BEPS and Digital Taxation
By Offshore-E-Com Editorial
This Offshore-Ecom special feature looks at the Organisation for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project, which is attempting to usher in major changes to the way that e-commerce companies and firms operating in the digital realm are taxed within the next couple of years.
The development of the Internet, in terms of its geographical reach, capacity and speeds, has been rapid. It has taken less than 20 years for the Internet to become a part of everyday life, and it can be said that for most of us, its ubiquitous presence is rather taken for granted these days. The rise of new business models exploiting these technologies commercially in all sorts of ways without the need for labour-intensive physical operations has been equally rapid. Governments however have been left trailing in their wake. Tax rules, still largely rooted in early 20th century concepts like permanent establishment, have failed to keep pace as traditional jurisdictional borders have been blurred and in many cases broken down. Therefore, it is not difficult for e-commerce companies operating across the world to optimise tax by structuring their businesses to take advantage of favourable tax regimes in low- or no-tax jurisdictions while still deriving most of their revenues in the large ‘high-tax’ markets. And they are doing so perfectly legally. However, governments, many of which have a pressing need to collect higher tax revenues, are fighting back under the aegis of the OECD, and early last year, the BEPS project was born.
Base Erosion And Profit Shifting: The Origins
The anti-BEPS campaign is not solely targeted at the world of e-commerce. It is a reaction to an increasing number of tax “scandals” that have hit the headlines in the mainstream media over the last couple of years involving multinational companies across various industries. The problem for governments however, is that this is not an issue of black and white. If these companies were operating illegally, they could be dealt with using existing anti-avoidance and anti-evasion laws. In the vast majority of cases however, multinationals are merely following the tax rules as they have been written. The emphasis of the BEPS project therefore is on changing tax rules themselves.
The OECD’s first BEPS report was published in February 2013 at the behest of the G20 group of nations. The report described the use of tax-efficient business structures by multinationals to lower group corporate tax liability as a first step to addressing base erosion and profit shifting. It was observed that due to imperfect interaction between nations' tax regimes, and their extensive networks of double tax agreements, the global tax system has failed to keep up with the changing needs of the 21st century in terms of mitigating corporate tax avoidance. The study claimed that these inadequacies have allowed multinationals to legitimately structure their tax affairs using profit-shifting arrangements to pay tax on their profits at rates as low as 5%, against the corporate tax rates of around 30% in place on fiscally immobile businesses in OECD member states.
The report stated: "The international common principles drawn from national experiences to share tax jurisdiction may not have kept pace with the changing business environment. Domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterized by a lower degree of economic integration across borders, rather than today's environment of global taxpayers, which is characterized by the increased importance of intellectual property as a value-driver and by constant developments of information and communication technologies."
The BEPS project was endorsed by ministers attending the OECD Council Meeting in Paris on May 29, 2013, at which a declaration on base erosion and profit shifting was adopted. Among other things, this declaration said that there is a “pressing need” to address BEPS and to work towards a level playing field in this area. It was agreed that national authorities should collaborate in evaluating the issues and developing potential solutions to address the challenges raised by BEPS. “Updated solutions to the issues related to jurisdiction to tax, in particular in the areas of digital goods and services,” the declaration goes on to state. “These solutions may include a revision of treaty provisions.”
Fifteen Actions To Put An End To BEPS
In July 2013, the OECD released its much anticipated BEPS Action Plan in time for the G20 finance ministers’ meeting in Moscow. The G20 asked that the Plan should "provide countries with domestic and international instruments that will better align rights to tax with economic activity" and the OECD claims that the Plan’s content offers governments a road map for the prevention of national tax base erosion and profit shifting by multinational entities.
The OECD contends that the process of globalization, while beneficial to domestic economies, has opened up a number of opportunities for multinational enterprises to "greatly minimize their tax burden." The result is a "tense situation in which citizens have become more sensitive to tax fairness issues." In turn, governments are now required to "cope with less revenue and a higher cost to ensure compliance."
The Action Plan identifies 15 specific actions needed in order to equip governments with the domestic and international instruments to address the challenge of BEPS. To ensure that the actions can be implemented quickly, the Plan proposed the creation of a multilateral instrument to amend bilateral tax treaties.
The tax challenges presented by the evolution of the digital economy are dealt with under Action 1, which urges governments to: “Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation.”
The report continues: “Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.”
Action 1 of the BEPS establishes a dedicated task force charged with identifying the issues raised by the digital economy and possible actions to address them. The work of the task force on the digital economy will cut across the work done on the other actions, which are organised according to three main principles: preventing double non-taxation due to the gaps that exist between countries’ tax rules; aligning taxation with substance; and improving transparency.
The Action Plan was validated by the G20 leaders at the St Petersburg Summit in September 2013. However, it was once again stressed that this is an area requiring “thorough analysis”, and the succession of consultations and discussion drafts on digital taxation that have followed in the wake of the Action Plan are an indication of how difficult it could be for the OECD to bring about change.
Consultation And Discussion Draft On The Digital Economy
In November 2013, the OECD launched a public consultation seeking input from businesses concerning the taxation of the digital economy as part of the BEPS project. The consultation sought general comments on Action 1, but also requested answers to a set of specific questions related to business models employed in the digital economy and how new technologies have impacted these models. These questions included the location in which value is created or monetized; what challenges are encountered when attempting to establish the location and extent of tax liability; and how business models and supply chains may evolve in the future due to advances in information technology.
Responses to the consultation fed in to the Discussion Draft published by the OECD on March 19, 2014, entitled ‘Tax Challenges of the Digital Economy’.
From a strategic point of view, the OECD says, the digital economy enables multinational companies to reduce not only corporation taxes, but also a wide range of other taxes, such as consumption taxes, payroll taxes, real property taxes, and environmental taxes. The Draft therefore highlights distortions to competition between digital economy businesses and the rest of the economy.
Four main policy challenges have been identified in the 81-page Draft:
- Establishing taxpayer location: The OECD is considering revising the traditional Permanent Establishment standard, as the digital economy enables companies to reduce their physical presence in the markets in which they supply goods and render services. The OECD suggests introducing a significant digital presence test, the concept of virtual PEs, or even a withholding tax on e-commerce transactions;
- Taxing data: This point deals with attributing the value created from data collection to a territory, which, according to the OECD, should account for location-specific factors and not just a risk-based or functional analysis. The report suggests that some taxing rights should be allowed on a place of supply basis.
- Classifying supplies: This section tackles a number of issues, including, for example, the challenges of establishing where taxable activities occur in particular in connection with cloud computing services; and
- VAT collection: This section refers in particular to electronically supplied services to private customers, and the challenges posed by the anonymity of persons using the Internet.
The report points out that the revenue that could be generated from taxing digital goods and services is enormous. According to the draft, the value of business-to-consumer (B2C) e-commerce sales alone is expected to have increased by 18.3 percent in 2013, to USD1.3 trillion. During the year, Asia-Pacific surpassed North America as the top market for B2C e-commerce sales. Nevertheless, the discussion draft points out that at the moment B2C e-commerce represents a small fraction of overall e-commerce, which is mainly made up of business-to-business (B2B) transactions.
Global B2B e-commerce, particularly among wholesalers and distributors, was estimated to be approximately US12.4 trillion in 2012. According to other estimates made by the International Data Corporation, the size of total worldwide e-commerce, when global B2B and B2C transactions are added together, equated to USD16 trillion in 2013.
The discussion draft presents few recommendations, but says the implementation of Guidelines 2 and 4 of the OECD's "Guidelines on place of taxation for B2B supplies of services and intangibles" would minimise BEPS opportunities for supplies of remotely delivered services made to exempt businesses, including exempt businesses that operate through establishments in multiple jurisdictions (multiple location entities, or MLEs).
Guideline 2 recommends that the taxing rights on cross-border supplies of services and intangibles between businesses be allocated to the jurisdiction where the customer has located its main business establishment, and that business customers be required to self-assess VAT on remotely delivered services acquired from offshore suppliers according to the rules of the jurisdiction in which they are located.
Guideline 4 provides that when a supply is made to a business that is established in more than one jurisdiction, taxation should accrue to the jurisdiction where the customer's establishment using the service is located. These Guidelines set out the possible mechanisms for tax authorities to achieve the desired result in practice, which is allocation of the right to levy VAT on B2B services to the jurisdiction where these services are used for business purposes irrespective of how the supply and acquisition of these services was structured.
Businesses, individuals and organisations had until April 14, 2014 to comment on the issues raised in the Discussion Draft, and on April 13, the Tax Executives Institute (TEI) released its response to the paper.
While referring to the options set forth in Section VII of the Discussion Draft to address the direct tax issues presented by the digital economy, TEI opined that such options "would impose high administrative costs on businesses conducting digital operations as they would have to register for tax purposes in every country where they sell their goods and services".
"Determining the country of the relevant activity or of a ‘virtual PE’ or applying and remitting the correct withholding tax may be difficult or impossible", it said.
TEI also urged the OECD to go easy in its reliance on "value chain analysis and profit split methods" for transfer pricing purposes in light of the increasingly integrated nature of multinationals through information and communications technologies.
The TEI noted however, that while profit splits may appear simple in concept, they “are fraught with difficulties” in application.
The Institute urged the OECD to “tread carefully” when reviewing these aspects of its BEPS project and “avoid implicitly endorsing a global formulary apportionment approach”.
In its response to the Discussion Draft, AmCham EU, which represents US business operating in the European warning, sounded a number of warnings about the direction in which the OECD’s proposals were travelling.
“AmCham EU believes that some options proposed by the OECD draft report raise concerns that could hurt the economy itself or reflect a fundamental misunderstanding of the digitalised economy,” the organization stated.
Specifically, AmCham EU raises five points in reaction to the Discussion Draft, as follows:
- A proposal that would identify a new taxable nexus based on ‘significant digital presence,’ which is based on the incorrect assumption that some businesses are conducted wholly digitally.
- A concept of imposing a taxable nexus based on the concept of a ‘virtual permanent establishment’ could in fact cause double-taxation for all digitalised firms - as a firm would have, for the same activity, a permanent establishment and a virtual one located in another country.
- A proposal of introducing a new withholding tax on digital transactions collected by financial institutions involved in those payments stands in contrast to the conclusion of the report that the digital economy cannot be ring fenced.
- The consumption tax challenges identified by the OECD must be addressed without introducing additional complexity or burdens on taxpayers.
- Proposals on taxation of data or the use of data to determine a taxable nexus that would stifle innovation and negatively affect the whole economy.
The Future: “Deliverables”
The BEPS Action Plan anticipates that the 15 actions will be finalised in three stages: September 2014, September 2015 and December 2015. An in-depth report identifying tax challenges raised by the digital economy and the necessary actions to address them is scheduled to be released by the first of these three dates. Since the OECD wants the BEPS project wrapped up by the end of next year, this will leave just over a year for some potentially fundamental tax changes to be implemented across the world.
Even the OECD admits that its chosen timetable is “extremely ambitious”. Some might say it is impossible. The upside of getting this project over and done with quickly is that the huge uncertainty it is creating will be relatively short-lived. However, there is a risk that a partially-completed BEPS project could be the worst of both worlds, raising costs for many e-commerce and other multinational firms without raising significant additional revenue for governments. The current international tax environment is not always ideal, but it would be tragic if a bad situation was made worse. As they say: “the best is the enemy of the good.”