Attribution of profits is a key consideration in developing a nexus based on significant economic presence. The option outlined on the page “New tax nexus based on significant economic presence” would establish nexus for taxation in cases where an enterprise has no physical presence in the country concerned. Consideration must therefore be given to what changes to profit attribution rules would need to be made if the significant economic presence option were adopted, while ensuring parity to the extent possible between enterprises that are subject to tax due to physical presence in the market country (i.e. local subsidiary or traditional PE) and those that are taxable only due to the application of the option.
1. Existing rules and principles
A significant economic presence associated with little or no physical presence in terms of tangible assets and/or personnel in the other country is not likely to involve the carrying on of any functions of the enterprise in the traditional sense. Unless significant adjustments are made to the existing rules, therefore, it would not be possible to allocate any meaningful income to the new nexus.
Several adjustments to existing principles were considered during the course of the work, including allocating business functions handled remotely through automated systems to the significant economic presence, as well as treating customers and users as performing certain functions on behalf of an enterprise under certain circumstances. Other substantial departures from existing rules, such as replacing a functional analysis with an analysis based on game theory that would allocate profits by analogy with a bargaining process within a joint venture, were also considered. All such potential adjustments, however, would require substantial departures from existing standards for allocating profits within a MNE operating in multiple jurisdictions, which are currently based on an analysis of the functions, assets and risks of the enterprises concerned. It was concluded, therefore, that, unless there is a substantial rewrite of the rules for the attribution of profits, alternative methods would need to be considered.
2. Methods based on fractional apportionment
Another approach considered would be to apportion the profits of the whole enterprise to the digital presence either on the basis of a predetermined formula, or on the basis of variable allocation factors determined on a case-by-case basis. In the context of a significant economic presence, the implementation of a method based on fractional apportionment would require the performance of three successive steps: (1) the definition of the tax base to be divided, (2) the determination of the allocation keys to divide that tax base, and (3) the weighting of these allocation keys.
It is important to note that the domestic laws of most countries use profit attribution methods based on the separate accounts of the PE, rather than fractional apportionment. In addition, fractional apportionment methods would be a departure from current international standards. Furthermore, pursuing such an approach in the case of application of the new nexus would produce very different tax results depending on whether business was conducted through a “traditional” permanent establishment, a separate subsidiary or the new nexus. Given those constraints, fractional apportionment methods were not pursued further by the OECD.
3. Modified deemed profit methods
The use of empirical presumption methods such as “deemed profit” systems is sometimes a way to avoid profit computations based on the taxpayer’s accounts in situations where a high proportion of expenses associated with revenues are incurred overseas, making it difficult from a practical perspective to audit locally. Deemed profits methods have been used, for example, in the insurance industry, by applying a coefficient based on the ratio of profit to gross premiums of resident insurance companies to gross premiums received from policy holders in the source country.
In the context of a nexus based on significant economic presence, one possible approach would thus be to regard the presence to be equivalent to a physical presence from which the non-resident enterprise is operating a commercial business and determine the deemed net income by applying a ratio of presumed expenses to the non-resident enterprise’s revenue derived from transactions concluded with in-country customers, hence aligning it to one of the key factors of the option as described above. Determining an appropriate ratio would depend on a number of factors, including the industry concerned, the degree of integration of the particular enterprise, and the type of product and service provided. One possible approach would thus be to classify taxpayers by industry and apply an industryspecific profit percentage. A more refined approach would be to divide taxpayers within a given industry into additional classes based on relevant factors (e.g. capital equipment, turnover, employees), with a specific profit percentage within each band. The determination of the latter percentage would require an extensive analysis of actual profit margins of domestic taxpayers operating in the same specific class of industry or type of business.
Deemed profit methods are generally perceived as relatively easy to administer and raise revenue. However, for large MNE groups with complex structures operating in many lines of business, applying multiple industry-specific presumptive profit margins to the same significant economic presence presents several practical challenges. Another challenge relates to the comparability of digital and traditional business models when considering the applicability of such deemed profit margins. Many digital business models have a different cost structure than traditional business models, such that adjustments to margins found in this context are very likely to be required. In addition, application of deemed profit methods in this context may be considered as a substantial departure from current international standards, resulting in a tax liability even where there are no actual profits generated through the significant economic presence. One possible way to mitigate this negative impact would be to create a rebuttable presumption limited to situations where the foreign taxpayer is able to demonstrate that its overall activity (or specific line of business related to the activity of the significant economic presence if it can be ring-fenced from other business activities of the enterprise) is in a loss-making position at the end of the fiscal year.