As the world becomes more and more reliant on technology and “the digital economy becomes increasingly the economy itself”, the OECD has tried to tackle head on the tax challenges the digital economy poses. As we discussed earlier this month, the final BEPS (Base Erosion and Profit Shifting project) recommendations suggest significant reforms to international taxation to account for the online and digital world we live in, as well as prevention of tax avoidance strategies that certain large multinationals use to reduce their tax bill.
In its “Action 1”, the OECD report has focussed on the Digital Economy. In doing so, it has taken a good look at our digital world and how that works, identifying the areas in which international tax issues arise within it. Whilst the report recognises that the digital economy does not create unique BEPS issues, some of its key features can increase BEPS risks and this report functions mainly as an umbrella to identify the issues discussed in other reports. All of the BEPS Actions 2-15 can be relevant for the digital economy but perhaps the most important are with regard to the controlled foreign company rules, transfer pricing and permanent establishment proposals.
Key features presenting BEPS risks
Key features have been identified in the report that gives some indication as to why BEPS is especially relevant to the digital economy. These are:
- Mobility of factors of production, especially intangibles, and of business functions and often products or users.
- Data reliance which allows better control of production processes and business routines, which in turn facilitate trade and reduce transaction costs.
- Network effects that have contributed to multi-sided business models such as search engines and app stores.
- Volatility due to rapidly evolving technology and lower barriers to entry to a market place.
These key features can currently be taken advantage of to reduce or eliminate tax in a multinational context, particularly by virtue of the mobility of intangibles, and digital intangibles in particular.
The potential for multinational groups to reduce taxation has also been magnified by the ability to fragment the physical operations of businesses within the digital world and hold central infrastructure away from a physical market place.
These concerns are not exclusive to the domain of tech, media and comms businesses, but they are prevalent within that sector.
So what does the OECD suggest for tackling these issues and what is the impact for tech, media and comms businesses?
- Permanent establishments (PE) – the PE definition in the OECD Model tax convention, used as a model for most double tax treaties, will be amended. Amendments will be made to prevent the use of certain arrangements that can enable a foreign enterprise to operate in another country without creating a PE and therefore a taxable presence. Such arrangements include commissionaires and the use of exemptions that were intended to apply to, and will now be expressly limited to, preparatory or auxiliary activities. In considering what would now give rise to a PE under the new definition, the OECD expressly provides the example of a large local warehouse with a significant number of employees that stores and delivers goods sold online to customers by an online seller of physical products. The proposed changes will make it harder for some multinational companies to avoid paying tax in certain jurisdictions.
- Transfer pricing – As we have discussed, intangibles, their creation and use in creating value and income are of great importance for businesses today, but particularly for those in the tech, media and comms sector. Companies will sometimes transfer intangibles or rights to intangibles to low tax jurisdictions and large allocations of income will be made to those companies holding the intangibles on the basis of contractual allocation, irrespective of whether they perform any business activity or take on any risk. The BEPS report on transfer pricing has looked at this situation in great detail and has proposed revisions to the OECD transfer pricing guidelines. These amendments revise the transfer pricing guidelines so that in respect of intangibles, legal ownership alone does not necessarily generate a right to significant income generated by the exploitation of an intangible. Again, the impact may be considerable for multinationals with complicated IP holding structures in low tax jurisdictions.
- Controlled Foreign Company (CFC) rules – The report highlights a common international issue, that income from digital goods and services provided remotely is often not subject to current taxation under the CFC rules. The BEPS report on the CFC rules has provided a proposed definition of CFC income that countries could incorporate in their domestic rules. The aim is to try and capture such “mobile” income and potentially prevent companies using deferral structures to permanently keep foreign income from ever being taxed in the jurisdiction in which the company is resident.
- VAT challenges – the collection of VAT is a challenge for all jurisdictions and is becoming more so as globalisation and the digital economy continues to grow. We saw in January 2015 the introduction of new rules in relation to e-services to collect VAT where the consumer is located not where the supplier is. The sale of physical goods still remains as the place where the supplier is located. The European Commission have also launched a consultation into the VAT rules with the aim of making them easier for businesses to deal with and administer. We wait to see how this consultation will work with the BEPS recommendations.
The OECD is very much alive to the fact that the digital economy is constantly changing and evolving and that any proposal for changes to the tax rules needs to be flexible enough to keep up with those changes.
Over the coming weeks we will bring you our further views on the BEPS reports. The UK Government has yet to comment on how it will take the BEPS proposals forward, but Spain and Italy have already begun to implement some of the proposals. The next few months will be of great importance for multinational companies and particularly those within the digital business sector.