The United Nations (UN), after a seating with its Committee of Experts on International Cooperation in Tax Matters, came up with ‘digital taxation’ concerns that arise out of Automated Digital Services (ADS). In light of this, in April 2021, the UN finalized a version of Article 12B of the United Nations Tax Treaty.

ADS means any payment/consideration made for any service provided on the internet or on an electronic network requiring minimum human involvement.  

With the purpose of avoiding double-taxation and/or non-taxation, the first draft of Article 12B was prepared in August 2020. There an effort made towards simplicity in the operation of this new tax, particularly in administrative facets, whilst ensuring that this new tax was developed after consultation of works of the Organisation for Economic Co-operation & Development (OECD), the European Union (EU) and the African Tax structures.
 

What is the ‘Pillar One’ OECD strategy?

The OECD Pillar One model sought to re-configure the international tax system by making changes in the profit allocation and nexus rules applied to business profits. The objective was to expand taxing rights to market jurisdictions where businesses have an active and sustained participation, impacting the economy of such jurisdiction through its activities – directly or indirectly.

The Pillar One policy applies to the 100 biggest and most profitable Multinational Enterprises (MNEs) and the tax regime then ensures that a part of their profits is distributed amongst countries where they sell their products and provide services. There are two amounts under the Pillar One method that were introduced to benefit the market jurisdictions:

• Amount ‘A’: This amount is a residual profit amount allocated to market countries using a certain formula/method, which is applicable to all businesses.
• Amount ‘B’: This amount is also known as ‘fixed baseline return’ and is applicable on an arm’s length principle to all in-country baseline marketing and distribution activities. This also includes an easier method for transfer pricing (TP) enforcement for transactions involving these routine activities.

The UN Proposal of Article 12B seeks to simplify this OECD proposal by reducing administrative and calculation hurdles.
 

What is the UN tax rule and why is it proposed?

Article 12B grants new taxing rights to the ‘source state’ on any income derived from ADS. This includes advertising services, digital content services, social media services, etc. None of this, however, is covered under Article 12A and “fee for technical services”. The new rule allows the source country to apply a ‘withholding tax’ on all gross payments that arise from any ADS. The rule, essentially, aims to hold big corporates liable for their digital services in the source country by giving such countries a taxing right on such transactions.

• The UN believes this simplifies compliance complications for big corporates while ensuring that developing countries are able to enforce this tax with limited administrative effort. The beneficiary owner from ADS may be taxed on the net profits annually instead of withholding tax on all gross payments.

• Income from ADS is said to have arisen in a Contracting State if the underlying payment for the service is made by a resident of that State - it is attributable to a permanent establishment of a non-resident in such a state. Essentially, payments for the ADS are sourced to the jurisdiction in which the services are used. The two methods of calculation are gross and net basis. Gross method is based on an imposition of withholding tax by the source country agreed through a bilateral agreement. Meanwhile, net basis taxation is subjecting qualified profits to the applicable domestic tax rate.

• Furthermore, the application of Article 12B does not require any permanent establishment, fixed base, or minimum period of presence. The UN sees this method as a convenient alternative to the previously proposed ‘Pillar One’ proposal of the OECD. Article 12B, unlike Pillar One, applies only to the ‘digital economy’ and not the entire economy.

 

Potential impact of Article 12B

Positive Impact

• Domestic Law Adoption: The approach suggested by Article 12B is, in fact, significant for many nations as it is a model that they may consider adopting in their domestic laws to address concerns regarding taxation of ADS. If there is an existing income tax treaty, adopting the UN approach will hardly make any difference, unless the treaty is renegotiated to include Article 12B. But in jurisdictions and markets not covered by any treaty, adopting such a law would have a direct impact on cross-border digital services.

• No PE Required: The main purpose of Article 12B is granting taxing rights to the source state on income derived from ADS. The application of this article does not require for any permanent establishment (PE) or minimum period of presence.

• Simplified Approach: Article 12B of the UN Tax Treaty intends to simplify tax administration, particularly for developing countries. The OECD Pillar One & Two proposals have been criticized for being too complicated and that the minimum global tax rule is harming emerging economies. Failure reconciliation between the UN and OECD may lead to double taxation.

 

Negative Impact

• No Prohibition of Systems: The UN rules do not prohibit the use of any other tax system which means that countries are free to operate two or more systems of digital tax concurrently. E.g.: For India, Article 12B may co-exist with ‘Equilisation levy’, which is the digital tax rule in the country. This lack of clarity may create trouble for the industry.

• Re-negotiation: Bringing Article 12B into the global economy would require a complete rejig of almost all major treaty agreements across the world. This would require significant time, effort and coordination between nations. All parties would have to agree to the framework which seems unlikely.  

• Administrative Hurdles: The net basis method of calculating tax requires computing the profits on an MNE in accordance with the laws of each country. This could raise administrative difficulties and add operating and compliance costs in several nationals – the very hurdles that the proposal seeks to eradicate.

 

Conclusion

The UN proposal seeks to improve the OECD model by limiting the distinctions made in the types of incomes; this reduces the complexity. The policy is not going to apply to all digital businesses but only to certain types. The main purpose of the policy is to significantly raise the taxable rights of market jurisdictions involved in the digital economy.

This allows jurisdictions, especially developing ones, to constantly receive a gross payment for transactions carried out in their territorial area. Increase in digitization has increased the significance of adopting a digital tax regime that allows jurisdictions to get their rightful amount for transactions conducted in their markets. Although, it is easier than the OECD proposal, it remains to be seen whether it covers all the concerns of the big market players and jurisdictions.
 

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