Further Work Expected on Digital Economy Issues Despite Issuance of Action 1 Final Report

By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA

One of the many ambitious goals of the OECD/G20 BEPS project was to issue a final report on Action 1 -- Addressing the Tax Challenges of the Digital Economy -- by September 2014. On September 16, the OECD indeed met that goal, as the final report on Action 1 was included in the flurry of 2014 deliverables issued on that date. As it turns out, however, the work on addressing the tax challenges of the digital economy is not yet done, as the Action 1 report notes areas which will be further explored during the period before the issuance of the final tranche of the BEPS reports at the end of 2015.
The work on Action 1 was conducted by the Task Force on the Digital Economy (TFDE), a subsidiary body of the OECD's Committee on Fiscal Affairs. The TFDE was established in September 2013, and included as fully participating members those G20 countries not also members of the OECD. The TFDE published a draft report in March 2014.1 This commentary will describe the potential options to address the tax challenges of the digital economy as presented in the final report, with particular focus on changes since the March 2014 draft report.
The final report is an impressive document, with detailed chapters on the evolution of information and communications technology, the emergence of new business models in the digital economy, and a discussion of how certain elements of digital economy business models created the impetus for spotlighting the digital economy in the BEPS project.2 The TFDE is to be commended for using as their starting point a sound factual description of the industry.
More importantly, the final draft includes a new chapter added since the March 2014 draft which describes the fundamental principles of taxation which underlie the current international tax system, as reflected in the various complementary and balanced provisions of the OECD Model Tax Convention on Income and Capital. Since at least some of the proposals on the table run counter to these established principles, it is indeed important to maintain in the forefront of the discussion the fundamental policy question of what set of activities or circumstances should give a State the jurisdictional authority to impose tax on an enterprise operating entirely or almost entirely outside its borders.
The final report includes five options under the heading of direct tax options and two under the heading of consumption tax options. This list includes one new option not present in the draft report, namely the introduction of a bandwidth or "bit" tax. The other options were all contained in the draft report, although they have been somewhat refined and elaborated in the final report.  Briefly, the options are as follows.
Modifications to the exemptions from permanent establishment (PE) status. The alternatives expressed under this option are based on the assumption that, as the economy has evolved, some of the activities identified as preparatory or auxiliary under Article 5(4) may have become core functions of certain businesses.  The alternatives under this option include eliminating paragraph 4 entirely (i.e., all of the preparatory or auxiliary exemptions), eliminating only some of the existing Article 5(4) activities, or conditioning a claim of Article 5(4) protection on showing that the activity conducted is not a core activity of the enterprise in question.  A new alternative added in the final report is to eliminate the word "delivery" in Article 5(4)(a) and (b) in order to exclude "certain types of warehouses" from coverage by those subparagraphs. That change would continue to allow an enterprise to rely on the warehouse exception for "storage and display" activities, but not for "delivery."  Since that proposal was not included in the document on which public comment was solicited, further input by business would be warranted on the practicality of that distinction.
A new nexus based on significant digital presence. This option was the most creative option included in the draft report. It would create a new nexus standard for an enterprise engaged in "fully dematerialized digital activities," if such enterprise maintained a "significant digital presence" in the country seeking to tax the profits of the enterprise. The final report provides more detail on what might be considered to constitute a significant digital presence, including factors such as the volume of contracts concluded remotely for digital goods and services, the "active engagement" of users in the jurisdiction, and the "overall level of consumption" of the enterprise's goods or services in the jurisdiction. This option is the most fully developed option in the final report focused on the taxation of profits arising from the remote delivery of digital goods and services by a certain group of enterprises.
Replacing PE with significant presence.  This option is similar to the one described above in that it would replace the existing PE concept with a "significant presence" test, but this option remains very much less elaborated than the "significant digital presence" proposal. The "significant presence" proposal apparently would include some physical presence in the country as one of the nexus criteria, including via a dependent agent, and would include as other criteria elements focusing on interactive customer relationships, such as a website offered in the local language, offering delivery from suppliers located in the jurisdiction, using banking or other faculties from suppliers in the country, offering goods or services sourced from suppliers in the country, and supplying goods or services resulting from or involving systematic data gathering or contributions of content from persons in the country. This alternative does not seem to provide a conceptually different approach than the "significant digital presence" proposal, other than, perhaps, including some physical presence of the group (not necessarily of the nonresident enterprise) in the taxing jurisdiction.
Creation of a withholding tax on digital transactions. This proposal is described generally as a backstop to the administrative and judicial challenges created by deeming an enterprise with no actual presence in a jurisdiction to have a direct tax nexus there. There is no discussion in the final report, however, of the transactions that might be subject to such a tax, other than a suggestion that characterization issues arise in the context of cloud computing and 3D printing. A gross-based withholding tax is a blunt instrument indeed; the suggestion in the final report that the option could be regarded as a backstop to the collection challenges of asserting nexus on an enterprise without an actual presence in the jurisdiction is a subtle reminder that some of these proposals have strayed quite far from the accepted jurisdictional bases on which States may levy an income tax.
Introducing a bandwidth or "bit" tax. As noted, this proposal has been introduced since the draft report was published. The final report notes that this proposal arose from public comments, presumably in contrast to suggestions from government representatives. The report suggests that progressivity goals could be met by imposing different tax levels based on the size of the enterprise, and somewhat optimistically (at least from the U.S. perspective) suggests that the tax would be creditable against corporate income tax.
Exemptions for imports of low value goods.  As did the draft report, the final report suggests that streamlining compliance mechanisms could justify lowering the threshold for exemption from VAT of low value imports. The final draft adds some text to suggest that simplified registration mechanisms could justify eliminating registration thresholds, even for smaller enterprises.
Remote digital supplies to consumers.  Expressing a theme that runs through several of the options, the final report expresses concern that the compliance burden imposed by an extraterritorial VAT collection obligation may weigh heavily on small and medium enterprises. The final report nevertheless suggests that these burdens can be ameliorated through "clear and accessible" registration mechanisms, and the market presence of third-party intermediaries to assist in performing compliance obligations.
Given that many of these alternatives are quite undeveloped, the TFDE has provided direction in the final report as to how work on the various options will proceed. The final report identifies the collection of VAT on B2C (business-to-customer) transactions as a "pressing issue that needs to be addressed urgently", and notes that Working Party 9 will complete work on this alternative by the end of 2015. The alternatives regarding the "preparatory or auxiliary" exceptions of Article 5(4) will be covered in the work under Action 7, dealing with preventing the artificial avoidance of PE status. Working Party 1 is given the task of working on characterization issues of "certain payments under new business models, especially cloud computing payments."
The TFDE itself also will continue its work through 2015. The TFDE will act as a "centre of expertise on the digital economy" to ensure that work carried out in other areas of the BEPS project tackles BEPS issues in the digital economy.  As part of that role, the TFDE will assess the degree to which the work completed under the other BEPS Actions addresses BEPS issues with respect to the digital economy.
Even though the original mandate of the TFDE was to expire upon the publication of this final report, its continued existence is to be applauded for various reasons. As noted, the TFDE commendably has endeavored to take a fact-based approach to its analysis.  The introduction in this final report of the section on fundamental tax principles is a useful reminder of the basic policy justifications as to when a State can properly exercise taxing authority when proposals such as the "significant digital presence" option are to be assessed. Many of the other Actions in the BEPS program will indeed address the tax challenges of the digital economy, so it will be useful to have a body such as the TFDE to observe the results of the rest of the OECD work in order to determine whether anything further is required with respect to the digital economy alone. The TFDE expects to publish a supplementary report on its further work by December 2015.
This commentary also will appear in the November 2014 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties — Income Not Attributable to a Permanent Establishment, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively-Connected Income, ¶7160, U.S. Income Tax Treaties.


1 For a prior commentary on certain aspects of Action 1, see Sprague, Extraterritorial Impositions of Tax and the BEPS Project, 43 Tax Mgmt Int'l J. 285 (May 9, 2014).

 2 "Digital economy" companies, of course, are not the only enterprises which make use of the structures described in the final report, but other industry sectors have managed to avoid the spotlight now focused on the digital economy.