Summary of Loyens & Loeff’s submission to the OECD’s Request for Input (13 October 2017)

Can we ring-fence the digital economy for corporate tax purposes?

Tax policymakers currently focus on the taxation of the digital economy. They react to the perception that, in particular, the U.S. tech giants do not pay their fair share of corporate tax in large European countries. As digital economy businesses are able to achieve a substantial turnover or profits without (significant) local presence, policymakers consider that they are not or insufficiently taxable in the consumer’s jurisdiction under current international tax rules.

In October 2015, the OECD issued its final report on Action 1 of the BEPS Package (Tax challenges of the digitalised economy). Recently, the European Commission listed several options to tax companies active in the digital economy. Simultaneously, the OECD organised a public consultation requesting input on a number of questions related to the tax challenges of the digitalised economy. Below is a summary of the submission filed by Loyens & Loeff’s digital economy taxation experts, expressing doubts about the possibility (and desirability) of ring-fencing the digital economy for corporate tax purposes.

Corporate tax challenge of digitalisation

The current corporate tax systems are still largely based on the presumption of locally organised businesses operating in close proximity of their customers. Nowadays, MNE businesses are often organised on a regional or even global basis. The internet has expanded the opportunity to globalise businesses and achieve a substantial income in a jurisdiction without a (significant) physical presence.

The digitalisation of the economy fosters an increasing geographic disconnect between the supply side and demand side of income production. As tech businesses may supply markets with no or a limited presence, lawmakers are tempted to turn to the ‘demand side’ (consumer markets) taxation to get a grip on the value created by digital businesses (often referred to as ‘destination-based’ taxation). The current international taxation principles are generally allocating taxation rights based on ‘supply side’ factors, i.e., the ‘origin’ of income production, being the place where the significant people functions, the assets and the risks are located.

BEPS is supply sided…

The BEPS Package so far has expressly and predominantly been looking for answers to counter base erosion and profit shifting issues within the boundaries of the existing international tax framework (and, of course, introduced many transparency tools). The impact remains to be seen, once the different measures will have been implemented. The BEPS motto is that profits should be taxed in the jurisdiction where the value creation occurs. As explained above, under current international tax principles, the value creation is largely tied to supply side factors (people functions, assets and risk).

Beyond BEPS?

The BEPS project does, however, not (or barely) address more fundamental political questions about value creation: in the digital economy, how to split value between the different components of the value creation chain? And where are these functions located? It should be noted, however, that these issues may not be limited to digital businesses. As ‘traditional’ businesses are getting more and more global and digitalised, these issues are likely to become increasingly relevant for companies that are currently not (yet) seen as typical digital companies.

As it seems difficult to locate and tax value creation on the origin side, some countries push towards taxing ring-fenced ‘digital’ activities and supplies in ‘market’ jurisdictions. An example is the recent French-led initiative calling for an equalisation tax in the European Union. It is a clear move away from the origin-oriented transfer pricing paradigm of taxing corporate profits in the appropriate ‘supply’ jurisdiction. Moving the point of taxation to the destination jurisdiction would entail a paradigm shift in international taxation going ‘beyond BEPS’.

Ring-fencing models: will they work?

Where should we tax corporate income? At origin, in Country A where that computer game was developed? Or at destination, in Country B, where a player registered on the website, downloaded the computer game and played? Recent tax reform initiatives aim at favouring the latter. This triggers the question whether it will be possible to separate the digitalised parts of the economy from the rest of the economy. And if not, what would be the impact on the non-digitised part of the economy? These questions seem to have been largely left unassessed so far. Below we provide an overview of various proposals

Significant economic presence: the virtual permanent establishment The concept of ‘significant economic presence’ would establish a tax nexus for an intangible or ‘virtual’ presence in the market jurisdiction. However, it is questionable whether under the current international taxation principles it will be possible to assign any substantial amount of profit to such a virtual permanent establishment. Today, permanent establishment profit attribution is about assigning tax base to the production jurisdiction and not to the market jurisdiction. It is no coincidence that effectively taxing the new commissionaire permanent establishment (BEPS action 7) is difficult. The principal does not perform any functions in the market jurisdiction in addition to the functions of its commissionaire (agent), for which the latter receives an appropriate remuneration. Any introduction of a ‘virtual’ permanent establishment in the market jurisdiction will inevitably have that same fate of becoming a fairly ‘profitless’ permanent establishment; at least as long as the current transfer pricing tax base division paradigm is left unaffected. It would be pretty hard too, if not impossible, to properly define such a ‘virtual’ permanent establishment, particularly considering that any subsequent efforts to assign any substantial amounts of taxable profits to such a permanent establishment would quite likely be in vain.

Withholding tax on certain types of digital transactions Any introduction of a withholding tax on digital supplies - similar to source taxes on dividends, interests, royalties - would create a tax nexus in the market jurisdiction for the foreign recipient of the income. Contrary to the permanent establishment alternative described above, such a source tax concept may actually lead to an influx of taxable base into that market jurisdiction.

However, a source tax on digital supplies would encounter two main problems. First of all, such a tax would be levied on a gross basis. As a consequence, it would raise cost prices of digital supplies and hence become economically distortive. For instance, it could easily transform pre-tax profitable business into an after-tax loss-making venture. Such a tax would also create inequitable differences in tax treatment in comparison to non-digital firms. In EU contexts, discrimination issues are likely to arise. The market distortions and inequities would particularly arise if such a withholding tax were to fall outside the scope of tax treaty networks, thereby leaving such a tax ineligible for double tax relief. In such cases, a withholding tax would effectively operate as a ‘sales tax’ on digital supplies.

Secondly, similar to the virtual permanent establishment alternative, the introduction of such a tax requires a proper definition of its scope. In an increasingly digitalised world, it may be very difficult to design an adequate definition of the digital transactions covered. Let us take the example of a consultant who prepares an advice for a client abroad and sends the advice, either per express mail (hard copy or USB-stick), as an attachment to an e-mail, or via some online platform in the cloud, together with the invoice. Which of these supplies should be the taxable digital supply? And should it matter in the first place? Should it matter, for instance, if the supply were to be a book or an e-book? A tangible CD or streaming the music of the CD? The difficulty of separating the digital product from the non-digital product for purposes of being able to source-tax digital supplies could result in arbitrary taxation, tax cascading, legal uncertainty and problems of an administrative nature – red tape.

Digital equalisation levy A digital equalisation levy would be levied from tech companies as a percentage on their turnover in the respective consumer market and, hence, constitute some form of turnover taxation at destination. Similar to source taxation, such a tax would seem problematic for two reasons. Levied on a gross basis it would basically constitute a contemporary version of the cascading turnover levies, or sales levies, that have been replaced by VAT in many countries, already since the mid 1950s; particularly if such a tax would not be creditable against corporate income tax. The reason for the abolishment of these taxes in favour of introducing VAT was because of these taxes’ distortive properties.

Secondly, as explained above for the digital withholding tax option, the scoping of such a equalisation tax would also be posing some severe issues, for instance in terms of properly tying down the targeted digital firms and their digital supplies. A new tax presupposes the ability to define the scope of such tax. The recent French-led initiative in the European Union would target companies operative in market jurisdictions where these conduct significant (virtual) business interactions with clients and users. This type of levies has already been suspected of violating WTO rules.

Other concepts Other concepts may include revenue based taxes on online advertising, online advertising space, website trafficking, ‘mouse-click’ numbers, ‘click-through’ numbers, et cetera. Issues involving revenue-based taxes on digital transactions echo those mentioned above regarding equalisation levies and withholding taxes. Taxes levied by reference to website trafficking, mouse-clicks, and the likes, seem little more than modern-day versions of ‘poll taxes’ (or ‘head taxes’ or ‘capitation’) and ancient ‘window taxes’. Window taxes were levied in many (European) countries until the 19th century by counting the number of windows in a taxpayers’ dwellings as a proxy for measuring his or her economic wealth.

Any ‘digitaxes’ that would tax by reference to mouse-click numbers and the like would basically do the exact same: resorting to counting things as a proxy for measuring economic accretion. Countries abandoned window and like-taxes for a simple reason: they are completely arbitrary. It would therefore seem to make no sense at all to reintroduce such ancient forms of taxation to address today’s tech-industries that operate in the forefront of innovation and technological development in a globalising market environment.

Enforceability and manipulation

In addition, all of the above mentioned options for taxing the digital economy only, are likely to raise issues in respect of enforceability of the tax and risks of manipulation. How to enforce tax on digital businesses that are difficult to pin down? Moreover, the technical possibilities of digitalisation in conjunction with a difference in tax treatment of digital and non-digital sales, may mean that the ability to manipulate the tax base of a digital tax could become a widespread problem.

Conclusions / final remarks

The above demonstrates that treating the digital economy separately or differently from the rest of the economy for corporate tax purposes is technically difficult if not impossible and bears important conceptual weaknesses that may lead to market distortions, inequities, arbitrary taxation, etc. It is in consequence, surprising that a lot of the tax reform initiatives seem to be pursuing that exact objective.

A ‘quick fix’ for the relevant inadequacies of the international tax framework with respect to the digital economy may not be readily available. Literature suggestions of more fundamental reforms range from supply-side oriented global (residual) profit splitting systems – echoing transfer pricing approaches though without pesky separate accounting and comparability issues – and supply-side and or demand-side global formulary systems, to even destination-based cash flow taxes; or the taxation of multinationals solely in the ultimate parent jurisdiction.

In our view it is not possible to separate digital from non-digital, so perhaps policymakers should not even try. The real policy question on the table perhaps should be: true corporate tax reform or no corporate tax reform?