Digitalization and Developing Countries

Dave Stewart: 0:01

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 part of 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 that will be linked to in the show notes, 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: 0:36

Thanks for having me.

Dave Stewart: 0:38

To start out, could you give the listeners a brief overview of what's in the OECD's pillar 1 consultation draft?

Martin Hearson: 0:43

Sure. So 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 that they'll be able to get countries to buy into, but it departs from three different proposals which 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 as a unified proposal, and it's got three components. The first component, it's called Amount A, and Amount A is the one that has got, I think, 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. So it establishes a new taxing rate in situations where you don't have a physical presence, but you do have significant market presence and it allocates portion of the company's residual profits to the countries that have the new taxing right using a formula. So it doesn't follow the arm's-length principle. So for those two reasons, it's caught the attention. People think it's very radical. I think it's not the part of the puzzle, which at this point seems to have the most money in it for developing countries. Then we have Amount B. Amount B allows countries to claim a fixed return on distribution and marketing activities. So this is a simplification that does in some ways go away from the way the arm's-length principle has worked for now. And this is where it looks like the most money is in it for developing countries. So 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 a lot for quite some time now. And so 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. Amount C 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. And 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: 2:25

Now as we're recording this, we're waiting on the OECD to release its pillar 2 draft. Pillar 2 is expected to set out a global minimum tax system. What are your expectations for pillar 2 and will it solve some of the issues for developing countries?

Martin Hearson: 2:39

So I was speaking to some people from the African Tax Administration Forum, which is a regional body that brings together a large proportion of the tax authorities of African countries. And their view is that pillar 2 is where it looks like the most money is and also where it looks like some of the biggest areas of unresolved tension are between developing and developed countries. So pillar 2 contains two different rules. In fact, there's more than two, but they're grouped together as two rules, both of which are ways of imposing a minimum tax that will deter profit shifting. One of them the income inclusion rule, and that's something that can be used by the residence country. And the other that tax on base eroding payments, that same that can be used by the source country. So obviously here you have two tools which could potentially come into conflict. And at that point there has to be a discussion about rule order, about which rule will prevail. And I think that's one of the big tensions that we see now is developing countries saying we want the world to be bottom up and developed countries saying we want it to be top down.

Dave Stewart: 3:30

Well, turning back to the pillar 1 draft. 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: 3:39

Yeah, so I've spoken to a number of government officials and revenue authority officials from developing countries about the proposal that's come from the OECD. And in fact, it's been out there for a few months now informally, that the publication of the formal draft was kind of a stage of consolidation of something which they'd been sounding out people for awhile from. There's an awful lot of moving parts within it. An awful lot of issues that countries are questioning. So 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. Although on the proposal as a whole, I did speak to a number of people from developing countries who had 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 and it doesn't have much in it that seems to be based on the group of 24 proposal. And I've actually just 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. So there's the question of scope. So which companies is what the supply to? What proportion of profits will be covered? What sectors will be covered? One thing that's 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. And 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. So 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. So for smaller developing countries, it's important that the threshold is adapted to that small market size to begin with. Otherwise, they're not likely to see much here. Second point is about how the profits are then allocated. And so under Amount A, the issue is here is whether the allocation key is purely based on sales or whether it might also incorporate users. And I think if it incorporates users, that might help because it's often the case I think for developing countries that you have significant use of the digital platform, but not actually much sales because it's provided free. And 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. So 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. And 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 the most prominent, which have got a pretty firm red line that they won't accept mandatory binding arbitration in tax treaties to date. So I'm not quite sure how the secretariat thinks they're going to be able to square the U.S. having insistence that this must be part of the proposal with the very strong objections from developing countries.

Dave Stewart: 6:34

What are the objections to binding arbitration?

Martin Hearson: 6:37

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 because 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. And the fact that 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. And I think the secretariat 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 two governments have to sit down in a room and reach an agreement and if they can't do it themselves through a map, then we need some kind of decision rulesthat can deal with this, the unresolved disputes. And so 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, which associates with that. 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, which is prevalent in the OECD. And 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. And 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, which is how they see it might be. So 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.

Dave Stewart: 8:39

Now we've heard from the African Tax Administration Forum 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: 9:50

Yeah, so ATAF has been really good at responding to what's come out of the OECD and publishing detailed technical notes. So 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. I really recommend that your listeners go on their website and download their technical notes. There's three of them now, plus a response to the unified proposal. What 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 and what they regard as perhaps the asymmetry between what OECD members and larger emerging markets are able to do and what smaller developing countries can do. So if we look at what ATAF identifies, there's a number of different issues. So I'm going to talk about a few maybe, some of which come from their reports some of it comes from my own conversations. So the first thing on this digital issue is that actually many African countries or many smaller developing countries are at an early stage of working out really what this issue is for them. This issue of the digitalization of the economy. 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. And that's not just about tax policy, that's about countries having their digital strategies more generally. So 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. So the first thing is actually being able to match the pace at which the OECD is going is difficult when you actually don't necessarily know what endpoint you want to reach. 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 and so on. For many African countries as well as developing countries, they'll have a handful of people who are able to follow the detail of say transfer pricing or treaty content, and those people are going to be spread quite thinly across both their domestic responsibilities and then also the 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, so 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 and so 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. But 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. And there again at an early stage of working together, the group of 24 is really organized around the IMF here in Washington, D.C. And they're not actually so used to influencing in the tax space at the OECD. So that's again in its early stages. So whereas you have developed countries, 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. And then the 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. So 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. So those are some issues that developing countries are really facing inside the inclusive framework right now.

Dave Stewart: 13:38

Now what can the OA=ECD do to be more inclusive and mindful of the challenges that these developing countries have?

Martin Hearson: 13:44

So 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. So 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 that in a process such as this, which is going at a very intense, 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. And it's not really designed for the way in which small countries are currently able to participate.

Dave Stewart: 14:54

Now as this process has continued, the OECD has been working on the digital economy project for a couple of years now, BEPS before that. Developed countries have moved forward with unilateral measures to address the digital economy. What are developing countries doing now to deal with the taxation of the digital economy?

Martin Hearson: 15:08

So as I said, a lot of developing countries are at quite early stages here of working out what it is they want to do. But we can probably sort of identify three kinds of things that countries are doing. So the first is that they are looking at the new tax handles that the digital economy creates. And this is something which is probably quite different in developing countries compared to developed countries. So there are countries such as Zimbabwe that have introduced taxes on digital financial transfers. So just as we increasingly have pay by card here, rather than using cash, digital transfers of money through mobile phones in developing countries, it's been a huge transformation in the last few years. And that enables the revenue authority to have a tax handle that previously didn't have. So that's one thing that countries have been doing and that there's a question about whether it's going to have an impact on financial inclusion. Whether it's going to make it harder for people who are really at the bottom of the income distribution to be able to actually participate in this new digital financial system. The other thing in this bracket of things that are being done to grab new tax handles is around taxes on digital communications. So Uganda introduced a tax on telecommunications, effectively a social media tax. And that was actually probably driven more by a desire to restrict freedom of speech than it was by a desire to raise tax revenue. And so again, it's a slightly problematic approach. So we're doing some work at the International Center for Tax and Development to try and look at the impact that these kinds of measures might have and whether they are in fact good tax policy. The second kind of thing developing countries are doing is in the VAT space. A lot of developing countries now looking at in part following OECD guidance about how to bring digital service provision into the tax net. And the challenge that they're finding actually there is sometimes it's actually very difficult to administer that in practice. So I had someone from a developing country saying, you know, we announced that all digital service providers who are active in our market needed to register for VAT, but they just didn't. And because they were not physically present in our country, we had nothing we could do about that. Small developing countries actually do face some challenges in the VAT space, but they are moving on. There are other examples of countries introducing VAT on app downloads and on over the top services, so that's like advertising on YouTube and so on. And then the third category of things in the direct tax space, and I think the sort of leading example of this is the equalization levy that India has imposed. And that's something which where I think likely to see spreading beyond India into at least the African continent. I've heard it mentioned by a number of African governments now.

Dave Stewart: 17:28

Oh, this has been fascinating. Martin, thank you for being here.

Martin Hearson: 17:30

Thanks very much for having me.

Dave Stewart: 17:33

And now, coming attractions. Each week we preview commentary that'll be appearing in the Tax Notes magazines. I'm joined by Executive Editor for Commentary Jasper Smith,.Jasper, what will you have for us?

Jasper Smith: 17:43

Thanks, Dave. In Tax Notes Federal, Christopher Giosa considers how the Pension Protection Act of 2006 may have decreased the amount of exempt organizations' reported unrelated business income. Patrick Driessen compares stated policy objectives with BEAT's inability to take into account foreign tax credits and argues for a change in the way baseline proposals are presented to the JCT. In Tax Notes State, Karl Nicolas reviews unintended consequences of new marketplace facilitator laws enacted in response to South Dakota v. Wayfair. William Hays Weissman discusses the influence of California tax policy on other states and the federal government. And in Tax Notes International, Barry Larking tracks the development of the EU and OECD actions to combat harmful tax competition and assesses the current state of play while Isabel Espinoza and Nahuel Acevedo make the case for private enterprises in Chile to use charitable donations to become more involved in the fight against poverty and inequality. In the Opinions page, Ben Willis discusses the implications of Treasury Secretary Steve Mnuchin ignoring Trump's orders to reduce taxes while Robert Goulder examined Sen. Elizabeth Warren's ambitious tax proposal. We'd also like to announce that the submissions period for the Christopher E. Bergin Award for Excellence in Writing is now open. This annual award recognizes superior student writing on unsettled questions in tax law or policy. Eligible students must be enrolled in an accredited undergraduate or graduate program during the academic year. For more information, visit taxnotes.com/students.

Dave Stewart: 19:16

You can read all that and a lot more in the November 11th editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me online at@TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org and as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.