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By Gary D. Sprague, Esq. Baker & McKenzie LLP Palo Alto, California
The OECD/G20 BEPS (Base Erosion and Profit Shifting) Project was not meant to be about changing nexus rules to reset the allocation of taxation rights between the state of residence and the state of source. In large part (but not entirely), that has been true with respect to those changes arising from the BEPS Project itself which will be implemented through changes to domestic law, treaties in force and to be negotiated in the future, and the OECD (Organization for Economic Cooperation and Development) Transfer Pricing Guidelines (“TPG”). The winds of change that are blowing across the international tax landscape at the moment, however, include strong gusts that are not part of the BEPS Project itself which indeed are implementing new nexus rules. While these unilateral actions are not part of the BEPS Project, one might speculate that it was the BEPS Project which provided inspiration and perhaps cover for governments to propose the more radical changes.
There is not enough space in a short Commentary such as this one to describe in detail all of the new nexus proposals, or the policy justifications for each of them. The purpose of this Commentary is to offer reflections on some of the different directions that countries and multinational organizations are taking around the world on nexus issues, to observe that many of these changes will erode the coherence and consistency of the existing network of cross-border taxation rules. This Commentary also is not intended to directly contribute to the debate whether the traditional balance is or is not appropriate in the current economy, or whether it should be jettisoned entirely for formulary apportionment or some other solution. Instead, the purpose is to observe where the historical nexus compromise is being eroded, as one suspects that more developments in the same direction can be expected in the future.
I have separated the developments into several categories: (i) changes which distinctly do move the nexus line even within the OECD/G20 BEPS Project framework; (ii) proposals which provide useful clarifications but do not change the nexus standard substantively (this is a short list); (iii) nexus changes which are proceeding outside the OECD/G20 framework but undoubtedly are inspired by the BEPS Project; and (iv) more radical proposals that are harder to classify. In this Commentary, I am categorizing the imposition of a withholding tax on a particular category of business profits as a nexus rule, as the intention is to create a tax liability of a nonresident on profits which historically have been regarded as arising from value created through the nonresident's business activities conducted outside of the market country.
Many aspects of the BEPS Project will result in more taxable income allocated to the source state, without changes to the nexus rules. The most obvious examples are changes to the OECD TPG. With the expressed intent of not deviating from the arm's-length principle per se, essentially all of the TPG revisions arising from Actions 8–10 will, as a practical matter, result in more taxable income being allocated to the market state. The policy goal of Actions 8–10 is to “[a]ssure that transfer pricing outcomes are in line with value creation.” It is hard to quibble with that statement on its face as a matter of policy.
The point that hasn't really been debated is the question of where “value” is created. Some of the interpretations of the TPG which have the effect of allocating more income to the destination state are based on the tax policy assertion that value is created by the simple existence of the market. In the nexus area, that policy view is inspiring governments to seek to impose new nexus standards on income derived from sales into their market. The new standards usually are justified on the basis that they are needed to capture a “fair share” of tax arising from the transactions.
In the first category, the OECD/G20 BEPS Project itself did result in some changes to the nexus standard expressed in the OECD Model Tax Convention (“MTC”). Here, the changes appear in revisions to MTC Article 5. Article 5 now sets the threshold for direct taxation of a nonresident enterprise based on the activities of a dependent person in the market country, if that person performs “the principal role” leading to the conclusion of contracts which are not materially modified by the nonresident. That nexus rule is intended to change the line at which point a nonresident enterprise becomes subject to direct tax jurisdiction of the market state. The elimination of access to the preparatory or auxiliary exception for most groups operating in the market jurisdiction through a separate entity where that entity engages in complementary functions which are part of a cohesive business operation with the nonresident similarly will bring a greater scope of business activities of nonresident enterprises across the line of tax nexus.
In the second category, namely the category of nexus-related changes which do not depart substantively from existing concepts, I would put (only) the Discussion Draft guidance on the application of the permanent establishment (PE) profit attribution principles to cases arising under the new PE standards. That draft adheres to the principle that business profits of a nonresident can be brought within the tax nexus of a jurisdiction only if the nonresident exercises functions, assets or risks in that jurisdiction. A word of caution here: enough grumbling has been detected as to the results of that analysis that taxpayers should be alert for possible future revisions to the Discussion Draft that might not adhere in such a principled way to that basis for determining profits subject to tax in the market state.
The third category includes nexus changes which are proceeding outside the OECD/G20 BEPS Project. One of the principal goals of the BEPS Project was to establish an international tax framework based on a consensus agreement, implemented consistently. This goal also was reflected in the official communiqué issued after the September 2016 Hangzhou Summit of G20 Leaders, in which the leaders noted that a focus of international tax reform should be on achieving “tax certainty.” Notwithstanding the goal of the G20 Leaders, there is considerable activity around the world focused on imposing new tax nexus rules on nonresident enterprises making sales into the market of the taxing jurisdiction. Many of these taxes are focused on the remote delivery models of digital economy enterprises, but not all of them. In many cases, the taxes will operate to impose nexus on a wide variety of payments made by residents of the taxing jurisdiction. The policy justification of many of these taxes is simply that payments are being made by a local payer; discussions of the location of value creation as the basis for the determinant of tax liability are missing, other than the assertion that the market itself creates value which is sufficient to create a basis for nexus.
The most dramatic examples are withholding taxes. The UN is poised to release revisions to its Model Treaty which will include an Article allowing withholding tax on payments for technical services. The UN also is considering a proposal that would allow withholding tax on any cross-border payment for software, including for user copies that most countries consider to be business profits akin to any other income from the sale of inventory property. Similar specific proposals are appearing on an individual country basis. Malaysia is poised to impose withholding tax on all cross-border payments for software, visual images and sounds — including for copyrighted articles which, the Malaysian courts have concluded, constitute sales of copyrighted articles for tax purposes under current law. Indonesia is considering the more extreme approach of requiring all over-the-top content (“OTT”) providers to establish a taxable presence in Indonesia via a subsidiary or a branch (along with other commercial requirements) before the provider can offer OTT services to the Indonesian market. The Indian Equalization Levy on digital advertising revenue is another high-profile case of taxation on remote suppliers in a particular industry segment, which is justified as a policy matter essentially on the basis that a withholding tax is necessary to impose the tax as the suppliers otherwise would not bear tax on sales into the Indian market.
There also is increasing interest around the world to impose tax on capital gains arising from the indirect disposition of shares in companies which operate in the jurisdiction asserting the tax nexus — i.e., nexus over gains arising from the sale of shares in holding companies formed in third jurisdictions. Many jurisdictions, including the United States through the FIRPTA (Foreign Investment in Real Property Tax Act) rules, assert tax jurisdiction when shares are sold of a domestic company whose assets consist principally of real property located in the country asserting the nexus to tax. Outside the real property holding context, extraterritorial capital gains taxes on sales of local company shares have been a feature of tax regimes of many countries for many years, although Article 13(5) of the OECD MTC would limit the taxation rights on such gains to the country of residence. The UN Model in its Article 13(5) allows for the taxation of such gains when the alienator holds a percentage of the capital of the company in excess of a percentage to be negotiated by the contracting states.
Assertions that a country may tax gains arising from indirect transfers, namely dispositions of shares of holding companies not organized in the jurisdiction imposing the tax, represent a significant expansion of the territorial basis for taxation. The policy argument against these taxes is that nexus for these gains should lie with the residence jurisdiction of the capital investor who took the risk of the investment, since the state in which the entity operates also has primary taxation rights over the profits of the business itself.
In light of the current environment which encourages jurisdictions to cast a wide net when considering tax nexus, it would not be surprising if these sorts of taxes were to proliferate. Indeed, the newly formed Platform for Collaboration on Tax — a joint effort among the International Monetary Fund, the OECD, the UN, and the World Bank — is apparently developing a toolkit concerning the taxation of indirect transfers of assets.
The U.K. Diverted Profits Tax (“DPT”) and the Australian Multinational Anti-avoidance Law (“MAAL”) deserve a category of their own. If they were intended only to be only a prod to taxpayers to take seriously the admonition of the BEPS Project to ensure that transfer pricing outcomes are in line with value creation, they perhaps could be regarded as only an overly enthusiastic implementation of the BEPS principles. But in practice they are developing into more than that, as new enhancements to the DPT in the United Kingdom and a DPT add-on to the MAAL in Australia seem to be intended as tools to tax profits arising offshore from investments made offshore, which in essence is a change from the normal nexus standards for determining tax liability. The mere fact that both laws are set to operate outside the treaty network suggests that they are intended to create results that would not normally occur simply by applying the MTC nexus rules and the TPG to onshore operations.
One of the notable aspects of the unilateral actions sprouting up around the world is that new nexus rules frequently are justified as a policy matter simply by pointing to prior similar actions taken by other countries. The Indian Ministry of Finance justified that country's Equalization Levy by reference to the U.K. DPT and the Australian MAAL. The French legislature approved a DPT (although the tax ultimately was overturned by France's Constitutional Council) and the Minister of Revenue of New Zealand stated recently in a speech that New Zealand will consider a similar tax. In both cases, advocates of the tax cited the U.K. and Australian examples as inspiration.
And then there is the United States. When practitioners and academics turn their attention to the source-vs.-residence debate, they sometimes speculate whether there are any countries left, besides the United States, whose tax policies clearly line up to emphasize the taxation rights of the residence country. From that perspective, it is intriguing to reflect on the House blueprint for tax reform that calls for a border-adjusted corporate cashflow tax. The border-adjusted tax certainly takes a different view of U.S. international tax policy, essentially taxing sales into the U.S. market of goods, services and intangibles, while exempting from tax gross revenue earned on exports. This approach is similar to a subtraction-method value-added tax that was labeled the Growth and Investment Tax (GIT), one of the two tax reform options presented by the President's Advisory Panel on Federal Tax Reform in 2005. Is this the revenge of the source-based taxation theorists, or is there another policy at work? It will be interesting to see how the tax policy choices underlying this approach, if taken, will be harmonized with the policy positions that the United States has historically taken for determining when nexus exists for cross-border transactions, with the quantum of local taxable income then determined under the arm's-length standard.
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