The report is the product of work undertaken as part of Action Plan 1 under the OECD’s Base Erosion and Profit Shifting (BEPS) Plan. It claims to seek to address the question of whether the framework of today’s international tax rules is ‘fit for purpose’ when applied to business conducted in the digital economy.
Comments on the questions raised in the draft report are invited to be received by 14 April 2014 and a public consultation is planned on 23 April 2014. The objective is to finalise a report which presents thought through solutions to the tax challenges posed by the digital economy by September 2014.
This is the first stage of output from this working group and is very much a draft report for discussion. In order to take full effect, the range of proposals set out in the report will need to achieve consensus amongst the countries that are participating in the BEPS Plan.
Achieving international agreement will not be straightforward and there is little evidence of consensus on how to tackle the digital economy. Some countries have argued that digital commerce should be taxed in the country of residence of the customer because the product is transformed when the customer uses it. Other countries have argued that digitisation is ubiquitous and that it would not make sense to create special rules for particular industries. It is arguable that the current draft does not make an especially convincing case for special rules for the digital economy.
Overview of the report
The report reflects the stated intention to review the tax challenges of the digital economy and to take stock and to enumerate the challenges. This overview comprises most of the report content. Many of the specific actions which are identified as possible proposals to take forward form part of a number of ongoing BEPS Plan actions that seek to address BEPS concerns across all sectors of the economy. In that sense, little of the detail set out in the report is new or specific to those businesses that conduct their business primarily through the digital economy. At the end of the report, proposals are set out which seek to apply the framework of current rules to businesses whose business model is based on ‘fully dematerialised digital activities’.
What is the ‘digital economy’?
The report does not define what is meant by the ‘digital economy’. Instead, the report provides readers with an overview of the evolution of business models which reflect the impact of the digital economy. It can be seen from the range of business developments which have been afforded by changes in information and communication technology (ICT) that the effects of the digital economy are visible across a range of businesses including traditional sectors such as manufacturing. It is clear that it is not possible to ‘ring-fence’ the digital economy from the rest of the economy.
Developments in the digital economy that are highlighted in the report are those that have contributed to the ability of businesses to centralise operations in locations which are remote from the consumer market and those that allow activities to be based in low taxed jurisdictions without creating a physical presence in the market of the end consumer. There is limited focus in the report on the extent to which these business activities contribute significant tax revenues to economies with large consumer markets in the form of VAT, other indirect taxes and employment taxes.
Recommended areas for further consideration
As the effects of the evolution of the ‘digital economy’ can be seen across business sectors, the report considers that many of the BEPS concerns will be addressed through a number of the 15 actions already underway in the overall BEPS Plan.
The draft sets out possible action areas for further consideration:
- Modifying the definition of permanent establishment (PE) so that there is a greater likelihood for businesses with remote or centralised sales functions to trigger taxable presences in the market of the end customer with resulting local tax on related profits. For example, it could result in a broader range of sales related activity conducted by a subsidiary in the local market being treated as creating a local PE for the seller. Activities currently considered to be ‘ancillary’ and below the scope of a taxable PE in the local market might be considered to be ‘core’ and create a taxable PE in the local market in future.
- Modifying the definition of PE to create a taxable presence based on significant digital presence. For those businesses that have no tangible assets apart from computing infrastructure and operations offices, the report considers if rules should be developed to recognise a ‘virtual permanent establishment’ as an extension of existing PE concepts. This might be a ‘virtual fixed place of business’ (created through websites on servers), a ‘virtual agency PE’ (where contracts are concluded in a market through technology) and an ‘onsite business presence PE’.
- Other options explored also include the creation of withholding tax on digital transactions and various consumption tax options which deal with the particular issues created by high volumes of sales of low value goods and remote digital supplies to consumers. The draft claims this proposal would address concerns that it may be possible to maintain substantial economic activity in a market without being taxable in that market under current PE rules because of a lack of physical presence in the market. The task force would need to consider whether that provision is compatible with trade obligations, and how to address the challenges of withholding that tax on individual consumers.
For businesses operating in the EU, these measures may involve a close consideration of the interaction of the VAT place of supply rules (and the changes that will affect a range of digital supplies to consumers from 1 January 2015) and the proposed measures which could result in the revision of rules on the recognition of a taxable presence for corporate income tax purposes. The report leaves open the question of whether measures directed at ‘dematerialised digital activities’ might more easily be collected through VAT or consumption tax measures instead of through corporate income tax measures.
What might these measures mean for business in Ireland?
The ultimate impact of the proposals is uncertain. In combination, these measures could result in more businesses with centralised or remote sales functions triggering a taxable presence in consumer markets. In circumstances where groups already have a local business presence, they may result in a greater attribution of profits under transfer pricing principles to the activities conducted in those markets. Those operations which have the greatest ‘on the ground’ substance in Ireland are least likely to see an erosion of their Irish corporation tax profits base particularly where key functions and activities which drive value in their business can be seen to be performed in Ireland.
Ireland is actively participating in the various actions under the BEPS Plan. As an economy with a heavy weight of participation in global flows in the ‘digital economy’ these interlocking developments are of central importance to Ireland. Irish government policy is to remain engaged in this process and is committed to achieving a positive outcome for Ireland.
To find out more about the issues and implications of the OECD report on Tax Challenges of the Digital Economy please do get in touch with any member of our tax team.
To get an overview of other actions in the BEPS Plan and expected developments over the next few months, read KPMG’s Update on OECD Action Plan on Base Erosion and Profit Shifting.