Taxation And Technology: Playing Catch-Up In A Digital WorldApril 28, 2016 | Download PDF
“Political leaders, media outlets, and civil societies around the world” says the OECD (Organisation for Economic Co-operation and Development) “have expressed growing concern about tax planning by multinational enterprises (MNEs) that makes use of gaps in the interaction of different tax systems to artificially reduce taxable income or shift profits to low-tax jurisdictions in which little or no economic activity is performed .”
It’s a familiar complaint from the OECD, given its traditional commitment to equity and a “fair sharing” of the tax base among countries. But these days the grievance has a special - and legitimate – urgency, and the rapid evolution of the digital economy has many countries worried that they are losing tax revenue. And it’s not an unfounded fear: Technology has rapidly outpaced tax legislation and governments worldwide are trying to catch up. In fact, applying existing tax laws is difficult because mobility and network effects make it difficult to determine where value is created and where income should be taxed.
According to the OECD, aggressive tax planning on the part of businesses, accounts for tax revenue losses of anywhere from $40 to $100 billion a year - or 4% to 10% of global corporate tax revenues.
Shifting taxing rights to source/market countries
With this in mind the OECD issued its Addressing the Tax Challenges of to the Digital Economy, Action 1 – Final Report in 2015. Its aim was to minimise aggressive tax planning and to encourage governments to minimise gaps and tax arbitrage opportunities in their domestic laws. However, while the aim was simple, accomplishing it adds extra layers of complexity.
The report recommended a modification of “taxing rights” among nations, shifting “taxing rights” from resident countries to source/market countries. In this way governments in the source/market country would be allowed to unilaterally tax economic activities within their borders - but only in the case of clear-cut treaty abuse (See Action 1 Recommendations, below for details). Of course, this may lead to double taxation if not accompanied with a foreign tax credit mechanism. But that is a topic for another time.
Still, the OECD needs to be congratulated for their work on the BEPS report. The level of expertise, as well as the quality of the analysis, is exceptional. The task which they have undertaken is difficult, to say the least.
In developing their recommendations, the OECD is clearly taking a measured approach to the whole subject. And they have wisely suggested that the digital economy not be ‘ring-fenced’, as it is quickly becoming a fundamental part of the entire global economy. They are taking a ‘wait and see’ approach so that they can gather additional data, assess outcomes and study other taxation options before taking on the broader challenges of the digital economy.
The effect of shifting taxing rights for direct tax purposes is clear enough, but what happens vis a vis the source/market country when considering the effect of the indirect tax system? In this instance the OECD recommends the implementation of Guideline 2 and 4 of their International VAT/GST Guidelines. While the direct income tax system is shifting toward source base, the indirect tax system is also source based for both Guideline 2 and 4. Thus, Guideline 2 would allocate taxing rights on cross-border supplies of services and intangibles to the location of the business owner’s establishment. Guideline 4 indicates that taxation accrues to the location where the customer actually uses the service or the intangibles. Both look to the source/market country or place of use.
To further complicate the creation of global standards for tax collection, the US indirect (sales/use) tax system is at the subnational level and is not part of the OECD treaty process. Thus it is excluded from the international discussions on VAT/GST.
Gathering data from 10% of corporate taxpayers and assessing outcomes
Over the next few years, the OECD and various countries will be gathering data collected from both the VAT/GST system as well as Country by Country (CbC) reporting. In this way, they will be able to assess the results generated by the BEPS report and determine if more extreme measures, or alternative concepts of taxation are required.
It’s worth noting that only MNEs with annual revenues of €750 million or more are required to file the CbC report (in addition to master files and local files). However, many governments believe that while this reporting requirement will fall on 10% of the largest taxpayers, it will nevertheless encompasses approximately 90% of all corporate revenues.
Although this methodology is clearly useful for various countries, it largely ignores the ever-growing population of Micro MNE’s. In fact, tax policies that target large enterprises often have unintended, often adverse, consequences for smaller players, such as additional tax complexity and the increased cost of compliance.
Not only do new tax policy recommendations need to be tested and their possible consequences explored in full, but safe harbors should also be established so that the smaller players have the opportunity to comply with complex international tax laws at a reasonable cost.
Action 1 Recommendations
Although Action 1 addresses the Digital Economy, many of the other 14 Action plans of the BEPS report are incorporated in Action 1. The OECD hopes that these measures will substantially address the BEPS issues exacerbated by the Digital Economy. The recommendations address the following issues:
1. Treaty abuse
2. Artificial avoidance of PE status
3. Use of artificial means of reducing tax in both market and parent jurisdictions
4. Nowhere tax in parent jurisdiction.
Treaty abuse (Action 6)
Governments observed that taxpayers might insert a shell company with little substance in a country with a favorable treaty network but little protection against treaty abuse. The OECD recommends limitation on treaty shopping and the use of dual resident companies. The source/market country could, under such circumstances, unilaterally ignore the tax treaty and assert that a Permanent Establishment (PE) giving rise to either local taxation or to the application of withholding taxes on the transaction, exists.
Prevent the artificial avoidance of PE status (Action 7)
Anti-Fragmentation: An enterprise might engage in activities in a country that were preparatory or auxiliary in nature and still not cross the “threshold”. The OECD recommends that the “preparatory or auxiliary” definition be modified in treaties and that a new “anti-fragmentation rule” be included. Activities of the group of related companies, operating in a country, will need to be taken together and evaluated as to whether the totality of the activity is still preparatory or auxiliary or whether, taken together, they are creating a PE in the source/market country.
Warehouse: In the past, the maintenance of a warehouse in a country did not create a PE. Targeting companies, such as Amazon, the OECD recommended that a large local warehouse, where a substantial workforce is in place to quickly fulfill customer orders, would no longer qualify as an exception to a PE. Such activities would be considered a core activity and would create a PE in the source/market country.
Signing Contracts: A company could avoid creating a PE in a country if the local subsidiary did not sign contracts on behalf of the principal/parent company. This very formalistic approach avoided the creation of a dependent agent in the source/market country. The OECD has recommended that if a local subsidiary, which is selling goods or services, in a country, plays the principal role in the conclusion of contracts and these contracts are routinely or automatically signed by the parent without making material modifications, then the local sub would be considered to be a dependent agent of the parent company. A dependent agent would create a PE for the parent company and would draw the parent into the tax net of the market country.
These three modifications serve to lower the threshold for establishing a PE in a source/market country. These provisions will add uncertainty and complexity in managing cross border operations by removing “bright line” tests. Now an added layer of judgment is required to analyze whether an activity is a “core activity” or yet whether a subsidiary is playing a “principal role” vs. a “supporting role” in the conclusions of contracts.
In some countries, such as the US, onerous consequences may apply to a non US company if it has an unintended PE in the US and does not file a tax return for such PE. Tax may be imposed on revenue and deductions might not be allowed! For Micro MNE with overall losses, such a ruling could destroy the business.
In future work on the digital economy, it would therefore be useful if “safe harbors” were developed, which would eliminate unexpected or “pop up”, PE’s for those companies who so elect this approach. For example, if a company sets up a subsidiary in the local jurisdiction, transfer pricing mechanism could be utilize to reallocate income rather than drawing an offshore related company in the local tax net as an unexpected PE.
Measures that will address BEPS issues in both market and ultimate parent jurisdictions Actions 2, 4, 5, 8-10)
MNE’s reduce taxation by moving income-producing functions to low tax jurisdictions. Governments allege that intangibles with artificially low valuation can be transferred to a country with a lower tax rate. After the transfer, a large return on investment is claimed in order to pay tax at a substantially lower rate of tax. In addition, to shifting profits, contracts have been artificially used to allocate roles and obligations to companies, which have neither the resources nor the skills to fulfill these responsibilities.
The OECD recommends the following Actions to minimize these abuses:
Action 2 – neutralizing the effects of hybrid structures by recommending that countries modify their domestic rules and by changing the OECD model treaty.
Action 4 – limiting base erosion via excessive interest deductions and other financial payments by recommending best practices for countries to incorporate in their domestic legislation, such as financial ratios and debt equity tests.
Action 5 – counter harmful tax practices employed by some countries, who have set up preferential IP regimes, which allow payment for research and development but no core activities are actually taking place in the country.
Action 8-10— assure that transfer-pricing outcomes are in line with value creation, That is, income should be allocated to the location that gives rise to that income. The areas of focus include:
• Transfer and use of intangibles including hard-to-value intangibles
and cost contribution arrangements
• Delineating the actual transaction and business risks
• Global value chains and transactional profit split methods.
In the past, an enterprise could develop intangibles in one country but these same intangibles were legally owned and funded by another company in a low tax country. The largest return on investment would go to the legal owner/investor who funded the activity and assumed risks even if no research and development activities occurred in that jurisdiction.
The OECD recommended that in order to be entitled to a higher return, the enterprise can no longer be merely a legal owner or an investor. Premium returns would only be available if the enterprise also participated in the DEMPE functions (Development, Enhancement, Maintenance, Protection and Exploitation activities) in addition to the legal ownership and funding aspects. Legal ownership alone does not entitle the owner to premium profits. Using these concepts, it might still be difficult to allocate income to the legal owner.
Clearly the OECD’s work relating to the digital economy is far from over. It’s an ongoing subject for study. It should come as no surprise then that the OECD has identified three key areas of current concern:
1. Nexus: A business is able to carry on business in a jurisdiction without
physical presence. The Internet recognises no borders.
2. Data: Data has value but has no specific location. So, how is this value
attributed to a particular geography?
3. Characterisation: Cloud computing and other digital products do not
conform to many of the old definitions of software. The question is key
in determining which country has the right to tax the income. For
instance, should the payments for cloud computing be treated as a
royalty subject to withholding tax at source in the market country?
Should these payments be treated as services, which would be taxed
as business profits granting taxing rights to the country of residence of
the provider of services?
Certainly reasonable approaches can be developed to interpret many of these digital transactions by referring to existing guidelines. A sound body of law has been developed over the years and needs to be adapted - and applied - to the digital economy as it moves forward.
With the growth of Micro MNEs in the digital economy, this issue will undoubtedly affect a large number of taxpayers. The characterisation of SW revenue is a controversial subject to begin with and has given rise to a great deal of litigation, especially for US SW companies selling products in India. As the digital economy evolves it is vital that a global consensus be achieved vis a vis all of the pressing tax issues and a cogent set of guidelines provided to the growing international business community. Anything less would create an unacceptable level of uncertainty.
Alternative concepts of taxation
To address the three foregoing concerns – and the fear that the BEPS report recommendations might not address all of the tax abuse issues – some countries would like to study other taxation approaches. These new options could actually lead to modifications in the PE rules and would create an even greater impetus in shifting taxing rights toward the source/market country. But these options could lead to taxation even if no PE exists. In developing its concept of an “economic presence”, the OECD looked at the following possibilities:
• Alternatives to the existing PE threshold
• Imposition of a withholding tax on certain types of digital transactions
• Introduction of an equalisation levy
A new nexus based on the concept of significant economic presence: Based on factors that demonstrate a certain level of activity, a taxable presence (e.g., technology or other automated tools) would be created when a non-resident enterprise has a significant economic presence in a country. These factors could be combined with others – based on the revenue derived from remote transactions - as well as digital and user-based factors. Once a significant presence has actually been established some method for attributing income to the particular jurisdiction in question would have to be devised.. Methods based on fractional apportionment of profits as well as deemed profit methods were considered.
A withholding tax on digital transactions: A tax which would be withheld by residents and local PE’s when payments are made to non-resident providers. This option is clear and simple, although it could lead to inequities as the tax results might differ for online transactions. As technology advances, the list of transactions subject to the withholding tax would need to be revised to avoid disputes among tax authorities. Furthermore, a withholding tax could also be used as a tool to support net-basis taxation discussed above. In practice, the collection of a withholding tax on outbound payments rests with the payer and customer or third-party processor. Thus the collector must have the necessary information in order to be able to comply. This approach would be problematic for most B2C models.
Introducing an equalisation levy: An excise tax approach, which addresses the disparities in tax treatments between domestic corporations and foreign corporations. Such a levy would be applied only when a non-resident enterprise has a significant economic presence. The levy would be imposed on the gross value of the goods or services provided to in-country customers and users, paid by in-country customers and users but collected by the foreign enterprise via a simplified registration regime - or collected by a local intermediary. Alternatively, the levy could be imposed on data and other contributions gathered from in–country customers and users. Predictably enough potential trade issues exist with the levy system, as well as duplications with a corporate income tax system.
From our point of view we think it fortunate that the OECD didn’t actually recommend any of these concepts. It’s certainly reasonable to monitor developments in technology and business models and study the impact of the current OECD recommendations to see if further changes are required. But predicting which innovations and developments will occur is next to impossible. The countries that were winners in the past may not necessarily be the winners in the future.
To sound a further note of caution, we feel that it is unfortunate that the OECD suggested that countries could experiment unilaterally and incorporate any of these novel approaches in their domestic laws and in bilateral treaties. However, while the OECD said they would study the results, allowing individual countries to act unilaterally will create disharmony and more controversy for taxpayers.
Time will tell how tomorrow’s technology and the marketplace it serves will develop, but it seems to be fairly clear that the absence of consensus among governments and the lack of guidelines for revenue characterisation from the digital economy will have a detrimental effect on global business. The current state of affairs may well result in increased compliance costs, to say nothing of the debates and disputes that will invariably arise because of double taxation issues. Taken together all of these factors could have unintended – and unwelcome - consequences for governments worldwide as well as taxpayers.
By focusing so intently on the loss of revenue attributed to aggressive tax planning by MNEs and ignoring other global taxpayers, many governments are moving away from the principles of the Ottawa Ministerial Conference on Electronic Commerce in 1998, which were to be used to frame tax policy.
It’s worth remembering what key principles were agreed to back then, namely:
• Neutrality between similar forms of business activity
• Efficiency so as to minimise compliance costs for business and government
• Certainty and simplicity so that the rules are clear and simple to understand
• Effectiveness and fairness to avoid double taxation or unintentional non-taxation.
• Flexibility to keep pace with technology and business developments.
The issue of equity and a ‘fair sharing’ of the tax base among countries has always been of paramount importance to the OECD, it’s clear that many governments continue to be more concerned with attracting capital and jobs to their respective countries
Unfortunately, with less neutrality and a lack of efficiency, simplicity, and fairness our globalised world will become a more contentious and expensive place for all parties.
About the Author
Jeanne Goulet, CPA, is a Senior Consultant at Marks Paneth LLP. A tax specialist, she has more than 25 years of experience in both industry and public accounting. Jeanne possesses a deep understanding of the tax issues related to e-commerce and the internet, including software development, global services and the cross-border sale of goods. Jeanne was a participant at the OECD’s Technology - Technical Advisory Group (TAG), as well as the OECD’s Business Profits -Technical Advisory group (TAG) from 1998-2003.
She is a frequent speaker on corporate tax and business advisory topics and has spoken at a variety of venues including George Washington University's International Tax Program, the International Fiscal Association (2001 Annual Global Congress), Harvard Law School's International Tax Program and Society for Law and Tax Policy, the Institute for International Research and The Conference Board.
Jeanne holds a Master of Science in Accounting from the Stern School of Business at New York University and is based in Marks Paneth's midtown Manhattan headquarters.