OECD summarises options for addressing the tax challenges of the digital economy

Tax Policy Bulletin
Tax Insights from International Tax Services
OECD summarises options for
addressing the tax challenges of the
digital economy
26 March 2014
In brief
The discussion draft released by the OECD confirms the view that tax measures designed exclusively for
the digital economy are likely to prove problematic, primarily because of the difficulties in identifying a
specific “digital” sector. Rather, the potential use of modern information and communications
technology by all businesses seems to raise “digital” tax issues. Nonetheless, the OECD clearly believes
that the perceived weaknesses in the territorial tax system and the international tax rules as a whole as
require change in the tax rules in order to cope with modern business practices.
The OECD’s Task Force on the Digital Economy was established in September 2013 under Action Plan
item 1 of the Base Erosion and Profit Shifting (BEPS) project. Its remit was to consider the taxation
issues arising from digital business and to identify potential measures to remedy any shortcomings,
considering both direct and indirect tax options. Widespread concern with the question of whether the
existing international tax rules have kept pace with the emergence of new business models enabled by
the rapid development of information and communication technology was a key driver behind the BEPS
Action on the Digital Economy.
The relatively lengthy discussion draft underlines the difficulties of identifying ready solutions to the tax
challenges of digital business. Nonetheless, by reference to the discussion draft’s own terms, it will be
important for any potential solutions to satisfy the neutrality principle. As the discussion draft states,
“ring-fencing the digital economy as a separate sector and applying tax rules on that basis would be
neither appropriate nor feasible.” Inevitably, this will be a challenge to the extent that any solutions are
designed for digital business alone. This suggests the OECD might seek to address the tax challenges of
the digital economy largely through the other BEPS workstreams. A revised version of this report is
likely to cross-reference how proposals potentially affecting broader types of business could have an
impact on the digital economy.
In detail
The discussion draft includes
some extensive background
discussion of the development
of the digital economy
including emerging and
possible future developments.
It also discusses the spread and
impact of information and
communication technology
across the economy, provides
examples of new business
models and identifies the key
features of the digital economy.
The draft then provides a
detailed description of the core
elements of BEPS strategies in
the digital economy and
discusses how the development
of measures envisaged in the
BEPS Action Plan and the
OECD work on indirect
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taxation are expected to
address them. Finally, it
identifies the broader tax
challenges raised by the digital
economy and summarises the
potential options to address
them that have been presented
to, and initially discussed by,
the OECD Task Force.
The discussion draft raises a
number of detailed questions
(relating to direct and indirect
tax) on which comments are
sought.
Unlike the other BEPS
workstreams, in the OECD’s
work on the digital economy
there is a significant focus on
VAT/ GST. In this context,
there seems to be a clear
consensus that, for digital
services, the place of taxation
should be based on the place
where the consumption occurs.
However, in order to
determine where taxation
should arise, there must be an
agreed proxy to determine that
location. It is also necessary to
identify who is liable to
account for the tax due and the
mechanisms to simplify
compliance and payment of the
tax due. These are the main
VAT/ GST issues that the draft
seeks to address.
Areas of concern to
the OECD
The discussion draft notes that,
in connection with direct
taxation, the common features
of tax planning that raise BEPS
concerns are:

minimisation of tax in the
source country either by
avoiding a taxable
presence or by maximising
deductions where there is
such a presence,

low or no withholding tax
at source,

low or no tax at the level of
the recipient, and

no current taxation of lowtax profits at the level of
the ultimate parent
In relation to VAT, the areas of
BEPS concerns are stated to be
VAT avoidance or reduction by
the use of:

remote digital supplies to
business in a jurisdiction
giving full deduction rights
with internal (branch to
branch) recharge to an
exempt business, and

underdeclared VAT on B²C
supplies,

understatement of value of
low value imports –
inappropriate use of
thresholds.
Approach to tackling
BEPS in the digital
economy
The discussion draft indicates
at a general level how the
OECD’s work on BEPS is
expected to address direct and
indirect taxation in the digital
economy. In relation to direct
tax, the main goal is to restore
taxation on what is described
as “stateless income” and this
is expected to be delivered by
various measures including on
treaty abuse, hybrids,
permanent establishments,
CFC rules, (including the
possibility of anti-inversion
rules) etc. This discussion
reinforces the view that the
OECD is increasingly seeing
the response to the challenges
raised by the digital economy
as a part of its BEPS package as
a whole, rather than as
exclusively the product of a
separate work stream on digital
business. Nonetheless, the
draft does also contain some
specific proposals which arise
out of the work of the Task
Force on the Digital Economy.
Options to address the tax
challenges of the Digital
Economy
Five options have been
specifically considered by the
Task Force and these are
discussed below. In assessing
these possible options, it is
clarified that regard should be
had to the “Ottawa Principles”
which were developed at the
time of 1998 OECD Report,
Electronic commerce: Taxation
Framework Conditions. These
principles consist of five
criteria – neutrality; efficiency;
certainty and simplicity;
effectiveness and fairness; and
flexibility.
The five specific options
proposed in the OECD paper
are:

modifications to the
exemption from PE status,

the creation of a
“significant digital
presence” PE,

varieties of a “virtual”
presence PE,

withholding tax on digital
transactions, and

consumption tax options
Modifications to the
exemptions from PE
status
Several variations are proposed
on changes to the exemptions
from PE status for various
items of a preparatory or
auxiliary nature (Article 5,
paragraph 4 of the Model Tax
Convention).
One option would effectively
remove all those exemptions
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except the one relating to the
maintenance of a fixed place of
business solely for the purpose
of carrying on, for the
enterprise, any other activity of
a preparatory or auxiliary
character.
A second option would be to
remove all the exemptions.
A third option would relate to
the following existing
exemptions in the current Art
5(4):

the use of facilities solely
for the purpose of storage,
display or delivery of goods
or merchandise belonging
to the enterprise,

the maintenance of a stock
of goods or merchandise
belonging to the enterprise
solely for the purpose of
storage, display or delivery,

the maintenance of a stock
of goods or merchandise
belonging to the enterprise
solely for the purpose of
processing by another
enterprise, and

the maintenance of a fixed
place of business solely for
the purpose of purchasing
goods or merchandise or of
collecting information, for
the enterprise
Under this option, all of the
above exemptions would be
available but only if the overall
character of the activity
conducted is preparatory or
auxiliary in nature, (and not
one of the core activities of the
enterprise).
Observation: In the context of
the issues raised by digital
business, etc. the report
suggests revisiting the
borderline between what is to
count as crossing the PE
threshold rule and what is
treated as not creating tax
nexus for the purposes of the
rule because of the potential
for the digital economy to
penetrate a market with
minimal physical presence.
This would presumably be
relevant to some (but probably
a limited number of) digital
businesses e.g. those carrying
out marketing activities, etc.
but the proposed change
would, potentially have a more
significant impact on wider
business.
The creation of an
‘economic presence’ PE
where a business includes
‘fully dematerialised
digital activities’ and such
activity in a territory
amounts to a ‘significant
digital presence’
A new nexus is proposed based
on a significant digital
presence for an enterprise
engaged in ‘fully
dematerialised digital activity’.
Two alternative proposals are
put forward, one based on the
use of personal data obtained
from users in the country and
the other based on other
elements of the business
model.
The discussion draft indicates
that there might be a test for
determining the nature of a
‘fully dematerialised digital
activity’. At the moment, only
possible elements of such a test
are considered in the draft.
Taking one example from the
eight possible options that are
included, it is suggested that
this approach could apply to a
core business that comprises
digital goods and/or services,
to which a substantial
proportion of profits can be
attributed. There could be
some physical activities (e.g.
systems maintenance) but
these would be incidental, and
most of the business
operations, including contracts
and payments, would be
carried out digitally or
remotely. One alternative
suggestion for when a
‘significant digital presence’
might be found is intended to
apply to a digital business
carrying out significant
business in Country A using
personal data collected from
the internet activities of
individuals in that country. The
discussion draft suggests that it
would require the use of data
obtained by regular and
systematic monitoring of
internet users through the use
of multi-sided business
models. Country A would use
the nexus to tax profits arising
from the use of that data.
The other alternative for
determining a ‘significant
digital presence’ relates to
other elements of the business
model of a digital business.
Again, only examples are
suggested. Included in this list
of four examples is the
situation of a branch in
Country A offering secondary
functions such as marketing
and consulting strongly related
to the core business of the
enterprise. The other examples
relate to the remote signature
of contracts with customers in
Country A; use and
consumption of digital goods
or services in Country A; and
substantial payments from
customers in Country A in
connection with the provision
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of goods or services in Country
A as part of its core business.
Observations: This seems
largely a different version of
the same question that arose a
number of years ago with
respect to business models
arising from the use of radio,
television, and mail-order. The
conclusion has long been that
merely selling into a market
without physical presence or a
dependent agent within the
market is not sufficient to
create a permanent
establishment allowing that
country to claim a share of the
enterprise’s profits. This would
be a substantial departure from
those principles. From a
technical perspective, one
might reasonably conclude that
there is nothing unique to
doing business in the digital
economy that should change
that conclusion, but the
magnitude of tax at stake as a
result of the application of
these principles to the digital
economy is such that the
OECD appears to be suggesting
that they may need to be
reconsidered.
A related question is whether
the mere fact that a market
(but no commercial activity of
the vendor) is located in a
particular country should allow
that country to consider that it
may tax a share of the profits of
the enterprise therefrom. That
idea was previously rejected on
the basis that the value
creating activities take place at
the location of production, not
the location of consumption, so
this would be another very
major shift in approach.
As these comments indicate
and notwithstanding the
difficulty in determining what
constitutes ‘significant
business’, the real issue is how
“profits arising” would be
measured. The ideas proposed
in the OECD draft effectively
represent a new threshold
concept. The discussion leaves
open the question as to how
the proposals could be
reconciled with the guidance
on Article 7 (profit attribution)
in respect of which it has
already been acknowledged
that attributing profits to a PE
is one of the most conceptually
difficult and practically
complex issues in international
business taxation.
In particular, in considering
the attribution of value to data,
there are differing views about
how the value really originates.
Is the value in the data itself or
the processes used to collect,
analyse and use that data? The
existing rules operate on the
basis that “value” resides in the
activities that create value from
data, and profits should be
attributed to the locations in
which they occur.
There are a number of terms
and concepts used in the
personal data alternative which
are not yet defined and this
raises additional questions as
to the viability of this proposal.
Alternative
thresholds based on
other “virtual” PE
concepts
The discussion draft notes the
options for alternative PE
thresholds proposed over the
years by the Business Profits
Tax Advisory Group (TAG):

a virtual fixed place of
business PE,

a virtual agency PE, and

an on-site business
presence PE.
However, it states that these
are included “only for the sake
of completeness”.
Observation: It is unclear
whether ‘for the sake of
completeness’ means that they
are not proposing to take
forward these suggestions at
this time. That does seem to be
the logical inference but in any
event seems to reflect a lack of
enthusiasm for these
alternatives. Many of our
comments above regarding
economic presence PE are also
relevant to virtual PEs. For
example, merely selling into a
market without physical
presence or a dependent agent
has not been sufficient to
create a PE, and this has been
true long before the advent of
the digital economy.
Withholding tax on
digital transactions
Under current permanent
establishment rules it is
possible for an e-commerce
provider to undertake
substantial economic activity
in a territory in which it has no
physical presence, without
being taxed there. It is
proposed that certain
payments made by residents of
that territory to such providers,
for digital goods or services, be
subject to a final withholding
tax.
Observation: The broad
international consensus for
some years has been to try to
minimise or eliminate
withholding taxes because
taxes imposed on gross income
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do not take into account
profitability and can act as a
deterrent to international
commerce by making
expansion across borders
unprofitable. Additionally, an
important potential collateral
impact is that withholding tax
could be imposed on broad
categories of “conventional”
commerce that previously were
not subject to withholding tax,
for example, payments for
software products, music discs,
movies, which are all digital
products. This illustrates the
potential collateral impact of
rules designed for a specific
targeted industry. In addition,
as noted in the report, there
are various considerations that
would need to be considered in
relation to this proposal, such
as trade obligations, and the
practicalities of collecting such
a tax, especially in the case of
individual customers, would be
highly challenging.
Clarification would also be
needed as to which payments
would be subject to the tax,
and whether the decision for
this, and the rates of tax, would
be at international or local
territory levels. The interaction
with indirect taxes may also be
a factor, as would double
taxation relief in the territory
where the profits are taxed.
Finally, many of the issues
revolving around revenue
characterisation of
transactions in digital products
and services are not new and in
fact have been discussed in
OECD guidance dating back
more than a decade.
Removing VAT
exemptions on the
import of low value
goods
To reduce administration and
compliance costs, many
jurisdictions operate a VAT
exemption on the import of low
value goods. The levels of such
imports have grown
exponentially in the digital
economy. The discussion draft
states that many tax authorities
would benefit from the review
of these thresholds, and that
improving the efficiency of
their collection mechanisms
could help them to lower the
threshold and increase the tax
revenues generated.
Observation: Collection is
again noted as an issue for
further consideration, with the
suggestion that the onus could
be on non-resident suppliers to
register in the importing
territory and be liable for
charging, collecting and
remitting the tax due on the
goods they supply. Whether
this would apply to all low
value goods and to all
recipients, remains to be seen.
VAT on remote digital
supplies to consumers
With several countries having
announced proposals for the
VAT registration of nonresident e-commerce suppliers
making sales in their
territories, but where there is
no economic benefit to that
territory, the OECD recognises
that these requirements are
likely to be administratively
onerous for both suppliers and
tax administrations. The
recommendation is that
countries should consider the
introduction of simplified
registration schemes and
thresholds to minimise the
compliance burden, and that
countries should improve
international co-operation and
information-sharing to
facilitate the enforcement of
tax collection and audits.
Observation: With similarities
between this proposal and that
for low value imports, there is
scope to combine both of these
proposals, especially with the
import element being key to
the identification of
transactions having taken
place, to the extent that these
are physical. The supply of
services would need careful
consideration. Other areas for
clarification include the
specifics of what and who
might be excluded from such
VAT.
The takeaway
The immediate impression
from the OECD paper is that of
the difficulty in devising viable
tax responses in this area.
For the most part however,
those suggestions that seem to
be predicated on the idea that
digital businesses can be
separated from other
businesses are likely to prove
inherently problematic and
also likely to have an impact
appreciably wider than their
intended targets. In our view,
any proposed rules should
maintain the principle of
neutrality and not single out
particular industries for
differential tax treatment.
Further, it does not seem
possible to define a “digital
business” in a way that could
not, potentially, apply to
virtually any business. As
stated in the discussion draft:
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“As digital technology is
adopted across the economy,
segmenting the digital
economy is increasingly
difficult. In other words,
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. Attempting to
isolate the digital economy as
a separate sector would
inevitably require arbitrary
lines to be drawn between
what is digital and what is
not.”
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