In July 2013, the Organisation for Economic Co-operation and Development (the "OECD") released the BEPS Action Plan in response to concerns expressed by policymakers around the world that multinational enterprises ("MNEs") were engaging in tax planning to artificially reduce taxable income or shift profits to low-tax jurisdictions, where little or no economic activity is performed. The BEPS Action Plan was endorsed by the G20 leaders in September 2013.
The BEPS Action Plan includes 15 actions for fundamental changes to domestic and international tax laws and the adoption of new approaches based on consensus among countries in order to prevent BEPS. This article is focused on Action 1 and the potential options to address the tax challenges of the digital economy discussed in the Public Discussion Draft, BEPS Action 1: Address the Tax Challenges of the Digital Economy, prepared by the OECD Task Force on the Digital Economy (the "Task Force") and released on March 24, 2014 (the "Public Discussion Draft").1
TAX POLICY CHALLENGES
The Task Force has identified four broad tax policy challenges raised by the digital economy in its Public Discussion Draft, those being nexus, data, characterisation, and value-added tax ("VAT") collection.
Domestic and international tax rules were established before the advent of the digital economy and are based for the most part on some form of physical nexus in the taxing jurisdiction. Traditionally, a non-resident would require some physical presence in a particular jurisdiction to do business with customers located in other jurisdictions such as local marketing, distribution, service or manufacturing functions. This is no longer the case. Suppliers of goods, services or intangibles can sell, transfer or provide goods, services or intangibles to customers in other jurisdictions without any or very limited local physical presence. This raises the question as to whether the current tax rules are appropriate under the circumstances.
Many companies or other entities engaged in the digital economy have developed sophisticated technology to collect, analyze and ultimately monetize information including, for example, the profile of existing or potential consumers or users. This information may be very valuable and may be used to target specific categories of consumers or users and could also be sold or transferred to other parties who may benefit from such information. This second category raises issues regarding how to attribute value to this data and how a supply of data should be treated for tax purposes (e.g., supply not subject to tax, barter transaction or some other treatment).
The sophistication of new digital products or services creates issues with respect to how the payment for such products or services should be characterised for tax purposes. For example, payments for cloud computing or payments made with bitcoins are fairly new and it is unclear how they should be characterised for domestic and treaty purposes.
Certain countries including Canada and the United States have issued some guidance as to how bitcoin transactions should be treated for tax purposes. The approach adopted by these two tax authorities is generally based on the application of the current tax rules to such transactions. The Canadian tax authorities have taken the position that bitcoins should be treated as a commodity rather than a currency and that bitcoin transactions are taxable for Canadian tax purposes.2 The United States tax authorities have adopted a similar position in respect of the taxation of bitcoin transactions.3
For Canadian tax purposes, where bitcoins are used to purchase goods or services, the vendor or service provider is required to include in computing its income the price expressed in Canadian dollars that the vendor or service provider would have normally charged to an arm's length person for the goods and services. If a sale is subject to the Goods and Services Tax ("GST") or Harmonized Sales Tax ("HST"), the registrant would be required to collect GST and HST calculated based on the FMV of bitcoins used as consideration. Transactions that involve the trading or selling of bitcoins would be treated the same as transactions involving the sale of other types of commodities. As a result, any gain or loss realized on the trading or selling of bitcoins could be on account of income or capital depending on the particular circumstances.
The significant increase in cross-border sale and purchase of goods, services and intangibles in the electronic economy gives rise to various issues in respect of the registration and collection of VAT. Where private consumers are involved, there is generally a high volume of very low dollar value transactions. The administrative costs for a tax authority in managing and enforcing VAT in these circumstances may outweigh any revenue that could be generated therefrom.
POTENTIAL OPTIONS TO DEAL WITH TAX CHALLENGES OF DIGITAL ECONOMY
The Task Force has received input from various sources and discusses potential options to deal with the tax challenges of the digital economy in its Public Discussion Draft. The review of the potential options is still at a preliminary stage and the Task Force has requested comments from the public before April 14, 2014. It is expected that an in-depth final report identifying tax challenges raised by the digital economy and the necessary actions to address it will be released by the OECD in September 2014.
Modification of the Exemptions from Permanent Establishment Status
This option proposes to modify the exceptions from permanent establishment in paragraph 4 of Article 5 of the OECD Model Tax Convention on Income and on Capital ("OECD MTC") to address the issue of nexus in the digital economy. The purpose of these exceptions is to prevent an enterprise of one state from creating a permanent establishment ("PE") in the other state if it carries on in the other state activities of a purely preparatory or auxiliary character.
Under paragraph 4 of Article 5 of the OECD MTC, a PE is deemed not to include the following activities: "(a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; (b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; (c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; (d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise; (e) the maintenance of a fixed place of business solely for purposes of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; and (f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs (a) to (e) , provided the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character."
Proponents of this option have suggested that paragraph 4 above should be eliminated in its entirety, or alternatively, that the activities described in subparagraphs (a) to (d) should be eliminated or available only to the extent that they do not constitute the core activities of a business. One example included in the Public Discussion Draft in support of this option is where the proximity to customers and the need for quick delivery to clients are key components of the business model of an online seller of physical products. In this case, the maintenance of a local warehouse in a particular jurisdiction could constitute a core activity of the online seller and create a PE in that jurisdiction.
New Nexus Concept Based on Significant Digital Presence
Another potential option suggests establishing a new nexus concept based on significant digital presence in a particular jurisdiction to address situations in which businesses are conducted wholly digitally. Under this new concept, a foreign enterprise engaged in certain "fully dematerialised digital activities" could be considered to have a PE in a particular jurisdiction if it maintained a "significant digital presence" in such jurisdiction.
Conduct of Fully Dematerialised Digital Activity
The Public Discussion Draft lists certain potential elements of a test that could be used to determine when a "fully dematerialised digital activity" would be considered to be conducted including among others:
- "The core business of the enterprise relies completely or in a considerable part on digital goods or digital services;
- No physical elements or activities are involved in the value chain other than the existence, use or maintenance of servers and websites or other IT tools and the collection, processing, and commercialisation of location-relevant data;
- Contracts are concluded exclusively remotely via the Internet or by telephone;
- Payments are made solely through credit cards or other electronic payments using on-line forms or platforms linked or integrated to the relative websites;
- All or the vast majority of profits are attributable to the provision of digital goods or services; or
- The actual use of the digital good or the performance of the digital service does not require physical presence or the involvement of a physical product other than the use of a computer, mobile device or other IT tools."4
Existence of Significant Digital Presence
The Public Discussion Draft also provides four examples of when a significant digital presence could be deemed to exist and constitute a PE of a foreign enterprise in a particular country.5 Under the first example, a significant digital presence could be deemed to exist in a particular country if a significant number of contracts for the provision of fully dematerialised digital goods or services are remotely signed between the foreign enterprise and a customer that is resident in that country. In the second example, the wide use or consumption of digital goods or services of a foreign enterprise in a particular country could be considered a "significant digital presence" in that country.
The third example describes a situation where substantial payments are made from clients in a particular country to the foreign enterprise in connection with contractual obligations arising from the provision of digital goods or services as part of the enterprise's core business. The fourth example deals with a situation in which a branch of the foreign enterprise in a particular country offers secondary functions including marketing and consulting to clients resident in that country which are strongly related to the core business of the foreign enterprise.
As an alternative potential option, the Public Discussion Draft also contemplates that significant digital presence could exist in a particular jurisdiction if a foreign enterprise engaged in a fully dematerialised digital activity does significant business in that jurisdiction using personal data obtained by regular and systematic monitoring of Internet users in that country through the use of certain business models.
Alternative PE Thresholds
Three broad options for an alternative PE threshold are also discussed in the Public Discussion Draft. These options were considered by the Business Profits Technical Advisory Group in their previous work on electronic commerce.
Virtual Fixed Place of Business PE
Pursuant to this alternative PE threshold, a PE would be created in a particular jurisdiction when a foreign enterprise maintains a website on a server of another enterprise located in that jurisdiction and carries on business through that website.
Virtual Agency PE
This alternative PE threshold would extend the dependent agent concept found in paragraph 5 of Article 5 of the OECD MTC to virtual agency PE situations. Currently, this concept requires physical presence in the other contracting state, and in particular, that the dependent agent has, and habitually exercises, in the other contracting state an authority to conclude contracts in the name of the foreign enterprise. Under the proposed extended concept, the conclusion of contracts in the name of the foreign enterprise with persons located in the other state through electronic means would be sufficient to create a PE.
On-Site Business Presence PE
This alternative PE Threshold is focused on the economic presence of the foreign enterprise in a particular jurisdiction. A PE could be created under this alternative to the extent the foreign enterprise provides on-site services or other business interface at the customer's location in the other jurisdiction. This alternative appears to bear some similarities to the services PE concept found in certain tax treaties, including in paragraph 9 of Article 5 of the Canada-US Tax Treaty.
Creation of Withholding Tax on Digital Transactions
Another option considered by the Task Force is to impose a final withholding tax on certain payments made by residents of a country for digital goods and services provided by a foreign e-commerce provider to address the lack of physical presence concern. This option raises the issue of who should be responsible for withholding tax from international payments for digital economy transactions which are generally made using credits cards or electronic payments. The Task Force suggests that such tax withholding could be made by financial institutions involved in processing these transactions.
Proposed Options for Consumption Taxes
The Task Force also discusses certain options to address VAT concerns in the digital economy including improving the efficiency of processing low value imports and of charging, collecting and remitting tax on such imports and requiring non-resident suppliers to register and account for VAT on cross-border supplies in the jurisdiction of the consumer.
Like many other countries, Canada is concerned about the collection of consumption taxes on e-commerce transactions between residents of Canada and foreign-based vendors. In its 2014 Federal Budget, the Canadian Federal Government announced that it would be seeking input from stakeholders on tax planning by MNEs to address BEPS. As part of this consultation process, the Canadian Federal Government has asked stakeholders to provide specific input on whether Canada should adopt the approach taken in some countries (such as South Africa and the European Union) and require foreign-based vendors to register with Canadian tax authorities and to charge GST/HST if they make e-commerce sales to Canadian residents.
DOMESTIC AND INTERNATIONAL FOCUS ON BEPS
The OECD continues to advance the BEPS Action Plan. In this regard, the OECD has also recently released Public Discussion Drafts on Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements (March 19, 2014), Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances (March 14, 2014) and Action 13: Transfer Pricing Documentation and Country-by-Country Reporting (January 30, 2014). Many countries around the world are struggling to find ways to prevent the erosion of their tax base through BEPS. It is expected that the OECD's final recommendations on the various BEPS Actions will be relevant in developing the domestic and international approach adopted by many countries in order to address BEPS.
1. Public Discussion Draft is available on OECD website.
2. CRA Views, Interpretation – Internal, Bitcoins Document # 2013-0514701I7 (December 23, 2013)
3. IRS Notice 2014-21
4. Refer to Public Discussion Paper at page 65 on OECD website for complete list of potential elements.
5. Public Discussion Paper at pages 65 and 66 on OECD website.
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