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By Lowtax Editorial, 09 May, 2014
Countries all over the world are becoming increasingly concerned that their outdated tax systems are failing to keep pace with rapid developments in technology and business practices which are eroding traditional principles of taxation like residence and permanent establishment and allowing multinational companies in many instances to legitimately reduce their exposure to tax, sometimes substantially. At a time when tax revenue is at a premium as governments scramble to reduce budget deficits, some revenue authorities are fighting back, for example by using tougher anti-avoidance laws or by subjecting taxpayers to more frequent and aggressive transfer pricing audits. However, in recognition of the fact that there is a limit to what can be achieved by individual nations to force multinationals to pay more tax, and encouraged by increasingly negative coverage of corporate tax affairs in the mainstream press, the G20 and the OECD have resolved to tackle this issue, and the BEPS project (base erosion and profit shifting) was created in 2013.
Addressing Base Erosion and Profit Shifting
On February 12, 2013, the OECD released its preliminary report on the problem of BEPS, which contained a series of observations about current shortcomings in the international tax system, and reaffirmed its view that current international tax standards have been left behind by changes in global business practices, especially with regards to companies which have a large presence on the internet, but a small physical presence on the ground and in the area of intangibles generally. The fact that it is possible to be heavily involved in the economic life of another country, for example by doing business with customers located in that country via the internet, without having a taxable presence there or in another country that levies tax on profits, was noted repeatedly in this report.
Domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterised by a lower degree of economic integration across borders, rather than todays environment of global taxpayers, characterised by the increasing importance of intellectual property as a value-driver and by constant developments in information and communication technologies, the report states.
Among its conclusions, the report said that, in addition to a need for increased transparency on effective tax rates of multinational entities, key pressure areas include those related to the application of treaty concepts to profits derived from the delivery of digital goods and services.
The BEPS Action Plan
Although the Addressing BEPS report acknowledged that cross-border businesses may suffer as a result of badly constructed international tax rules which can result in the double taxation of income, the BEPS Action Plan produced by the OECD in July 2013 for the G20 dealt more with the question of how to stop the double non-taxation of multinationals income occurring in the future.
The Action Plan identifies 15 specific actions needed in order to equip governments with the domestic and international instruments to address the challenge of BEPS. Action 1 deals specifically with the tax challenges associated with the digital economy, although many parts of the Action Plan have relevance to the digital and e-commerce realm in by tackling such issues as abuse of permanent establishment status and the transfer pricing of intangibles, among others.
The introductory text to Action 1 observes that: BEPS is a concern in the context of the digital economy. The actions will help address these concerns.
However the report goes on to note the existence of specificities that need to be taken into consideration.
This will require a thorough analysis of the different business models, the ever-changing business landscape and a better understanding of the generation of value in this sector, the document states. Moreover, indirect tax aspects should also be considered.
According to the report, Action 1 itself aims to: Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation.
It goes on to state that: Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.
OECD Consultation and BEPS Discussion Draft on the Digital Economy
In November 2013, the OECD launched a public consultation seeking input from businesses concerning the taxation of the digital economy as part of the BEPS project. The consultation sought general comments on Action 1, but also requested answers to a set of specific questions related to business models employed in the digital economy and how new technologies have impacted these models. These questions included the location in which value is created or monetized; what challenges are encountered when attempting to establish the location and extent of tax liability; and how business models and supply chains may evolve in the future due to advances in information technology.
Responses to the consultation fed in to the Discussion Draft published by the OECD on March 19, 2014, entitled Tax Challenges of the Digital Economy.
From a strategic point of view, the OECD says, the digital economy enables multinational companies to reduce not only corporation taxes, but also a wide range of other taxes, such as consumption taxes, payroll taxes, real property taxes, and environmental taxes. The Draft therefore highlights distortions to competition between digital economy businesses and the rest of the economy.
Four main policy challenges were identified in the 81-page Draft:
The report points out that the revenue that could be generated from taxing digital goods and services is enormous. According to the draft, the value of business-to-consumer (B2C) e-commerce sales alone is expected to have increased by 18.3 percent in 2013, to USD1.3 trillion. During the year, Asia-Pacific surpassed North America as the top market for B2C e-commerce sales. Nevertheless, the discussion draft points out that at the moment B2C e-commerce represents a small fraction of overall e-commerce, which mainly consists of business-to-business (B2B) transactions.
Global B2B e-commerce, particularly among wholesalers and distributors, was estimated to be approximately US12.4 trillion in 2012. According to other estimates made by the International Data Corporation, the size of total worldwide e-commerce, when global B2B and B2C transactions are added together, equated to USD16 trillion in 2013.
As regards the indirect tax consequences of cross-border digital sales, the discussion draft says the implementation of Guidelines 2 and 4 of the OECD's "Guidelines on place of taxation for B2B supplies of services and intangibles" would minimise BEPS opportunities for supplies of remotely delivered services made to exempt businesses, including exempt businesses that operate through establishments in multiple jurisdictions (multiple location entities, or MLEs).
Guideline 2 recommends that the taxing rights on cross-border supplies of services and intangibles between businesses be allocated to the jurisdiction where the customer has located its main business establishment, and that business customers be required to self-assess VAT on remotely delivered services acquired from offshore suppliers according to the rules of the jurisdiction in which they are located.
Guideline 4 provides that when a supply is made to a business that is established in more than one jurisdiction, taxation should accrue to the jurisdiction where the customer's establishment using the service is located. These Guidelines set out the possible mechanisms for tax authorities to achieve the desired result in practice, which is allocation of the right to levy VAT on B2B services to the jurisdiction where these services are used for business purposes irrespective of how the supply and acquisition of these services was structured.
The OECD published the responses to its discussion draft on April 16, and generally speaking, the business response to the OECDs ideas on addressing the tax challenges of the digital economy has been negative. Many respondents warned that the proposals would mark a substantial shift from the current international tax system and could create a more confusing situation than the one at present. Others warned that if brought about, such changes could significantly disrupt investment and growth in the digital economy, particularly for small firms and start-ups,
On the OECD's proposal of establishing a new nexus based on 'significant digital presence,' the Chartered Institute of Taxation (CIOT) said: "A direct tax on profit attribution based on sales, which is what the 'New Nexus based on Significant Digital Presence' represents, goes against principles that value is created where a product is created, not simply by a market for that product; it would be a fundamental - and, in our view, inappropriate - shift in the international tax system."
"A system based on a New Nexus based on Significant Digital Presence would also be very complex to administer and substantially increase compliance costs for business through increasing the number of returns required and the complexity of attributing profit to various jurisdictions," CIOT added.
Similar are the views of KPMG's Global International Tax Services Group, which thinks that a new nexus based on significant digital presence "should not be pursued as it is impractical and opens the door [to] significant risk[s] of double taxation."
In a separate response, the Confederation of Indian Industry warned that: "Such broad factors/interpretation may also create PEs of the MNEs in every country on account of significant advertisers and end-user presence."
Commentators also expressed concerns about allocating tax rights in the location where a website is hosted, especially in cases where a company's profit-making site is hosted by another company based in another jurisdiction. Krister Anderson, Head of the Tax Policy Department at the Confederation of Swedish Enterprise, opined: "There is no jurisdiction for a country to tax income where there is no physical nexus to that country."
Paul Dillon, Chairman of the Consultative Committee of Accountancy Bodies-Ireland (CCABI), warned: "All of these proposals are unacceptable as they represent a fundamental change to taxation of the profits of companies by aligning the taxation of company profits away from where value is created to locations where products are sold."
While referring to the OECD's suggestion of imposing withholding tax on digital transactions, KPMG's Global International Tax Services Group commented: "Many of the enterprises offering digital goods and services are either loss-making or generating relatively low margins that would not support a final gross basis withholding tax."
In its discussion draft, the OECD had also requested public comments about the possibility to ring-fence the digital economy from the rest of the economy, and, if not, whether specific types of digital transactions could be identified and addressed through specific rules.
In this regard, the Confederation of British Industry said that: "Every traditional business will be 'digital' at least to some extent and every digital business will be 'traditional' at least to some extent. It is not practical to identify a clear dividing line between digital and non-digital business activities."
"It is also impractical to identify specific types of digital transactions for the purpose of applying a special set of rules. Any such attempt is likely to result in uncertainty and difficulty at the boundary, and give rise to complexity and compliance cost," it added.
W J I Dodwell of Deloitte argued along similar lines that: "Due to the nature of the digital economy, including the rapid pace of change of technology and the effect these changes have on a wide variety of international businesses in different sectors in different ways, we do not think it is possible to ring-fence the digital economy."
In its response to the Discussion Draft, AmCham EU, which represents US business operating in the European warning, sounded a number of warnings about the direction in which the OECDs proposals were travelling. AmCham EU believes that some options proposed by the OECD draft report raise concerns that could hurt the economy itself or reflect a fundamental misunderstanding of the digitalised economy, the organization stated.
The Future: Deliverables
The BEPS Action Plan anticipates that the 15 actions will be finalised in three stages: September 2014, September 2015 and December 2015. An in-depth report identifying tax challenges raised by the digital economy and the necessary actions to address them is scheduled to be released by the first of these three dates. Since the OECD wants the BEPS project wrapped up by the end of next year, this will leave just over a year for some potentially fundamental tax changes to be implemented across the world.
Even the OECD admits that its chosen timetable is extremely ambitious. Some might say it is impossible. Indeed, many tax executives at many US multinational companies do not believe the OECD has allowed adequate time to accomplish the plans goals, according to a recent survey.
The survey of 220 US senior tax professionals by KPMG, which was conducted prior to the firms Cross-Border Tax Conference in Miami on May 6-8, revealed that 64 percent of respondents think that the OECDs 24-month timetable was not sufficient to address concerns regarding profit shifting or double non-taxation and provide a level playing field among tax systems and taxpayers. Only 21 percent were positive on the issue of timing.
Nevertheless, while tax leaders may be sceptical about the OECDs bold timelines for BEPS, the reality is that with the significant political demand for immediate action, the deadlines are not likely to change.
As Manal Corwin, national leader of KPMGs International Tax practice observes: Corporate tax departments need to engage with the OECD and policymakers on the specifics, keep a sharp focus on the potential compliance implications, and anticipate the impact of likely changes on their global operations.
Because, in short, the BEPS project isnt going to go away anytime soon.