. If, however, the tax is designed to ensure a minimum level of tax on income, then it seems more appropriate to apply the minimum rate (or another rate that is lower than the full domestic rate).

As a general matter, we believe that taxation rules should avoid creating “cliff effects” that would create inappropriate incentives. Such incentives would result if income that is taxed at just below the appropriate minimum rate would be subject to full taxation at the domestic rates of the parent jurisdiction, but income taxed at a rate just above the minimum rate would not. This would create incentives to engage in structuring to achieve a rate of taxation that is just above the minimum rate. In contrast, imposing tax under the income inclusion rule at a rate at or near the minimum rate would appear to avoid those perverse incentives for MNEs to raise their effective tax rate.

D. Mechanisms for avoiding double taxation

With respect to multiple jurisdictions imposing the income inclusion rule on a single chain of entities, entities that are higher in the ownership chain should receive credits for taxes imposed by jurisdictions lower in the chain under the income inclusion rule. A mechanism would be needed for linking the taxes on the intermediate entity to the income of the underlying entity. For example, assume P Co is the parent of an MNE group. P Co is resident in Jurisdiction P, and owns B Co, an entity resident in Jurisdiction B. B Co owns C Co, an entity resident in Jurisdiction C. Both P Co and B Co are subject to the income inclusion rule with respect to the earnings of C Co. When Jurisdiction P’s income inclusion rule is applied with respect to C Co, P Co should receive credit for taxes imposed on B Co with respect to the earnings of C Co. Those taxes should be deemed to have been paid by C Co in applying the income inclusion rules in Jurisdiction P.

In light of the goal of the proposal to act as a back-stop to ensure an effective rate of taxation, we believe that the inclusion rule should not apply to income of a foreign subsidiary that meets the designated effective tax rate test, with the result that such income would be excluded altogether from the relevant parent jurisdiction’s tax base. This observation is based in part on the fact that the inclusion rule is not being framed as a push for worldwide taxation by parent jurisdictions but rather as an anti-base erosion proposal. This observation is also based on our experience with the U.S. GILTI rules, and the complexity of using a foreign tax credit mechanism to implement a minimum tax on CFC income. Jurisdictions may want to consider a country-by-country exemption approach, under which the tax does not apply to income with respect to another jurisdiction if that income is subject to a sufficient level of taxation in that other jurisdiction.

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E. Coordination of the Income Inclusion Rule with the Base Eroding Payments Rule

For the reasons described above, we believe that the tax on base eroding payments should not apply if the recipient entity or parent entity is subject to the income inclusion rule using a sufficiently high effective tax rate test and a sufficiently robust tax base. If such an exception were provided, it may make sense to limit it to situations in which the ultimate parent is located in a jurisdiction with the income inclusion rule (rather than just any intermediate holding company), in order to avoid the need for anti-conduit rules to address payments to one affiliate in a “good” ownership chain that is subject to an income inclusion rule but that are then base eroded to another affiliate that is not subject to the income inclusion rule.

The parent entity has access to the information that is needed to apply the income inclusion rule, and a payor entity may not have the information to apply the tax on base eroding payments. In addition, such an approach significantly reduces the complexity of the tax on base eroding payments, creates an incentive for jurisdictions to implement the income inclusion rule (thereby further reducing complexity), and reduces the comparative disadvantage for MNEs that have a parent in a jurisdiction that implements the income inclusion rule.

If the approach above is not adopted, however, the income inclusion rule should treat the tax on base eroding payments as a tax paid by the recipient entity on its income.

F. Other approaches to reduce complexity and ensure certainty

Regardless of which specific design choices are adopted, the proposal will require detailed, complicated rules. To the extent possible, the Task Force should develop those rules in a coordinated way at a level of detail that minimizes the possibility of country-to-country variation. This approach would give taxpayers and tax administrations additional certainty as to how the rules will apply. As the regime evolves, additional questions will certainly arise. To the extent possible, those questions should also be resolved on a coordinated basis.

G. Considerations related to adoption in EU Member States

In order to be implemented at the level of the European Union (EU) (or by individual EU member states), any OECD proposal will have to be compatible with EU primary law, including EU state aid rules, the fundamental freedoms, and a number of underlying principles. In this regard, the principles of subsidiarity and proportionality would be important.

1. Subsidiarity principle

As direct taxation falls outside the exclusive competence of the European Union, the subsidiarity principle foresees that coordinated action at the EU level in this field may only be carried out if issues cannot be appropriately dealt with at the level of each individual Member State. According to the Consultation Document, the proposed anti-base erosion measures aim at addressing “the continued risk of profit shifting to entities subject to no or very low taxation.” It is reasonable to expect that any proposal at the EU level that would define a minimum taxation

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level in absolute percentages would raise concerns about a potential infringement to the EU Member States’ sovereign powers to design their own direct tax system.

It should further be noted that national parliaments of EU member states also have the possibility to object to any draft legislation proposed by the European Commission by issuing a reasoned opinion (the so-called yellow card procedure under which the national parliaments of EU Member States can object to a draft legislative act on grounds of the principle of subsidiarity).

2. Proportionality principle

The EU principle of proportionality on the other hand, requires that any action at the EU level – or at the level of the individual member states - is suitable and does not go beyond what is strictly necessary to meet the objective of the proposed measures. The Court of Justice of the European Union has consistently confirmed - since its landmark judgement in the Cadbury Schweppes case (CJEU 12 September 2006, C-196/04) - that national measures that do not exclusively target wholly artificial arrangements and introduce an irrebuttable presumption of abuse do not meet the proportionality test. By applying indistinctly to any transaction deemed “undertaxed”, the suggested income inclusion rule and tax on base eroding payments would entail such a presumption of abuse. Particular attention should therefore be given to introducing the possibility for taxpayers to evidence that the “undertaxed” transaction has been made for valid commercial reasons and reflects genuine economic activities (see paragraphs 86 and 87 of the CJEU ruling of 26 February 2019, case C-135/17, X GmbH vs Finanzamt Stuttgart). As a practical matter, this risk might be mitigated if implemented through an EU directive adopted unanimously rather than through unilateral measures of EU member states, as the Court of Justice of the European Union is less inclined to find a conflict with primary EU law in the case of secondary EU law as compared to unilateral measures.