Thought leadership from our experts

Can the Arm’s Length Standard be Used to Resolve Tax Challenges of Digitalisation of the Economy?

For the past several years the question of how to tax the digital economy, both for companies specializing in digital activities (search engines, on-line market places, social media) and the on-line activities of companies more broadly has been a key concern for tax administrators. Recently the European Union has considered numerous proposals, both collectively and unilaterally by member states for how to tax these activities. There is some momentum to have resolution of these issues by the end of 2019. This paper addresses one aspect of these efforts, reconciling a recent OECD proposal with the widely-accepted arm's length standard.

As part of the 2015 BEPS final reports, the OECD BEPS Task Force on the Digital Economy concluded in their Action 1 Report that the digital economy raised fundamental issues around countries' jurisdiction to tax digital transactions ("tax nexus") , the role of digital users' data in the digital economy, digital income characterization and allocation of digital economy income taxing rights among jurisdictions, especially digital user jurisdictions.

A subsequent OECD report issued in 2018 identified three attributes of the digital economy that complicate income taxation of digital-economy transactions:

  • Scale without mass-the ability of a company to conduct business digitally in numerous jurisdictions while having a minimal physical (or agency) presence in only a few;
  • heavy reliance on intangible assets- creating opportunities for taxpayer income shifting; and,
  • data and user participation- whereby users create value to the company in jurisdictions in which the MNE has no traditional taxable presence.

More recently, the OECD issued a public consultation document on digital economy taxation, "Addressing Tax Challenges of the Digitalisation of the Economy" (the "Digital Discussion Draft"). The Digital Discussion Draft presented proposals for public comment which OECD's 128 Inclusive Framework members are considering in order to deliver a set of consensus-based solutions by 2020.

These most recent OECD proposals squarely place at issue whether the arm's length standard can be used to resolve the tax challenges that have been identified by OECD or whether a formulary approach is required. In this vein, a number of jurisdictions are adopting or considering a gross revenue based digital services approach as an alternative to income taxation of digital services income.

Recent OECD Proposals for Addressing Profit Allocation Issues

The Digital Discussion Draft "Pillar 1" proposals would broaden the taxation rights (tax nexus) of digital user jurisdictions beyond traditional permanent establishment restrictions and create a new category of digital user country intangibles subject to the expanded taxation rights. Three alternative conceptual frameworks are suggested for dealing with the Pillar 1 nexus and profit allocation challenges.

The User Participation framework would only apply to a narrow set of companies in the search engine, social media, and online market place businesses. The User Participation proposal would enable a tax authority to assert taxation based upon local digital platform users' participation regardless of the physical (or other) presence of the companies maintaining or using the digital platform. The level of tax would be based on a residual profit split method ("RPSM"), driven by the level of user participation and the revenue generated through advertising or other transactions in a given jurisdiction. The proposal acknowledges there are many complexities to applying RPSM, and suggests a role for formulas and pre-agreed percentages to simplify computation and administration.

The second proposed digital tax framework is called Marketing Intangibles. This proposal would apply to all taxpayers regardless of the type of digital business being transacted. This proposal advocates a separate regime for taxing all forms of marketing intangibles, including a marketing intangible that is not owned exclusively by the legal entity that develops, funds and manages the intangible, but is rather ascribed to the jurisdiction where the digital-user intangible is exploited regardless of physical (or other) presence of the companies maintaining or using the digital platform. The Marketing Intangible proposal envisions application of RPSM to identify income associated with marketing intangibles; this residual income would be allocated among jurisdictions by certain metrics of value (for example, revenue), without regard to the DEMPE functions performed to create the intangible. This second framework envisions a role for formulary apportionment to simplify calculation and administration.

The third proposal, the Significant Economic Presence proposal would establish a three-factor allocation model of global income if a company meets the threshold of significant digital presence. The Discussion Draft notes that this proposal was a late addition, and implementation discussions are still ongoing.

The three alternative conceptual frameworks for OECD's proposed Pillar 1 all envision a role for a formulary apportionment of income either as a simplification to an arm's length RPSM or as a primary income allocation method.

Public Reactions to the Digital Discussion Draft

OECD solicited written comments and hosted a public consultation to hear comments on the Digital Discussion Draft. In response, over 200 written comments were submitted and over 400 people from business, government, academia, and civil society attended the public consultation meeting.

The written and oral comments reflected a fairly broad acceptance by business taxpayers that some changes are needed to the nexus and profit allocation rules to allocate limited additional taxing rights to the digital transaction market jurisdiction. However, there was less acceptance of moving away from the arm's length standard. The consensus taxpayer view was that any movement away from the arm's length standard must be based on principles that are broadly accepted by OECD and Inclusive Framework member countries. Commentators feared that changes to existing rules without a broad based consensus on relevant taxation principles would likely lead to increased disputes, with a high likelihood for economic double taxation.

Consistent with the 2015 BEPS Action 1 report and the 2018 interim report, the message from nearly all commentators was that ring-fencing the digital economy is not possible due to the rapid digitalization of the global economy. There was a general view that new rules must be able to stand the test of time without the need to be readdressed in 10-15 years as new forms of digital economy transactions or digital platforms emerge. Other common comment themes were the need to have rules that could readily be understood and administered by taxpayers and tax authorities alike, coupled with efficient dispute prevention or dispute resolution procedures.

Although the complexity of residual profit split approaches was noted by many commentators, the general consensus of comments was that the marketing intangibles proposal was the most likely approach upon which an international consensus could develop.

Challenges for Arm's Length Approaches

Two of the Pillar 1 proposals rely upon some form of RPSM. In theory, application of RPSM is fairly straight-forward:

1. Identify the consolidated income to be split among the taxpayers and tax jurisdictions

2. Identify the routine functions performed by each of the related parties engaged in the digital transaction; value the routine contributions; and then subtract the aggregate routine profit contributions from the consolidated income identified in the prior step to arrive at the residual profit to be split.

3. Identify the non-routine functions performed, or intangible assets owned, by each of the related parties engaged in the digital transaction; value the non-routine contributions and intangible assets; and then allocate the residual income identified in the prior step based on the relative non-routine contributions or assets.

The User Participation and Marketing Intangible proposals assume that the entity that engages in the digital transaction at issue will be treated as having a taxable presence in the jurisdiction where the transaction has an effect (but is not necessarily where the transaction is conducted). In many instances, the MNE that developed, updates, maintains and legally protects (i.e., performs DEMPE functions) a digital platform (such as an internet search engine and the algorithms to organize digital user data) will not have a traditional PE in many countries where the digital platform is being used. In addition, the MNE may not have an affiliate selling advertising in a country where digital users are using the platform.

A typical digital transaction within the scope of the Pillar 1 proposals might be income derived from the sale of targeted digital adverting, such as the "pop-up" ads that commonly appear when internet users use an internet search engine. Assuming that the nexus/taxable presence rules are changed to permit a digital user country to assert an income tax on this transaction, can the arm's length standard be used by the digital user country and other countries to tax the income derived from the transaction using the RPSM or is a formulary method the only alternative ?

In the transaction described above, the digital platform owning MNE or an affiliate will make a routine contribution (selling advertising) that can readily be valued. The digital platform owning MNE (possibly in combination with affiliates) makes non-routine intangible contributions by developing and maintaining the internet search engine and the personal data algorithms. The digital user country contribution (effectively treated as an additional intangible contribution by either the platform owning MNE of an advertising-selling affiliate) is the digital users' data. Assuming for purposes of simplicity that the income derived from the search engine, personal data algorithms and personal data is limited to advertising revenue, it would seem that a variation of the US "income method" could be used to define and split the residual income.

In this context, the value of the internet search engine and data algorithms might be determined by reference to relevant development and maintenance costs, while the personal data in the digital user country might be valued by reference to the value of customer lists, which have historically been valued as part of acquisitions of retail banks, newspapers, broadcasters and similar businesses.

So, in answer to the question posed above, while it is not simple to do so, the principles of the arm's length standard can be applied to value the digital transaction described above- and most likely the bulk of other digital economy transactions as well. Rules of thumb or formulas could be used to simplify administration of taxation of digital transactions. However, the international business community and tax authorities have regularly rejected similar rule of thumb or formulary approaches due to the arbitrary nature of "one size fits all" approaches applied to varying business patterns. There does not appear to be any reason why such approaches need to be used to tax digital economy tranactions.

The arm's length standard has been the bedrock foundation for international taxation for the better part of a century, serving as a guiding principle for taxpayers and tax authorities to assess income taxes, plan transactions and to resolve disputes. Moving away from this principle risks a tax system based on arbitrary rules and formulas, creating confusion and uncertainty. Rather than signaling the end of the arm's length standard, the Digital Discussion Draft provides the OECD and taxpayers an opportunity to demonstrate that the arm's length standard is flexible enough to accommodate changing business models in market driven economies.


  1. Mike Patton is a Tax Partner in the Los Angeles office of DLA Piper (US) LLP. Paul Flignor is a Principal Economist in DLA Piper's Chicago office. The views expressed in this article are the authors opinions and do not necessarily reflect the views of DLA Piper US) LLP.