Political leaders, media outlets, and civil society around the world have expressed growing concern about tax planning by multinational enterprises that makes use of gaps in the interaction of different tax systems to artificially reduce taxable income or shift profits to low-tax jurisdictions in which little or no economic activity is performed.

There are 15 parts of the BEPS action plan. Only one of them focuses on the digital economy. The key concerns with the digital economy in terms of taxation are summarised as follows: [2]

The spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system.

Strategies to Avoid Taxation

The officials have noted that multinationals tend to adopt four strategies to avoid taxation in this digital commerce environment. The first is to take steps to minimise the taxable presence of the business in the country where the market is. Typically, the market country will be an affluent western country where consumers will buy the product or service at attractive prices from the vendor’s perspective. The vendor multinational will try and make sure that its taxable presence in that jurisdiction is minimised.

It will typically do that by transferring the profit out of that jurisdiction. That is done by paying various impositions for the use of intangible property rights. The holder of the intangible property right is typically a related party but one located in a low- or no-tax jurisdiction. This process maximises the deductions that can be claimed in the market jurisdiction and therefore lowers the profit in that jurisdiction.

Another way of avoiding a taxable presence in the market jurisdiction is to transact from a server that is not in the market jurisdiction. In such situations the sale is being made across the border, often by digital means. By transacting over the internet,

the vendor company does not need to have staff and a physical presence in the market country and therefore does not have a permanent establishment in the market country. The permanent establishment concept is the current method of allocating profit to the economic activity in the market jurisdiction but that concept relies on a physical presence in that jurisdiction in the sense of people and office space. Where the transaction is digital, these bricks and mortar concepts do not engage.

Transacting from outside of the market country occurs not just with the supply of electronic services but in relation to physical goods as well. In the case of physical goods, states will normally have some ability to impose tax at a customs level as the goods physically enter the jurisdiction. However, that is a costly way of collecting tax. In New Zealand there is a $400 value threshold such that goods imported under that value do not have GST added. Therefore consumers can buy identical goods over the internet from a vendor outside of New Zealand and avoid the impost of 15 per cent GST. That obviously has ramifications for the tax base but also for the viability of New Zealand retailing businesses in some sectors.

The other technique to avoid taxation in the market jurisdiction is the avoidance or minimisation of withholding taxes. Modern jurisdictions have withholding taxes on certain types of cash outflows, eg interest and royalties. The tax treaties with some jurisdictions mean that the withholding tax imposed is zero or minimal. By locating the vendor in the country that has a favourable treaty with the market country, withholding taxes can be reduced. This gives rise to the phenomenon of treaty shopping whereby the vendor business looks for the country in which to locate its function by reference to the terms of the tax treaty between that country and the market country.

Proposed Responses

With this summary of some of the key problems facing governments, the BEPS officials have indicated what steps they would like to take conceptually to address these problems. There is a large area of overlap between the proposed responses to the digital economy and the responses proposed by the BEPS project generally.

Firstly, the officials are suggesting that changes be made to the domestic laws of the market jurisdiction with a greater reporting obligation on entities in the market jurisdiction, including an obligation to report aggressive tax arrangements under mandatory disclosure rules.

Secondly, treaty terms will be amended to eliminate double non-taxation. The point of tax treaties between countries was to eliminate double taxation of the entities’ income once in the market country and again in the home country. However, some multinationals have used the treaties to obtain double non-taxation. They do this through being able to claim tax residency in more than one jurisdiction. To address the problem, the definitions of residency are recommended to be changed.

The other treaty term that is proposed to be amended is the definition of permanent establishment. In particular, the current list of exemptions that often appear in treaties and the definition of permanent establishment will be reduced.

In terms of treaty abuse generally, the suggestion is also to have clauses which are specifically addressed at abuse. This is intended to be achieved by having purpose clauses added and clauses limiting the benefit that can be derived from the treaty.

Thirdly, the use of hybrid financial instruments will be clamped down on. Hybrids are instruments that are taxed one way in one jurisdiction and taxed another way in another. A recent example in New Zealand was the optional convertible notes issues by Alesco New Zealand to its parent company in Australia. The notes were treated differently for tax purposes in the two jurisdictions. [3]

Fourthly, limiting excessive interest deductions and deductions for royalties paid to parties in low-tax jurisdictions. The BEPS paper explains that this can occur where a party within the broader group is located in a low-tax jurisdiction and borrows from third party banks and then funds other group members with intercompany loans.

Fifthly, the officials note that some OECD countries have provided favourable tax treatment for income derived from certain intellectual property. This has generally been by way of a 50 per cent to 80 per cent deduction or exemption on income derived from intellectual property. There is a strong hint in the paper that the officials concerned find such concessions to be harmful tax practices. The paper says that countries which have such harmful tax preferences will be invited to remove them from their statute book. No explicit sanction is mentioned in the report for non-compliance.

Sixthly, the place of hard to value intangibles will be reviewed. The paper says that digital economy companies rely heavily on intangibles in creating value and producing income. The problem is that: [4]

Depending on the local law, below value transfers of double non-taxation can be facilitated through licensing arrangements, cost contribution arrangements or tax structures that separate deductions relevant to the development of the intangible from the income associated with it. Below value transfers of intangibles can occur
(i) because of difficulties in valuing transferred intangibles at the time they are transferred;
(ii) because of unequal access to information relating to value between taxpayers and tax administrations; and
(iii) because some arrangements result in the transfer of hidden or unidentified intangibles without payment.