International Fiscal Association Western India Brianch

“Taxation of the Digital Economy”

Peter H. Blessing phblessing@kpmg.com

Mumbai

December 4, 2013

Agenda - Overview

•Scope of Discussion

•Examples of Digital Economy

•Taxation under Traditional International Norms

•OECD TAG Review

•Current Pressures to Revisit

•Policy Concerns Raised

•Are the Concerns Able to Be Addressed under an Income Tax System?

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Scope of Presentation

•Focus is on the background and conceptual questions, similar to Action 1 of the OECD BEPS Action Plan

•Not a detailed examination of e-commerce or of taxation of “the cloud” in various jurisdictions

•No consideration to the important issues of detecting/tracing digital activity or dealing with avoidance

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Meaning and Examples of Digital Economy

•Internet based activity is a successor to prior remote-access technologies used to promote sales such as telephone/fax, radio/television ads, and mail orders.

•Nearly all businesses are involved to at least some extent; some operate in it and most use it. Examples:

• Remote sales of tangible goods or of local services, directly or via online marketplace (business or consumer)

• Remotely provided services (business, such as document management, software development, consulting, data processing; or consumer, such as courses or software support )

• Data or content access via subscription

• Remotely hosted software applications (SaaS) and streaming access to content

• Cloud computing infrastructure (IaaS) and platforms (PaaS)

• Advertising supported free services/on-line advertising

(National Institute of Standards and Technology, Special Pub. 800-145 (Sep 2011))

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Current Taxation under International Norms/Model Treaties

•Characterization of income for domestic law/treaty purposes

• Royalties vs. services

• Services: eg, if software is provided for use in browser (or downloaded as app on mobile) for monthly subscription fee; also, eg, most cloud computing services, such as data base access or other hosted services.

• Royalties: for knowhow; or for right to reproduce and distribute a copyright (need a transfer of IP)

• IRC §7701(e): factors for lease vs. services contract (eg, control, property right, etc); cited by OECD in 2001 TAG report on Treaty Characterization

• Technical services (if technical support/special skill or knowledge)

• Services, if not technical services, = business profits for treaties

• Eg, Infrasoft Ltd. v. ADIT (ITAT/DEL 2008) (fees for voice and data services)

• Royalties vs. sale income. Microsoft Corp. v. DIT (2010)

• Consider also under US law communications income: but for transmission of communications)

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Current Taxation under International Norms/Model Treaties (Cont.)

•Source of income for domestic law/treaty purposes

• Creaky domestic law rules are being applied to new forms of income; rules often are based on legal forms rather than substance

• Services generally are sourced where provider of services performs them

• But some countries may say where the customer is located (destination principle adopted for VAT), though treaty business profits articles would prevent this from being taxed

• How apply place of performance? Most digital services are supplied by automated servers

• Royalties may be sourced where IP is used (US rule)

• Or may be sourced where licensee is resident/place of PE

•Withholding tax

• Tension on scope, due to nexus issues for net based taxation

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Current Taxation under International Norms/Model Treaties (Cont.)

•Nexus (Business Connection) - domestic law

• Generally not if not physical (e.g., radio advertising – e.g., Piedro Negras (US 1941); internet advertising—e.g. Telmark Global Solutions (Mumbai ITAT 2010))

•Nexus – Treaties

• Fixed place of business? Server owned or rented and operated with a website likely yes; not for a mere user having a website on ISP’s server. OECD Comm., art. 5, par 42.2, 42.5-42.10.

• Typically, servers, sales offices and data centers are owned by different legal entities than derive the customer income

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Current Taxation under International Norms/Model Treaties (Cont.)

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Current Taxation under International Norms/Model Treaties (Cont.) •Attribution of profits if nexus: eg, allocate to a server?

• Transfer pricing may avoid: Morgan Stanley (2008)

• Transfer pricing principles vs. cliff effect

• Major difficulties because eg difficult to track usage of servers

•Transfer pricing for services

• Cost plus (benchmarking analysis); safe harbors (Singapore; OECD proposal); other for high value digital services

•Transfer Pricing for IP

• TNMM (one-sided) vs Profit Split (each side must justify relative contributions): evolving views

•VAT

• Generally zero-rated for exporter of service to nonresident abroad

• If foreign supplier, may have to register for VAT; otherwise, imposed on importer of services for business user (reverse charge)

• EU Sixth Directive (eff. 2003) deemed place of supply of electronic services to be place of consumption, to “even the playing field”; electronic supply by remote vendors became VATable and registration was required

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Illustration of eTailer

ParentCountry A

Distributor Co

Country B

Separate legal entities for different functions permits the activity of each entity to be isolated from the activity of the other entities for eg nexus purposes

Distributor Co operates a warehouse, performs marketing, and buys and resells the goods to customers in Country C

Data Center/Server Co provides website access to customers, for which Distributor Co pays a fee

Distributor Co pays a royalty to IP Co for marketing IP, and contracts for services with Parent (or an affilate)

Presence in Market Country can be avoided

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Data Center--

Server CoCountry B

IP CoCountry A

Market Country C

Illustration of Seller of Cloud Services

ParentCountry A

Sales CoCountry B

Separate legal entities for different functions permits the activity of each entity to be isolated from the activity of the other entities for eg nexus purposes

Sales Co performs sales and marketing of the cloud services/apps to customers in Country C, and Data Center/Server Co provides cloud access to the customers, in each case for a fee

Sales Co subcontacts from IP Co and pays a royalty to IP Co, and subcontracts for services on a cost plus basis with Parent (or an affilate)

Parent (or an affiliate) pays cost plus to Data Center/Server Co for services, and also licenses from IP Co for a royalty.

Again, no taxable presence in Market Country

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Data Center--

Server CoCountry B

IP CoCountry A

Market Country C

Online Advertising

•An online advertiser in effect runs an electronic billboard in a very attractive location, with many viewers

•Instead of rent, it may be considered as deriving royalties for the nonexclusive use of the site for the period the banner is displayed

•Or, more conventionally (eg, per section 7701(e) factors, p. 4 above), it may be considered as deriving a fee for the service of disseminating the banner to many viewers, much like a radio or TV broadcaster.

•In either case, the residence of the persons using the site for searches is not relevant in traditional sourcing concepts

• But see Colin & Colin Report, discussed below.

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Earlier OECD Efforts to Address

•Report of the Indian High-Powered Committee on Electronic Commerce (2001)

• Concern re absence of PE jurisdiction over sales and base eroding consequences

• Proposal of withholding tax on deductible payments (can be viewed as expansion of fees for technical services)

•OECD E-commerce project in 1997-2005 resulted in various reports including:

• Working Party No. 1, Concept of Permanent Establishment in Electronic Commerce, leading to Comm. art. 5 par 42.1-42.10

• TAG Report, Treaty Characterization of Electronic Commerce Payments (2001)

• TAG Report, Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transactions (2001)

• TAG Report Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce (2005)

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Current OECD and EC Efforts to Address

•OECD Action Plan 1

• Task Force to prepare report addressing ability of a company to have a significant digital presence in…another country without being liable to taxation”

• Scope includes PE, attribution of profits, source and character of income, but also indirect taxation (is this a signal of the likely answer?)

Certain other OECD Action Plans directly relate to digital economy

Addressing economic but nonphysical nexus (remote sales, etc.)

Review of treaty permanent establishment definition

Query how the nonphysical nexus review relates to decision to tax “where value is created” (where operational, including distribution, functions are), given the country of focus is the country of use, not creation, and in which typically physical presence is lacking?

•European Commission dec. of 22 Oct 2013 setting up Commission Expert Group on Taxation of the Digital Economy

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Report of TAG on Treaty Rules for Business Profits from E Commerce

•Established criteria for analyzing the issues

•Considered various “fundamental changes”

• Source withholding taxes

• Nexus for base-eroding (deductible) payments (withholding with option to file)

• Virtual PE nexus

• Formulary apportionment instead of separate entity accounting

•Considered various “nonfundamental changes”

• E.g., force of attraction for remote sales if other goods sold thru PE

•Concluded that fundamental changes should be adopted only if clearly superior

• No evidence of significant tax revenue loss

•No action resulted (other than service PE project—but still tied to physical)

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Possible Policy Concerns

•Coherence of tax system

• Is more favorable treatment available to foreign enterprises for similar income, while the original rationales for distinctions have weakened?

• Eg, redomiciliation phenomenon

•Efficiency of tax system/avoiding economic distortions

• Economists favor income tax levied only by country in which the owner of capital generating the income resides (CEN) than the source country

• But overidden by the real world: “Everything is economics, but economics is not everything”

•Revenue impact

•Inter-nation fairness/distribution

•Taxpayer morale/perceptions of unfairness

•Magnitude of economic nexus of remote vendors/providers has grown exponentially over the past 20 years

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Overarching Policy Considerations

•The world has changed in terms of how geographically income is generated.

• So fair to ask, how would allocation rights for an income tax being designed today be allocated?

• Nothing has changed “other than” the means of delivery….

•Is the right to tax allocated incorrectly, and how is “correct” measured?

• Consider separately (i) traditional goods and services and (ii) services that had no precedent and e.g. are based on algorithms.

• Consider source of value (relevance of market) and whether an income tax on such basis is administrable.

• Not new concepts—see, eg, 1923 League of Nations Report (formula)

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Overarching Policy Considerations (Cont.)

•For traditional activities provided remotely, should there be an effort to replicate in today’s economy the relative tax bases that would have resulted under the “old economy” model?

• A country has no right to a level of income tax regardless of where the income is generated (see TAG Report on Treaty Rules for Business Profits from E-Commerce)

• But ability to impose withholding creates “right” .

• Has the corporate income tax ceased to be a viable tool for raising revenue? Can reliance be placed on VAT or other consumption taxes?

• In weighing a consumption tax against an income tax, consideration must be given to the extent in each case the consumer bears the burden of the tax through an increased price structure for the country.

• Does not address the objective of inter-nation equity

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Could the Concerns Be Addressed in an Income Tax System?

•Withholding tax approach for remote services?

• Would in effect be adopting theory of services being deemed performed (in part) where the user/customer is located.

• Change from current law, eg, holding in eBay International AG v. ADIT (2012) that persons are needed to create technical service income

• Where user is a company with many offices, hard to determine place of use

• Customers can be a basis to determine source (eg, Graetz 2001)

• Perhaps justified as quasi royalty for use of IP by customer, though transfer of IP is only ad hoc rather than for a term

• Rate could be selected to reflect fact that market is only one factor

• Difficult to approximate a tax on profit where substantial costs to generate the income; but like sales-based royalties in that respect

• Need to identify withholdable payments (e.g., subscription fees) and person to withhold

• A credit country would have to allow a foreign tax credit; change cannot be unilateral.

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Could the Concerns Be Addressed in an Income Tax System? (Cont.)

• Nexus approach for remote sales or services?

• E.g., if remote sales are made into the country above a threshold amount

• E.g., if remote services are provided or hosted services are provided to country residents above a threshold amount (again, issue of identifying usage within a multi-location enterprise)

• Revenues do leave the country and there may be profit associated with them, but how determine attributable profit?

• How account for e.g. R&D expenditures?

• Would affiliates be aggregated (can’t just look to profit of low risk distributor)?

• Would one compare the profit a retailer that bought from an unrelated wholesaler made before the internet reduced “brick and mortar” profitability?

• A credit country would have to allow foreign tax credit; change can’t be unilateral

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Colin & Colin Report

•Report commissioned by French Government and released January 2013

•Would deem a PE to exist (virtual PE) if an enterprise collects data arising from regular and systemic tracking of Internet users in a country, to provide a service

• Remote data collection activity viewed as substitute for local physical presence (with uncompensated workers)

•Tax based on value creation by Internet users

• Profits attribution based on profit split (treating imagined free local labor as a valuable intangible).

•But how would the State of the customers have power to enforce the tax?

• Withholding tax on presumptive basis?

• But no obvious withholding agent if not B2B.

• Lack of information

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Concluding Remarks

•Fundamental change would be very disruptive and complicated

• Could a consumption tax serve the purpose?

•Fundamental change would affect most enterprises

• Need for certainty and simplicity

•To avoid double taxation, States would have to act in unison

•Change targeted to online advertising firms not the solution

• Broad spectrum of virtual activity; neutrality/fairness concerns

•Unlike certain other areas addressed by the BEPS initiative, this one would directly involve a change in allocation of taxing rights and hence tax revenues

• Therefore, support for change will be at most uneven (e.g., US is publicly opposed)

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