Submission to The Netherlands' public consultation on their tax treaty policy

The present submission was made to The Netherlands’ public consultation on their tax treaty policy regarding services payments.

Digitalisation and globalisation have transformed the global economy, driving a shift to services and an enormous growth of cross-border services. Services have become both deliverable remotely, and increasingly also produced digitally and delivered automatically from the cloud. This will accelerate due to artificial intelligence, so that services will be deliverable from anywhere to anywhere in the world. At the same time, digital communication has greatly strengthened the links between services suppliers and their customers or users, enabling systematic collection of data and even contributions of content from them, reinforcing the claim to taxing rights for countries at source.

These changes have fundamentally undermined two basic principles of international tax embodied in tax treaties: the restriction of taxing rights at source unless there is a physical presence, and the allocation of rights to tax the profits of multinational enterprises (MNEs) based on the residence of legal persons. It has become infeasible to define the place of performance, traditionally the basis of jurisdiction to tax income from services, since they can be delivered with little or no physical presence, while delivery from the cloud makes it hard or impossible to specify the location of the supplier.

A new approach is now clearly needed for the allocation of taxing rights over MNE income in a globalised and digitalised world economy, especially in relation to cross-border services. This should provide a fair and equitable allocation of taxing rights between countries based on the location of real activities that generate the income. Such an allocation should strike a balance between supply side factors, the location of personnel and assets, and also the demand side, sales to customers essential for the realisation of profit and from whom considerable value derives (data and contributions of content). A detailed methodology for achieving this has already been agreed in the proposed rules for Amount A of Pillar One. However, adoption would require broad agreement among states, and acceptance by MNEs which would be required to supply data needed for implementation.

The urgency of the problem means that a solution must be found which can be introduced rapidly, and is easy to administer. The most suitable methodology is a tax that can be collected by withholding from payments to non-residents. It is simple to apply, provides revenue certainty and it is especially suitable for countries with little administrative capacity. Concerns about its relation to profitability can be addressed when setting the rate.

This consultation is welcome and timely because it clearly recognises these issues. It accepts the case for conceding some taxing rights to countries where services are delivered. Although the proposed policy change states that this should be limited to developing countries, in our view it should have a wider scope. Some of the treaty partners of The Netherlands that are not developing countries have introduced taxes on digital services of various kinds. The rapid expansion of ADS provides a strong case for a much wider scope for such taxation. The status of such taxes under tax treaties is unclear, since they have elements allowing them to be considered as sales taxes, yet some are formulated as income taxes, and this may become more general. The consultation proposal also envisages that taxpayers should preferably be offered the option of taxation on a net basis, which can be problematic if taxpayers are able to choose the option which is more favourable to them. It also does not resolve the difficulty of agreeing on a suitable rate to apply to gross payments.

We have addressed these issues in our recent submission on the services protocol, which puts forward a proposal that could provide a way forward. We propose that the Protocol should allow source taxation based on a method for a profit-related withholding tax, with a voluntary option of a more comprehensive net income method. The withholding tax rate would be calculated by multiplying the operating profit margin of the MNE corporate group to which the recipient of the income belongs by the standard rate on profits in the country applying it. This would reflect the actual profitability of the enterprise concerned, taking into account its worldwide expenses and revenues. Profitability rates for services vary widely, and according to our preliminary research this method should produce a range from 1.25% to 17.5% for countries with a standard corporate income tax rate of 25%.

This should be combined with an option for the enterprise concerned to accept taxation of a share of its net global income based on an apportionment among states using factors reflecting the location of its real activities (employees, physical assets and sales). The apportionment methodology could be based on the rules developed for the proposed multilateral convention for Amount A in Pillar 1 of the BEPS project, although they should be simplified. An apportionment methodology could also include standards for the allocation of income among countries from which services are supplied, based on the real location of personnel and physical assets.

An apportionment approach could be attractive, as it would greatly reduce the uncertainty and conflicts resulting from the application of the current rules on 'transfer pricing’, which are especially acute in relation to services involving high-value intangibles such as software. It would benefit both MNEs and tax administrations by establishing a method that would ensure that MNEs can be taxed only once, and at least once, on their global income.

We believe that this approach is in line with this consultation’s proposed revision to the treaty policy of The Netherlands. It retains the benefits of certainty and ease of administration by withholding but at a rate that is related to profitability, combined with the option of a more comprehensive net income methodology. The Netherlands should therefore lend its support to the adoption of a protocol along these lines, and accept revision of its tax treaties with countries joining such a protocol.

Read the complete submission here.