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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
The Wall Street Journal editorial page blasted the Organisation for Economic Co-Operation and Development's (OECD's) recently released Action Plan on Base Erosionand Profit Shifting as "A Global Revenue Grab,"1 despite (or perhaps because of ) its unanimous endorsement by the G-20 finance ministers at a meeting in July 2013 and expected embrace by the G-20 heads of state at a meeting in September 2013. While pointing out that U.S. (and other OECD countries') corporate tax receipts as a share of GDP have stayed remarkably constant over the past 30 years, the editorial belittles the OECD's claim of growing fiscal danger from alleged base erosion and profit shifting (BEPS) and labels the plan as nothing more than "an attempt to limit corporate global tax competition and take more cash out of the private economy." While at first glance this may seem right-wing hyperbole, some internal inconsistencies between a few of the planned Actions outlined may give at least some support to the Journal's claim.
Nowhere is this more evident than in comparing Action 1 with several of the later enumerated Actions. Action 1 is entitled "Address the tax challenges of the digital economy." Some of the issues that are noted are the basic questions of character and source with respect to "income derived from new business models" involved in the digital economy. While, like most of the Action Plan, this is so vague as to not provide much illumination, there is nothing immediately worrisome identifiable with regard to those issues.
Other issues to be examined as part of Action 1, however, while also vague, even in their vagueness appear considerably less benign. One such issue is:
… the ability of a company to have a significant digital presence in the economy of another country [presumably a country other than its country of residence] without being liable to taxation due to the lack of nexus under current international rules ….
What constitutes a "significant digital presence" is, of course, unclear, but it at least seems unmoored from traditional concepts of a permanent establishment (PE). No bricks and mortar are necessary, of course. But it also seems that no people need be present either, a conclusion that runs 180 degrees counter to the labor-and-activity-centric verbiage in other Actions, discussed below. And perhaps a "significant digital presence" exists without the taxpayer having any assets, tangible or intangible, in the jurisdiction. Perhaps the OECD is suggesting that such a significant presence might exist simply because a large number of unrelated customers located in the particular country view and utilize a website on their computer screens or smart phones. Even in the Piedras Negras Broadcasting Company case2 of more than 70 years ago, the IRS did not assert the existence of a U.S. trade or business under such a theory. While the IRS asserted in that case that radio advertising revenue was U.S.-source and subject to the predecessor to §881 based on the location of the radio audience in the United States, an assertion it lost, it did not appear to assert that the broadcast of radio shows from Mexico aimed at the U.S. market created a U.S. trade or business simply because the listeners were in the United States. Whether a website is a virtual marketplace for goods or a place where services are provided, the proposition that its location (and a resulting PE) is in all the places where customers access it will likely prove controversial. And whether or not one agrees with such a possible proposition, it is directionally opposite the trend towards requiring more significant "presence" for taxation in other Actions, discussed below.
Equally potentially controversial, and equally contrary to other Actions discussed below, another Action 1 issue to be examined is:
… the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services ….
Again, it is impossible to determine definitely what this means from the Action Plan, but it might mean that advertising revenue derived from advertisers, based on data that website owners glean regarding their customers' clicks and/or purchases, ought to be treated as revenue attributable to a PE in the jurisdiction where the customers are located. If that is the theory being pursued, no website owner's employees need perform activities there and no website owner's assets need be located there. But lots of taxable income might be attributed to a PE there because advertisers pay for information about the website owner's customers' actions there.
Contrast these speculations regarding the expansion of the concept of a PE and what income is attributable to a PE that may come out of Action 1 with the very different message from other Action items. In Action 5, for example, it is stated that a way to counter the euphemistic and vague "harmful tax practices" might be by "requiring substantial activity for any preferential regime." Other parts of the write-up seem to indicate that the sort of "activity" that must be substantial is activity performed by an entity's employees. Under Actions 8 and 9, it is at least implied that the return on intangibles might be entirely allocated to the jurisdiction where R&D takes place, rather than allocating any return to the jurisdiction where the capital that pays for those activities is deployed and the risk of success or failure is borne. Action 9 is quite forthright in declaring that "special measures" (which appears to be code for abandonment of the arm's-length principle) might be required "to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital." This, of course, can reach much more broadly than just with respect to intangibles, which presumably is why Action 9 is separated from Action 8 (which deals only with intangibles). Action 10, continuing the theme, speaks of another possible need for "special measures" to deal with "contractual allocations of risk to low-tax environments in transactions that would be unlikely to occur between unrelated parties." This appears, perhaps, to conjure up the image of ignoring the transfer of "crown-jewel" intangibles from a multinational enterprise (MNE) to a subsidiary, because of the unsubstantiated but long-held claim that unrelated companies never do that.
Another action item, Action 7, continues the theme (contrary to Action 1) of looking more prominently to activities of people, rather than to the location of risks or the ownership of assets. In Action 7, it is suggested that commissionaires that replace more traditional buy-sell distributors will be attacked (or existing attacks ratified) since they purport to allow a shift of profits out of the country where sales take place "without a substantive change in the functions performed in that country." Presumably, it is the actions of marketing and sales personnel that the OECD thinks are the substantive functions that count, and not, for example, the ownership of inventory that may be damaged or become obsolete, or the risks run by the owner of accounts receivable due to their potential uncollectibility.
When the implications of Action 1 are compared to the implications of Actions 5, 7, 8, 9, and 10, the Wall Street Journal's "global revenue grab" criticism might appear a little less unreasonable. The only common denominator providing consistency across that comparison is that very little nexus is required for high-tax, large-market countries to assert taxing jurisdiction while a great deal of nexus is required for low-tax, small-market countries to assert taxing jurisdiction.
Under Action 1, for example, taxable nexus for a website owner or e-retailer may require only taps on a smart phone screen by enough customers. That is obviously helpful for the predominantly high-tax, large-market countries of Europe and North America. Under Action 5, however, any preferential (i.e., low-tax) regime should not create a tax nexus without substantial activity in the jurisdiction, presumably human activity. That is obviously also helpful for the predominantly high-tax, large-market countries of Europe and North America whose MNEs seek to move assets and risk to lower-tax jurisdictions. Virtually no activity by the taxpayer might create a nexus in the Action 1 case, while substantial activity by the taxpayer's employees is needed for a nexus in the Action 5 case. Except as a revenue grab, how can the predominantly high-tax, large-market countries of Europe and North America justify such an obvious inconsistency?
Equally striking, under Action 1, income might be attributed to a PE simply because the remote collection of data regarding customers in that jurisdiction helps sell advertising. This might be suggested under Action 1 despite the complete lack of employees or assets in, or risk-taking by, such a PE (assuming one exists-but see above). Again, this is obviously helpful for the predominantly high-tax, large-market countries of Europe and North America. Under Actions 8, 9, and 10, on the other hand, "inappropriate returns" claimed by an MNE's subsidiary in a low-tax jurisdiction will be forbidden if the reason for those returns is to provide a return on capital such entity has provided or to reward its contractual assumption of risk.
So which is it? Are people and physical activities required to create a taxable presence? Is the only income attributed to a taxable presence that derived from such activities? Or is a taxable presence established and income attributable thereto simply because of something as insubstantial as mouse clicks by customers there? If the OECD wants to rebut the claim that the BEPS project is, as the Wall Street Journal claims, "a global revenue grab," it will have to reconcile these seemingly contradictory currents revealed in its Action Plan.
This commentary also will appear in the September 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions, Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties - Income Not Attributable to a Permanent Establishment, and in Tax Practice Series, see ¶2330, Interest Expense, ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers, and ¶7160, U.S. Income Tax Treaties.
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