Tatiana Falcão is a Brazilian lawyer specializing in international taxation and policy development. She was formerly at the secretariat of the United Nations, overseeing the work of the Committee of Experts on International Cooperation in Tax Matters, and is now a member of the Subcommittee on Environmental Taxation. She is also a founding member of the Women in Tax group (London) and an associate expert with the BEPS Monitoring Group.
In this article, the author discusses how to devise rules that can address the challenges of the digital economy.
The objective of the base erosion and profit-shifting project was to tackle the erosion of the tax base caused by aggressive tax planning. BEPS action 1 was not intended to open a forum to revisit the international tax framework on the digital economy. However, discussions about the new ways of doing business in light of digitization have started a debate that extends far beyond the mere restoration of traditional principles to tax stateless income.
Technological advances and digitization of the traditional ways of doing business have fundamentally changed the way businesses carry out their global activities and are posing new challenges to the international tax framework — a system devised almost a century ago, based on criteria that rely primarily on physical presence.
The digital economy is characterized by the ability of a multinational enterprise to be economically active in a particular country or region with little or no substantive physical presence, thus circumventing the rules that determine taxable presence. The challenge is thus to devise rules that can address the problems caused by the digitization of the traditional ways of doing business. Those rules should address both traditional and digital business models; observers concede that the digitization of business transactions should not be ring-fenced but instead absorbed as an integral part of the new normal.
The Recent Debate
The digitization of the economy has received wide attention from multiple stakeholders, particularly after the OECD announced its intention to produce by April an interim report about the effects of digitization. The drive to revisit the topic before the original 2020 deadline given in the 2015 BEPS action 1 final report seems to have come from other intergovernmental organizations. Particular attention should be given to the United Nations Committee of Experts in International Tax Cooperation work program, which made the topic a subject for consideration by the new membership, firmly putting the digital economy and its effect on developing countries high on the agenda for the coming years. The Committee of Experts’ decision to analyze the impacts of the digital economy on the application of tax treaties may have driven the OECD to produce its interim report.
The U.N. has been a quiet front-runner in this field. Away from the buzz surrounding the BEPS project, the U.N. Tax Committee approved the new version of the U.N. Model Taxation Convention Between Developed and Developing Countries (U.N. model), which introduces a new article 12A on fees for technical services. According to the (unpublished) U.N. model commentaries to article 12A:
Until the addition of Article 12A, income from services derived by an enterprise of a Contracting State was taxable exclusively by the State in which the enterprise was resident unless the enterprise carried on business through a permanent establishment in the other State (the source State) or provided professional or independent personal services through a fixed base in the source State. With the rapid changes in modern economies, particularly with respect to cross-border services, it is now possible for an enterprise resident in one State to be substantially involved in another State’s economy without a permanent establishment or fixed base in that State and without any substantial physical presence in that State. In particular, with the advancements in means of communication and information technology, an enterprise of one Contracting State can provide substantial services to customers in the other Contracting State and therefore maintain a significant economic presence in that State without having any fixed place of business in that State and without being present in that State for any substantial period.1
New article 12A provides a formal solution to a problem faced by many developing countries: domestic legislation foreseeing the application of withholding tax on payments of fees for technical services. The article acknowledges the practice and paves the way for an initial debate, which the Subcommittee on the Digital Economy can now expand on.
It has long been affirmed by institutional stakeholders (the World Bank, the IMF, and the U.N.) that base erosion and profit shifting is not a topic exclusive to the OECD. Despite having been conceived as a program by the OECD and mandated by the G-20, base erosion and profit shifting is a concern for all countries, so work flows should be developed at all levels, by all stakeholders.2
The rush to derive policy advice regarding the tax consequences of the digital economy is not confined to the work of intergovernmental organizations. In September 2017 the European Commission issued “A Fair and Efficient Tax System in the European Union for the Digital Single Market,” COM(2017) 547 final (the 2017 communication), on setting up a single EU digital market as a follow-up to the 2014 report issued by the European Commission’s Expert Group on Taxation of the Digital Economy. In October 2017 the commission issued a public survey based on the 2017 communication as a result of concerns that absent EU action, the single market would be fragmented by unilateral measures, hampering the EU’s competitiveness.
That concern is not without justification. In November 2017 the U.K. issued a position paper — also open for comments — on corporate tax and the digital economy, regarding its intention to issue a unilateral withholding tax on royalties.3 In December 2017 it issued a consultation paper on a proposed royalties withholding tax, adding to the array of unilateral measures.
Unilateral Measures
The BEPS action 1 final report did not recommend unilateral action to account for digitization, although it recognized it as a temporary action while countries await a long-term multilateral solution. Countries have resorted to equalization levies, diverted profits taxes, and withholding taxes on digital transactions to capture income from digital activity.
Australia, France, India, New Zealand, and the United Kingdom have already instituted taxes like those, and many other countries are considering unilateral action.4 The United Kingdom, the creator of the diverted profits tax, is also examining a royalties withholding tax for countries with which it does not have a tax treaty or with which it has a treaty that lacks article 24 on nondiscrimination.5 The objective of those taxes is to increase the country’s collecting ability despite other countries’ right to tax. Absent multilateral action to correct the unilateral application of those taxes, the taxpayer must resolve conflicts caused by the undue application of the taxes.
The main merit of those taxes is that they are relatively easy to administer, which is why they have become popular with governments. Their unilateral administration has so far met little resistance from the private sector, because many MNEs will simply pass the taxes directly to consumers through increased pricing.6 MNEs may therefore consider them tolerable, because they do not directly affect profits. They might affect market growth, however, if some countries impose higher withholding taxes than others, thus leading back to a tax competition scenario.
Unilateral measures should be seen as loophole-closing instruments. They can tackle tax competition, deter aggressive tax planning, and avoid the erosion of the tax base at a macro level. However, they generally tend to increase complexity and are unlikely to lead to a more stable tax system. They are only short-term fixes that do not address the core concerns of digitization.
Digitization has brought important changes to business models. It enables cross-border sales without the need for physical presence or for a fixed place of business as would be required under current PE rules. Although that had already long been the case for services, improvements in communications resulting from digitization have heightened the problem for goods.
The commentary to the 2008 version of the OECD model introduced the alternative services PE provision, extending the definition of a PE to include cases when services are provided in a source state for an extended time but are not provided through a single fixed place of business for a minimum period of six months.7 The OECD model has had to adapt to new ways of doing business over the years, and the digitization of business is one circumstance requiring policies to be rethought.
Source vs. Residence, Developing vs. Developed
This is the first time that the source versus residence split is not synonymous with a split between developing and developed countries, or between industrialized and emerging economies. The introduction of unilateral source-based taxes to tackle the digital economy is being led mainly by the same developed countries that tend to defend residence-based taxation.
That is an important part of the discussion, because the international tax community has an opportunity to redraft the framework as it should be, and not according to the predominant interests of countries that share similar economic status. The digitization of the traditional ways of doing business will affect other aspects of doing business, and therefore requires reframing the tax system to respect the principle that a multinational group’s profits should be taxed where the group generates value.
Paradigm Shift — Nexus and Substantiality
The challenge is how to align taxable profits with real economic activities and value creation in a digital economy. That would require establishing a new nexus for determining PE status based on maintaining a significant digital presence, while replacing the PE threshold concept with a significant digital presence test. Tax nexus and presence must be discussed simultaneously if there is to be a consistent remodeling of the international tax framework.
Nexus basically translates to the criteria identified to connect to a location the revenue generated by the MNE. A recent paper argues that the two best options would be to tax an MNE either at the shareholder or consumer level because individuals are much less mobile than the key elements of a multinational business and are unlikely to move to lower the MNE’s overall tax liability.8 I support focusing on the location of the customer base because where an MNE makes sales to third parties is likely to be the only real immovable element in its business. The location of the customer base also seems to be the principle driving the imposition of most unilateral taxes, despite reluctance by some tax administrations to adopt that as a criterion.9
The objective is not to tax companies that are incidentally doing business in a foreign country, but to tax those that are undertaking substantial economic activity while engaging with the consumer market, making use of the country’s local infrastructure, developing an interactive relationship with customers, or gathering data that can add value to the business. Those would be the main, noncumulative criteria suggested to identify significant presence.
In the BEPS Monitoring Group’s written submission to the OECD’s open consultation on the tax challenges of digitization, and in my personal involvement in the meeting, we suggested the following criteria for substantiality:
relationships with customers or users extending over six months, combined with some physical presence in the country, directly or via a dependent agent or any related-party service provider;
sale of goods or services by means involving a close relationship with customers in the country, including through a website in the local language, offering delivery from suppliers in the country, using banking and other facilities from suppliers or warehouses in the country, or offering goods or services sourced from suppliers in the country;
supplying goods or services to customers in the country resulting from or involving systematic data-gathering or contributions of content from persons in the country.
The goal of the above requirements is to capture situations in which the entity has a significant digital presence in the host country and to include the element of value added from systematic collection of data and contributions of content from persons in the host country.
Of utmost significance is the proposition made by India in its Finance Bill, 2018,10 that “clarifies” that “the significant economic presence of a non-resident in India shall constitute ‘business connection’ in India.” With that clarification, India proposes to insert a “significant economic presence” test,11 or to establish a nexus rule, into its domestic tax legislation. The memorandum explaining the Finance Bill, 2018,12 in fact elucidates that “the proposed amendment in the domestic law will enable India to negotiate for inclusion of the new nexus rule in the form of ‘significant economic presence’ in the Double Taxation Avoidance Agreements,” and that the rule will only apply to the treaties that are renegotiated to include a nexus rule.
It is remarkable how fast this subject is moving along. The OECD open consultation meeting took place on November 1, 2017. That was when the suggested criteria to define nexus and substantiality were first discussed with representatives from the tax administration. The Indian proposal was released on February 1, 2018, a mere two months after the open consultation meeting — and three months after the U.N. Committee of Experts meeting.
Valuation Concerns
A further concern is how to value transactions. If the content provided by the digital provider is free, and the revenues generated by those services derive from advertising (and from using data collected to tailor the advertising to a targeted audience), global methods will have to be used to attribute the income to a country.
At first glance, formulary apportionment could be regarded as the most adequate way to tackle valuation concerns, although getting developed and developing countries to agree to a single apportionment formula might be controversial. For that reason, perhaps the most adequate approach would be to adopt transitional measures to move toward formulary apportionment, such as strengthening the profit-split method of transfer pricing and formulating concrete allocation keys and weightings for common business models.
For companies that use the digital platform only to conclude sales (and not to generate value), the most likely option might be to establish a simple quantitative threshold, such as a minimum level of sales, assets, or employees within the country. That might be the best option for a technical digital database or an online retailer, for example, and would be easier to apply — but perhaps also easier to avoid. If the company engages in other value-creating activities, it might have to move up the policy spectrum to more complex valuation approaches.
Incorporating Proposed Changes Into a Treaty
The significant economic presence test can be incorporated into a tax treaty framework only by remodeling some of the international tax rules therein. To effectively implement those rules, so they can operate and correlate to all tax-related treaty provisions, it would be necessary to include a new article establishing the parameters for a digital PE. The commentary to that proposed article would explain when a digital PE would arise, provide examples, and direct the reader to article 7 to clarify the rules for profit attribution.
Article 7 and its commentary would then define a single method for attributing profits between the digital PE and the head office and provide consistency in the way countries tax income derived from digital activities where there is little or no physical presence in the source state. Consequential changes to other tax treaty articles would have to follow, as would changes to domestic tax legislation, to adhere to the new concept of a digital PE.
Conclusion
The digitization of the economy is likely to affect many of the other BEPS project work flows. Potential reform of the OECD model tax convention in light of the digitization of the traditional ways of doing business is likely to affect transfer pricing (BEPS actions 8, 9, and 10), how and when countries exchange tax information (BEPS action 13), and the PE concept (BEPS action 7). It could also provide a solution to the problems of double nontaxation (BEPS action 3) and source versus residence. Ultimately, a thorough reform of the international tax framework may require some reformulation of the multilateral instrument, discussed under BEPS action 15.
The OECD has published a report meant to guarantee the maintenance of the destination-based principle on application of the VAT in at least one jurisdiction. The objective of the report is to guarantee greater coordination on the application of VAT when trading on international goods or services, especially in light of the digital economy.
The OECD’s 2018 interim report is not likely to address any of the long-term measures touched on in this article. It is likely to suggest ways in which countries may coordinate their unilateral measures and stimulate greater cooperation between them. However, thorough, long-term reform of the international tax system is imperative and should observe states’ tax sovereignty.
FOOTNOTES
1 From the author’s files.
2 For an overview of the competences of intergovernmental organizations, see U.N. Inter-Agency Task Force on Financing for Development, “Financing for Development: Progress and Prospects, 2017” (2017), at “Chapter 2: Domestic Resolution Mobilization.” According to the graph, of the four stakeholders, only the U.N. and the OECD take it upon themselves to develop policy guidance (as an instrument of soft law).
3 HM Treasury, “Corporate Tax and the Digital Economy: Position Paper” (Nov. 2017). Also in November, the OECD held a public consultation at the University of California, Berkeley, on the “Tax Challenges of Digitalization,” which the author attended, representing the views of the BEPS Monitoring Group.
4 U.N., “The Digitalized Economy: Selected Issues of Potential Relevance to Developing Countries” (E/C.18/2017/6) (Aug. 8, 2017).
5 HM Revenue & Customs and HM Treasury, “Royalties Withholding Tax” (Dec. 1, 2017).
6 See the BEPS Monitoring Group’s submission on the OECD’s consultation on the “Tax Challenges of the Digital Economy” (drafted by Jeffery M. Kadet and Sol Picciotto, with contributions and comments from Attiya Waris, Tommaso Faccio, and Tatiana Falcão) (Oct. 17, 2017).
7 The U.N. introduced a services PE provision in the 1980 version of the U.N. model. Many tax treaties signed by non-OECD member countries contain a services PE provision based on article 5(3)(b) of the U.N. model. While the inclusion rate of the service PE provisions in tax treaties has increased since its introduction in the 1980 U.N. model, more than half of the tax treaties in force in 2013 signed by at least one non-OECD member country do not contain the provision. In treaties between OECD member countries, the inclusion of the U.N. model service PE provision remains exceptional.
Article 5(3)(b) applies only if a nonresident enterprise performs services in the source state for at least 183 days. Among the tax treaties incorporating the provision, there is significant deviation in the time period, ranging from 30 days to 18 months. Most tax treaties, however, incorporate the suggested 183 days test (2011 U.N. model) or the six months test (1980 U.N. model).
8 Michael P. Devereux and John Vella, “Implications of Digitalization for International Corporate Tax Reform,” WP 17/07, Oxford University Centre for Business Taxation, Saïd Business School (July 2017).
9 See, e.g., HM Treasury, supra note 3, at paras 2.4 to 2.9, which argues that customer location should not be the only factor in determining a country’s right to tax. However, paras. 4.17 and 4.18 argue for extending the U.K. withholding tax and for taxing the profits multinational groups make from selling products and services to U.K. customers if those profits have been transferred to an entity in a low-tax country that has ownership of the group’s intangible assets. HM Treasury thus cites BEPS as a reason to use customer base to impose a unilateral digital-based tax. It does not define the threshold for no or low tax.
10 Indian Ministry of Finance, Finance Bill, 2018, Chapter 3 (Direct Taxes), Clause 4 (Amendment of Section 9), Explanation 2A, at 7.
11 According to the Finance Bill, 2018, it is proposed that “significant economic presence” shall mean, for domestic Indian legislation purposes:
(i) any transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India if the aggregate of payments arising from such transaction or transactions during the previous year exceeds the amount as may be prescribed; or
(ii) systematic and continuous soliciting of its business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means.
Although the proposition is indeed laudable — India is the first country in the world to suggest a significant economic presence test, and hence to try to unilaterally identify a long-term solution to the problem derived from the digitalization of businesses — the text fails to identify the criteria for attribution of the income. The memorandum explaining the Finance Bill, 2018, oversimplifies this issue by stating simply that “only so much of income as is attributable to such transactions or activities shall be deemed to accrue or arise in India.” The amendment will take effect from April 1, 2019, and will apply to all transactions or activities considered to have a significant economic presence in India, regardless of whether the nonresident has a residence or place of business in India or renders services in India.
12 Indian Ministry of Finance, Memorandum Explaining the Finance Bill, 2018, “‘Business Connection’ to Include ‘Significant Economic Presence’” (explanation to Clause 4), at 8.
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