Winner: Mazars Tax Essay Challenge by Terrance Goh

I. Introduction

Tax regimes around the world have traditionally relied on residence and source as the legal bases behind a nation’s taxation structure.¹ Insofar as the determination of a country’s right to tax is concerned, both principles have hitherto fulfilled their purposes well in an economy where physical presence in a market jurisdiction is inevitable.² However, with the global order evolving where digitalisation has increasingly permeated through all sectors of the economy, both of these principles may not be able to stand for long.³

In Part II, this paper shall first seek to analyse the various tax-related challenges arising from the digital world. Subsequently, Part III will discuss the BEPS Project that the OECD has developed to tackle these problems. Finally, Part IV will further elaborate on the options being considered for determining source, with a particular emphasis on the potential reforms to the traditional conception of a “permanent establishment”.

II. Challenges arising from digitisation

As briefly alluded to above, the key challenge emerging from a digitalised economy is that it is increasingly becoming the economy itself.⁴ Consequently, difficulties have since started to surface with regard to “ring-fencing” the digital economy from the “traditional” economy for taxation purposes.⁵

For a start, the present tax framework was originally developed in a time that was suitable for “brick and mortar” businesses and will not be relevant in the modern context.⁶ Businesses of today are increasingly reliant on hard-to-value intangible assets, data and automation,⁷ with online platforms rendering traditional “brick and mortar” companies otiose.8 Examples of such online platforms typically follow the form of the “online retailer model”,⁹ “social media model”,¹⁰ “subscription model”11 and the “collaborative platform model”.¹²¹³ The paramount advantage of online platforms – which also serves as the critical source of vexation for taxation of the digital economy – will be their non-necessity of a physical presence in countries where their businesses operate in.¹⁴ This essentially goes against the underlying quid pro quo basis of corporate taxation, where profits of companies are taxed since they have taken full advantage of the source country’s infrastructure, resources and rule of law institutions in order to generate those same profits¹⁵ this creates a “free rider” problem.

III. The BEPS Project and its suggested mitigation measures

In an attempt to understand and overcome the BEPS risks presented by the digital economy, the OECD has, for the past four years, embarked on the BEPS Project Action 1 to come up with various solutions to tackle the problem.16
Four key recommendations include:¹⁷

1. Modifying the list of exceptions to the definition of “permanent establishment” in Article 5 paragraph 4 of the OECD Model Convention regarding preparatory or auxiliary activities as they relate to a digital environment, and to introduce new anti-fragmentation guidelines to deny exploitation of these exceptions through the fragmentation of business activities;
2. Amending the definition of “permanent establishment” to address the conclusion of contracts resulting from certain artificial arrangements;
3. Making a correlative update to the transfer pricing guidelines; and
4. Reforming the CFC rules to attribute income typically earned in the digital economy to the parent company for taxation.

Further, it is anticipated that the taxation of digital businesses in the market jurisdiction will be further enhanced by the other actions of the BEPS Project, namely Action 6 on the prevention of treaty abuse, Article 7 on the prevention of the artificial avoidance of the PE status, Article 2 on hybrid mismatch arrangements, and the limitation of base erosion via financial payments.¹⁸

Looking from a wider perspective, it is also expected that Actions 8 to 10 will play a significant role toward addressing the major tax challenges of the digital economy. Most significantly, the OECD’s promotion of a wider application of the transactional profit split method is said to be key.¹⁹ This calls for placing a lesser emphasis on the separate legal entities of companies and their affiliates and taking a closer look into value chain analyses to align profits according to their value creation in digital business models where intangibles are used.²⁰

Notwithstanding, criticisms have been levied at the OECD’s approach. For one, when applying the method to the taxation on investment activity, the OECD will consider all cost factors to be maintained.21 This might result in a distortion of the businesses’ investment decisions since business functions are increasingly mobile and that their locations may be decided based on tax planning objectives.²² It has been suggested that a revenue-based profit split method may be more appropriate.²³
Secondly, it has also been found that the outcomes resulting from the BEPS Project may be underwhelming and have fallen short of its initial goals.²⁴ A reason for this is because there is still yet to be any “shared comprehensive recommendations” being put forth hitherto.²⁵ Instead, discussion drafts relating to Action 1 had merely recognised such an absence and had left the door open for countries to unilaterally adopt any measure they deem fit. This will be especially detrimental considering that it will be inevitable that the lack of consensus between nations will result in the problems of “jurisdictional overlaps, and, possibly, cascade taxation”.²⁶

IV. Developing a more comprehensive approach to determine source

The OECD has explored five different options to identify the appropriate source country in a digital economy. These range from modifications to the exemptions from a permanent establishment status, a withholding tax on digital sales, a new nexus that is based on having a “significant economic presence”, and developing an entirely new concept of a “virtual permanent establishment”.²⁷

(a) Expanding the “permanent establishment” definition

A common underlying theme can be isolated for most of these options, and that is the expansion of the traditional permanent establishment definition to prevent its exploitation by businesses through the use of digital assets.
The first option appears to be the least radical of the five. It seeks to retain the traditional permanent establishment definition but take into account the business activities currently exempted that may form the core functions of a business in the digital economy.²⁸ While this option has been supported by some,²⁹ it has nevertheless been subjected to various criticisms.³⁰ The reason mainly lies in the option’s persistence in retaining the physical presence requirement, and this is deemed unsatisfactory considering that it “hardly ever applies in the digital economy”.³¹
Further, some aspects of the digital economy remains uncaptured by this definition, and examples include the grey areas of cloud computing and internet advertising,³² and the confusing position as to when a server will constitute a permanent establishment under the current definition.³³

(b) Introduction of “Virtual Permanent Establishment

The most radical of options being explored by the OECD revolves around the idea of the proposed “virtual permanent establishment”. This essentially brings into play three extensions to the current permanent establishment definition, namely:34

1. Adding a “virtual fixed place of a business” nexus (an electronic equivalent of the traditional permanent establishment concept);
2. Adding a “virtual agency” nexus (another electronic equivalent of the current dependent agent permanent establishment concept); and
3. Adding an “on-site business presence” nexus (the broadest of the three, which captures “virtual presence” that is entirely removed from any physical presence).

Similar to the other options being explored, the question remains as to whether the move to embrace a “virtual permanent establishment” would be welcomed.

On one hand, it must be acknowledged that the aim of such a move will fall within the overarching principles behind taxation – namely the souring theory, benefit theory, entitlement theory, and other various practical considerations which bestows upon a country the right to impose taxes on a company.³⁵ This will allow countries to take to task companies which are exploiting their digital presence to avoid owing any tax liabilities to countries with high taxes.³⁶

However, as the OECD acknowledged, introducing the concept of a “virtual permanent establishment” will be fraught with difficulties.³⁷ For one, our tax jurisprudence may not be ready for a dramatic shift from current rules regarding the attribution of profits and a significant reinterpretation of the arm’s length principle “in order to introduce the notion of virtual functions, assets and risk assumption. Secondly, challenges in ensuring and enforcing compliance will surface since it will require considerable international co-operation and co-ordination.³⁸

V. Conclusion

The rise of the digital economy has certainly raised important questions for our current global tax policies. While the OECD’s BEPS Project may still only be scratching the surface of this issue and reaching a resolution is definitely far from completion, one thing that remains undisputed would be the recognition of the need for our taxation framework to play catch-up and to remain relevant in the face of developments.

Sources:

_{1 J. Frenkel, et. al., International Taxation in an Integrated World (Massachusetts Institute of Technology Press, 1991) at p 22.
2 D. Pinto, E-commerce and Source-based Income Taxation (IBFD Publications, 2003) at p 57.
3 OECD Public Discussion Draft on ‘BEPS Action 1: Address the Tax Challenges of the Digital Economy’ (Discussion Draft), 24 March 2014, p 64, at http://www.oecd.org/ctp/tax-challenges-digital-economy-discussion-draft-march-2014.pdf.
4 OECD, “OECD/G20 Base Erosion and Profit Shifting Project Explanatory Statement”, 2014, p 8, at www.oecd.org/tax/beps-2014-deliverables-explanatory-statement.pdf.
5 Ibid.
6 European Commission, Press release – Commission gathers views on how to tax the digital economy fairly and effectively, 26 October 2017, at http://europa.eu/rapid/press-release_IP-17-4204_en.htm.
7 European Commission, Communication from the Commission to the European Parliament and the Council, 21 September 2017, p 2, at https://ec.europa.eu/taxation_customs/sites/taxation/files/1_en_act_part1_v10_en.pdf.
8 Id, at p 5.
9 Examples include Amazon and Alibaba.
10 Examples include Facebook and Youtube.
11 Examples include Netflix and Spotify.
12 Examples include Airbnb and Uber.
13 Supra n 7, at p 5.
14 Supra n 7.
15 Supra n 7, at p 7.
16 OECD, Background Brief – Inclusive Framework on BEPS, January 2017, p 9, at http://www.oecd.org/tax/beps/background-brief-inclusive-framework-for-beps-implementation.pdf.
17 OECD, OECD/G20 Base Erosion and Profit Shifting Project –Addressing the Tax Challenges of the Digital Economy, Action 1: 2015 Final Report, p 12, at https://ec.europa.eu/futurium/en/system/files/ged/45-oecd-addressingtaxchallengesdigitaleconomu-2015-toconnected.pdf.
18 M. Olbert; C. Spengel, “International Taxation in the Digital Economy: Challenge Accepted?”, 22 August 2016, p 12, at https://www.sbs.ox.ac.uk/sites/default/files/Business_Taxation/Events/conferences/2016/Doctoral_mtg_2016/olbert.pdf.
19Ibid.
20 OECD, Addressing Base Erosion and Profit Shifting, 12 February 2013, p 92, at http://dx.doi.org/10.1787/9789264192744-en; W. Schön, “Transfer Pricing Issues of BEPS in the Light of EU Law” (2015) 3 British Tax Review 277, at p 419.
21 Supra n 18, at p 13.
22 Ibid.
23 Ibid.
24 G. Teijeiro, “The BEPS Project Lacks Comprehensive Definition on the Taxation of Digital Economy in Market Jurisdictions”, Kluwer International Tax Blog, 24 October 2015, at http://kluwertaxblog.com/2015/10/24/the-beps-project-lacks-comprehensive-definition-on-the-taxation-of-digital-economy-in-market-jurisdictions/.
25 Ibid.
26 Ibid.
27 Supra n 3, at p 64-68.
28 Supra n 3.
29 KPMG, “Comments on the OECD Discussion Draft on the Tax Challenges of the Digital Economy”, 14 April 2014, at https://home.kpmg.com/content/dam/kpmg/pdf/2014/06/digital-economy-discussion.pdf.
30 P. Hongler; P. Pistone, “Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital Economy” IBFD Working Paper, 20 January 2015, p 14, at https://www.ibfd.org/sites/ibfd.org/files/content/pdf/Redefining_the_PE_concept-whitepaper.pdf.
31 Ibid; P. Collin; N. Colin, Task Force on Taxation of the Digital Economy – Report to the Minister for the Economy and Finance, the Minister for Industrial Recovery, the Minister Delegate for the Budget and the Minister Delegate for Small and Medium-Sized Enterprises, Innovation and the Digital Economy, January 2013, p 63, at https://www.hldataprotection.com/files/2013/06/Taxation_Digital_Economy.pdf.
32 Supra n 30, at p 50-54.
33 A. Cockfield, “Reforming the Permanent Establishment Principle through a Quantitative Economic Presence Test” (2003) 38 Can. Bus. L.J. 400, at p 409.
34 OECD, “Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce? – Final Report”, 2005, p 65-66, at http://www.oecd.org/tax/treaties/35869032.pdf.
35 M. Santoso, “Virtual Permanent Establishment for Digital Economy” (2017) Journal of International Scientific Publications (11) 268, p 273, at https://www.scientific-publications.net/get/1000025/1503418132732447.pdf.
36 A. Bohórquez “Virtual Permanent Establishment: an approach to the Taxation of Electronic Commerce Transactions” Revista de De- recho Fiscal n.° 8, Bogotá: Universidad Externado de Colombia, June 2016, at p 94.
37 Supra n 34.
38 Supra n 36, at p 100; A. Bardopoulos, eCommerce and the Effects of Technology on Taxation: Could VAT be the eTax Solution (Springer, 2015) at p 350.}