David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: the other DST.

While we've done a number of episodes on the OECD's two pillar solution for taxing the digital economy, a subject that we haven't really delved too far into is one of the problems it's set out to solve.

Digital services taxes arose in a number of jurisdictions to prevent companies from escaping taxation where their customers are located. But solving one problem often leads to others. And the OECD's pillar 1 was put forward to bring order to that chaos.

Joining me now to talk more about this is Tax Notes contributing editor Nana Ama Sarfo.

Ama, welcome back to the podcast.

Nana Ama Sarfo: Thank you, David. It's really great to be back.

David D. Stewart: Why don't we start off with just the basic definition. What is a DST?

Nana Ama Sarfo: That's a really great question. Broadly speaking, a DST is a tax that's applied to gross revenue generated from digital services or goods offered in a country.

The definition of a digital service or good varies depending on the country, but what we've seen is that DSTs are taxing [activities] like online streaming services, cloud computing services, online gaming, online advertising, online intermediation services. All of that to say that the category as to what constitutes a digital service or good is pretty broad.

Countries are implementing DSTs because of the way in which international tax rules currently work. And that is that a company must have a physical presence within a country to be taxable there. But as we know within our digital economy, digital companies are operating in countries around the world without any need to open physical offices or physical operations. That has created a lot of resentment within governments witnessing digital companies like social media networks become very large and very successful based off of users in their country, but yet they're not able to tax that online activity.

I mentioned all of that background because governments that have created DSTs have generally structured them to apply to the largest digital companies that are able to meet really high global and domestic revenue thresholds. They're basically targeting the Googles and Amazons and Facebooks, and they generally apply to foreign companies and not domestic companies that are already taxable within their jurisdictions, although some countries have implemented or have introduced DSTs that have some combinations of that.

Another thing to note regarding DSTs is that they're applied at a relatively low rate, around a 3 percent tax rate, but some countries have certainly levied higher rates that are double that or even higher.

David D. Stewart: OK. So it seems that it's the change in the world where all of our activity has now become this other thing that it wasn't before, and governments are trying to get a piece of tax revenue. What is the problem with that system?

Nana Ama Sarfo: There actually are a few major concerns, but I would highlight two interrelated ones. One is the belief amongst digital companies that DSTs are discriminatory, that they are discriminating against large foreign tech companies, which are predominantly U.S.-based tech companies.

The other concern is that they are widely viewed as destabilizing because they are created outside of standing tax treaties. There is no bilateral agreement between a country that decides to create a DST and a country where the affected companies are headquartered. They are created unilaterally without any coordination.

On top of that, as I had mentioned, the precise services that are taxed vary between countries. That could expose a single taxpayer to a really wide array of tax liabilities around the world and create a lot of complexity because they are not coordinated and are not bilaterally agreed upon. Also, it raises the threat of double taxation.

David D. Stewart: For a number of years now, we've been watching as the OECD attempts to update the international tax regime to match what the modern economy looks like. As I understand it, pillar 1 was in part meant to fix this DST issue. What does it do?

Nana Ama Sarfo: Pillar 1 is supposed to fix the DST issue by providing a coordinated set of tax rules for countries to use to apply to the world's largest multinationals. That group includes digital companies. With that new set of rules, which are called the amount A rules, the starting point is that amount A will apply to multinational companies earning at least €20 billion in global turnover, and they must have a profitability level that exceeds 10 percent.

With those parameters, that means that amount A will apply to about 100 companies. Not all of them are digital companies, but a significant portion of them are, and over half of them are U.S.-headquartered companies. So amount A is supposed to address the DST issue by applying to some of the world's largest digital companies that fall within that hundred-company group.

The way in which the amount A rules work is that they are designed to reallocate 25 percent of a company's residual profits — those profits that exceed 10 percent of revenue. They reallocate them to jurisdictions where [the] multinational has nexus, where it has operations using some formulas.

Countries are supposed to follow this set of rules by ratifying a multilateral convention (MLC) that the OECD is hoping or expecting to release this summer. In turn, the countries or jurisdictions that have joined the MLC and want to receive their share of this amount A amount are supposed to withdraw any DSTs or unilateral measures that they have enacted.

Since pillar 1 and amount A are still being finalized, we don't know just how much revenue specific jurisdictions expect to receive through amount A, but the OECD has issued some global calculations. Under the most recent calculations, the OECD estimates that about $200 billion in profits could be reallocated to market jurisdictions. That would lead to between $13 billion and $36 billion of global tax revenue gains.

That is a pretty considerable increase from the OECD's first set of calculations. In 2021 the OECD had estimated that about $125 billion of profits would be reallocated. So that's about a 60 percent increase.

David D. Stewart: All right, so where do things stand on finalizing pillar 1?

Nana Ama Sarfo: Well, the OECD has conducted some consultations on pillar 1, and it has solicited feedback from the international tax community.

On the national side, countries need to wait until the OECD releases the MLC. That is expected to be released sometime in the middle of this year or around the summer and go into effect in 2024.

We don't have a specific date in 2024 when the MLC will go into effect. And that matters because in October 2021, when most of the inclusive framework made a political agreement on the two pillars, they promised that they would refrain from implementing any new DSTs before December 31 of this year if the MLC had not yet come into force by that date.

Since the OECD's now saying 2024, there's a question as to whether or not countries will be able to implement DSTs in that holding period before the MLC goes into effect. Based on feedback to some of the OECD's consultations, we know that some stakeholders are actually asking the inclusive framework to extend that moratorium past December 31 to account for any potential delays.

David D. Stewart: Given all of the challenges in implementing pillar 1, the second pillar out there that creates a global minimum tax, does that take any of the pressure off or does it not help at all?

Nana Ama Sarfo: I think that's a really interesting question because it depends on how one views the entire two-pillar project. Of course, the OECD created pillars 1 and 2 to be a package deal with the understanding that inclusive framework members would implement both parts. But that being said, I have seen some arguments that perhaps the entire project could be split into two separate parts.

So if you belong to the camp believing that the pillars can be split, then progress on pillar 2 might not be as persuasive. But if you believe that pillars 1 and 2 are this inseparable deal, then I think that the progress that has been happening with pillar 2 would certainly help and be persuasive, especially for those countries that are really eager to implement this 15 percent global minimum corporate tax rate.

David D. Stewart: Now, what are you hearing from people about arguments for and against the OECD's approach under pillar 1?

Nana Ama Sarfo: Well, I think the largest argument in favor is that the OECD's approach would bring or is expected to bring some standardization and coordination to this pretty unruly area of DSTs and potentially head off any trade conflicts or trade wars.

The argument in favor is that the OECD is approaching this DST issue from a very multilateral perspective. I mean, in the inclusive framework, 138 jurisdictions have agreed to both pillars, which is not the entire inclusive framework, but it's most of it.

But that being said, even amongst the supporters of pillar 1, I think there are some who believe that the OECD's approach to DSTs perhaps isn't stern enough and could be stronger and that the OECD could take a much tougher approach in deterring countries from implementing DSTs and other unilateral measures.

On the other hand, I would say the main argument against the OECD's approach is that it could potentially interfere with countries' sovereignty if it ultimately requires inclusive framework members to commit or promise that they will never impose DSTs.

Another argument against the OECD's approach is the fact that amount A is very tailored, as I had mentioned, since it will apply to about a hundred companies. That could change as pillar 1 grows older, but that narrow scope is problematic for some developing countries because they say that most companies operating within their jurisdictions won't fall under amount A, and they would like the scope to be expanded so that medium-sized companies would be taxable.

David D. Stewart: Are we hearing from individual countries taking out these various positions?

Nana Ama Sarfo: Yes. I think the first country to mention here would be the United States. I would say that things are looking pretty tenuous. While the Biden administration supports pillar 1, the problem is that it will be difficult to get congressional approval for the MLC simply because the United States needs a two-thirds majority in the Senate to ratify the MLC.

Senate Republicans, congressional Republicans in general, have made it clear that they want to protect America's sovereignty. Some of them feel as though pillar 1 amount A would result in a global tax surrender, as some have called it, which would allow foreign governments to tax revenues of U.S. companies. So within the United States, it's pretty uncertain as to whether or not pillar 1 can be approved by Congress.

Two countries to also mention would be Kenya and Nigeria. They're both also reluctant to eliminate their DSTs. They are two members of the inclusive framework that have not signed on to the political agreement. They're also concerned with the scope of pillar 1. They feel that it's too small and doesn't capture enough companies operating in their jurisdictions.

On the other hand, we see that the European Union as a block does support pillar 1. In fact, it plans to rely on it as a funding source for the entire EU. So they definitely have been a proponent of pillar 1 and have been pushing for countries to approve that regime and approve the future MLC that will be issued.

David D. Stewart: Are there any ways that the pillar 1 plan can be updated to address the various concerns of the parties?

Nana Ama Sarfo: Yes. Well, I would hope that we should expect to see some updates compared to the draft rules that were released at the end of December.

At the end of December, the OECD launched a consultation on pillar 1 and then released some draft MLC provisions that addressed DSTs and relevant similar measures. It received comments from less than three dozen commentators, and they represent multinationals, the business community, developing countries, and civil society. The OECD will take those comments into account. So from that perspective, there definitely is room to update pillar 1.

Now, one thing to point out is that the OECD is going to create a specific list of prohibited unilateral measures. It has stated that a special group, which is called the Task Force on the Digital Economy, will be involved in creating that list.

However, that process will not be open to the public. Whether or not that is subject to change is unclear. Some stakeholders have asked the OECD to open that process up for input by the business community, but nothing has been started there.

David D. Stewart: With all that in mind, and the idea that this pillar 1 plan is supposed to bring stability, do you think that it will bring stability to the international tax system?

Nana Ama Sarfo: That's a very good question. That is an open question, and I think it depends on how you define stability and from whose perspective you're defining it. Based on the draft rules that were released, it's clear that they were crafted to give countries flexibility. I say that because inclusive framework members that sign the MLC or ratify the MLC are supposed to remove their DSTs.

That being said, the draft rules say that countries that maintain DSTs simply won't receive their amount A allocation. The draft rules also stated that the OECD is thinking about whether or not countries that do maintain DSTs can potentially receive a partial amount A allocation depending on the scope of their DST.

All of that means that in this universe that the model rules have created, there potentially is space for inclusive framework members to create DSTs or maintain existing DSTs.

So if you're looking at this from the perspective of a large digital company, large multinational, or from the perspective of the U.S. government — whose companies are most affected by these DSTs — that is not very reassuring. Because from their perspective, the purpose of pillar 1 is to completely eliminate the need for DSTs. And if a significant portion of countries decide that DSTs are more lucrative than amount A, then that approach isn't resolving the problem.

But if you're approaching this from the perspective of countries that are not headquarter jurisdictions for these 100 amount A companies, I think that for them stability hinges on their ability to maintain some sort of sovereignty and decide what will work best for them, whether that's unilateral measures or amount A, and also working within their own legal and constitutional constraints and implementing rules that will stand up to constitutional or legal scrutiny.

David D. Stewart: Well, that leads me to my last question, which is: Is pillar 1 the right mechanism for dealing with DSTs, assuming that eliminating DSTs is the ultimate goal?

Nana Ama Sarfo: I think that's an interesting question because we don't have an alternative mechanism that we can use to make a side-by-side comparison with pillar 1. But I will say this: Judging by the fact that inclusive framework members continue to participate in the process, I think that shows that jurisdictions do have faith in the process that they have started, that pillar 1 will create some stability, and that the negotiations will create a final product that meets their interests, whatever that may be.

David D. Stewart: Well, all right. This is definitely an issue that we'll be tracking for some time to come. Ama, thank you for being here.

Nana Ama Sarfo: Thank you so much for having me, Dave.

David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?

Jasper B. Smith: Thanks, Dave. In Tax Notes Federal, Stephen Curtis and Reuven Avi-Yonah break down Microsoft's cost sharing arrangement and explain how corporate taxpayers have been able to exploit the cost sharing regulations to shift profits offshore with little or no IRS detection or enforcement. Three KPMG practitioners explain the credibility criteria of the new U.S. foreign tax credit final regulations.

In Tax Notes State, Tony Santiago interviews Tim McDonald, retired vice president of Global Tax at Proctor & Gamble, on how young tax leaders should build, develop, and retain their teams. Scott Peterson examines some of the ongoing issues in sales tax and discusses the potential effects of these issues in 2023.

In Tax Notes International, Peter Mason reviews the development of the arm's-length principle and questions whether this basis of transfer pricing is still fit for the modern digital age, or if an alternative formulary apportionment basis may be better suited. Richard Ray examines the tax implications of the Canada-U.S. tax treaty for individuals who are citizens of one country, but live and work in the other.

And finally, in Featured Analysis, Carrie Brandon Elliot reviews the 897 regs that clarify the exemption from FIRPTA for foreign pension funds.

David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for 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.