OECD Proposals Undermine The Arm’s Length Principle

March 29, 2019

The Organisation for Economic Cooperation and Development (OECD) recently released a policy note (approved by the 127 members of its Inclusive Framework (IF)), hosted a webcast and held a public consultation meeting to consider possible solutions to the tax challenges arising from digitalization of the economy.

The policy note recognizes that the digitalization of the economy is pervasive, raises broader issues, and is most evident in, but not limited to, highly digitalized businesses. Importantly, the webcast noted explicitly that the proposals are going beyond the arm’s length principle.

Four proposals are being examined, which affect how business broadly is taxed, not only those businesses that are highly digitalized. One proposal is focusing on a minimum tax that would limit tax deductions for outbound payments and include income in investors’ profits where the profits were not otherwise subject to sufficient levels of tax. The other three proposals are focusing on digital economy business models from different perspectives. These assume significant value creation contributed by business’s activity or participation in user/market jurisdiction that is not recognized in the current BEPS framework for allocating profits.

As can be seen in the following points, the latter three proposals differ from the current OECD framework on the arm’s length principle, as OECD will be redefining the nexus and the profit allocation:

User participation

  • This proposal only applies to certain highly digitalized businesses such as social media, search engines, and online market places where active participation of users are a critical component of value creation of the business;
  • The value created by user activities can be determined on the assumption participation of users would attract a non routine or residual profit split;
  • The reallocation of the non-routine profits of the business could rely on formulas that would approximate the value of the users, and the users of each country, to a business. The difficulties on how to use the approximate value of the users may arise as it may lead to different values per countries;
  • The proposal differs from the current arm’s length principle as the non-routine profits allocated on the basis of active-user contribution regardless of the absence of risk assumed by the users.

Marketing intangible

  • The proposal would not only apply to a subset of highly digitalized businesses with no local presence but also to the highly digitalized business with local Limited Risk Distributor (LRD), consumer products business operating remotely or through LRD structure;
  • It would modify existing rules, i.e. to allocate marketing intangibles and risks associated with such intangibles to be allocated to the market jurisdiction;
  • The allocation of the nonroutine function could be determined by calculating the delta between marketing intangibles allocated based on current rules on the basis of Development, Enhancement, Maintenance, Protection, and Exploitation (DEMPE) versus 100% or less of the marketing intangibles allocated to the market jurisdiction;
  • This proposal deviates from the arm’s length principle as the residual profit applies to marketing intangibles.

Significant economic presence (SEP)

  • A taxable presence in a jurisdiction would originate when a nonresident enterprise has a significant economic presence on the basis of factors that show a purposeful and sustained interaction with the jurisdiction via digital technology (i.e. number of users, volume of digital content, billing in local currency, maintenance of a website in a local language, responsibility for the final delivery of goods to customers, or sustained marketing and sales promotion activities);
  • This proposal may require an explicit deviation from the arm’s length principle as existing profit allocation rules would be unable to allocate meaningful profit to a SEP permanent establishment.


The aforementioned proposals will lead to the following consequences:

  1. The proposals lower the threshold of permanent establishments, as physical presence is no longer needed to justify the taxing right of the jurisdiction.
  2. The transaction-by-transaction approach as set out in the current guidelines phases out, since OECD proposals initiate to tax the MNE group on a consolidated basis by endorsing the use of fractional apportionment approach and residual profit split approaches to allocate the profit.
  3. A result could be that quantitative Value Chain Analysis and/or Profit split based on fixed formulas (i.e. Common Consolidated Corporate Base) are taking over.

Taking into account the proposals’ deviation on arm’s length principal and its consequences, what do you think of the proposals at first glance?

  • As the whole economy is digitalizing, it is not possible to segregate the digital business;
  • The proposals imposing tax on revenue rather than on profit seems unfair in situation with losses;
  • Through the use of conflicting tax policy, double/triple/quadruple taxation may arise with no adequate resolution of multiple levels of taxation.

** Steef Huibregtse is CEO of Transfer Pricing Associates B.V. and managing partner of TPA Global.

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