BEPS Action 1 – Addressing the tax challenges of the digital economy

By Maria Margarita G. Mallari-Acaban

Over the years, advances in Information and Communication Technology (ICT) have revolutionized and disrupted the business models of companies, regardless of size. In retail, for example, customers can now place orders online. In manufacturing, production processes can now be monitored through automated systems. In healthcare, it is now possible to conduct remote diagnosis. In broadcasting/media, new avenues have been developed for content delivery and user participation — think user-generated content and social networking. These new models, which are largely characterized by mobility with respect to intangibles, users, and business functions, or use of multi-sided business models, make up for what is now called the Digital Economy.

Direct and Indirect Tax Challenges of the Digital Economy

While the Digital Economy has clearly innovated business processes and improved the way companies do business, it has also challenged the traditional concept of permanent establishment (PE) and value added tax (VAT), thereby resulting in stateless income, artificial shifting of income and VAT avoidance.

For example: Our current tax rules require some degree of physical presence or on-the-ground activities before business profits can be subjected to tax. However, where online sales are involved, a non-resident company’s increased reliance on selling through a website or mobile application has significantly decreased its reliance on or need for local physical presence, thereby avoiding taxable presence. Similarly, as business functions are becoming more mobile, companies can contractually allocate functions and risks and assign them in low-tax jurisdictions or favorable tax regimes.

In its Base Erosion and Profit Shifting (BEPS) initiative, the Organisation for Economic Co-operation and Development (OECD) categorized these direct tax issues and tax policy challenges into three main issues, namely:

Nexus: The continual increase in the potential of digital technologies and the reduced need for extensive physical presence in order to carry on business – combined with the increasing role of network effects generated by customer interactions – can raise questions as to whether the current rules to determine nexus with a jurisdiction for tax purposes are appropriate.

Data: The growth in sophistication of information technologies has permitted companies in the digital economy to gather and use information across borders to an unprecedented degree. This raises the issues of how to attribute value created from the generation of data through digital products and services, and of how to characterize for tax purposes a person or entity’s supply of data in a transaction.

Characterization: The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterization of payments made in the context of new business models.

From a VAT perspective, the Digital Economy also presents greater challenges in cross-border trade, particularly in cases of imports of low value parcels from online sales which are treated as VAT-exempt in many jurisdictions, as well as sale of services and intangibles where no or minimal VAT is imposed due to the complexity of collecting the VAT from said consumers.

Recommendations in the Final Report on Action 1

While the Final Report on Action 1, Addressing the Tax Challenges of the Digital Economy, acknowledges all these tax challenges and BEPS concerns, it likewise notes that it would be extremely difficult to isolate the Digital Economy as a separate sector, due largely to the way the digital economy has integrated itself into the rest of the economy. Accordingly, in order to ensure that the proposed solutions fully address the BEPS concerns on the Digital Economy, Action 1 takes into account how these challenges relate to other BEPS action items particularly Action 6 on treaty abuse, Action 7 on artificial avoidance of PE, Action 2 on hybrid mismatch arrangements, Action 4 on interest deductions and other financial payments, Action 5 on harmful tax practices, and Actions 8-10 on Transfer Pricing.

The key recommendations in Action 1 include the following:

• On PE definition and exceptions:
    » Modification of the exceptions to PE status to include only those activities that are in fact preparatory or auxiliary in nature thereby ensuring that profits derived from core activities performed in a country can be taxed in that country. Under this new standard, the maintenance of a local warehouse by an online seller (whose business model relies on the proximity to customers and the need for quick delivery to clients) where a significant number of employees are housed for purposes of storing and delivering goods sold online to customers would constitute a PE.

    » Introduction of a new anti-fragmentation rule to ensure that it is not possible to benefit from the exceptions to PE status through the fragmentation of business activities among closely related enterprises.

    » Modification of the PE definition 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 this purpose, a Parent Company will be deemed to have a PE whenever the sales force of a local subsidiary of an online seller (of tangible products or advertising services) habitually plays the principal role in the conclusion of contracts with prospective large clients and these contracts are routinely concluded without material modification by its Parent.

• On Transfer Pricing (TP):
Revision of the TP guidance, which ensures the appropriate allocation of returns (generated by the exploitation of the intangible) within a group of companies – i.e., not dictated by legal ownership alone but by the performance of important functions and contribution of important assets, among others.

• On Controlled Foreign Corporation (CFC) Rules:
    » Inclusion of the definitions of CFC income that would subject income typically earned in the Digital Economy to taxation in the jurisdiction of the ultimate parent company.

Of the several options considered to address the direct tax and indirect tax challenges related to nexus, data, and characterization, the OECD’s Digital Economy Task Force concluded the following:

Option to modify the exceptions to PE status – i.e., limit to actual preparatory or auxiliary activities — is expected to be implemented across the existing tax treaty network through the conclusion of the multilateral instrument (Action 15).

• VAT collection on cross-border transactions between businesses and consumers is an important issue. As such, countries should apply the principles of the International VAT/GST Guidelines and consider the introduction of the collection mechanisms included therein.

• None of the other options analyzed by the OECD’s Digital task Force – i.e., the new nexus in the form of a significant economic presence, withholding tax on certain types of digital transactions and equalization levy, were recommended as internationally agreed standards considering that these measures would require substantial changes to key international tax standards and further work.

• Countries are not precluded from introducing any of these three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations and remain consistent with their existing international legal commitments.

Next steps

Considering that these conclusions may still evolve as the digital economy continues to develop, it is imperative that companies continue working on these issues and monitoring significant developments. In particular, they should keep an eye on new business models that may impact on international tax policy, the impact of implementation of the BEPS measures, actions taken by countries in the implementation of BEPS-driven domestic law measures or in their bilateral tax treaties and other relevant developments in VAT.

Future work is expected on Action 1 following the completion of the work on other Actions of the BEPS Project. This future work will be conducted in consultation with a broad range of stakeholders, and on the basis of a detailed mandate to be developed this year in the context of designing an inclusive post-BEPS monitoring process. Another report is expected to be released by 2020 which will reflect the outcome of the continued work on the digital economy.

Maria Margarita D. Mallari-Acaban is a Senior Director of SGV & Co.