Although discussions about how best to tax the digital economy are often so polarized that it sometimes seems difficult to imagine reasonable and consensus-based solutions, signs of progress are beginning to emerge.
That might largely be the result of increased U.S. willingness to adopt a more proactive leadership role in addressing the problems. The U.S. Treasury — which has consistently said there’s no such thing as a ring-fenced digital economy that deserves special tax rules — appears to be shifting its stance to acknowledge the need to address fundamental problems the digital economy poses to international tax rules. Recent statements by U.S. Treasury officials hint that the country might be willing to revisit basic concepts of the international tax system in light of broad global economic changes. The U.S. Supreme Court’s recent decision in South Dakota v. Wayfair Inc. , No. 17-494 (2018), might also nudge the United States to revisit the permanent establishment standard. And practitioners and academics are increasingly suggesting incremental measures that could still produce the changes needed to adapt international tax rules to a modern economy, indicating that there might be palatable options that don’t require a complete rewrite of the system.
At the same time, there’s been somewhat of an EU backlash to the European Commission’s proposed measures to tax the digital economy — particularly its proposal for a turnover tax on the revenues of digital companies. On July 12 the European Economic and Social Committee Plenary voted overwhelmingly in favor of a rapporteur opinion expressing concern over the effect of the commission’s proposal.
The combined willingness of the United States to seek more holistic solutions and the realization of many European countries that radical interim measures aren’t viable might lead to meaningful long-term change.
The Rejects
Before outlining some promising approaches, it’s worthwhile to consider some of the rejected proposals. Moving ahead will require walking away from them.
Taxation Based on Gross Revenue
The European Commission has proposed an interim digital services tax on revenues resulting from the supply of specific services by specific entities. The tax would be applied to revenues from the provision of services that rely largely on user value creation, where — according to the commission — the difference between where the profits are taxed and where the users are located is typically greatest.
The imposition of a gross revenue tax on digital services has raised many objections, including from within the EU. In its interim report on taxing the digital economy, the OECD highlighted many challenges posed by those kinds of taxes, noting that even an interim measure would increase the cost of capital, reducing the incentive to invest and harming growth.
Formulary Apportionment
In 2007 professors Reuven S. Avi-Yonah and Kimberly Clausing proposed adopting formulary apportionment in the international tax arena. They suggested calculating the U.S. tax base for multinational corporations based on the fraction of U.S. to worldwide sales, similar to the method used by many U.S. states. But using the U.S. states as a model for how to allocate income across jurisdictions is troubling because their methods are known to face numerous challenges.
Allocation based on sales is problematic in the international area for many other reasons. Questions regarding sales through intermediaries and how to determine the location of sale must be answered. Also, allocation based simply on sales doesn’t address the thorny problem of how to determine that a sale has taken place in a jurisdiction if the seller has no physical presence there. Commentators have asked how formulary apportionment can be reconciled with existing source rules and how it would properly match income with expenses incurred in developing the product sold (see Paul Oosterhuis and Amanda Parsons, “Destination-Based Income Taxation: Neither Principled Nor Practical?” Tax L. Rev. (forthcoming)).
Other proposals for unitary taxation, such as one by professor Sol Picciotto, have been raised. They would generally allocate a multinational’s profits based on a multifactor test that includes assets, labor, and sales, and would require global consensus on a method for calculating and allocating a group’s profits. None provides a mechanism for allocating losses, nor have any received wide acceptance.
Destination-Based Taxation
The destination-based cash flow tax has also been rather thoroughly debunked. The proposal, which would change the corporate income tax to a cash flow tax that would make it more similar to a consumption tax and incorporate principles of a destination-based tax much like most countries’ VATs, was included in the U.S. House Republicans’ 2016 blueprint for tax reform. Commentators raised serious concerns about the idea, with Michael Graetz referring to them as the “known unknowns.” He highlighted many problems, including the possible effect on the exchange rate, with likely consequential losses for U.S. holders of foreign assets; the potential effect on foreign sovereign holders of U.S. denominated debt; and the interaction with trade agreements and tax treaties.
The Future: Incremental Approaches
Rather than offer radical measures and wholescale rewrites, more recent proposals suggest that many of the concerns about digital economy taxation specifically and international tax rules generally could be addressed more incrementally.
A Non-Physical PE
One of the biggest challenges in taxing an online economy is that physical presence is no longer needed to establish strong customer relationships that will lead to a profitable business. That sales model isn’t easily reconciled with the PE standard found in virtually every tax treaty; treaties generally define a PE as a fixed place of business through which the business of an enterprise is wholly or partly carried on.
In its base erosion and profit-shifting project, the OECD never tried to answer whether the “fixed place of business” standard was the right threshold for imposing source-country-based taxation. The European Commission has proposed as a longer-term solution establishing a taxable nexus for online businesses based on a “significant digital presence.”
Although the U.S. Treasury declined to sign off on the proposed changes to the article 5 PE standard throughout the BEPS project, Treasury officials have recently seemed more open to revisiting the physical presence test, a good step toward bringing the international tax rules up to date.
That’s not to say that abandoning the current physical presence test in favor of one that acknowledges the high prevalence of remote selling will be easy. Precisely what standard should replace the current one is difficult to gauge. Once physical presence has been abandoned, establishing a threshold test for nexus becomes much more challenging, and attributing profits to a non-physical PE will be even harder. The OECD is still wrestling with how to write guidance for attributing profits to the revised PE standard developed as part of the BEPS project.
Wayfair reinforced the idea of moving away from a physical presence PE threshold. Although the case was about a retail sales tax in the wholly domestic context, the strong language used by the Supreme Court in rejecting a physical presence test will undoubtedly provide grounds for those wishing to do the same in the income tax area. In Wayfair, the Court said that its holding in Quill requiring physical presence before a state can impose a retail sales tax had “come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers.” It noted that avoiding physical presence that way “has become easier and more prevalent as technology has advanced.”
Revisiting Source Rules
In a recent presentation at the U.S.-China Tax Seminar in Shanghai hosted by the East China University of Political Science and Law and the University of Florida Levin College of Law, Pat Brown of General Electric Co. suggested a fresh look at the source rules, particularly for intellectual property. As Brown noted, current source rules treat all types of IP the same, while differentiating among types of IP transactions (for example, income from selling a product with embedded IP is sourced differently from income from licensing IP).
Brown suggested that the United States could go a long way toward addressing those meaningless distinctions — without having to completely rewrite the international tax rules — by changing the source rules to allow them to capture more of the tax on income derived from exploiting valuable IP in the country (the argument is that exploiting IP via a U.S. sale relies in part on the protection of U.S. law to protect the value of that IP). That kind of change may be more compelling for the value derived from marketing-based intangibles than from value derived from patents or copyrights.
Non-Arm’s-Length Standard
Others have proposed ideas that would involve a shift away from the arm’s-length standard. Bret Wells and Cym Lowell have argued that U.S. transfer pricing principles should require that cross-border payments from a U.S. payer to a related foreign entity be subject to a base-protecting surtax. They proposed that companies be exempt from the surtax if the U.S. payer agreed with the IRS — after evaluating the related parties’ income in light of the overall business and its U.S. functions and risks — that a lower or no base-protecting surtax was required. According to Wells and Lowell, the surtax would ensure that income earned by the U.S. payer, as well as its resulting domestic tax liability, represented an appropriate application of U.S. transfer pricing principles.
Wells and Lowell’s proposal was undoubtedly behind the base erosion surtax in the House tax reform bill introduced last November: Wells had testified on that kind of proposal before the Senate Finance Committee just a few weeks earlier. The failure of transfer pricing rules to adequately capture appropriate U.S. tax on U.S.-inbound sales was also undeniably the rationale behind new section 59A (the base erosion and antiabuse tax), which was enacted instead of the base erosion surtax proposed by Wells and Lowell.
BEAT has received widespread criticism, with even some of its proponents conceding that the difficulties regulators will face on implementation might be unsurmountable. But both BEAT and the base-erosion surtax proposal reflect attempts to use a more formulaic approach to allocate profits in some situations. Those proposals acknowledge the deficiencies of the transfer pricing rules but don’t suggest discarding them completely. Even if this version of BEAT is scrapped, some form of it is likely to remain.
A Holistic, Incremental Approach
In their forthcoming Tax Law Review article, Oosterhuis and Parsons argue that any approach should integrate all three of the above ideas: revising source rules, PE thresholds, and transfer pricing rules. Transfer pricing, taxable presence, and source rules would be modified to focus on assigning greater tax rights to the jurisdiction of ultimate sale to a customer. According to the authors, revising the international tax rules would be a way to mitigate base erosion and provide in the longer term for a more stable, long-term basis for allocating income among jurisdictions.
Oosterhuis and Parsons review a model that would incorporate rethinking treaty rules regarding income from royalties; treaties (which generally provide the residence country with sole rights to tax royalty income) often override the domestic source rule (which sources royalty income to the jurisdiction where the intangible property is used). According to Oosterhuis and Parsons, sourcing royalty income to the place of use acknowledges the benefits that country’s government provides in protecting the intangible property. “Attributing the net income of the royalty recipient to that taxable presence would not be inconsistent with the principles of taxing income based on source,” they write. “A strong argument can be made that the jurisdiction where the base of customers or network exists is a natural source for these intangibles.”
Like Brown, Oosterhuis and Parsons focus on the challenge of “bundled” transactions, asking whether the valuable intangibles embedded in property sold should be disaggregated to allow for a separate tax on their value. They consider whether the value of intangibles protected by the laws of a jurisdiction or relating to customers there could be sourced to the location where the intangibles are legally protected or where the sale to the customer takes place. Alternatively, sales to customers by sellers with at least some type of taxable presence in that jurisdiction could be treated as sourced there, or the income from those sales could be split between their imbedded intangible element and their physical transformation and functional element.
Once source rules have been revised to attribute some of the intangible value of a sale to the customer’s jurisdiction, the PE threshold must be addressed. Oosterhuis and Parsons consider whether changing the PE standard to something between the PE physical presence test and a pure economic presence test might make sense, and point to the U.K. diverted profits tax as an example.
Finally, the authors revisit transfer pricing methods to see whether there’s a better way to allocate value to a market jurisdiction. One idea they highlight is applying arm’s-length methods to allocate a routine return to tangible property, while allocating the residual profit to reflect the value of intangibles in excess of routine goodwill and going concern value.
In short, the authors conclude that some combination of general revisions to the source rules, taxable presence rules, and outsourcing model transfer pricing rules could lead to a more destination-based tax that’s still consistent with the principles of an income tax.
One might think that revising the international tax rules to allocate a greater share of taxing rights to market jurisdictions would receive support from countries such as China, which, like the United States, has a large market and could benefit from that change. But at the U.S.-China tax seminar where Oosterhuis discussed those ideas, participants from both China and the United States were less than enthusiastic about any destination-based proposals.
Conclusion
Measured approaches that can lead to an international tax system that reflects today’s economic realities are gradually gaining more attention. None provides an easy fix, and none is likely to be adopted as proposed, but it seems the right questions are beginning to be asked. Proposals that provide for incremental fixes rather than a total rewrite will likely be further refined to make them more workable.
The evolving debate over taxing the digital economy offers reasons for optimism that changes needed to adapt outdated rules to a rapidly changing economy can finally be developed and agreed upon.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu
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