Extraterritorial Impositions of Tax and the BEPS Project

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By Gary D. Sprague, Esq.

Baker & McKenzie, Palo Alto, CA

The Task Force on the Digital Economy, a subsidiary body of the
Organisation for Economic Co-operation and Developments (OECD's)
Committee on Fiscal Affairs, recently released a discussion draft
as contemplated under Action 1 of the Base Erosion and Profit
Shifting (BEPS) project. The Task Force held a public consultation
on the discussion draft on April 23.

The purpose of Action 1 is to "Address the tax challenges of the
digital economy." The text of Action 1 itself states that the first
"difficulty" is to address "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… ."  Government officials from
across the globe have noted with concern the ability of enterprises
to make sales remotely into jurisdictions without having a
significant local physical presence.1

Public statements by OECD officials to date suggest that the
BEPS project is not likely to result in a separate set of tax rules
for the "digital economy." That said, since the Action 1 mandate is
to produce a report that includes a variety of options for
addressing the tax challenges of the digital economy, the
discussion draft includes various options which would impose a net
income tax, withholding tax or VAT collection obligation on defined
categories of nonresident suppliers who provide, promote, or
otherwise commercialize their goods and services across borders
through digital communications.

The option which departs most radically from accepted
international tax principles would create a direct income tax
liability for certain enterprises which maintain a "significant
digital presence" in the economy of another country. The draft also
includes "virtual permanent establishment" options which would
create direct tax nexus based on an enterprise's website being
hosted on a server of another enterprise in the jurisdiction, or
based on online contracting with users in the jurisdiction. In both
cases, the options would allow direct tax nexus of the nonresident
despite the fact that the nonresident enterprise has no actual
physical presence in the source jurisdiction. The closest analogue
to such a rule under the OECD Model Income Tax Convention today is
the dependent agent rule of Art. 5(5), which allows the imposition
of a tax liability on a nonresident on the policy basis that the
exercise of contract conclusion authority by the nonresident's
dependent agent carried out in the state is sufficient to create
source-state nexus. In contrast to Art. 5(5), the Action 1
"significant digital presence"/"virtual PE" (I'll refer to both
options hereafter as a "virtual PE" rule) options create direct tax
nexus when the nonresident doesn't even maintain a dependent agent
in the source state.

These options would represent a significant expansion of the
circumstances in international tax jurisprudence in which a
government may seek to impose a prescriptive extraterritorial tax
obligation, i.e., a tax reporting and payment obligation on an
enterprise that is not subject to the legal jurisdiction of the
state by virtue of the normal connections of physical presence.
Extraterritorial obligations create compliance difficulties for
both tax administrators and taxpayers. More importantly, if the
standards for creating nexus are in any way subjective or
imprecise, then many taxpayers will be placed in very challenging
circumstances of not knowing with certainty whether they have a
direct tax obligation in one or many jurisdictions in which they do
not operate. Unless there are very high volume thresholds,
compliance in multiple jurisdictions may not be practically
possible for smaller enterprises, meaning that any such virtual PE
rule could create the unsatisfactory situation of emerging
companies facing at some point in their development large
unresolved liabilities in many countries. Legislators or treaty
negotiators who may be faced with the decision of whether to impose
or agree to such extraterritorial impositions should give these
aspects of such impositions careful thought before allowing the tax
law to expand in that direction.

Extraterritorial tax obligations are not unknown in the
international tax law.2 The most direct
corollary to any virtual PE options to be developed under Action 1
is the European Union's (EU's) Electronically Supplied Services
(ESS) Directive, which imposes an obligation on all nonresidents
not established in an EU Member State to collect and report VAT on
all sales of ESS to any consumer in the EU. The discussion draft
includes an ESS-type obligation for B2C supplies, essentially
inviting other jurisdictions to follow the EU model. At the time
the ESS Directive was proposed, there was much discussion of how
compliance could be enforced. The European Commission (EC)
expressed confidence that nonresidents would comply with the new
extraterritorial obligations, emphasizing their message by
referring to civil and criminal liability for the managers and
owners of the businesses covered by the obligation. The EC even
connected the satisfaction of tax obligations with the ability of
nonresidents to enjoy the protection of their intellectual property
(IP) rights in EU courts, a remarkable suggestion that taxpayers
may lose commercial rights under law as a consequence of tax
noncompliance.3 Many observers argued
for reasonable thresholds before the obligation would apply, so
that small enterprises would not be forced into noncompliance due
to the practical impossibility of complying at small sales volumes
into the EU. As it turned out, the EU decided to impose the
obligation with no threshold, so in principle all nonresident
suppliers with one Euro of ESS delivered to EU consumers are
subject to the obligation.  Switzerland, Norway, and Iceland
also have followed the EU's example, although all three have
implemented a turnover threshold.

It is likely that other jurisdictions will be encouraged by the
European experience to do the same. South Africa recently enacted
similar legislation to impose an extraterritorial obligation on
nonresident suppliers of "electronic services" to any South African
resident to register for, collect, and remit South African VAT. The
law includes a de minimis threshold of approximately
$4,500 in any 12-month period but, in a poke at nonresidents, that
threshold is set at a lower amount than the threshold at which
South African residents are required to register for VAT.4 In the 2014
Canadian budget, citing the BEPS project as inspiration, the
Canadian Department of Finance invited input on how to ensure the
effective collection of Canadian sales tax on e-commerce sales to
Canadians by foreign-based vendors.5 The Japanese
government also recently stated that it intends to revise the
Japanese consumption tax regulations to require non-Japanese
companies that provide digital products to Japanese consumers to
register for and pay Japanese consumption tax.6 Other countries
may decide to jump on this bandwagon. Clearly, the idea of
extraterritorial taxation in the indirect tax area is gaining

Extraterritorial taxation in the direct tax area also is not
unknown, but historically such impositions have operated only in
very specific circumstances and limited to particular types of
income, and almost always with a physical connection of some sort
to the source state. Under the law of the United States and many
other countries, nonresidents are subject to income tax on
dividends, interest, and royalties derived from local sources,
although the enforcement of the obligation is made easier by
imposing a collection obligation on the local withholding agent.
The appreciation of the value of real property has been regarded as
having a particularly close connection to a source state so as to
justify the imposition of tax on nonresidents, such as under the
U.S. Foreign Investment in Real Property Tax Act (FIRPTA) rules.
Some countries go further than FIRPTA and impose tax on the
extraterritorial transfer of all shares in local

None of these taxes, however, applies to ordinary business
income as described in the business profits article of the OECD
Model Convention. The income intended to be taxed under the Action
1 virtual PE options will be the ordinary business income of the
affected nonresident enterprise. Imposing extraterritorial
obligations in this context will be breaking new ground, and will
raise questions of whether the tax is based on solid policy

The best framework to use to consider questions such as this is
the Ottawa framework principles agreed in 1998 to guide the OECD's
first discussions on the international taxation of e-commerce,
namely neutrality, efficiency, certainty and simplicity,
effectiveness and fairness, and flexibility. Putting aside
questions of whether the definition of a virtual PE and its
associated profit attribution consequences could ever be defined
with sufficient clarity to meet the Ottawa framework condition of
certainty and simplicity, the extraterritorial element of such a
tax principally implicates the Ottawa framework conditions of
neutrality, efficiency, and effectiveness and fairness. The
neutrality principle means that taxation should seek to be neutral
and equitable between conventional and digital transactions. The
efficiency criterion means that "[c]ompliance costs for taxpayers
and administrative costs for the tax authorities should be
minimised as far as possible." The effectiveness and fairness
criteria mean that "[t]axation should produce the right amount of
tax at the right time. The potential for tax evasion and avoidance
should be minimized while keeping counter-acting measures
proportionate to the risks involved."8

The virtual PE options would fail the neutrality principle, as
the purpose of the options would be to result in different outcomes
for business profits arising from certain digital transactions.
There also is little doubt that a virtual PE rule would score low
on the efficiency criterion. For taxpayers, the requirement to
determine attributable profits in many countries, probably under
multiple interpretations of profit attribution rules, applying
various local tax accounting systems, all triggered at potentially
low thresholds of sales, in jurisdictions where the enterprise
otherwise has no operations, is burdensome indeed. From the tax
administration side, the enforcement challenges are obvious, as all
of those items mentioned above must be reviewed and assessed with
no personal jurisdiction over the taxpayer.  The policy
justifications for the tax would need to be strong indeed to
warrant that degree of inefficiency.

The effectiveness and fairness criteria raise more fundamental
issues of how the international tax system should be structured. It
is important that tax obligations be regarded as fair and
reasonable. Voluntary compliance rests on the foundation that
taxpayers respect the integrity of the tax system, and believe that
the obligations imposed on them are fair. What is "fair" depends on
your point of view, of course. Assertions that multinationals have
not been paying their "fair" share of tax has been a constant theme
in the BEPS project. At that abstract level, however, the
"fairness" criterion is not a particularly useful guide to tax

At the more concrete level of the application of a particular
tax, the "fairness" criterion has more legitimacy as a policy
determinant. Certainly one element of whether a tax is fair is
whether, in fact, it applies equally to similarly situated
taxpayers. Rules such as the virtual PE options in the discussion
draft must necessarily assume some degree of noncompliance, unless
the volume thresholds are set very high. It just will not be
practical for smaller enterprises to fulfill their
multijurisdictional legal obligations at small sales volumes. That
condition will not be healthy for the perceived integrity of the
tax. A justification for such a tax that it is better to tax some
nonresidents than not to tax any of them certainly is not fair to
compliant taxpayers.

The BEPS project is proceeding at an accelerated pace, being
driven by political pressures which are unusual in the normally
academic environment of international tax policy. Undoubtedly, the
project will produce significant and perhaps fundamental changes to
international tax law. None of the other measures currently under
contemplation pursuant to the various BEPS Actions raises the
extraterritoriality issues discussed in this commentary. Tax
policymakers, therefore, need to be particularly thoughtful as they
consider whether to create a new category of extraterritorial
taxation of business profits under Action 1.

This commentary also will appear in the May 2014 issue of
 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,
Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax
Treaties - U.S. Competent Authority Functions and Procedures,
and in Tax Practice Series, see ¶7130, Foreign Persons -
Effictively-Connected Income, ¶7160, U.S. Income Tax


  1 It certainly is debatable whether these
transactions in fact cause the sort of artificial base erosion
which is the focus of the BEPS project. Payments by consumers don't
erode any tax base as such payments are not deductible expenses for
any tax purpose, and it is hard to see how a B2B payment for an
input the purchaser considers valuable for its business constitutes
base erosion.

  2 The contemporary international law view is that a
state may not extend its prescriptive jurisdiction outside its
territory in the absence of rules that expressly permit the state
to do so. Outside the context of human rights violations, such
rules generally limit exercises of extraterritorial jurisdiction to
instances in which there is nexus between the state and the person
or activity over which the state seeks to exercise jurisdiction.
Thus, exercises of extraterritorial jurisdiction are the exception
rather than the rule.

  3 European Commission, COM(2000) 349 final

  4 See Section 23, Value-Added Tax Act,
1991 (Act No. 89 of 1991).

  5 See Department of Finance, The Road to
Balance: Creating Jobs and Opportunities

  6 See Kotaro Fukuoka, "Japan to tax
e-content sales by foreign firms," Nikkei Asian Review (1/14/14),
available at

  7 In the United States, the
Quill decision (504 U.S. 298 (1992)) precludes the
extraterritorial imposition of state taxes. The recent
controversies over agency nexus involve administrative and
ultimately legislative efforts to create nexus through agency
activity in the state. See, e.g., N.Y. Tax Law
1101(b)(8)(vi); and 35 ILCS 105/2 and 35 ILCS 110/2.

  8 Organisation for Economic Co-operation and
Development, Taxation and Electronic Commerce: Implementing the
Ottawa Taxation Framework Conditions 18 (2001).

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