On 16 September 2014 the OECD issued its paper, Addressing the Tax Challenges of the Digital Economy (Paper).

The Paper follows a draft paper issued earlier in 2014, and considers Action Point 1 of the OECD's wider 15 point Base Erosion and Profit Shifting (BEPS) Action Plan.

The BEPS Action Plan as a whole is discussed in more detail in our earlier Alert, OECD releases BEPS Action Plan.

In this Alert we consider the main issues and options for taxation reform raised in the Paper.

BEPS issues

The Paper highlights BEPS issues which arise from the digital economy including:

  • Whether current physical nexus tests for residence or the existence of a permanent establishment continue to have relevance in the digital economy , as there is an inability for the country of customer source to impose tax on a purely digital transaction if the e-commerce entity is neither tax resident nor has a physical presence in that jurisdiction.
  • Fragmenting physical operations to avoid taxation – for example by centralising infrastructure at a distance from the market jurisdiction, and conducting substantial sales remotely using minimal personnel.
  • Business structuring using offshore entities to create base erosion and profit shifting opportunities especially via the transfer of ownership of intangible property - structures achieving this have been adopted by some of the world's leading technological companies including the infamous Double Irish Dutch sandwich structure adopted by a number of companies including Google, Apple and Facebook.
  • The characterisation of payments such as cloud computing payments for tax purposes, and the avoidance of withholding tax
  • Avoiding VAT or GST by having no presence in a country where the bulk of the profits are made.

Potential reform

The Paper states that a number of the other papers in the BEPS Action Plan or which are being currently completed by Working Parties at the OECD will impact upon the digital economy. The Paper outlines a number of issues that should be considered in those other papers.

Changes to the permanent establishment concept

The paper on Action 7 Prevent the Artificial Avoidance of Permanent Establishment Status is due in September 2015. That paper will make recommendations to amend the model double tax convention. The Paper suggests that in relation to the digital economy that the following be considered in Action 7:

  • Reconsideration of the exclusions from the concept of a 'permanent establishment' and whether they have modern day relevance
  • Alternatively, adapting those exclusions so that:
    • the exclusion that applies to a fixed place of business maintained for activities that have a preparatory or auxiliary function should be limited, so that it does not exempt an entity from having a permanent establishment if that function represents the core business of the enterprise;
    • other exclusions, such as the exclusions which apply to facilities maintained for the purpose of storage or warehousing of goods, or for collecting information should be similarly limited if those functions represent the core business of the enterprise;

Alternatively, expanding the concept of a 'permanent establishment' to provide that a permanent establishment could arise where: 

  • the enterprise operates 'fully dematerialised digital activities' (measured by reference to whether the core business relies completely or in large part on digital goods and services) there is a tax nexus via a 'significant digital presence' (eg measured through volume of digital sales, numbers of customers, expenditure in a jurisdiction, the significance of the digital presence to the overall business); or
  • there is a 'virtual fixed place of business' – eg a website on a server of another business; or
  • there is a 'virtual agency' – eg via sales staff in a jurisdiction, or via the digital conclusion of contracts; or
  • there is an 'onsite business' presence – eg via an interface on a customer website.

Domestic source rules

There is the potential for some of the issues raised in the Paper in relation to the permanent establishment concept to impact on domestic source rules – for example the Paper considers where contracts are formed if they are concluded remotely. Those issues are not fully canvassed in the Paper but may be considered further by the Australian Taxation Office.

Transfer pricing amendments

Actions 8, 9, 10 and 13 of the wider BEPS Action Plan consider transfer pricing issues and each relate to ensuring that transfer pricing outcomes are in line with value creation, and that appropriate documentation is maintained. Finalised papers on each of those Actions are due in September 2014 (some have been released) and September 2015, and a number of aspects are still being worked on by the OECD.

The Paper notes that particularly relevant to the digital economy are the transfer pricing issues relating to intangibles.

The Paper suggests that a profit split method be advocated to ensure that appropriate value is attributed to the jurisdiction where the intangible was created.

Amendments to Controlled Foreign Company regimes

The paper on Action 3 of the BEPS Action Plan Strengthen CFC Rules is due in September 2015, and will make recommendations of changes to domestic law.

The Paper suggests that adaptations should be considered to CFC rules so that income typically earned in the digital economy should be attributed to the jurisdiction of the foreign controller, due to its mobility.

The Paper suggests a simple concept 'income from digital products and services' be considered attributable income. This would obviously require a domestic law change. In Australia, changes to the CFC regime have been on hold for some time, and we do not expect they will be progressed until after the OECD issues its paper on Action 3.

Amendments to withholding tax

The Paper refers to Working Party Number 1 of the OECD's Committee of Fiscal Affairs and its report which is due by December 2015 on issues relating to withholding tax (amongst other issues).

The Paper suggests that report may include a recommendation that all cloud computing payments be subject to withholding tax – including infrastructure-as-a-service, software-as-a-service and platform-as-a-service arrangements.

Bandwidth tax or 'bit' tax

The Paper briefly canvases a bandwidth tax. This is a tax paid based on the number of bytes used by a website. The reasoning is the larger the bandwidth the greater the capacity for data flow and economic activity. Any such tax would apply only above a certain level of bytes, and would apply progressively according to internet speed. It would also need to be creditable against the corporate income tax.

A bandwidth tax seems merely a 'thought bubble' in the Paper. It seems very unlikely to advance further because of United States legislative issues. In the United States, the Internet Freedom Act 1998 effectively prevents taxation on the internet, and grandfathers taxes in ten States. That Act does not prevent indirect taxation such as sales taxes on online purchases, but does prevent taxation directly on the internet, such as a bandwidth tax.

VAT/GST

The Paper refers to Working Party Number 9 of the OECD's Committee of Fiscal Affairs and its report due by December 2015 on VAT/GST issues, including on International VAT/GST Guidelines.

The Paper suggests that the report may consider subjecting remote business to customer digital supplies to VAT/GST in the country of residence of the customer. Proposals of a similar nature are being adopted within the European Union in 2015 (details here) and have been considered by earlier OECD guidelines (details here and here).

The Paper notes that for VAT or GST to be levied in this manner there needs to be a simplified compliance and collection regime, and this may require a multilateral instrument (which is being considered as Action 15 of the BEPS Action Plan).

The Paper also highlights concerns in relation to VAT/GST exemption thresholds for customer imports of goods, and suggests that this is an area that needs to be reconsidered. Included amongst the issues considered here is the possible imposition of import taxes on suppliers.

While we need to wait for the OECD report in 2015, our prediction is that despite an appetite for change in this area (given the revenue impact), designing a simple and effective regime to require entities to account for VAT/GST in all the jurisdictions in which their customers are located will be extremely difficult. We expect the success or failure of the European Union's action in this area will be monitored carefully by revenue authorities, including the Australian Taxation Office.

Other relevant Actions in the BEPS Action Plan 

The Paper also highlights other Actions in the BEPS Action Plan which impact upon enterprises in the digital economy – including:

  • Action 4: Limit Base Erosion via interest deductions and other financial payments. A paper is due in September 2015 and December 2015. 
  • Action 2: Neutralise the effects of hybrid mismatch arrangements. A paper was issued in September 2014 on Action 2. That Paper made recommendations to change domestic law, including to deny deductibility of a cross border cash flow where the recipient is exempted from tax on receipt. The paper also made recommendations as to model double tax convention changes in relation to dual resident entities and transparent entities, to limit or prevent arbitrage opportunities from the use of such entities. 
  • Action 6: Prevent Treaty Abuse. A paper issued in September 2014 on Action 6. The paper recommended limitation of benefits provisions and anti-abuse provisions in model double tax conventions. These provisions are designed to prevent multinational enterprises structuring business operations to tax advantage of jurisdictions with favourable tax treaties. A further paper is due in September 2015 recommending domestic law changes.

What has already happened in Australia?

Australia is a member of the OECD's Taskforce on the Digital Economy. The Australian Taxation Office has been involved with other jurisdictions in identifying global e-commerce risks, trends and issues, and sharing information about business structures.

The Australian Taxation Office has also established an International Structuring and Profit Shifting group. Mark Konza (Deputy Commissioner – International, Public Groups and International) has advised that the International Structuring and Profit Shifting group is investigating 86 multinationals and that a number of BEPS relates themes have arisen (particularly in relation to transfer pricing, the use of hybrid instruments, and debt funding related issues).

Mr Konza has also stated that the Australian Taxation Office and Treasury are considering whether domestic law reform is needed to counter these issues.

Our predictions

It is expected that at the G20 meeting in November 2014 (chaired and hosted by Australia) the G20 leaders will strongly endorse action on the OECD's BEPS Action Plan. We anticipate that the Australian Taxation Office and Treasury will consider domestic law changes in future.

Our prediction is that domestic and international changes will arise particularly in the transfer pricing area (be they legislative or by way of Australian Taxation Office enforcement) at least initially. Domestic law changes have already been made to the thin capitalisation regime to affect interest deductions (for further details see here), and, amongst other matters we anticipate changes to the controlled foreign company regime in future (these have been on hold for some time).

We expect that other international developments will take longer, into 2015 and 2016 as further work from the OECD is released. In particular, we need to wait for the paper on Action 7 Prevent the Artificial Avoidance of Permanent Establishment Status as it could well make proposals that could impact very directly upon enterprises involved in the digital economy.