Organisation for Economic Co-Operation and Development (OECD) Issues Final Report on Action Item 1: Addressing the Tax Challenges of the Digital Economy
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The Organisation for Economic Cooperation and Development (OECD), a non-governmental forum established to promote economic growth, has developed a 15-point action plan to shape “fair, effective and efficient tax systems.” The OECD’s project regarding Base Erosion and Profit Shifting (BEPS) has addressed issues arising from tax planning strategies that exploit gaps or mismatches in member countries’ tax rules.
This tax alert is one installment in a series of alerts on the release of the OECD/G20 Base Erosion and Profit Shifting Project (the BEPS Project).
On October 5, 2015, the OECD released the final report (the “Report”) of the BEPS Project. This alert discusses Action Item 1: Addressing the Tax Challenges of the Digital Economy.
Background and Details
In an effort to address BEPS issues in a coordinated and comprehensive manner, the G20 finance ministers called on the OECD to develop an action plan to equip countries with instruments that will better align tax with economic activity. Action Item 1 specifically addresses the digital economy which, to a large extent is the genesis of the BEPS Project. In particular, the rise of “stateless income,” which prompted many countries to join in the OECD-led effort, is perceived to be directly related to the digital economy. It is no accident that the report on Action Item 1 is about taxing the digital economy.
A fundamental challenge is that the digital economy’s transaction structures and income streams do not fit neatly into the longstanding tax concepts and rules that have evolved over the past century of the traditional economy’s flows of tangible goods and personal services. The difficulties facing the Action Item 1 working team are illustrated by the fact that earlier draft reports from the BEPS Project included no concrete recommendations for taxing the digital economy – only considerations for further discussion.
The primary conclusion reached in the final report is that “the digital economy is increasingly becoming the economy.” The key players in the digital economy are not just a few high profile technology companies from Silicon Valley, but rather a large and growing number of ordinary consumers and traditional “bricks and mortar” businesses that actively participate in the digital economy on a daily basis.
A direct implication of this conclusion is that it becomes difficult, if not impossible, to ring-fence, i.e., to propose tax rules that apply just to the digital economy. The digital economy tends to exacerbate the risks addressed by the BEPS Project rather than present unique risks that require unique rules. Therefore, the tax rules applied to the digital economy should be the same tax rules that apply generally.
Accordingly, the report on Action Item 1 includes limited recommendations specifically directed at the digital economy. The orientation is that every action item applies to the digital economy – rules relating to permanent establishments, treaty shopping, transfer pricing, controlled foreign companies (“CFCs”), and information reporting. The real impact of the BEPS Project on the digital economy will be a function of how all of the action items are implemented and administered, rather than the application of Action Item 1 on a standalone basis. The report on Action Item 1 does provide some insight on how the other action items can address the issues raised by the digital economy, including the following:
- Revised definitions of tax nexus (see the report on Action Item 7: Preventing the Artificial Avoidance of Permanent Establishment) are viewed as a critical first step to be taken in appropriately addressing BEPS issues, including the digital economy.Specifically, there are recommendations to modify the exceptions to permanent establishment status in order to ensure that they are available only for activities that are preparatory or auxiliary in nature, along with new “anti-fragmentation rules” to prevent the avoidance of tax nexus by the fragmentation of business activities among closely-related enterprises.There are also recommendations to address circumstances in which artificial arrangements relating to the sales of goods or services of one company in a multinational group effectively result in the conclusion of contracts, such that the sales should be treated as if they had been made by that company. For example, where the sales force of a local subsidiary of an online seller of tangible products or an online provider of advertising services habitually plays the principal role in the conclusion of contracts with prospective clients for products or services, and these contracts are routinely concluded without material modification by the parent company, this activity would result in a permanent establishment for the parent company.
- Revised transfer pricing rules and related information reporting requirements (see the reports on Action Items 8 through 13) clarifying that legal ownership alone does not necessarily generate rights to the returns generated by the exploitation of the intangible. Instead, the entities performing the important functions, contributing the important assets, and controlling economically significant risks, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return. The report also noted that specific guidance will ensure that the transfer pricing analysis is not weakened by information asymmetries between the tax administration and the taxpayer in relation to hard-to-value intangibles, or by using special contractual relationships, such as a cost contribution arrangement.
- Strengthened rules for taxing controlled foreign companies (see the report on Action Item 3: Designing Effective Controlled Foreign Company Rules) to prevent ultimate parent companies from inappropriately avoiding home country tax on digital economy-related profits arising in CFCs.
The report on Action Item 1 also notes that the collection of value-added tax (“VAT”) and goods and services tax (“GST”) on cross-border transactions, particularly those between businesses and consumers, is an important issue. Countries are thus recommended to apply the principles of the OECD’s International VAT/GST Guidelines and consider the introduction of the collection mechanisms included therein.
None of the other options analyzed by the report on Action Item 1, namely (i) a new nexus in the form of a significant economic presence, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalization levy, were recommended at this stage. The report states that this is because, among other reasons, it is expected that the measures developed in the BEPS Project will have a substantial impact on BEPS issues previously identified in the digital economy; that certain BEPS measures will mitigate some aspects of the broader tax challenges; and that consumption taxes will be levied effectively in the market country. However, the report does note that countries could introduce any of these three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties. The report further notes that adoption as domestic law measures would require further calibration of the options in order to provide additional clarity about the details, as well as some adaptation to ensure consistency with existing international legal commitments.
It is clear from the report that the digital economy continues to evolve and that rules enacted now might prove inadequate in the future. The “next step” recommendation in the report on Action Item 1 is to monitor closely the combined effect of all of the action items on the digital economy, via “detailed mandate to be developed in 2016” and digital economy report to be produced by 2020. The practical implication is that if implementation of the current report on Action Item 1 does not deal effectively with the problem of stateless income in the digital economy, then a new report will be drafted.
The BEPS Project’s critical path is clearly focused on the problem of stateless income and the general approach is to use each of the action items in this effort rather than propose a set of ring-fenced rules within the parameters of Action Item 1. Accordingly, it is incumbent on participants in the digital economy to consider carefully each action item of the BEPS project, as well as the interaction of all the action items. The encompassing view that the digital economy is the economy has far reaching implications that guide tax developments for years to come.
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