Yesterday, a discussion document for Action Point 1: Taxing the Digital Economy was published. It is a very wide-ranging document. One of the notable suggestions are the proposals to allow/force the greater taxation of companies selling digital products in their “market jurisdictions”. This primarily arises from the ability of such companies to circumvent the existing rules on permanent establishment because of the intangible nature of the product.
The proposal is not a move to formulary apportionment. The document puts forward proposals to alter the existing source principle of corporation tax to try and ensure that more/some of the profits earned by these companies are attributed to the country of their customers using changes to PE rules. Other proposals include the new concept of a “virtual” permanent establishment, the creation of a withholding tax on digital transactions and the use of consumption tax options.
There is a lot in the document and some extracts summarising the problems the OECD group are trying to tackle in this area are below the fold. Whether there will be any effective solutions by the end of the process remains to be seen.
Permanent establishment and the digital economy.
124. Companies in many industries have customers in a country without a permanent establishment in that country, communicating with those customers via phone, mail, and fax and through independent agents. That ability to maintain some level of business connection within a country without being subject to tax on business profits earned from sources within that country is the result of particular policy choices reflected in domestic laws and relevant double tax treaties, and is not in and of itself a BEPS issue. However, while the ability of a company to earn revenue from customers in a country without having a PE in that country is not unique to digital businesses, it is available at a greater scale in the digital economy than was previously the case. Where this ability, coupled with strategies that eliminate taxation in the State of residence, results in such revenue not being taxed anywhere, BEPS concerns are raised. In addition, under some circumstances, MNEs may attempt to artificially fragment their operations among multiple group entities to qualify for the exceptions to permanent establishment status for preparatory and auxiliary activities, or to otherwise ensure that each location through which business is conducted falls below the permanent establishment threshold. Structures of this type may permit an MNE to artificially avoid tax in the market jurisdiction, which raises BEPS concerns.
Paragraph 133 gives a useful summary of the techniques used to minimise tax in an “intermediate” country where a company has a taxable presence (such as Ireland).
133 Companies may also reduce tax in an intermediate country by generating excessive deductible payments to related entities that are themselves located in low- or no-tax jurisdictions or otherwise entitled to a low rate of taxation on the income from those payments. For example, an operating company located in an intermediate jurisdiction may use intangibles held by another affiliate in a low-tax jurisdiction. The royalties for the use of these intangibles may be used to effectively eliminate taxable profits in the intermediate jurisdiction. Alternatively, an entity in an intermediate jurisdiction may make substantial payments to a holding company located in a low- or no-tax jurisdiction for management fees or head office expenses. Companies may also avoid taxes in an intermediate country by using hybrid mismatch arrangements to generate deductible payments with no corresponding inclusion in the country of the payee. Companies may also use arbitrage between the residence rules of the intermediate country and the ultimate residence country to create stateless income. In addition, companies may assert that the functions performed, assets used, and risks assumed in the intermediate country are limited.
Paragraph 135 is a thinly-veiled reference the wide-scale system of tax deferral available to US companies for their non-US-sourced income.
135 In addition, companies in the digital economy may avoid tax in the residence country of their ultimate parent if that country has an exemption or deferral system for foreign-source income and either does not have a CFC regime that applies to income earned by controlled foreign corporations of the parent, or has a regime with inadequate coverage of certain categories of passive or highly mobile income, including in particular certain income with respect to intangibles. For example, the parent company may transfer hard-to-value intangibles to a subsidiary in a low- or no-tax jurisdiction, thereby causing income earned with respect to those intangibles to be allocated to that jurisdiction without appropriate compensation to the parent company. In some cases, a CFC regime might permit the residence jurisdiction to tax income from these intangibles. Many jurisdictions, however, either do not have a CFC regime, have a regime that fails to apply to certain categories of income that are highly mobile, or have a regime that can be easily avoided using hybrid mismatch arrangements.
And paragraph 146 promises the end of “stateless income”
146 Structures aimed at artificially shifting profits to locations where they are taxed at more favourable rates, or not taxed at all, will be rendered ineffective by ongoing work in the context of the BEPS Project. At the same time, the work on BEPS will increase transparency between taxpayers and tax administrations and among tax administrations themselves. Risk assessment processes at the level of the competent tax administration will be enhanced by measures such as the mandatory disclosure of aggressive tax planning arrangements and uniform transfer pricing documentation requirements, coupled with a template for country-by-country reporting. The comprehensiveness of the BEPS Action Plan will ensure that, once the different measures are implemented in a coordinated manner, taxation is more aligned with where economic activities takes place. This will restore taxing rights at the level of both the market jurisdiction and the jurisdiction of the ultimate parent company, with the aim to put an end to the phenomenon of so-called stateless income.