As the pace of change around the digital economy continues to accelerate, and the wider economy itself becomes more digitized, developed countries continue to explore new ways to raise taxes in a way that will be perceived to be more fair, and enable those countries significantly impacted by digitization to receive a greater slice of the tax cake. The Organisation for Economic Co-operation and Development (OECD) is leading the approach as part of the later stages of the implementation of its Base Erosion and Profit Shifting (BEPS) project.
BEPS was introduced in 2012 to tackle both the perceived and real challenges to the international tax base resulting from multinational enterprises structuring their affairs in such a way to limit or minimize the levels of tax they paid within countries where their consumers resided. This was generally achieved by applying an international tax model developed early in the first half of the 20th century and essentially out of date with modern business, particularly the digital economy.
Following the introduction of the BEPS project, in 2015 the OECD published its recommended 15 Actions. Since 2015, OECD member countries, including the U.K., and numerous other countries, have adopted many if not all of the recommended Actions, by way of unilateral action, the adoption of the EU Anti-Tax Avoidance Directive (ATAD), which incorporated various BEPS Actions, and the signature of the multilateral Instrument (MLI) on June 7, 2017, which had the impact of simultaneously amending numerous double tax treaties.
At the center of the challenge faced by the OECD and its various members in seeking to tax international transactions is the historical principle that tax generally lies in the country of residence of the business provider, as opposed to the jurisdiction of a transaction itself: this led to a proliferation of companies moving their residence to low or zero taxation jurisdictions.
One of the aspects of the digital economy that presents particular challenges, and at the same time opportunities, is the significant reliance on intangibles. Intangibles include patents, copyright, trademarks, know how, trade secrets, and goodwill. Because of the very fact that intangibles are not physical assets, they are essentially mobile, and so it is comparatively simple to hold them or transfer them to entities in locations anywhere in the world, without significant transportation or maintenance costs.
Creating a New Tax Model for Digital Business and Private Client Structures
It was acknowledged by the OECD, when releasing the various BEPS Actions in 2015, that significantly more work was required on BEPS Action 1, which was designed to consider the specific challenges of the digital economy.
Following the release of the BEPS Action 1 Report the OECD Inclusive Framework of over 100 countries set about seeking to collaborate to consider some of the fundamental challenges that existed in the taxation of the digital economy.
On March 16, 2018, the OECD released an interim report setting out the key areas to be considered. Those key areas included the principles of tax “nexus” and profit allocation.
Under historical tax rules a company is only taxable on its business profits where it is resident, or in another country if it has a permanent establishment in that other country—i.e. where it has its tax nexus. Once that nexus position has been resolved, the profits to be taxed are allocated accordingly, and, where associated enterprises are involved, applying arm’s length principles.
More recently, in March and May 2019 we saw further updates and analysis and, in October 2019, the OECD issued a report to G-20 Finance Ministers seeking their guidance and decisions on points of a more political nature towards the way ahead, with the aim of trying to secure some form of agreement in 2020.
Pillars One and Two
The latest position is that the OECD is currently considering two proposals, under two separate pillars.
Pillar One looks at the way that digital businesses operate by way of engaging with users of services, often in third countries, or operating in such a way to market their services in an organized and targeted way. Additionally, it looks at those businesses with a significant economic presence, for example in the U.K., but where there is not a permanent establishment as such.
The OECD sets out that a “significant economic presence” includes:
- the existence of a user base and associated data input;
- the volume of digital content derived from the jurisdiction;
- billing and collection in local currency or with a local form of payment;
- the maintenance of a website in a local language;
- responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales services or repairs and maintenance; or
- sustained marketing and sales promotion activities, either online or otherwise, to attract customers.
Pillar Two takes a different approach, seeking to introduce a method to re-enforce tax sovereignty to the extent that where a country fails to enforce its own taxing rights, a third country can “tax back” profits, by applying an approach which potentially ensures that a minimum level of taxation is applied.
At the time of writing this article, Pillar Two is continuing, but the OECD has recently issued a public consultation, Secretariat Proposal for a “Unified Approach” under Pillar One to consider the merits of Pillar One.
The latest developments around Pillar One set out that the Inclusive Framework of over 100 countries sees merit in the three different proposals. Whereas the User Participation proposal focuses very much on digital business—essentially, social media, search engines and online marketplace businesses—the other proposals in practical terms extend potentially to most sectors, perhaps with the exclusion of, say, business in extractive sectors, such as mining.
The Inclusive Framework has chosen to propose a “Unified Approach” of the three proposals. The Unified Approach proposal looks to introduce a new tax “nexus.” This essentially departs from the historical principal dependent on physical presence, and instead focuses on sales. It appears the current thinking of the OECD is to apply thresholds of sales income, to ensure smaller companies are not burdened by the new rules, although, as stated, this is still at consultation stage, and so all of these aspects might change.
Once nexus has been achieved based on sales, it is then necessary to introduce new “profit allocation rules.” These rules will effectively extend beyond the arm’s length principle rules within Article 9 of the Model Tax Convention on Income and Capital.
Pillar One also sets out that the OECD is looking to introduce administrative rules with the aim of providing greater certainty around the revised rules.
Tax Challenges to Current Digital Structures
One of the reasons for the OECD to bring forward its proposals is to address the fact that OECD members are taking unilateral action by introducing their own digital services tax (DST). France and Hungary have already introduced their own DST, and there are already proposals from the U.K., Italy, Spain, Belgium and Austria. Poland and Czech Republic have also made announcements.
U.K. Digital Services Tax
The U.K. DST is due to come into force from April 2020. It will seek to charge 2% on sales income relating to users above 25 million pounds ($32 million) on groups with worldwide sales income over 500 million pounds. The U.K. approach is very much that mentioned above, focusing on social media, search engines and online marketplace businesses.
The U.K. DST will be a tax in its own right and will potentially be allowable as a deduction for corporation tax purposes, providing it amounts to an expense of the company wholly and exclusively for the purposes of the trade. It will not amount to a tax within the scope of double taxation agreements.
The DST is not the only action taken by the U.K. government to tackle tax issues arising from digital economy businesses. In April 2015, the U.K. government introduced the Diverted Profits Tax (DPT): when introduced, many media commentators called it the “Google tax.”
The DPT sought to tackle three things: transactions between large companies without sufficient economic substance; companies operating in the U.K. via a permanent establishment, and again with transactions lacking economic substance; and overseas companies operating in the U.K. in such a way as to avoid having a permanent establishment.
The technical detail of the DPT is complex, and some would say has led to a lack of real understanding of how it works. The DPT actually operates beyond digital businesses and so its being coined the “Google tax” may have contributed to some of the problems. Statistics from HM Revenue & Customs (HMRC) show that the DPT collected yield as follows:
- 2015–16: 31 million pounds
- 2016–17: 281 million pounds
- 2017–18: 388 million pounds
In January 2019, HMRC stated that they had identified many cases where companies were failing to comply with the DPT rules, and so introduced a disclosure facility enabling companies to make disclosures of DPT failures but also of wider transfer pricing failures and cases of failure to comply with withholding tax rules.
From April 2019, the U.K. government also introduced new profit fragmentation anti-avoidance rules, which further require transfer pricing principles to be fully complied with.
De-risking of International Tax Structures to Ensure they are Fit for Purpose
The world is becoming ever more transparent, with the advent of increased anti-money laundering requirements and various requirements for automatic exchange of information, including the EU Directive on Administrative Co-operation, the OECD Convention on Mutual Administrative Assistance, the OECD Standard for Automatic Exchange of Financial Account Information (Common Reporting Standard), the U.S. Foreign Account Tax Compliance Act (FATCA) and the introduction of various beneficial ownership registers.
We have also seen several well-publicized leaks of data.
As a result of both increased resulting tax interventions and a quite correct concern over risk to reputational damage, we have seen many clients and advisers reviewing cross-border structures to determine whether they are fully tax compliant. Additionally, we are seeing some of the same clients and advisers “de-risking” structures to reduce tax risk. U.K. government policy over the last decade has been to introduce more and more sanctions to penalize non-compliant cross-border structures. An example of this is the U.K. Offshore Penalty legislation introduced in 2010. Those rules provide maximum penalties of 100% for domestic tax matters, and tax matters relating to various countries with compliant exchange of information rules. Other countries with less strong exchange of information rules are charged penalties of up to 200%.
Some entities are de-risking by moving structures back into the U.K., or into developed countries as opposed to so-called low or zero taxation territories. They are also structuring into countries with full double tax treaty agreements. As a result of BEPS, we are also seeing those countries with double tax treaties review and revise them to ensure they are BEPS compliant.
Also, as a result of BEPS Action 5, we are seeing most low or zero taxation territories introducing new substance legislation, in part because the EU, under the EU Code of Conduct on business taxation, has started to list those countries as uncooperative jurisdictions. The new substance rules effectively require that companies operating in the relevant territories are properly managed and directed in these jurisdictions, but also have “adequate” people, assets and expenditure in relevant business activities as set out in BEPS Action 5.
The re-shaping of the international tax framework is now well underway and BEPS well inbedded in most developed countries.
The focus back towards the digital economy is seen as a very important outstanding piece of the jigsaw. That said, with every day, we are seeing the digital economy develop and spread into our daily lives.
The proposals of BEPS Action 1 under Pillars One or Two seek to counter much of the so-called abuse undertaken by multinational enterprises, but given the ingenuity of the tech sectors I would expect the BEPS project, or certainly changes in international taxation to require further supervision and amendments in the years ahead.
Gary Ashford is a Partner (non-lawyer) at Harbottle and Lewis LLP. He is a Chartered Tax Adviser and sits on the Council of the Chartered Institute of taxation (CIOT) and is Vice President of CFE (Tax Advisers Europe).
The author may be contacted at: email@example.com
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners