On 16 September 2014, the OECD released the report on the tax challenges of the digital economy (the "Report") under its Action Plan on Base Erosion and Profit Shifting ("BEPS").
The Report recognises that because the digital economy is increasingly becoming the economy itself, it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes. As a result, the Report concludes that the tax challenge and BEPS concerns raised by the digital economy are better addressed by analysing existing structures adopted by multinational enterprises, focusing on the key features of the digital economy and determining which features raise or exacerbate tax challenges or BEPS concerns.
Digital Economy: Key Features and BEPS Opportunities
The Report identifies certain key features of the new business models emerged in the digital economy that can exacerbate BEPS risks: mobility, with respect to intangibles (on which the digital economy relies heavily), users, and business functions (resulting from a decreased need for local personnel to perform functions as well as flexibility to choose location of server or other resources); the massive use of data; network effects; the spread of multi-sided business models; tendency toward monopoly or oligopoly; and volatility due to lower barriers to entry into markets and rapidly evolving technology.
The Report acknowledges that structures that can be used to implement business models in the digital economy highlight existing opportunities to achieve BEPS to reduce or eliminate tax in jurisdictions across the whole supply chain, including market and ultimate parent company countries. For example, the importance of intangibles, combined with the mobility of the same for tax purposes under existing rules, generates substantial BEPS opportunities in the area of direct taxes. The centralisation of infrastructure at a distance from a market jurisdiction and the sales of goods and services into that market from a remote location, together with the ability to conduct substantial activity with minimal use of personnel, generates potential opportunities to achieve BEPS by fragmenting physical operations to avoid taxation. Some key features of the digital economy also increase risks of BEPS in the context of indirect taxation, in particular in relation to remote supplies to VAT exempt businesses.
Tackling BEPS in the Digital Economy
The Report recognises that many of the BEPS concerns apply equally to the digital and conventional economy, and it anticipates that the work on other Actions of the BEPS Action Plan will address some of the BEPS concerns raised by the digital economy. These include, inter alia:
- Action 7 (Prevent the Artificial Avoidance of PE Status), which should ensure that core activities cannot inappropriately benefit from the exceptions to PE status and that artificial arrangements relating to sales of goods and services cannot be used to avoid PE status.
- Actions 8, 9, and 10 (Ensure that Transfer Pricing Outcomes are in line with Value Creation), which should have the goal of reflecting the value of intangibles if they are transferred intra-group and to align income from intangibles with the economic activity that generates it. Further, they should provide clearer guidance on the application of transfer pricing methods, including profit splits in the context of the global value chain.
- Action 3 (Strengthen CFC Rules), which should take into consideration the possible need to adapt CFC rules to the digital economy.
- International VAT/GST Guidelines on place of taxation of B2B supplies of services and intangibles, which should minimise BEPS opportunities for supplies of remotely delivered services made to exempt businesses.
Broader Tax Challenges Raised by the Digital Economy
The Report identifies four main broader tax challenges raised by the digital economy:
- Nexus. The continual increase in the potential of digital technologies and the reduced need in many cases for extensive physical presence to carry on business raises questions as to whether the current rules are appropriate.
- Data. The growth in sophistication of information technologies has permitted companies in the digital economy to gather and use information to an unprecedented degree. This raises the issues of how to attribute value created from the generation of data through digital products and services, and of how to characterise for tax purposes a person's or entity's supply of data in a transaction, for example, as a free supply of a good, as a barter transaction or some other way.
- Characterisation. The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation of payments made in the context of new business models, particularly in relation to cloud computing.
- VAT Collection. Cross-border trade in both goods and services creates challenges for VAT systems, particularly where such goods and services are acquired by private consumers from suppliers abroad.
Potential Options to Address Broader Tax Challenges
The Report provides an overview of the potential options to address these broader tax challenges. They include:
- Modification to the exemptions from PE status for activities that were previously preparatory and auxiliary in the context of conventional business models which may have become core functions of certain businesses.
- Creation of a new nexus for fully dematerialised digital activities based on a significant digital presence. To address administrative concerns, certain minimum thresholds, based on the number of contacts, users, and levels of consumption in the market country, would be considered.
- Replacement of the existing concept of PE with a significant presence test to reflect the relationships and interaction with customers located in a certain market country.
- Creation of a withholding tax on digital transactions to be levied by the financial institution involved in payments.
- Introduction of a bandwidth-tax-based or "Bit" tax on the number of bytes used by websites (creditable against corporate income tax).
- Establishment of lower thresholds for imports of low-valued goods and requiring non-resident suppliers of remote B2C supplies to register and account for VAT purposes in the jurisdiction of the consumers.
In this regard, on 18 December 2014, the OECD released a discussion draft of guidelines concerning (i) the place of taxation of B2C supplies of services and intangibles, and (ii) provisions to support the application of these guidelines in practice.
Finally, the Report recognises that further work is required to evaluate the impact of the BEPS Project on the digital economy, focusing on nexus, data, multi-sided business models, characterisation, and potential options to address the tax challenges of the digital economy. A supplementary report is expected by the end of 2015.