Australia: Tax challenges raised by the digital economy

Last Updated: 23 November 2014
Article by Gregory J. Hartker and Frank W. Dworak

On September 16, 2014, the Organisation for Economic Cooperation and Development ("OECD") released a report on Action 1 of the OECD/G20 Base Erosion and Profit Shifting Project (also known as the "BEPS" project) titled "Addressing the Tax Challenges of the Digital Economy" (the "Digital Economy Report"). While the Digital Economy Report continued to advance the ball, there are still many areas of uncertainty, and they leave the reader with a sense that a clear path forward in many areas is still a long way off.1 While the OECD continues to emphasize the notion that the digital economy cannot be "ring-fenced" with its own special set of rules, the Digital Economy Report indicates that businesses that are sufficiently "dematerialized" may be subject to their own set of OECD-designed nexus rules. Although the Digital Economy Report focuses both on direct (i.e., income taxation) and indirect (VAT/GST) taxation, we have to a significant extent concentrated our summary on the applicable income tax issues.

Key Concepts
As background to set the table for addressing areas of concern and potential solutions, the Digital Economy Report categorizes the issues raised by the digital economy in three broad categories: nexus, data, and characterization.

Nexus: Ability to Tax Business Profits
With regard to nexus, the Digital Economy Report notes that although companies have long been able to avoid taxation of business profits in a country under bilateral income tax treaties by conducting business in market jurisdictions without a physical presence (e.g., through phone, mail, fax, and independent agents), advances in information and communication technology ("ICT") enable businesses to do so on a greater scale in the digital economy. This may raise BEPS concerns, particularly when coupled with strategies for avoiding taxation in the residence jurisdiction. For example, businesses may use ICT to centralize management of functions outside of market jurisdictions or to fragment functions across market jurisdictions below the permanent establishment ("PE") threshold, thus permitting businesses to operate in market jurisdictions without being subject to tax. The greater ability to avoid nexus in market jurisdictions is exacerbated due to the significance of intangible assets in the digital economy and the ability to hold such intangible assets in low-tax jurisdictions. When coupled with contractual allocations of risk to such low-tax jurisdictions, the Digital Economy Report notes that businesses may artificially shift profits away from both market and residence jurisdictions, resulting in so-called "stateless" income — a disconnect between taxation and economic activity. These concepts should come as no surprise in that the long established brick and mortar PE concept has been viewed by certain governmental authorities as anachronistic.

Data and Data Gathering
Several issues raised by the significance of data in the digital economy are also discussed. For example, an enterprise may generate significant value by gathering data in a jurisdiction, even though the factors for allocating taxable income — i.e., functions, assets, and risks — are located outside of that jurisdiction. Data gathering also raises questions regarding allocation of income among jurisdictions where an enterprise generates value through data in more than one jurisdiction. For example, a business may gather data in one jurisdiction using technology developed in another jurisdiction, or a business may offer a service to customers in one jurisdiction for less than cost and then sell the data gathered from such customers to persons in another jurisdiction (e.g., the gathering and sale of data of users of online social networks). The Digital Economy Report notes that these issues are not necessarily distinct from nexus.

Characterization of Income
The Digital Economy Report also identifies several segments of the digital economy that raise issues as to the appropriate characterization of income. For example, the Digital Economy Report notes that the character of payments for cloud computing is not addressed in the existing commentary to the OECD Model Tax Convention, and that it is unclear whether such payments should be treated as royalties, fees for technical services, service fees, rent, or business profits.2 In addition, the Digital Economy Report notes that 3D printing may raise character questions in the case of design licenses for remote printing by purchasers.

Potential Options to Address Tax Challenges Raised by the Digital Economy
The Digital Economy Report identifies several potential options to restore taxation to both market jurisdictions and residence jurisdictions (thereby reducing stateless income) through better alignment of taxation with economic activity, both for income and VATs . With respect to income taxes, the Digital Economy Report identifies the following potential options:

Modification to the Exemptions from PE Status
One potential option identified is to modify or eliminate the exceptions for preparatory and auxiliary activities described in paragraph 4 of the OECD Model Tax Convention's PE article. The Digital Economy Report notes that, in the digital economy, certain activities that were considered preparatory or auxiliary in nature (e.g., sales through a storefront) or exempt (maintenance of a warehouse) may be core business functions in the digital economy (e.g., sales through a website).

A New Nexus Based on Digital Presence
Another potential option identified is the establishment of an alternative form of nexus to address situations in which business activities are conducted wholly digitally. Under this proposal, an enterprise engaged in "fully dematerialized digital activities" could be deemed to have a taxable presence in a jurisdiction if it maintains a "significant digital presence" in the economy of that jurisdiction. This option is intended to target businesses that require minimal physical elements in the market jurisdiction for the performance of core activities.

The Digital Economy Report identifies a number of potential elements to test whether an enterprise is engaged in fully dematerialized digital activities, including a focus on core business and the manner in which an enterprise generates the majority of its profits. Unfortunately, this approach may pick winners and losers based in part on enterprise-wide business characteristics rather than the focusing on the functions of the enterprise that relate to the generation of income in the relevant market. That being said, businesses employing "dematerialized" digital activities are now on notice that a special set of rules may be applicable to their operations in the future.

Replacing PE with Significant Presence
The Digital Economy Report also includes a potential option that would involve replacement of the existing PE concept with a "significant presence" test. It is stated that the significant presence test would take account of the changing nature of customer relationships in the digital economy while continuing to rely in part on physical presence. The criteria for this test would include:

  • Relationships with customers or users extending over six months, combined with some physical presence in the country, directly or via a dependent agent;
  • Sale of goods or services by means involving a close relationship with customers in the country, including (i) through a website in the local language, (ii) offering delivery from suppliers in the jurisdiction, (iii) using banking and other facilities from suppliers in the country, or (iv) offering goods or services sourced from suppliers in the country; and
  • Supplying goods or services to customers in the country resulting from or involving systematic data gathering or contributions of content from persons in the country.

Creation of a Withholding Tax on Digital Transactions
In addition to addressing nexus issues through changes to the PE concept, the Digital Economy Report identifies a potential option involving the introduction of a withholding tax on certain payments made by residents of a jurisdiction for digital goods and services of a foreign provider. It is noted that the withholding tax could be introduced as a standalone provision to address the ability to conduct significant digital business in a market jurisdiction without triggering the current PE rules, or the withholding tax could be used as an enforcement tool for one or more of the new nexus standards discussed above. However, compliance may be problematic with respect to transactions involving direct dealings with end-user individuals, similar to the compliance issues that affect self-charged VAT and the reporting and paying of use taxes in the United States. Thus, the Digital Economy Report suggests that financial institutions that process payments may be charged with acting as withholding agents.

Other Items of Note
The Digital Economy Report also identifies several other noteworthy topics, including some that raise unique approaches or concerns.

Multi-sided Business Models
Multi-sided business models, which are described as "a business in which multiple distinct groups of persons interact through an intermediary or platform, and the decisions of each group of persons affect the outcome for the other groups of persons through a positive or negative externality," may raise some perceived unique issues.3 A multi-sided business enterprise can exploit the information or data gathered via the targeted sale of products or the information generated by such user participation. There is a concern that jurisdictions may not adequately account for/capture, via the imposition of tax, the value springing from the exploitation of data generated by or gathered from their residents. Attributing and accounting for such "value" would seem to be a difficult transfer pricing problem to say the least, and the Digital Economy Report offers no concrete options to address this issue .

Introduction of a Bandwidth or "Bit" Tax
The Digital Economy Report also identifies a potential option involving taxation of a website's use of bandwidth in a jurisdiction. It is noted that the bandwidth tax would be progressive and would only apply if bandwidth use exceeded a minimum threshold. Further, in order to maintain equity between digital businesses and traditional businesses, the Digital Economy Report envisions that the bandwidth tax would be creditable against the corporate income tax.

Evaluation of Potential Options and Next Steps
The Digital Economy Report's identification of the potential options described above is not a final evaluation of the options, and the Digital Economy Report notes that none of the options have been adopted at this time. The Task Force on the Digital Economy will further evaluate and develop the potential options in light of anticipated work in other BEPS action plans (forthcoming in late 2015), further consider whether the potential options are proportionate to the tax challenges raised by the digital economy, and decide whether the potential options comport with the basic tax principles of neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility and sustainability. Thus, there is still time for stakeholder input.

As a final note, for what it is worth, the Digital Economy Report may leave the reader with the impression that the OECD is moving further toward "market"-based sourcing with respect to the digital exploitation of goods and services and data gathering and usage, which could, in turn, lead to the erosion of PE as a meaningful concept. We have seen this work its way through many U.S. states, which have abandoned physical presence thresholds with nexus standards based on dollars generated in the relevant states. Readers of the Digital Economy Report may be left wondering whether formulary apportionment is far off.


1 Since the digital economy permeates through all areas of BEPS project, we may not see a separate list of actionable items in 2015 related to the digital economy. Rather, it is more likely we will see suggested solutions in bits and pieces in other areas of the BEPS project reports.

2 This uncertainty has been around for some time, and practitioners have struggled with a dearth of analogous law, including under section 7701(e) of the U.S. Internal Revenue Code.

3 Digital Economy Report at ¶ 4.3.4

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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