Interview: Taxing The Digital Economy and Developing Countries
A business woman checks her smart phone while getting a ride on a moto taxi in downtown Nairobi, … [+] Kenya.
Martin Hearson, the international tax program lead at the International Center for Tax and Development, discusses how the OECD’s work on taxation of the digital economy affects developing countries.
Read the podcast transcript below. The post has been edited for clarity and length.
Dave Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: digitalization and development. The OECD recently released its two-pillar plan for addressing the taxation of an increasingly digital economy. Now we’ve talked about this more generally in a previous episode, but this week we’re looking into how the proposals in this draft will affect developing countries. I’m joined by Martin Hearson, the international tax program lead at the International Center for Tax and Development. Martin, welcome to the podcast.
Martin Hearson: Thanks for having me.
Dave Stewart: To start out, could you give a brief overview of what’s in the OECD’s pillar 1 consultation draft?
Martin Hearson: Sure. I think it’s worth starting by saying that the consultation draft is a secretariat paper. It’s a suggestion for a consensus approach they think they’ll be able to get countries to buy into, but it departs from three different proposals that we had on the table at the start of the year. Those three proposals came from the U.S., the U.K., and the group of 24 developing countries. What we have now is a unified proposal and it’s got three components. The first component, Amount A, is the one that has gotten the most attention because it breaks some of the rules that we’re used to thinking of as being unbreakable in the international tax system.
It establishes a new taxing rate in situations where you don’t have a physical presence, but you do have significant market presence. It also allocates a portion of the company’s residual profits to the countries that have the new taxing right using a formula. It doesn’t follow the arm’s-length principle. People think that’s very radical. Then we have Amount B, which allows countries to claim a fixed return on distribution and marketing activities. This is a simplification that in some ways goes away from the way the arm’s-length principle has worked. This is where it looks like the most money is for developing countries. Amount B, as I say, it’s a simplification. It will allow developing countries to deal with problems such as limited risk distributors, which they’ve been complaining about for quite some time now.
That will bring money to them, not from other large countries, but from offshore centers, investment hubs, where profits have been shifted to up to now. And then there’s Amount C, which allows countries to, if they think that Amounts A and B aren’t giving them enough, allows them to use existing transfer pricing rules to go up and above that. The other point about this proposal is that all three of those things are subject to mandatory binding arbitration, although the OECD is trying to move away from that word, and instead saying dispute settlements.
Dave Stewart: Are you hearing from policymakers in developing countries on how they view where the OECD has landed on at least its secretariat proposal?
Martin Hearson: I’ve spoken to a number of government officials and revenue authority officials from developing countries about the proposal from the OECD. I think it’s less a point about having an overall view on the proposal and more about having a view on what within the undetermined parts of that proposal is going to make the biggest difference. I did speak to a number of people from developing countries who compared it with the original proposals from the U.S., the U.K., and the group of 24 developing countries and said they felt it looks a lot more like the U.S. proposal. I’ve seen some remarks made by an Indian official also saying they’re frustrated that they don’t really think it’s picked up much from what they were pushing through the group of 24. But if we look inside the proposal, at the things that are still to be resolved, I think we can divide the issues for developing countries into three.
There’s the question of scope. One thing in the proposal which is important I think to developing countries is that extractive industries will be excluded from the scope of pillar 1, at least from Amount A. I think that’s really important because the shift of taxing rights towards market countries and extractive industries would shift taxing rights away from the countries where the minerals are extracted in the first place. On this scope, I think the other key point for developing countries is around the threshold for market presence that will constitute the new taxing right. If that threshold is quite high, that’s likely to limit the number of cases in which small countries, which have small markets to begin with, the presence of a multinational will cross that threshold. For smaller developing countries, it’s important the threshold is adapted to that small market size to begin with. Otherwise, they’re not likely to see much here.
My second point is about how the profits are then allocated. Under Amount A, the issue is whether the allocation key is purely based on sales or whether it might also incorporate users. I think if it incorporates users, that might help because it’s often the case for developing countries that you have significant use of the digital platform, but not much sales because it’s provided free. The second point in allocation is under Amount B. There’s going to be a fixed return if it won’t be carried through into the final proposal on marketing and distribution activities. The question is how big that fixed return is and that’s clearly going to make a difference whether or not it seems like to developing countries that it’s going to be more beneficial than just using the existing transfer pricing rules.
Then the third thing in this proposal that I think has attracted a lot of controversy from developing countries is the quite strong insistence on mandatory binding dispute settlement. There’s a number of developing countries, India perhaps most prominently, which have got a pretty firm red line that they won’t accept mandatory binding arbitration in tax treaties to date. I’m not quite sure how the secretariat thinks they’re going to be able to square the U.S, insistence that this must be part of the proposal with the very strong objections from developing countries.
Dave Stewart: What are the objections to binding arbitration?
Martin Hearson: There are two ways of looking at this. One is the way that I think the secretariat sees it, which is that it’s a bit of a misnomer to call this arbitration. Developing countries that have this experience with investment arbitration, where they signed up to investment treaties not quite anticipating the way in which they will be used by investors to challenge different introductions of regulations and laws, but by governments. They felt like they completely lost control of the ability to regulate foreign investment because it was these unaccountable panel of arbitrators who would decide, and often would decide against the governments. I think the secretariat’s view and the view I hear from a lot of people inside the tax profession is, well that’s not what this is. This is a proposal to say governments have to sit down in a room and reach an agreement. If they can’t do it themselves, then we need some kind of decision rules that can deal with this unresolved disputes. It’s not like arbitration in which you’re going to see investors taking governments to court and that kind of semi-judicial process.
On the other hand, I think the skepticism from developing countries isn’t just about their bad experience with something else and poor branding of this as arbitration. It’s also about a concern that it’s hard to imagine a process being designed in the world that we live in, which is one in which international tax rules have by and large been written by OECD countries and a tax profession largely identifies with the Orthodox way of interpreting those rules. The developing countries sometimes want to push the envelope a bit.
They didn’t write those rules. Sure, they signed up to them, but often they signed up to them under pressure or not quite knowing the full extent of what they were committing to. They don’t necessarily want to be in a situation where the final decision about whether they get to tax a company is made by a tax lawyer from an OECD country. There’s ways that the eventual process could be designed that helps to try and mitigate those concerns. I think at the end of the day, if you are coming from a country which has been peripheral to the international tax regime up to now, there’s a limit to how much confidence you have in letting that regime become really hard and binding outside of your own country’s judicial system.
PARIS, FRANCE – OCTOBER 07: In this photo illustration, social media, Twitter, TikTok, WhatApp, … [+] Instagram, Threads, Snapchat, Facebook, Messenger and Telegram application logos are displayed on the screen of a smartphone on October 07, 2019 in Paris, France. The social network Instagram launched last week Threads its new application to promote the constant and intimate sharing between users and their closest friends. This Snapchat-inspired email app complements the popular Instagram image sharing service. (Photo by Chesnot/Getty Images)
Dave Stewart: Now we’ve heard from the African Tax Administration Forum (ATAF) that they generally support the inclusive framework at the OECD. Have they identified any concerns or challenges for developing countries with this proposal?
Martin Hearson: ATAF has been really good at responding to what’s come out of the OECD and publishing detailed technical notes. A lot of the comments I made earlier about what I think are the issues for developing countries inside that pillar 1 proposal come from the ATAF technical notes and from conversations with the ATAF secretariat. They’ve also published is a report which offers a critical commentary on the way in which the inclusive framework makes decisions and the difficulties that African countries face in trying to navigate that process.
If we look at what ATAF identifies, there’s a number of different issues. The first thing on this digital issue is that many African countries or many smaller developing countries are at an early stage of working out really what this issue is for them. They’re recognizing that there’s some economic activity happening that they’re not able to tax, but actually quite understanding what it is they want to do about that is a journey that will take a while to go on. You have a few countries such as Kenya that have gone quite far down the route of thinking this through and publishing digital strategies, but others which are at a much earlier stage. The first thing is actually being able to match the pace at which the OECD is going. That’s difficult when you actually don’t necessarily know what endpoint you want to reach.
The second thing is about the capacity that smaller developing countries have to be able to follow this intensive process of discussions in Paris. Simply the cost of going there and the opportunity cost for a skilled and knowledgeable official to take a week out of their schedule to go and leave all the responsibilities at home behind or to read the documents. For many African countries as well as developing countries, they’ll have a handful of people who are able to follow that level of detail and those people are going to be spread quite thinly across both their domestic responsibilities and also the different OECD committees. Whereas for a larger country, they’ll have someone different on each committee and that person will be a dedicated policy person.
The third issue is the relatively recent emergence of caucuses of developing countries. We’ve talked about ATAF. ATAF has done not only technical work trying to analyze what’s coming out of the OECD, but also they’ve done some good work trying to organize African delegates to the inclusive framework to come with a united front and a strategy about how they’re going to influence, because it’s a political negotiation. It’s not just about working out what you want. It’s also about trying to work out how to use the relatively limited influence that you’ve got to try and shape outcomes. That’s at an early stage and they’re still getting the hang of that. The other developing country body that’s been active in the inclusive framework is the group of 24. As I mentioned, it was their proposal that was one of the three that the inclusive framework had on the table in January. They’re also at an early stage of working together. You have developed countries like OECD members, EU members, G-7 members, all used to sitting down in smaller groups, formulating positions and strategies and taking those to the other forums, for developing countries, it is at an earlier stage.
My final point is about the disconnect between the technical officials who are often participating in these discussions for developing countries and the political side of things. The finance ministries and their political matters often are actually quite outside this conversation in developing countries, whereas developed countries typically represented at the inclusive framework by someone either from their finance ministry or from their revenue authority who’s got a clear policy mandate. Developing countries are often sending somebody from the revenue authority who doesn’t actually have the same authority to talk about policy and to push the envelope on a contentious policy issue because that’s really the mandate of finance ministry.
Dave Stewart: What can the OECD do to be more inclusive and mindful of the challenges that these developing countries have?
Martin Hearson: I think there’s a lot of people scratching their heads about that right now. The OECD secretariat has some funds given to it by development donors to work on this. The people inside the secretariat really want it to work because they’ve created this inclusive framework. They’ve brought countries in and they want those countries to be able to work through that framework effectively. Otherwise it’s not going to be successful as an enterprise. There’s an awful lot of capacity building work that’s going on.
There’s an awful lot of work to think through. For example, organizing regional meetings where the OECD secretariat comes and does a kind of a training for inclusive framework members and other developing countries in the region and then helps them to think through what they might want to advocate for in Paris. But I think we also have to be realistic here. In a process such as this, which is going at a very intense and very fast pace, we have to realistic about the extent to which developing countries are going to be able to influence given all the constraints that I’ve mentioned earlier. I think there’s probably a slight incompatibility between the OECD secretariat and the OECD members as well and that desire to see developing countries at the table with the fact that this process is designed for countries that have the capacity that OECD members and large emerging markets have. It’s not really designed for the way in which small countries are currently able to participate.
Dave Stewart: This has been fascinating. Martin, thank you for being here.
Martin Hearson: Thanks very much for having me.