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The digitalization of the economy is considered as a key driver of innovation, economic growth, and societal change. At the same time, it poses a major challenge to the international tax system.

The OECD has addressed this challenge in its extensive Action 1 Final Report as part of the BEPS project, which also includes a diverse set of scholarly reform proposals and unilateral initiatives. The EU has issued a similar report confirming the OECD’s view.

Neither the OECD’s Final Report on Action 1 nor the academic literature produce a clear and unanimous answer to the question of how to address the tax challenges of the digital economy. With regard to the determination and taxation of corporate profits, the OECD and the EU are unlikely to propose a departure from the current principles of assessing the “functions, assets and risks of the enterprises concerned”. Rather, they promote selective adoptions of current standards.

BEPS Actions will not make much difference

The implementation of specific BEPS action points in national or supranational law faces obstacles of compatibility with EU law, and proposals regarding transaction and withholding taxes for the digital economy might collide with international trade law. Several scholars highlight that the key question for taxing businesses in the digital economy is how to allocate profits generated by the underlying new types of business models.

Yet, the OECD’s preferred proposal to amend the exception of auxiliary and preparatory activities from the permanent establishment (PE) status will not significantly affect income allocation in the digital economy (amended Paragraph 4 of Article 5(4) of the OECD-Model).

The academic work by Hongler and Pistone (2015) and Báez Moreno and Brauner (2015) provide well-thought-out ideas on how to tax purely digital companies. However, establishing new or alternative nexus rules based on wholesale thresholds (e.g. transaction volumes) contradict the idea of not ring-fencing the digital economy for tax purposes. New concepts of nexus might lead to the additional problem of misalignment of the allocation of taxing rights and the ability to enforce taxation.

Still, these reform proposals are the first to highlight the importance of consumer markets for digital business models and this fact should be reflected in the allocation of taxable profits either via the profit split method proposed by Hongler and Pistone (2015) or extended withholding taxation described in Báez Moreno and Brauner (2015).

Concrete action has been taken in Australia, Hungary, Italy, the United Kingdom, Hungary and, most recently, in India, to tax digital companies. Often, specific rules are aimed to define taxable income or levy surcharges on digital transactions. These unilateral initiatives might hinder the development of the digital economy while their respective effects on corporate decisions and tax revenues are unclear.

Digital business models entail substantial opportunities for (aggressive) tax planning but also raise broader issues for the tax system (taxable nexus, the use of data including the attribution of value and the characterization of payments). While taxing profits according to value creation is detected as the new paradigm in international taxation, the understanding of the digital economy and corresponding reform proposals for taxation are premature. The OECD has so far missed the opportunities to define the paradigm of value creation and to analyse digital business models accordingly. The OECD acknowledges that the key features of digital business models are potentially relevant for designing tax regulations. Thus, the evaluation of tax policy regarding digital business models should closely follow the analysis of the organizational and economic characteristics of the depicted developments.

Digital Business Model Analysis for International Taxation

Our recent article presents a thorough analysis of digital business models in the B2C and B2B sector as well as in the form of the digital transformation of a traditional business model. The case studies illustrate that digital business models expand internationally via slim organizational structures. Under current tax law, digitalization leads to a convergence of core activities and thus taxable nexus at the location of the parent company or regional hubs.

In local markets, elements of information technology (IT) infrastructure are observable and might constitute a taxable nexus in the form of a PE. These elements of the IT infrastructure can be controlled remotely, rented from third parties and moved across jurisdictions. Depending on the activities performed at the location of the hardware elements, they might not contribute much to value creation in the current interpretation by solely hosting data and providing computing power. As a result, little profit stemming from digital business models of foreign companies is attributed to market jurisdictions for tax purposes. This specific form of innovative business model and its implied organizational consequences are not necessarily tax-driven but rather represent outcomes of the technological development.

In this sense, the focus on servers for tax purposes might become obsolete and more evolving technological developments need to be discussed in the future. Our analysis confirms the OECD’s finding that functions and assets can spread across multiple countries but this flexibility is limited; as the core functions including the development of intangible assets can only take place where key personnel are located. In addition, providing high-quality digital services to end users requires a certain degree of infrastructure in proximity to the customer market – a feature that might be picked up in the discussion of future transfer pricing policies.

Transfer pricing should be the focus

Apart from indirect empirical evidence, we do not know of any reliable scientific knowledge concerning whether the degree of digitalization influences tax-motivated corporate decision-making. Against this background, the OECD sees both a risk of overstating and of understating the respective tax challenges. Much more research and political discussion is needed to examine the effect of the current tax system on digital business models, fiscal competition as well as the consequences that potential reform options would imply for corporate decision-making and tax revenues.

Considering the current challenges, the key pressure area for taxing digital businesses in the near future is transfer pricing. Yet, the OECD has not directly elaborated transfer pricing for transactions of digital business models. Relying on scientific evidence from diverse disciplines in business research as well as a profound business model analyses can certainly help to refine transfer pricing guidance in order to come closer to the goal of aligning profit taxation with value creation.

We propose an elaboration of transfer pricing guidance for digital business models since such guidance would directly relate to the work on Action 1 of the OECD’s BEPS project. This report has focused on the technological features of the digital economy and could thus serve as a starting point for drafting transfer pricing guidelines for digital business models.

A common definition for the analysis of value drivers would be needed. Insights from management science and industrial economics suggest that novel and less physical elements should be considered for this purpose. Economic concepts such as Economic Value Added (EVA) could be used to guide profit allocation. Such an approach is inherent to the promotion of the PSM by the OECD that most probably will affect highly integrated digital business models.

A Framework for Meeting the Challenges in a Pragmatic Way

A future solution could lie in a more frequent use of some kinds of formulary method. This scenario will most likely provoke further opposition since it implies a further departure from the traditional arm’s length principle and makes global harmonization of these profit allocation methods indispensable to prevent double taxation and legal uncertainty. Promoting specific transfer pricing guidance would not ring-fence the digital economy for tax purposes but directly address its novel characteristics when applying the arm’s length principle equally to companies from all sorts of industries. In our view, policy makers should carefully consider the impact of taxes on corporate decisions while designing tax policy for the digital economy. In the future, businesses may see tax policy as another economic factor when evaluating location decisions for digital ventures. The political aim should be to arrive at an administrable taxation of corporate profits that does not distort corporate decisions and paves the way for digital innovations. Such an approach could make the difference between addressing and meeting the tax challenges of the digital economy.

This post is based on Olbert & Spengel’s article published in World Tax Journal 1/2017, International Taxation in the Digital Economy: Challenge Accepted?.

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