Developed countries erode BEPS Action Plan on Digital Economy

IT is ironic that what was almost at the centre of the BEPS project has ended up in not having a concrete agreement and with a vague promise of some review by the year 2020. One may recall that it was the big digital companies and their tax affairs that were the trigger of the movement in Europe against the current international tax order and that, in turn, started the work relating to BEPS. The enquiries against these firms brought out in the open the practices that showed people that many a times such companies did not pay any tax anywhere and that the current international tax treaties with the avowed aim of preventing double taxation ended up promoting double non-taxation. It is true that these facts are nothing new and have been discussed earlier by academics and representatives of developing countries. However, the international financial crisis brought some traction to the issue.

The OECD was entrusted by the G-20 to come up with a solution and it went about its task with seriousness of purpose. However, there are competing interests and cynics always pointed out that the United States that hosts all the top internet companies was unlikely to compromise on its sovereign right to tax the profits of its companies on world wide basis. It is not that the United States is not worried about the tax dodge by its multinationals. It certainly is. But it wants the tax money itself. If other countries are given a share in the tax pie of the American digital companies incorporated elsewhere, then the US Treasury will have to give credit for the taxes paid by these companies abroad and that is an expenditure that the US simply does not want to incur. Therefore, the USA did all it could to dilute the international efforts to find an equitable solution to the vexed problem.

To achieve this objective, the clever argument adopted is that the digital economy cannot be ring fenced. It is surprising that the OECD should discover this suddenly after already starting the BEPS project. In fact, in its very first report- ‘Addressing Base Erosion and Profit Shifting’, the OECD inter-alia, stated as follows:

“This report also shows that current international tax standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of the digital economy. For example, today it is possible to be heavily involved in the economic life of another country, e.g. by doing business with customers located in that country via the internet, without having a taxable presence in that country. In an era where non-resident taxpayers can derive substantial profits from transacting with customers located in another country, questions are being raised on whether the current rules are fit for purpose. Further, as businesses increasingly integrate across borders and tax rules often remain uncoordinated, there are a number of structures, technically legal, which take advantage of asymmetries in domestic and international tax rules.” Accordingly, the report identified the focus areas and one of such areas was a proposal to develop: “Updated solutions to the issues related to the jurisdiction to tax, in particular in the areas of digital goods and services. These solutions may include a revision of treaty provisions.”

It is this part of the report that got the developing countries excited about the prospect of a new international tax order at least in the area of the digital economy. It is important to recall that earlier attempts to find a common ground was also thwarted by the OECD on the ground that digital economy had not been shown to reduce the tax base of the market economies. Having now contradicted itself on the same issue a decade later, it was important for the OECD to show some results.

We were hopeful when subsequently the OECD came out with its action plan and put digital economy as the first item on the agenda- action point 1. The OECD stated:

“BEPS is a concern in the context of the digital economy. The actions will help address these concerns. However, there are specificities that need to be taken into consideration. This will require a thorough analysis of the different business models, the ever-changing business landscape and a better understanding of the generation of value in this sector. Moreover, indirect tax aspects should also be considered. Drawing on the other actions included in this plan, a dedicated task force on the digital economy will be established.”

ACTION 1

Address the tax challenges of the digital economy

“Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties , taking a holistic approach and considering both direct and indirect taxation. Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.”

It is thus obvious that issues relating to source, income characterization and attribution was very much on the agenda. However, politics started almost immediately. To retain its relevance, the OECD had invited some of its observers (like India and China) to participate in the project. Since, much of source country taxation rights are lost due to the inherent nature of the distribution of the taxing rights, particularly in the context of the digital economy, these countries wanted the project to include discussion on the nature of such distribution. This would have got to the very root of the problem.

It has been widely reported that the USA, whose MNCs are the real beneficiaries of the current distribution of taxing rights, is not at all keen on changing the same. Alarmed by the wide remit of the project, it forced the OECD to immediately throw cold water and asserted that the project is only about base erosion and the emphasis is on tackling the issue of double non-taxation. Any discussion on the basis of distribution of taxing rights was off the table.

However, the exploitation of weak rules under the current architecture in a digital environment affects even the developed economies and in fact this realization in a way created the BEPS project. As has been reported earlier, the French were particularly keen to find some alternatives of taxation in a digital environment as indicated in the Colin and Collin report. However, the US was opposed to discuss anything that will reopen the basic nexus for business taxation- the existence of a Permanent Establishment. It managed to get any action postponed by constituting a task force that would only give recommendations. Inevitably, the task force came to be dominated by the US interests and some intellectual justification had to be found to kill the initiative. In due course the task force gave its report that harped on the same issue of digital economy not being separate from other sectors of the economy and passed the buck to other action points.

No wonder that the USA was pleased with the outcome. The Digital Economy Task Force was co-chaired by Robert Stack, the Deputy Assistant Secretary (international tax affairs) of the US Treasury. As reported in Tax Notes, when Stack was asked which deliverable outcome he was happiest with, he mentioned action points 1,2 and 13. He apparently said: ” that the U.S. contingent had deep concerns at the beginning of the project over some countries’ efforts to develop special rules for the digital economy. “We got the group to recognize that you can’t ring fence the digital economy and that other BEPS action items were likely to deal with lots of issues that are specific to the digital economy,” (Source – Robert Stack-BEPS and the United States- Kristen Parillo-Tax Notes International)

That’s precisely what the final OECD report on action point 1 said. “Because the digital economy is increasingly becoming the economy itself, it would be difficult, if not impossible, to ring-fence the digital economy for tax purposes…” The only concession is the statement that some of the key features of the digital economy, particularly those relating to mobility exacerbate BEPS concerns. These concerns were to be dealt with by strengthening the CFC rules (Action 3), addressing the artificial avoidance of the PE status (Action 7), transfer pricing (Actions 8-10).

While there is some truth that all these areas do indeed affect each other, the focused attention that would have been given had an agreement relating to the digital economy been worked out was thus scuttled.

Strengthening CFC essentially means strengthening the rules for residence country taxation. Such rules in effect will allow companies registered elsewhere to be treated as domestic companies for tax purposes. In this connection, it is also interesting to look at the Obama administration’s budget proposal for 2016. Although not passed as yet, the proposals reflect the direction of international tax reform that the USA is considering.

The most interesting proposal in the context of BEPS seems to be the proposal to levy a minimum tax on foreign profits of American companies. The accumulated profits of American companies estimated at over $2 trillion have been the subject matter of much examination in the US. Currently, US MNCs do not pay any tax on the income of their subsidiaries until such profits are repatriated or when certain passive incomes of such subsidiaries are subject to CFC rules. (Sub-part F in the American lingo). Under the proposal the deferral will be limited to a per-country minimum tax and even active income will be considered for the levy. Essentially, the proposal envisages the imposition of a minimum tax on the foreign income of MNCs@ 19 %. There will be no deferral and the minimum tax will be imposed on income as it is earned. Of course, such minimum tax would be reduced by 85 percent of the effective foreign tax rate imposed on that income. For the purpose of the levy, a branch would be treated as a subsidiary. There is also a proposal to levy a one time levy@ 14% on the untaxed foreign income of companies. [https://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2016.pdf]. There are finer details of these proposals but the essence seems to be the taxation of foreign income of American companies and this does not square with the efforts of the rest of the world to make such companies pay taxes in their jurisdictions.

The only saving grace of the final OECD report on digital economy is the recognition at least that there are broader tax challenges raised by the digital economy. It is possible that these were incorporated at the instance of other non-OECD G-20 countries and India possibly played an important role. Besides, unilateral actions were already initiated by the UK and Australia in the form of diverted profits tax and some justification had to be found for their actions.

Any observer of the Indian international tax scenario comes across numerous cases of characterization of income – mostly relating to whether the income is in the nature of business or in the nature of royalty. The Tribunal routinely harangues the Revenue officers based on the outdated OECD Model commentary that refuses to see any changes. Therefore, it is interesting to note the following observations in the report:

“Under most tax treaties, business profits would be taxable in a country only if attributable to a PE located therein. In contrast, certain other types of income, such as royalties, may be subject to withholding tax in the country of the payer, depending on the terms of any applicable treaty. Whether a transaction is characterised as business profits or as another type of income, therefore, can result in a different treatment for tax treaty purposes. There is therefore a need to clarify the application of existing rules to some new business models.

At the same time, when considering questions regarding the characterisation of income derived from new business models it may be necessary to examine the rationale behind existing rules, in order to determine whether those rules produce appropriate results in the digital economy and whether differences in treatment of substantially similar transactions are justified in policy terms. In this respect, further clarity may be needed regarding the tax treaty characterisation of certain payments under new business models, especially cloud computing payments (including payments for infrastructure-as-a-service, software-as-a-service, and platform-as-a-service transactions). In addition, issues of characterisation have broader implications for the allocation of taxing rights for direct tax purposes. For example, if a new type of business is able to interact extensively with customers in a market jurisdiction and generate business profits without physical presence that would rise to the level of a PE, and it were determined that the market jurisdiction should be able to tax such income on a net basis, modifying the PE threshold and associated profit attribution rules could permit such taxation. …” (Paragraphs 271 and 272 of Action 1: 2015 Final Report)

India’s official position on the OECD model and its commentary also stands vindicated when the report mentions in para340:

“The digital economy triggers systemic questions about the ability of the current domestic and international tax systems to deal with the changes brought about by advances in information and communication technology (ICT). These tax policy issues have implications for the overall design of tax systems. These challenges may therefore have broader implications than BEPS and the countermeasures developed in the course of the Project. These include issues related to the allocation of taxing rights among countries as well as to the tax policy considerations that should be taken into account when weighing the relative costs and benefits of the various tax solutions. With respect to direct taxes, the broader tax challenges raised by the digital economy go beyond the question of how to put an end to double non-taxation, and chiefly relate to the question of how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries. With respect to indirect taxes, the challenges chiefly relate to how to ensure that effective and efficient collection mechanisms are in place.”

In fact, the digital economy task force in its 2014 report had considered four potential options to meet these challenges. These were – modifications to the exceptions from the PE status, alternatives to the PE threshold, imposition of a final withholding tax on certain types of digital transactions and the imposition of an excise tax or other levy.

Ultimately, however, the OECD chickened out in chapter –IX of the final report.

“The options analysed by the TFDE to address the broader direct tax challenges, namely the new nexus in the form of a significant economic presence, the withholding tax on certain types of digital transactions and the equalisation levy, would require substantial changes to key international tax standards and would require further work. In the changing international tax environment a number of countries have expressed a concern about how international standards on which bilateral tax treaties are based allocate taxing rights between source and residence States. At this stage, it is however unclear whether these changes are warranted to deal with the changes brought about by advances in ICT. Taking the above into account, and in the absence of data on the actual scope of these broader direct tax challenges, the TFDE did not recommend any of the three options as internationally agreed standards.

Nevertheless, and perhaps to placate countries like China and India and to justify the unilateral actions of some of the OECD member countries, the OECD allowed individual countries to adopt in their domestic legislation either a substantial economic presence test or a withholding tax on certain types of digital transactions or an equalisation levy with the caveat that these measures must respect the treaty obligations or else the treaties should be renegotiated.

While the other two concepts are fairly well known, the concept of an equalisation levy is rather intriguing. The OECD paper mentions that to avoid some of the difficulties arising from creating new profit attribution rules for purposes of a nexus based on significant economic presence, an “equalisation levy” could be considered as an alternative way to address the broader direct tax challenges of the digital economy could be considered as an alternative way to address the broader direct tax challenges of the digital economy. The basic idea is that a firm could have significant presence in a country without creating a PE under the traditional definition and thereby enjoy an advantage over domestic firms and such an advantage could be neutralized by the ‘equalisation levy.’ The paper cautions that the levy should be used only if the firm has significant economic presence in the country concerned.

The paper is quite sketchy about the nature and scope of the proposed levy. From the policy perspective, it mentions that if the policy priority is to tax remote sales transactions with customers in a market jurisdiction, one possibility is to apply the levy to all transactions concluded remotely with in-country customers. One factor reflecting the level of penetration in a country’s economy is the number of “monthly active users” (MAU) on the digital platform that are habitually resident in a given country in a taxable year. MAU refers to registered user who logged in and visited a company’s digital platform in the 30-day period ending on the date of measurement. The paper therefore suggests that if the policy priority is to tax the value contributed by customers and users, then a levy could be imposed on data and other contributions gathered from in-country customers and users. For that purpose, one option could be to impose a charge based on the average number of MAU in the country. However, the calculation of AMU may prove to be difficult.

Internet search about ‘equalisation levy’ does not throw up any useful result in our context. The OECD paper however mentioned that in the insurance sector some countries have adopted equalisation levies in the form of excise taxes based on the amount of gross premiums paid to offshore suppliers. The OECD paper mentions that such taxes are intended to address a disparity in tax treatment between domestic corporations engaged in insurance activities and wholly taxable on the related profits, and foreign corporations that are able to sell insurance without being subject to income tax on those profits, neither in the state from where the premiums are collected nor in state of residence.

Section 4371 of the I.R.C imposes an excise tax on policies issued by foreign insurers or reinsurers covering U.S. risks. The rate of tax is 4 percent of each dollar of premium paid for property and casualty insurance and 1 percent of each dollar of premium paid for life, sickness, or accident insurance or for reinsurance. The beneficiary of the policy and any person who issues or sells the policy are jointly and severally liable for the tax. [Source: Determining “Premiums Paid” For Purposes Of Applying The Premium Excise Tax To Funds Withheld Reinsurance]. Apparently, the House Ways and Means Committee discussing section 502 of the Revenue Act 1942 had explained that the revised provision would yield an appreciable amount of revenue, and at the same time eliminate an unwarranted competitive advantage favouring foreign insurers. [Source: https://www.questia.com/magazine/1G1-18679729/the-irs-issues-advice-on-cascading-excise-tax]

Interestingly, the India-US tax treaty does mention the levy. Article 2 of the treaty defining ‘taxes covered’ mentions:

“The existing taxes to which this Convention shall apply are:

(a) in the United States, the Federal income taxes imposed by the Internal Revenue Code (but excluding the accumulated earnings tax, the personal holding company tax, and social security taxes) and the excise taxes imposed on insurance premiums paid to foreign-insurers and with respect to private foundations (hereinafter referred to as “United States Tax”); provided, however, the Convention shall apply to the excise taxes imposed on insurance premium paid to foreign insurers only to the extent that the risks covered by such premiums are not reinsured with a person not entitled to exemption from such taxes under this or any other Convention which applies to these taxes …” The issue of credit for such taxes in the country of residence is not clear as article 25 dealing with relief from double taxation mentions only the income tax paid.

All in all, the final report on digital economy is a big disappointment. It shows a pattern of US bullying others to protect its domestic interest. This is a pattern that is discernible in all multilateral negotiations- be it BEPS, climate change or WTO. In this situation, India should also take unilateral actions to protect its revenue interests. Obviously, the OECD did not try hard to find a solution that would appeal to the developing countries. The discussion in earlier paragraphs indicates that pressures from the developed world were mainly responsible for the stalemate.