Digital Economy — Tax Challenges
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Trends in Regulating Digital Economy
One of the recent trends to significantly influence the business environment worldwide is seen in the ever-increasing role of digital components in earlier traditional businesses.
The phenomenon of the so-called “digitalization of the economy” was driven by changes in industries like retail, finances, education and health care, as well as media and broadcasting. But the extension of the digital economy poses challenges for international taxation.
While exploring the penetration of “digitals”, it is hard, if not impossible, to differentiate between the traditional and special digital sectors of the economy. Moreover, the use of information and communication technology (ICT) by all businesses clearly shows that specific “digital” tax issues would apply on a much wider scale. Many digital economy business models have parallels in traditional business.
There have been a number of initiatives and legislative developments tackling tax challenges raised by the digital economy. The most remarkable initiative is the OECD’s Action Plan on Base Erosion and Profit Shifting (BEPS) project published in July 2013. The Action Plan identifies 15 actions to address BEPS in a comprehensive manner and even sets deadlines to implement these actions.
BEPS Action 1
The OECD’s Task Force on Digital Economy was established in September 2013 under Action Plan item 1 of the BEPS project. Its aim was to consider the taxation issues arising from digital business and to identify potential measures to remedy any shortcomings, considering both direct and indirect tax options. The call for such an action plan was raised by the overall concern that the existing international tax rules drop behind the new business models and tax issues resulting in rapid development of ICT. The Task Force issued its paper on “Addressing the Tax Challenges in the Digital Economy” (the Report).
The following features are noted in the Report as examples of new business models resulting from the evolution of ICT:
— E-commerce (including business-to-business, business-to-consumer, and consumer-to-consumer models),
— App stores,
— Online advertising,
— Cloud computing (including infrastructure-as-a-service, plat- form-as-a-service, content-as-a-service, and data-as-a-service),
— Payment services,
— High frequency trading,
— Participative networked platforms.
The key features of the digital economy and new business models that are potentially relevant from a tax perspective are identified by the Report as:
— Mobility, including mobility of intangibles on which the digital economy relies, mobility of users of the digital economy, and mobility of business functions resulting from a decreased need for local personnel to perform functions as well as flexibility to choose the location of servers or other resources,
— Reliance on data (collection, analysis and storage),
— Network effects (understood with reference to where user participation, integration and synergies are important),
— Use of multi-sided business models (a business model in which the two sides of the market may be in different jurisdictions and interact through an intermediary or platform increasing flexibility and reach),
— A tendency towards monopoly or oligopoly in certain business models,
— Volatility (resulting from relatively low barriers to entry and rapidly evolving technology).
The Report identifies the common features of tax planning strategies that concern BEPS issues in connection with direct taxation, particularly:
— Minimisation of taxation in the source country (through the minimization of functions, assets and risks or other avoidance of a taxable presence by contractually allocating risk and legal ownership of intangibles, or in the case of a taxable presence, by shifting profits or maximizing deductions);
— low or no tax withholding at source;
— low or no taxation at the level of the recipient (achieved through low-tax jurisdictions, preferential regimes, or hybrid mismatch arrangements);
— Absence of current taxation of low-tax profits at the level of the ultimate parent.
In relation to indirect taxation, the Report identifies the fact that VAT is avoided or reduced via the following:
— Remote supply of digital goods and services to VAT exempt businesses,
— Remote supply of digital goods and services to a centralized location for re-supply within a multinational group not subject to VAT,
— Underdeclared VAT on B2C supplies,
— Understating value of low-value imports, allowing inappropriate use of thresholds.
The most important outcome of the Report on Digital Economy is the list of five options to address the tax challenges of the Digital Economy:
— Modifications to the exemption from creating a permanent establishment for activities that were previously preparatory or auxiliary in the context of conventional business models which may have become core functions of digital businesses;
— Creation of a permanent establishment for fully dematerialized digital activities based on a “significant digital presence”. This will be potentially addressed by reference to numbers of contracts, users, consumption levels, etc.;
— Replacement of the existing permanent establishment concept with a “significant presence” test to reflect the contribution of close customer relationship by applying the following possible criteria:
(a) Presence of long-term relationships with customers along with actual local presence, including via an agent,
(b) Sales of goods or services through websites in local languages, providing local delivery, etc.
— withholding tax on payments made for digital goods or services;
— consumption tax options such as:
(a) Lower thresholds for low value imports and requiring vendors to register and account for VAT in the jurisdiction of importation,
(b) Requiring non-resident suppliers of remote digital B2C supplies to register and account for VAT in the jurisdiction of consumer.
We can see that Action 1 covers not only conventional norms, such as permanent establishments, but also encompasses indirect taxes which mean that a significant part of changes should be done locally by each country.
EU Contribution to Addressing Digital Economy Challenges
The EU has already implemented one of the consumption tax options for addressing tax challenges of Digital Economy suggested by the OECD. Starting from 1 January 2015 a new method of accounting for VAT applies to all Member States for B2C supplies of digital services. From 1 January 2015, supplies of telecommunications, broadcasting and electronically supplied services by suppliers located in the EU to private consumers and non-taxable customers will be taxable in the Member State where the recipient is established, has a permanent address or normally resides.
Prior to the new VAT rules coming into effect, where such services were supplied to non-taxable persons, VAT was accounted for by the supplier based on where it was established and thus any VAT collected on such sales was simply accounted for in the supplier’s basic VAT returns.
Suppliers of such services now, therefore, need to determine where their customers are established or usually reside and need to account for VAT at the applicable rate in that Member State. Such requirement applies irrespective of where the supplier itself is established or registered for VAT. As a consequence, suppliers may need to register for VAT in all EU Member States where they have customers. At the same time, there are no minimum thresholds and thus one-off supply to just one customer in a Member State actually triggers VAT registration in the customer’s country.
However, the new rules provide for an alternative to the multiple VAT registration in all Member States, which are the customers’ countries. The affected suppliers are able to opt for accounting VAT across the EU via a single electronic declaration to be filed with the tax authorities in the country of the supplier’s registration. Such an alternative system is referred to as a Mini One-Stop Shop.
The main challenge of the new VAT rules for e-services arising for the suppliers will be to correctly identify the customer’s jurisdiction so as to apply the correct VAT rate.
Other Initiatives Regarding Taxation of Digital Economy
Following the EU legislation effective as of 1 January 2015, on 18 December 2014 the OECD presented the Draft of the Guidelines on the Place of Taxation for Business-to-consumer Supplies of Services and Intangibles (the “Guidelines”) based on the destination principle. The Guidelines follow the earlier Action Plan on BEPS. Action 1 regarding challenges posed by the Digital Economy in which the OECD admits that the international legislative framework lacks comprehensive tools that allow the collecting of VAT due by non-established suppliers in the country of the customer’s residence.
With VAT concerns further developing, the OECD is expected to issue new publications by the end of this year to improve VAT administration and collection on B2C transactions of digital supplies.