1st Runner Up: Mazars Tax Essay Challenge by Mavis Wee

1. Introduction to Digital Economy

The advancement of information and communication technology (ICT) has evolved and created business models that could not have been practical in the past. Companies today are operating in a fundamentally different manner than at the time international tax rules were designed. For example, physical presence which was the key threshold of taxation for international tax policies is increasingly becoming more difficult to establish as non-resident companies can now easily transact in markets without any form of physical presence. Although international tax rules have traditionally covered such situations, ICT has enabled companies to reach a wider network of market jurisdictions and trade at a potentially unlimited scale through the web. The outcome is a new era of economy where there is growing interconnectedness among parties and activities being substantially conducted through the internet and mobile technology. This is also known as the Digital Economy.

In addition, coupled with liberation of trade policies, the digital economy has also encouraged companies to adopt centralised management model and setting up global value chains that are efficient enough to minimise duplicated functions. For example, a single manufacturer may supply to more than one country. This results in many high-tax jurisdictions having difficulties attributing taxable profits to themselves despite some form of commercial activities being subtly conducted in their market and therefore increased international tax disputes.

2. Understanding Base Erosion and Profit Shifting (BEPS) risks

With reference to the 2013 BEPS Action Plan published by the OCED, BEPS concern arises when taxable income can be artificially segregated from activities that generate it. The BEPS issue is fiercely disputed, because it presents a loophole that undermines the integrity of tax system resulting in jurisdictions suffering from substantial loss of revenue. It creates uneven level playing field, as those with the ability to shift profits are commonly the multinational enterprises (MNEs) and those who bear the burden of paying relatively higher taxes are smaller corporations operating in domestic markets.
It is important to understand that BEPS issue does not arise merely because businesses are able to avoid being taxed at source on foreign sourced business profits. Such situation has already been addressed in domestic laws and double taxation agreements. Rather, it is the opportunity to substantially eliminate tax at various taxable stages of transactions from the market level all the way to the ultimate parent level that triggers BEPS concerns.

In February 2013, the OECD published a report on addressing BEPS that identified four elements of co-ordinated strategies associated with BEPS in the context of direct taxation. It includes: -
a. Eliminating or reducing tax in market countries by having minimal Permanent Establishment (PE) presence; inconsistent functions, assets and risks corresponding to actual allocation; or maximizing deductions via intercompany transactions;
b. Avoiding withholding tax by locating recipient entity in countries with favourable treaty networks;
c. Eliminating or reducing tax in the intermediate country by locating it in preferential tax regimes; taking advantage of hybrid mismatch arrangements; or maximizing deductions via intercompany transactions; and
d. Eliminating or reducing tax in the country of residence of the ultimate parent by contractually allocating risks and ownership of intangibles to low-tax jurisdiction and attribute residual profits to it; or by locating ultimate parent in a country with exemptions, deferral system for foreign-source income, no controlled foreign company (CFC) regime or regimes with inadequate coverage for certain categories of passive income;

3. Mitigating BEPS Risks in the Digital Economy

Addressing BEPS risks requires taxation to be aligned with the location where economic activities take place. It is not an easy feat to be achieved because it would entail significant amendments to international tax policies. The BEPS project sets out 15 Actions to equip governments with the necessary domestic and international instruments to address tax avoidance. According to the 2015 BEPS Action 1 Final Report by the OECD, all 15 Actions will have an impact on BEPS in the digital economy. However, Action 3 on strengthening CFC rules, 7 on preventing artificial avoidance of PE status and 8-10 on assuring transfer pricing outcomes are in line with value creation have been identified as particularly relevant to the digital economy.

3.1 Action 3 – Designing Effective Controlled Foreign Company (CFC) Rules

A controlled foreign company is a corporate entity that resides in a different jurisdiction that than of its controlling firm. While CFC rules generally vary from countries to countries, the main objective is to prevent artificial deferral of taxation and opportunities of profit shifting by enabling the jurisdiction of the controlling firm to tax income earned by its foreign subsidiaries where certain conditions are fulfilled.
The main problem with past CFC rules in the current context of digital economy was that certain incomes like income from digital goods and services were often not covered within its scope. Moreover, not many countries did adopt CFC rules and as such it enabled MNEs in the digital business to potentially retain residual income in a low-tax jurisdiction while avoiding tax in the source country and country of ultimate residence. The 2015 report on Action 3 by the OECD hopes to mitigate this problem by providing recommendations in the form of six building blocks to design effective CFC rules. The building blocks will help jurisdictions without CFC rules to implement effective CFC rules while also helping those with CFC rules to realign their rules accordingly.

3.2 Action 7 – Preventing Artificial Avoidance of Permanent Establishment (PE) Status

PE is a concept found in double tax agreements that is used as a proxy to enable a jurisdiction to attribute taxes on business profits earned by a foreign enterprise. There are different forms of PE, but the objective is always to determine whether a foreign enterprise must pay income tax in the market jurisdiction (source state). It is an important concept under international taxation, because it gives source state the authority to tax business profits of a legal entity that resides in another state. If the entity is found not to have a PE in the source state, then the source state shall not have any rights to tax the business profits of the entity in the first place. If planned properly, it is possible for MNEs in the digital business to avoid having a PE status in the market jurisdiction and thereby avoiding being taxed there.

Action 7 of BEPS project by the OECD aims to mitigate this problem by, among other changes, updating the PE standard in light of features found in the digital economy. Changes to the PE includes expanding the definition in certain circumstances (eg. commissionaire arrangements) as well as modifying Article 5(4) of the OECD Model Tax Convention to ensure that taxpayers do not artificially fragmentise their business activities to meet the “preparatory and auxiliary” condition for PE exemptions.

3.3 Action 8-10 – Aligning transfer pricing outcomes with value creation

Transfer pricing focuses on the consideration agreed between related parties within an MNE group. The rules were developed to ensure that the intercompany transactions are set in consistent with the arm’s length principle and thus profits are fairly allocated between each jurisdiction involved. BEPS concerns are triggered, when allocation of profits is deemed not to be aligned with the economic activity that generates it. In the context of digital economy, the mobility of intangibles together with fragmentised business activities and the use of data for communication has made it more difficult to determine whether transfer prices are fair.
Action 8-10 of the BEPS project by OECD has highlighted that the relevance of transfer pricing allocation methodologies needs to be reviewed. It suggests that in certain situations, it would not be wholly appropriate for a group to allocate routine profits to a low-risk subsidiary and the residual profits to a low-tax entity who has contractually been allocated all the risks. In other words, the substance of the low-tax entity must be able to justify the risks that it holds and thus the residual profits it deserves, not the contractual forms. There must be functions and assets in the low-tax entity to complement the risks that it undertakes.

4. Determining the source of income from e-commerce operations

E-commerce involves the sale of goods or services typically through the internet where orders are placed. Income from such business model can be tricky for jurisdictions using source-based tax system because it is not always obvious where the income is sourced from. The lack of physical presence, the reduced need for human interaction and flexibility to remotely conduct business activities makes it difficult to clearly pinpoint where income is sourced. In 2003, a thesis written by Dale Pinto argued that even though the principles of source-based taxation should be maintained, the definition of source should be reconceptualised considering certain characteristics presented in e-commerce models.

Given the pervasive nature of digitalisation and its effect in integrating the world, it seems that the direction of source-based taxation should move towards economic indicators rather than physical presence, especially for e-commerce businesses. This can be observed by the OECD’s new nexus proposal discussed below.

5. Expanding the definition of 'Permanent Establishment'

The topic on PE is one the most majorly discussed tax issue when it comes to digital economy’s impact on international taxation. Currently, there are 3 types of PE construed in the OECD Model Tax Convention – Fixed Place of Business, Construction or Project, and Dependent Agency. The UN Model Tax Convention has an additional type of PE for Services. Based on these PEs, one would notice that digital presence is not covered within the scope. In other words, if a business trades in a foreign market jurisdiction through the internet, it is hard for the foreign tax authoriy to argue that there is a PE vis-à-vis a similar business trading in the foreign market jurisdiction through a branch. Hence, there is a gap in the definition of PE that needs to be reconsidered.

Among various suggestions given, one of those was to introduce a new additional nexus of “electronic (virtual) PE”. However, even with the introduction of this additional nexus, it would not entirely resolve the fundamental problem from other issues like valuing data generation and attributing value creation from it.

Action 1 of the BEPS project by OECD has instead proposed a new nexus based on the concept of “Significant economic presence”. Income would be considered sourced in a country if a foreign enterprise has a significant economic presence in that country based on factors like revenue, digital and users that evidence a purposeful and sustained interaction with the economy of that country. Determining income attribution can be based on fractional apportionment by a predetermined formula or a “deemed profit” approach by applying a ratio of presumed expenses to the foreign enterprise’s revenue derived from transactions concluded with local customers. Determining the appropriate ratio will be based on various economic factors.

The introduction of significant economic presence concept is a refreshing idea, as it seems to be flexible enough for application in different circumstances while at the same time provide a good basis and support for a jurisdiction to assert that there is nexus for taxation purpose. In fact, the Illinois Circuit Court used this concept in a 2015 dispute West Virginia Tax Commissioner v. MBNA to test and found that the taxpayer did had significant economic presence in Illinois and hence is liable to income tax therein. Nevertheless, this new concept does require more research and cost-benefit analysis before concluding its effectiveness.

6. Conclusion

Revamping the international tax policy is an extremely huge and tedious project as observed through the many years it has been discussed and debated. The BEPS project was introduced only in recent years and it still needs to be monitored and improved as new circumstances, data and researches arise.
Nevertheless, given the pervasiveness of digitalisation, it is no longer possible to allow tax policies to remain as it was decades ago. Moreover, as globalisation intensifies and more companies are adopting global value chain structure, it becomes even more challenging to identify the source of business profits using just physical presence as an indicator.
Perhaps the best solution to this digitalised era is to look at economic activities from a global standpoint and identifying where the corporation has “significant economic presence” by evidences from various economic factors. Of course, this solution is very judgemental based and provides a certain amount of uncertainty especially to taxpayers. Regardless, the digital era has brought forth many flexibilities in the way a business may operate and it would not make sense to introduce a rigid solution. Flexible solutions are needed to deal with tax concerns in the digital economy.

References

• _{Pinto, D. (2003), E-commerce and Source-based Income Taxation, IBFD Publishing, The Netherlands, https://www.ibfd.org/IBFD-Products/E-Commerce-and-Source-Based-Income-Taxation}
• _{OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264202719-en}
• _{OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264192744-en}
• _{OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264241046-en}
• _{OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 - 2015 Final Report, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264241152-en}
• _{OECD (2015), Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7 - 2015 Final Report, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264241220-en}