BEPS action plan 1: The digital economy

SUITS THE C-SUITE By Ma. Margarita Mallari-Acaban

Business World (01/05/2015 – p.S1/4)

IN A PREVIOUS column (http://www.bworldonline.com/content.php?section=Economy&title=the-oecd-action-plan-on-base-erosion-and-profit-shifting&id=99561), we wrote about the general framework of the Base Erosion and Profit Shifting (BEPS) initiative, why addressing BEPS is a key priority for many governments across the globe, and the 15-point BEPS Action Plan drafted by the Organization for Economic Co-operation and Development (OECD). The Action Plan aims to ensure that profits are taxed where economic activities generating the profits are performed and where value is created. In this column, we tackle the OECD Report on Action 1, which addresses the tax challenges of the digital economy.

Over the years, many stakeholders have raised concerns on how businesses operating in the digital economy have made use of their mobility as well as the gaps in the different tax systems to create “stateless income.” Questions have likewise been raised on how to attribute value from the generation of data through digital products and services, or how to characterize payments for digital goods or services. More significantly, the question is whether current tax residence or Permanent Establishment (PE) rules are still applicable considering the rise of “digital presence.”

THE DIGITAL ECONOMY: KEY FEATURES, NEW BUSINESS MODELS AND BEPS OPPORTUNITIES

Some key features of the digital economy identified by the OECD include mobility with respect to intangibles, users/consumers and business functions; reliance on data and use of multi-sided business models where two sides of the market are located in separate jurisdictions. These features have allowed enterprises to conduct substantial business in different market jurisdictions from a remote location, or transfer intangible assets to associated enterprises with relative ease and, often, to those which do not have any economic activity, in order to reduce or avoid taxes in countries in the entire supply chain. To date, digital enterprises have been successful in doing so due to gaps in the countries’ tax systems and tax treaties. If not addressed soon, more and more digital enterprises will have “stateless” income which will remain untaxed to the detriment of governments and smaller businesses.

WHAT NEEDS TO BE DONE

To address these challenges in the digital economy, the approach should be comprehensive and coordinated. The OECD proposes to do this by combining the BEPS measures under Action 1 with the other Action Areas such as Action 2 (Neutralizing the effects of hybrid mismatch arrangements), Action 5 (Counter harmful tax practices), Action 6 (Prevent Treaty Abuse) and Action 7 (Prevent the artificial avoidance of PE status) in order to align taxation with economic activities and value creation.

In Action 1, the OECD proposes several corporate income tax and VAT options to address the digital issues, such as:

CHANGES IN PERMANENT ESTABLISHMENT (PE) RULES.

The OECD notes that some activities which have been previously defined as merely preparatory or auxiliary under the treaty have now become the main business activity of some enterprises. To the extent, therefore, that these exceptions do not or cannot apply to digital activities, it is proposed that they be removed from the treaty, or at least limit the PE exemption to those activities which are actually preparatory or auxiliary in nature.

Action 1 introduces the concept of “significant digital presence” whereby an enterprise engaged in “fully dematerialized digital activities” will be deemed to have a PE in a certain jurisdiction if it maintains “significant digital presence” therein.

According to the report, “significant digital presence” can be deemed to exist if a significant number of contracts for the provision of fully dematerialized digital goods or services are remotely signed between the enterprise and a customer who is a tax resident in the country, or if digital goods or services of the enterprise are widely used or consumed in said country. Meanwhile, an activity will qualify as a “fully dematerialized digital activity” if: (1) The core business of the enterprise relies completely or in a considerable part on digital goods or services; (2) No physical elements or activities are involved in the actual creation of the goods or services and their delivery other than the existence, use, or maintenance of servers, Web sites or other IT tools and the collection, processing, and commercialization of location-relevant data; (3) Contracts are generally concluded remotely either through Internet or telephone; (4) Payments are made solely through credit cards or other means of electronic payments; (5) Web sites are the only means used to enter into a relationship with the enterprise; no physical stores or agencies exist for the performance of the core activities other than offices located in the parent company or operating company countries; (6) All or a majority of profits are attributable to the provision of digital goods or services; (7) Legal or tax residence and the physical location of the vendor are disregarded by the customer and do not influence its choices; and (8) Actual use of the digital goods or the performance of the digital service do not require physical presence or the involvement of a physical product other than the use of a computer, mobile devices or other IT tools.

The proposal to replace the PE concept with “significant presence” is meant to account for the contribution of closer and interactive customer relationships in digital transactions. The criteria include (1) long-term [i.e., more than six months] relationships with customers combined with some physical presence in the country; (2) sale of goods or services through a Web site in the local language, offering delivery from suppliers in the jurisdiction, using banking and other facilities from suppliers in the country, or offering goods or services sourced from suppliers in the country; and (3) supplying goods or services to customers in the country resulting from or involving systematic data-gathering from persons in the country.

WITHHOLDING TAX ON DIGITAL TRANSACTIONS

Considering that digital enterprises have been able to conduct business activity in different jurisdictions without creating a PE therein, the OECD proposes to impose a final withholding tax on payments made by residents of a country for digital goods or services supplied by said enterprises. To operationalize this proposal, the OECD suggests that the withholding be done by the financial institutions involved with the payments, instead of requiring the customers themselves to do the actual withholding of the tax.

BANDWIDTH OR “BIT” TAX

A bandwidth tax refers to a tax paid based on a Web site’s bandwidth use. Said tax assumes that a larger bandwidth equates to more data flow and economic activity. It is envisioned that this tax would only apply once a certain threshold annual bandwidth is reached.

VAT

A digital enterprise’s ability to sell its goods without paying VAT on its supplies due to certain import exemptions has created undue advantage over domestic suppliers. To address this issue, the OECD suggests a review of the thresholds for exemptions on imports of low-valued goods. It likewise calls for the VAT registration of non-resident suppliers of digital business-to-consumer (B2C) supplies in the jurisdiction of their consumers, as this will ensure that the VAT is properly collected on said B2C transactions.

The OECD Report on Action 1 acknowledges that there is still work to be done to fully understand the tax challenges of the digital economy and, consequently, develop a comprehensive solution to counter these challenges. As such, the Task Force on Digital Economy has expressed its commitment to ensure that work will be carried out in the remaining action areas affecting the digital economy. While there is still much debate on these areas, it is clear that the initial report offered good starting points in addressing the BEPS issues affecting the digital economy. Businesses are well advised to follow these developments.

Ma. Margarita Mallari-Acaban is a Tax Senior Director of SGV & Co.