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Comments submitted to the OECD by Macfarlanes on the discussion paper: BEPS Action 1:
Address the Tax Challenges of the Digital Economy

Letter sent on 14 April 2014 to Centre for Tax Policy and Administration, OECD, Paris

Dear Sirs

We write in response to the request for comments on the Public Discussion Draft on BEPS Action 1:

Address The Tax Challenges Of The Digital Economy 24 March 2014. We are pleased to offer our comments as follows.

In respect of the specific issues on which you have requested comments:

  • Whether it is possible to ring-fence the digital economy from the rest of the economy, and if not, whether specific types of digital transactions could be identified and addressed through specific rules;

It is fair to say that today’s economy has digital features which in some areas determine the way business is conducted. In other business activities digital features merely alter certain processes but do not change the business model fundamentally. As such there is no separate digital economy just as there is not a separate economy for other technological innovations. However the way that business is now carried out does render certain aspects of international tax law outmoded. This does not mean that long established and widely recognised concepts such as the residence principle and the arm’s length principle need be set aside. We therefore feel that solutions should be developed within the existing framework of international tax principles that underlie the OECD Model Tax Convention.

  • The key features of the digital economy identified by the Task Force and whether there are other key features that should be taken into account;
  • The examples of new business models in the digital economy and whether (and if so which) other business models should be considered;

The discussion draft provides a useful summary of the key features of the digital economy and many new business models that have arisen as a result of changes in technology. One striking feature of current progress has been the acceleration of the speed of change in information technology and related fields. There is a need to find solutions which are sufficiently flexible so that they are not quickly outdated. While it is never easy to speculate on what the future holds it should be possible to introduce rules suitable for the medium rather than the short term.

A feature that should be recognized is the highly speculative nature of much development in this field. For every business initiative that has a successful outcome with commercial value, many initiatives fail. It should therefore be recognised in tax arrangements that not all ventures will be profitable and governments should not expect tax revenues to ensue from all activities. Tax incidence at an early point in the value chain, irrespective of commercial outcome, will stifle investment returns. This will discourage investors from taking the risks necessary to generate the economic benefits that flow from technological progress.

  • The ability of the measures developed in the course of the BEPS Project and the current work on VAT/GST to address BEPS concerns in the digital economy;

As the discussion draft recognises, many jurisdictions with a value added tax or other consumption taxes use a destination principle to determine whether VAT should be charged. In our view, business to business supplies create few BEPS concerns from a VAT perspective, with the exception that businesses that carry out exempt activities may achieve a VAT saving in some cases. For example, where the destination country does not operate a reverse charge, or if the supplier can charge VAT at a lower rate than applies in the destination state.

Within the European Union, specific rules governing the place of supply of electronically supplied services, coordinated at the EU level, have existed since 2002, with substantial changes in 2010, and again from January 2015. In the case of business to business supplies, VAT is usually accounted for by the customer in the jurisdiction where they are based, under the reverse charge mechanism. In the case of business to consumer supplies, from January 2015, all suppliers will be required to account for VAT based on the rates applicable where their non-business customers are based. They will either register for VAT in each EU jurisdiction where they have customers, or in one place under a special "one stop shop" scheme.

Compliance for consumption taxes on cross-border supplies is also a problem. The draft recognises that the excessive cost of collection can justify exemptions from VAT for the import of low value parcels, but heavy use of the exemptions by suppliers moving operations overseas can have a significant revenue cost and distort competition with domestic suppliers. Similarly, it is difficult to collect VAT on the remote delivery of services by non-established businesses (for example, software downloads, or streaming of music or films). Adopting a source principle would allow suppliers to establish in low-tax jurisdictions, and individual consumers cannot be expected to self-assess under a destination system. Vendor collection (as adopted in the EU) is perhaps the best route, but relies to an extent on enforcing compliance extraterritorially. Compliance can be encouraged by adopting simple online registration and accounting systems, backed by exchange of information and mutual assistance.

We believe that a solution based on consumption tax options will give rise to double taxation because consumption taxes, such as VAT, GST, sales and purchase taxes, are particularly poorly coordinated across jurisdictions compared to direct taxes.

  • Whether other measures should be developed during the course of the work on other aspects of the BEPS Action Plan to address BEPS concerns in the digital economy and if so which ones;

We believe there needs to be a close connection between the allocation of taxing rights and the ability to measure the amount of profit, or other tax base. For example BEPS Action Point 8 (Assure that transfer pricing outcomes are in line with value creation: intangibles) will be of particular relevance. The discussion draft recognises that the digital economy is characterised by an unparalleled reliance on intangible assets. It also recognises that many areas of the digital economy rely heavily on the mobility of intangibles. This mobility should not be limited by tax policies that infringe the neutrality principle and thereby create a disincentive for businesses to deploy them internationally. This would nullify much of the social gain that has arisen from technological progress. For example, a jurisdiction claims taxing rights based on cash flows in relation to an intangible and then deems the intangible to be subject to an exit charge, based on future cash flows. Those future cash flows will be taxed again in a second jurisdiction causing double taxation, both juridical and economic, likely to extinguish the commercial viability of such transactions in the future.

A consensus on whether a PE has arisen will be of little value unless it is accompanied by agreement on how to attribute taxable profit. The OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments was a helpful document in that it set out how the approved method could be applied to three specific businesses, banking, global trading of financial instruments and insurance. A similar approach would prove very helpful in this work too. Otherwise we are concerned that in the BEPS project a considered and detailed approach to the practical issues could be sacrificed in order to meet tight deadlines.

Similarly BEPS Action Point 9 covering risks and capital and BEPS Action Point 10 covering other highrisk transactions will also be important points of convergence.

  • The broader tax challenges raised by the digital economy which have been identified by the Task Force and how these challenges should be addressed, taking into account both direct and indirect taxation;
  • The options to address these broader tax challenges discussed by the Task Force and summarised in the discussion draft;

A distinction between those business models that have evolved as a consequence of digital technology and those enterprises that have merely enhanced their existing business models will be useful in developing solutions. It would not make sense for a business that has digitally enhanced an existing business model to face significantly different tax outcomes.

As noted above, residence based taxation has been the approach underlying much of the work done to develop an international consensus in tax matters. While source based solutions “bridge the gaps” they should not predominate. We are therefore concerned lest the options outlined cause a move to taxing a business merely because it has customer cash flows arising in a jurisdiction but no actual part of its value chain.

We feel that eliminating paragraph 4 of Article 5 entirely would represent a large step backward in the history of the OECD Model Tax Convention. Similarly to remove paragraph 4 (a) through (d) only, would expose many enterprises to an unjustified change of tax outcome. If the feeling is that the “preparatory or auxiliary exemption” is being abused then this should be addressed by clarifying the guidance in the commentary. Interpretation of Article 5 has been problematic even though the guidance has been expanded. Since there is much uncertainty on to how to apply Article 5 in practice, this is often considered by recourse to cases in jurisdictions other than the country in question. Such cases are of interest because the point under consideration has been litigated there, but usually they cannot be relied on as determinative. There are, therefore, good grounds to develop the Article 5 commentary much further.

We have misgivings about the idea of a ‘virtual PE’. In any case, it would be important that a ‘virtual PE’ test should be interpreted in the same way across different countries. The factors in such a test would need to be are applied consistently across jurisdictions. Questions such as whether all or only a number of factors would need to be present also require similar uniformity.

We also have concerns on the comments on the value of “Big Data”. Data itself has limited value as it is only when data can be converted into useful information that it provides commercial advantages. The focus should therefore be on information rather than data collection.

  • The potential cost of compliance arising from the options proposed to address the tax challenges of the digital economy and suggestions for more cost efficient alternatives;

Some of the greatest advances in technology come from smaller and medium-sized international businesses. Often this is from the vision of one or more individuals who are prepared to take risks to test and develop ideas that may not appear reasonable to larger organisations at first sight. This is especially true of the information technology and communications sector. We propose that exemptions should be extended to SMEs, especially in growth markets, to encourage innovation and to avoid stifling the commercial application of advances in technology. This should particularly assist those economies that are yet to fully engage with the digital economy, where capital and specialist skills may be scarce.

Many of our concerns, in fact, relate to a question of balance. A business may have some degree of presence, whether digital or otherwise. However it is inefficient to tax this unless that presence is sufficiently significant to make it worthwhile to measure the attributable value and to incur the costs of making a local tax filing. To find the right balance will always involve a challenging compromise but to push too far in either direction is neither in the interest of international development nor in the long-term interests of governments.

  • Whether the Ottawa taxation framework principles identified above are an appropriate framework for analysing options to address the tax challenges, and whether and how they should be supplemented.

We agree that the Ottawa framework principles serve as a good guide with which to approach possible solutions. We would add the ability to pay principle and the benefits principle insofar as they are not specifically covered by the principle of ‘fairness’.

More generally we would like to make the following comments on this discussion draft:

The reform of the definition of a permanent establishment, how and when one arises and how profit should be attributed for the special features of the digital economy should be part of a separate process. This is partly because the BEPS timetable is a tight one and partly because it involves issues beyond base erosion and profit shifting. Any work to produce a new Article 5 and /or commentary should involve specifying as much detail as possible. The same is true of Article 7.

There must be a connection between the definition of a PE and the amount of profit that will be attributed to the PE. These two issues should not be divorced. A number of model business cases should be examined in further work. These would trace though the process from how a PE would be defined to how a profit attribution would work.

It would be helpful to classify digital business transactions further, expanding some of the references in the discussion draft such as “cloud services”, “fully dematerialised transaction” etc. For each one, the model itself and the terms used to express it could be defined. Some examples could then set out the key digital facets of the model, how these give rise to the challenges seen, how each of these would fit a proposed solution and, for each solution, how the attributable profit would be determined under an ‘OECD approved model’.

The discussion draft acknowledges the complexity of the issues. There may be a danger that the extent of work needed to provide practical solutions that are clear and are widely accepted may be underestimated. Superficial guidance with widely differing interpretations between jurisdictions on digital commerce issues will only prove counterproductive. We believe there are many points at issue that need to be worked through beyond the immediate priorities of the BEPS project.

Please contact the undersigned with any questions or comments.

Yours faithfully

Martin Zetter
Head of Transfer Pricing and Senior Economist on behalf of Macfarlanes LLP

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Martin Zetter

Head of transfer pricing and senior economist at Macfarlanes.

Martin is an experienced transfer pricing professional with over 25 years of experience working in transfer pricing and finance. He joined Macfarlanes from Ernst & Young where he was a Director in the transfer pricing practice.

He has conducted in depth transfer pricing studies for some of the world's largest international groups. He has led transfer pricing implementations and developed transfer pricing assurance for complex groups. He has considerable experience of the financial sector working with banks, investment managers and insurance companies in addition to a broad spectrum of industries including manufacturing, retailing, technology, property and service sectors.

Serving previously as the global head of transfer pricing for one of the world's largest diversified financial services groups, he set up and managed the transfer pricing function, successfully implementing the group's transfer pricing and putting in place an ongoing control and governance structure.

Martin has led the transfer pricing response on major tax audits in jurisdictions across the globe including the UK, USA, France, Germany, Italy, Japan, and India.

He has prepared economic analyses for APA and ATCA submissions as well as group structuring and re-organisation scenarios.

Martin lectures in transfer pricing for the Chartered Institute of Management Accountants and BPP.

Website: www.macfarlanes.com

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