Digital Transactions: A taxing Issue

In March 2018, the OECD released its interim report entitled “Tax Challenges Arising from Digitalisation”.  The report is a response to the Action 1 report released in 2015 for the Base Erosion Profit Shifting (“BEPS”) initiative.  In that initial report, the OECD was tasked with assessing the unique challenges faced by taxation authorities regarding the digitalization of the economy as well as begin a process to achieve a global consensus on how such transactions should be taxed. An interim report was due in 2018 while the final report is scheduled to be released in 2020.

Increasingly, we live in a society where connectivity is ubiquitous, and the volume of data processed doubles approximately every two years.  By the 2020s, over 40 zettabytes (over 40 billion terrabytes) will have been produced. In addition, there is an increasing number of Internet-of-things (“IoT”) devices as well as “Big Data” increasingly driving business decision-making and shaping personal behaviours. Blockchain has further digitized not only currency, but with this technology, applications in finance, law, and insurance are now a reality.  The sharing economy has developed over the past decade where both user information and input play an integral role in certain operations such as Uber or cloud-based services.  Lastly, online-services such as Netflix have helped shaped the perceptions of what a digital presence might constitute.

Unlike with the traditional flow of tangible goods, digitalization has resulted an increased globalization of businesses “without mass”.  This has resulted in global value-chains along with the collection and exploitation of user data.  Furthermore, digitalization has increasingly resulted in features such as mobility, two-sided platforms, and a growing tendency toward oligopoly or even monopoly (such as Amazon with digital books).

From a tax perspective, digitalization creates issues in terms of nexus and the characterization of transactions.  Because user-input data may be collected in one jurisdiction, processed and analyzed in another, with the data then subsequently used in a third jurisdiction to drive certain activities, the question of digital presence is paramount.  Ultimately, the question of how digital taxing rights should be allocated between jurisdictions is the aim of this Action 1 initiative.

The interim report does not prescribe definitive solutions at this time, but it does offer a few suggestions.  For example, the notion of a “significant economic presence” test is introduced to determine when a business would be taxable within a jurisdiction.  Other ideas such as a withholding tax (to be applied against gross revenues) or equalization levies (to account for disparities between domestic and foreign businesses) are also discussed as possibilities.

The report strongly advises that whatever direction is taken regarding the digital economy should be applied on a uniform basis globally.  That being said, the report writers acknowledge that some jurisdictions may wish to tackle this issue on an interim basis before the final report in 2020 is scheduled to be issued.  However, such early implementation may inadvertently create other problems such as:

  • A negative impact in investment, innovation and growth—A lack of uniformity may result in capital and investment decisions to flow away from jurisdictions engaging in early implementation. This may have longer term negative ramifications regarding innovation and growth as businesses evolve their digital platforms elsewhere.  Even if uniform adoption is eventually created, the reversal of earlier business decisions may be difficult to enact (i.e., the damage may already be done).
  • Impact on the welfare of the economy—Taxing decisions made in isolation of neighbours may result in economic distortions that have negative ramifications for the economy as a whole including employment and standard of living.
  • Price sensitivity—digital taxation may ultimately increase the costs of good or services, which may impact the decisions of end-users.
  • Over-taxation—digital taxation might also result in a form of double taxation if services are taxed both at a gross revenue and net profit level. Again, this may result in unintended consequences in terms of business investment and innovation.
  • Uniformity—Once a country implements a certain taxation policy, reversing course or tweaking existing legislation can be disruptive to business. Thus, jurisdictions engaging in early implementation may find it difficult to change their legislation to reflect the eventual global consensus.

Digital taxation can impact any multinational enterprise whether or not it engages in related party transfer pricing.  However, MNEs should be aware that many of the arguments used in the OECD’s work on the digital economy can and likely will be applied by local taxation authorities when assessing a company’s transfer pricing exposure.  The reality that an MNE may produce software or apps that may have applicability in multiple jurisdictions may increase its exposure in related party transactions.  For example, a company’s head office might be in Canada, software developed in the US, and users based in Europe.  In such cases, the apportionment of profit may become increasingly complex and confusing.

Key Takeaways

  • The OECD is currently looking at the impact of digital taxation and is scheduled to finalize its report in 2020.
  • The concept of users as a value-driver is one of the key components of early arguments.
  • Potential early adoption of rules by some countries may create a somewhat chaotic field especially if the final recommendations of the OECD differ from the early adopted rules.