Governments globally and across the Asia Pacific are examining treaty-based transactions more closely in audits. They are also looking into ways to update traditional tax treaty principles to address how profits are made in the digital economy.
There are three areas of biggest concern for companies employing tax-effective treaty-based structures for their Asia Pacific investments and operations:
- 'permanent establishment' concepts
- intellectual property planning
- treaty shopping and beneficial ownership issues.
'Permanent establishment' concepts
While it remains well suited to issues involving physical manufacturing and retail operations with tangible inputs and products, policy makers realize that the ‘permanent establishment’ concept is ill-equipped for dealing issues arising from transactions in the digital economy.
With online shopping, both buyer and seller can be located anywhere. Sales can be solicited from outside a jurisdiction, and physical goods can be sold in a country without the seller’s presence, so the business activity required to create a permanent establishment does not exist and no tax obligation is triggered.
Beyond online sales, the internet has fostered revenue streams even more removed from traditional sales of goods and services that occur at specific places. Exactly where these activities are located for tax purposes raises questions that current taxation principles cannot answer.
Australia and France
In the quest to develop answers, the governments of Australia and France are perhaps the most advanced. Australia has struck an advisory committee of policy makers and tax professionals to determine how to collect revenue from non-residents on their profits derived in Australia from digital economy activities. So far, the committee’s thinking appears to be influenced by a report1 on taxation and the digital economy issued by the government of France in February 2013.
The French report (known as the 'Colin & Collin' report, after its co-authors) notes that the activities of digital companies lack 'points of stability' required to create a permanent establishment. The report calls for the concept to be redefined to encompass 'permanent virtual establishments' that earn income from digital economy activities in countries without any fixed base. The report also points out that current tax concepts do not address data created by users. Based on this argument, the report calls for a tax on data collection through regular and systematic monitoring of users’ activity in France. Such a tax could be introduced in France as early as 2014.
The Australian government is similarly committed to collecting a greater share of the tax revenue from e-commerce, and so companies should consider making submissions to the advisory committee.
China’s domestic tax regulatory framework lags behind Australia and France in the cross-border taxation of e-commerce. The Chinese tax authorities have referred to the OECD discussion paper titled Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transactionson, and they are increasing scrutiny on inbound business-to-business e-commerce and cloud computing transactions. However, the levels of sophistication and experience of the Chinese tax authorities in different locations still vary. Non-resident enterprises conducting e-commerce in China should perform tax risk analyses and prepare detailed supporting documents to support their tax positions, taking technical merits and local administrative practices into account.
The e-commerce industry in India is rapidly expanding, with analysts projecting a five-fold increase in revenues by 2016, compared to 2012. To help address taxation issues arising from transactions in this sector, in 2001, the Indian Government constituted a High Powered Committee (HPC). The HPC’s report agreed with the OECD Technical Advisory Group’s thinking at the time that e-commerce and regular commerce transactions should be treated tax-neutrally. The HPC also recommended developing an alternative permanent establishment concept for e-commerce transactions.
Since then, no legal principles for tax e-commerce transactions have been codified, leading to substantial litigation in the area, particularly over the taxation of software. Indian courts and tax tribunals have tended to followed the OECD’s e-commerce principles, ruling that the use of copyrighted articles does not give rise to royalties and so Indian withholding tax applies. The issue is now pending before India’s Supreme Court.
Further, India recently amended its domestic tax law retroactively to provide that payments for use of computer software would give rise to royalties. Under India’s domestic law, royalties are defined broadly and they are taxable as passive income. But despite their domestic tax impact, these amendments cannot be read into a tax treaty, as affirmed by the Indian courts in WNS North America Inc.
India’s government has formed an expert committee to examine tax issues related to the information technology and information technology enabled services sector. Its report is due for release in April 2013. To help reduce litigation, the government also formed an advisory panel to examine international tax and transfer pricing issues. As the committees attempt to develop solutions, many companies in India are invoking mutual agreement procedures under tax treaties to help resolve issues regarding permanent establishment attribution in the digital economy.
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Intellectual property planning – high value and mobility
Intellectual property plays a central role in driving value for many global businesses in the digital economy, especially marketing related assets (such as trademarks, designs and logos) and technology-related assets (such as patents).
The intangible nature of these assets makes it easy to move their ownership to new locations. These assets can generate both costs and income depending on whether they are being developed or exploited. In development, grants and tax relief may be available. During exploitation, the rate at which profits are taxed becomes more important. Intellectual property planning involves holding mature assets in lower-tax jurisdictions, relying on transfer pricing and treaty-based withholding tax reductions on royalties to reduce the global company’s overall tax bill.
Some governments, such as China, have put in place measures to encourage foreign enterprises to move and hold valuable intellectual properties in their countries. For example, under China’s 'high-and-new technology enterprise' program, qualified companies pay corporate income tax at 15 percent, rather the usual 25 percent rate. A key condition to qualify for this treatment is that the Chinese enterprise has core intellectual property situated in China. Further, Chinese companies that conduct R&D activities to develop their own intangible properties can claim a 150 percent bonus deduction.
In India income from intellectual property is governed by current domestic tax laws. Indian tax authorities are looking into issues regarding:
- situs of incorporeal assets on inter-group transfers of intellectual property
- apportionment of income attributable to Indian operations
- transfer pricing and indirect taxes.
The Authority for Advance Rulings recently held that the transfer of intellectual property and related rights owned by a foreign company to another foreign company was taxable in India in view of nexus of the intellectual property with an Indian subsidiary of the transferor. The definition of capital asset in the domestic tax laws has also been amended to include any rights that could be interpreted to include intellectual property rights.
With India gearing up to enforce its general anti-avoidance rules (GAAR) from 1 April 2016, any tax planning measures undertaken purely with a tax motive could be characterized as tax avoidance transactions and disregarded. Thus intellectual property migration should be backed by sound commercial rationale. As Indian transfer pricing authorities are closely scrutinizing valuations done on transfer, companies should ensure intellectual property valuations have the strength to withstand the test of transfer pricing audits.
Australia is taking action on several fronts to defend its tax base against inappropriate profit shifting involving intellectual property:
- New rules introduced in February 2013 go beyond the traditional arm’s length principle for determining transfer prices, requiring them to be set with an eye to the broader economic and business context in the allocation of expected profits among international groups.
- Australia is reviewing the permanent establishment terms of its tax treaties to address intellectual property concerns.
- Australia’s domestic GAAR can override the terms of tax treaties, giving it more power to tackle treaty-based intellectual property planning structures. Intellectual property planning structures are also being challenged on the basis that the entity that owns the property lacks sufficient business substance in the treaty country, under the beneficial ownership rules.
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Treaty shopping and beneficial ownership issues
A third issue of top priority for many Asia Pacific tax authorities is treaty shopping, by which residents of third countries gain inappropriate access to tax treaty benefits. This access is often achieved through the use of shell corporations set up in treaty countries. While traditional companies have engaged in such planning for some time, the high mobility and lack of physical location of activities in the digital economy facilitates its use by companies in the sector.
Many countries, including India and China, employ so-called “beneficial ownership” rules to look through companies without business substance to deny treaty benefits.
In 2009, the government of China issued Circular 601, which sets out rules requiring that, before claiming treaty benefits, non-residents extracting certain passive income from China must prove they are the beneficial owner of income by showing that the business has sufficient substance in the treaty country based on factors such as staff, premises and business operations.
But Circular 601 did not set specific thresholds or other criteria for assessing these factors. Uncertainties arose over how the rules apply to determine beneficial ownership in practice, especially for group companies and for agents, such as private equity funds, that are the registered owners of equity interests but are acting on the true beneficial owner’s behalf.
In Announcement 30, released in July 2012, the State Administration of Taxation (SAT) introduced several welcome clarifications and safe harbors to help ease beneficial ownership determinations in some cases. Announcement 30 emphasizes that no single factor can determine beneficial ownership. The assessment should be made based on a totality of factors.
Briefly, two of the most important clarifications in Announcement 30 are as follows:
- Companies that are publicly listed in the treaty country are automatically considered to have sufficient business substance in that country, as are certain direct and indirect subsidiaries of such companies (regardless of whether the subsidiary is a listed company).
- Where an agent, such as a private equity fund, receives China-sourced income on behalf of another party (the principal), the Chinese tax authorities should look at the principal to determine the income’s beneficial ownership, regardless of whether the agent itself is a tax resident of the treaty country.
While Announcement 30 does not resolve all of the uncertainties arising from China’s beneficial ownership rules, it offers much-needed guidance for the situations it addresses. It also signals the SAT’s willingness to provide detailed interpretational guidance, and we expect this is just the first of a series of announcements that may be forthcoming.
The Indian judiciary has often traversed the thin line between tax planning and tax avoidance arising out of treaty shopping. Usually, the Indian courts have followed the Westminster principle and recognized that developing countries often set favorable treaty terms to attract investment.
India is seeking to tighten its tax policies without raising the ire of global investors by bringing about clarity in anti-abuse laws. To this end, it has deferred introduction of GAAR to April 2016. On the sidelines, it has started treaty talks with various countries, including Mauritius, and now requires non-residents to produce a tax residency certificate to access treaty benefits. While India’s government has assured investors that it would accept these certificates as proof of residence, it has not committed to what characteristics the certificate should have to stand the test of beneficial ownership.
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