Rethinking traditional source concepts in a digital economy

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Department of Law Spring Term 2019

Master Programme in International Tax Law and EU Tax Law Master’s Thesis 30 ECTS

Rethinking traditional source concepts in a digital economy

Author: George Daniel Costache Supervisor: Katia Cejie

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1 Outline

I. Abbreviations ... 2

1. Foreword/ Problem ... 3

1.1. Objective ... 3

1.2. Delimitations ... 4

1.3. Method used ... 6

2. Survey of the current tax landscape ... 8

2.1. What is the digital economy? ... 8

2.2. What has been proposed so far and by whom? ... 8

2.2.1. OECD´s BEPS package ... 9

2.2.2. EU proposals ... 10

2.2.3. Digital nexus and the issues of the “virtual PE” concept ... 11

2.2.4. (Indirect) Digital Services Tax on consumer markets ... 11

2.2.5. Digital VAT ... 12

2.3. Why does the digital economy pose a challenge for taxation purposes and of what kind? ... 13

2.4. Interim conclusion... 16

3. The debate ... 17

3.1. Source versus residency based taxation ... 17

3.2. Digital nexus versus Digital Services Tax ... 19

3.3. The alternative ... 25

3.4. Where, if at all, does the CCCTB fit? ... 26

4. Likely future scenarios based on what was discussed so far and the implications of introducing the virtual PE standard ... 30

4.1. The fixed place of business PE test ... 31

4.2. The dependent agent PE test ... 32

4.3. Case study - Sale of tangible goods through an online marketplace 32 4.3.1. Case introduction ... 32

4.3.2. With double tax treaties ... 33

4.3.3. PE test ... 33

4.3.4. Server location ... 36

4.3.5. Without double tax treaty ... 37

5. Next steps ... 39

5.1. Unilateral action with respect to the Digital PE ... 39

5.2. Unilateral action with respect to the Digital Services Tax ... 40

6. Concluding remarks about how realistic it all looks ... 42

7. Bibliography... 44

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I. Abbreviations

BEPS: Base Erosion and Profit Shifting

DAPE: Dependent Agent Permanent Establishment

DEMPE: Development, Enhancement, Maintenance, Protection and Exploitation

DTT: Double Tax Treaty DST: Digital Services Tax

CCTB: Common Corporate Tax Base

CCCTB: Common Consolidated Corporate Tax Base EU: European Union

ICJ: International Court of Justice IP: Intellectual Property

MLI: Multilateral Instrument OECD

OECD: Organization for Economic Co-operation and Development OECD-MC: The OECD Model Tax Convention on Income and Capital PE: Permanent Establishment

PPT: Principal Purpose Test R&D: Research and Development TCJA: Tax Cuts and Jobs Act

TFEU: Treaty on the Functioning of the European Union TPG: Transfer Pricing Guidelines

VAT: Value Added Tax

VCLT: Vienna Convention on the Law of the Treaties WHT: Withholding Tax

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1. Foreword/ Problem

The issue of international taxation in the context of rapidly developing business models toward digitalization gained significant importance over the last years, with official government bodies and organizations attempting to develop fair and effective measures of taxation in order to attract much- needed tax revenue. These efforts, however, have not reached a consensus due to the complexity of the issue at hand.¹Therefore, this current topic deserves its fair share of attention. Several significant challenges arise in respect of determining correct taxing measures of highly digitalized enterprises, some of which will be discussed in this thesis. An analysis of conventional taxing measures, as well as of proposed measures will be discussed, in order to gain an overall understanding as to why these challenges arise. The thesis will focus on those aspects, which constitute a departure from traditional concepts of taxation, specifically from those, which are based on physical presence. Digital business models, which sell goods and / or services online, have been accused of eroding their tax base, especially in recent disputes between European countries and US giant tech companies, such as Google, Apple or Amazon. It is clear that in our fast developing world, our current tax system is outdated. The problem is that in order to update such a complex system with ramifications extending to bilateral and multilateral tax agreements, an issue that will be addressed in this paper, significant hurdles have to be efficiently and effectively overcome. Toward the end of this thesis, a proposal will be described as being most appropriate for solving taxation issues of the Digital Economy.

1.1. Objective

The purpose of this thesis is to provide meaningful understanding of the current state of business activities, which generates the need for implementing new taxing measures, analyse the challenges arising from this need, as well as their cause. Furthermore, the aforementioned challenges will be explained in the context of existing traditional taxing systems and proposed measures will be analysed. After reading this thesis, the goal is for the reader to be able to understand current trends and to gain an idea of how states might try to harmonize their taxing systems in order to meet the requirements set out by the rapid digitalization of companies. In addition, being a field under development and with no consensus reached so far, the taxation of the digital economy cannot be emphasized too much. In order to reach a solution, one first has to understand the problem and this is precisely

1 Marcel Olbert and Christoph Spengel, International Taxation in the Digital Economy: Challenge Accepted?, IBFD world Tax Journal, 20 April 2017

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what this thesis is attempting to do. Furthermore, one initiative will be considered more advantageous than others, based on legal principles of fairness and neutrality, as well as economic reasons. Finally, with an overview of the current state of affairs, the reader will be able to interpret which measures are more appropriate than others are and how taxing the digital economy could look like in the future. Both questions of “what will happen next?” and “how should it happen?” will be answered by this thesis.

At chapter level, general questions will be answered as follows:

Chapter 1: What does the international tax landscape regarding the digital economy look like and who are the main actors and what has been proposed so far?

Chapter 2: What is being debated about taxing the digital economy?

Chapter 3: How will businesses be likely impacted by the new rules?

Chapter 4: What is going to happen next? How much progress has been made?

Chapter 5: Which are the takeaways?

1.2. Delimitations

In the first chapter of this thesis, I will provide an overview of the current tax landscape regarding the digital economy, as well as identify the challenges posed by the digital economy and explain why these arise in the current economic landscape and international taxing framework. Only the most relevant challenges, as considered by available literature, will be discussed.

This chapter will also present the discussions, debates, proposals, trends and initiatives, both at the European Union level, as well as internationally through the OECD. Focus will fall on who proposed what.

The second chapter will focus on the traditional taxing concepts available today and recognize a possibly necessary shift in trends regarding source and residency based taxation in the context of the digital economy. Furthermore, technical details of a controversial proposed measure regarding the determination of a digital nexus concept, namely the virtual permanent establishment (PE), will be analysed. Implications thereof will be inevitably discussed because of the comparison with traditional taxing methods, but also with the different proposal of introducing digital withholding taxes and value added taxes for digital goods and services. This part should provide the reader with necessary technical details and compare two proposed measures with each other. The Corporate Common Consolidated Tax Base (CCCTB) will also be put into context and its implications discussed briefly.

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The third chapter will focus on highly probable future scenarios. At this point, having gained theoretical knowledge about taxing the digital economy, the thesis will provide the reader with hypothetical scenarios based on lessons learned and available literature regarding this matter. The chapter will include an example, which is meant to provide a better understanding of possible consequences of applying the proposed Digital PE standard to available business models.

The fourth chapter represents a summary of the status regarding the subject of taxing the digital economy. It also includes unilateral measures adopted by certain countries.

Finally, the last chapter will summarize the discussed points, aiming at providing the reader with an overview and understanding of the current issue.

In this thesis, many of the relevant topics will be approached as part of the wide discussion, which is taxing the digital economy. While it provides an overview of the proposed measures, it does not exhaustively elaborate on all of them, nor does it provide all of the versions and variations these proposed taxes have.

Furthermore, the thesis approaches the Common Consolidated Tax Base to a limited extent. The same applies to Transfer Pricing rules, which carry significant importance for the topic of digital economy, but which is far too complex in order to capture within this thesis. Also exceeding the scope of this thesis are Controlled Foreign Companies.

Emphasis is clearly placed on:

• an overview of proposed measures, as well as the type of tax these constitute and the challenges arising thereof,

• the current developments on an international level,

• the taxing jurisdictions,

• the concept of value creation and

• the Digital PE standard, where it elaborates on technical aspects and proposes a theoretical exercise of applying it to existing business models.

Intangibles and value creation are both complex concepts that I will only discuss to the extent that they enable an understanding of the scope of taxation. In this respect, value creation will be described as an allocation key for profits, without going into detail regarding technical aspects, such as analysing how a online platform can process data into valuable information through large numbers of users.

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1.3. Method used

For achieving the main objective of this thesis, a comparison will be performed between traditional and proposed taxation concepts. In this respect, the conventional source and residence-based taxation will be compared to a digital nexus, where no physical presence is required in the conventional sense. Furthermore, initiatives and proposals will be analysed.

As a result, EU discussion papers and reports, as well as OECD´s BEPS Project and its actions points will be addressed in this paper. Legal tax principles and economic reasons will be used in order to determine preferred initiatives.

Relevant aspects will be approached, such as:

• the potential violation of the Treaty on the Functioning of the EU (TFEU) by implementing the virtual PE,

• the amendment of bilateral tax treaties through the Multilateral Instrument (MLI),

• the more appropriate tax for the purpose of digital goods and services, such as Value Added Tax (VAT) or Corporate Income Tax (CIT),

• upholding the principles of neutrality and proportionality²,

• the line between virtual PE and Transfer Pricing (TP) related issues in respect of people functions, assets and risks test,

• the possibility to offset taxes through the use of a tax credit for virtual PE in order to prevent double taxation (how to determine allocation of costs).

Literature will constitute the basis for the theoretical aspects of this thesis.

Further, tax law articles will serve as guidelines for the structure of this thesis.

Key technical elements will be based on works of both the EU and the OECD through its BEPS Project (MTC, TPG, BEPS Actions, discussion papers, proposals, Directives). These elements will help build chapters 2 and 5.

The comparative method will be the hallmark of chapter 3, “The Debate”, where proposals of two different policy administrators will be compared, namely the European Union and the OECD.

A case study will be developed for the purpose of chapter 4. Ultimately, chapter 6 will summarize all of the above.

2 The principle of neutrality entails the non-discriminatory taxation of persons in view of not affecting economic choices, thus potentially hindering progress. The proportionality principle in tax is linked to the ability to pay taxes of a tax subject and should ensure that persons are not burdened by disproportionally high taxes. Both principles aim to ensure a equitable and fair taxation, which will be discussed later on in this thesis.

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Throughout the thesis, I will use a functional method to compare different taxation proposals, by analysing their aim, scope, requirements and implementation effort, as well as their potential impact on the business environment.

Further, I will use a structural comparative method for the analysis of the physical and digital permanent establishment concepts.

Parts of the thesis will entail a historical research method, where conventional business models will be compared to currently emerging digitalized business models. This comparison is vital to understanding how we can use the rules for taxing physical business models in order to identify creation of value.

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2. Survey of the current tax landscape

2.1. What is the digital economy?

Simply put, the digital economy is new, whereas the tax system is old, thus the challenge for the tax authorities arises. The incompatibility between the two deepens, as the new highly digitalized business models emerge, which rely heavily on intangible property in order to create value along the business´s value chain. Digitalization has affected businesses across all industries, sectors and world markets. Not only high tech giants, such as Google, Apple or Amazon are covered by this scope, but traditional business models as well, whether these are manufacturing companies or financial services providers, the digitalized business models range across all industries.

Throughout the thesis, the discussion will revolve around two key aspects:

intangibles and value creation. The reason for this being that digitized business models operate differently than brick and mortar ones. The tax system currently in place was built to address the latter of the business models.

2.2. What has been proposed so far and by whom?

There are currently three measure categories by type of tax, which have been proposed for the purpose of taxing the digital economy, namely an equalization tax, a withholding tax and a new nexus standard for significant economic presence, which will commonly be referred to as a “virtual or digital permanent establishment”.³ I chose these measures after researching which taxation legislative proposals are currently being analysed at an international level and which enjoy most popularity in terms of chances of successful implementation according to literature and widespread scholar views.

Action 1 of the Base Erosion and Profit Shifting (BEPS) Project developed by the Organization for Economic Cooperation and Development (OECD) regarding the taxation of the Digital Economy is the only Action out of 15, which has not yet been completed. In 2018, OECD issued an interim report concerning tax challenges arising from the digitalization of business models.

The conclusion of this report is the lack of consensus among countries with respect to methods of taxation. Despite not having recommended the introduction of unilateral measures, the report sets out a direction for the work to be performed regarding the ability to address the challenges generated by the Digital Economy.

Shortly thereafter, the European Union published its own proposals for digital taxation reform. These include both an interim solution, taking the form of a Digital Services Tax, as well as a long-term solution, which

3 OECD BEPS Project, Addressing the Tax Challenges of the Digital Economy, Action 1, 2015, Final Report

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involves the introduction of a virtual nexus for significant digital presence, that would mean an extension of the already established concept of the permanent establishment.⁴

2.2.1. OECD´s BEPS package

The aim of the OECD´s initiative, namely the BEPS package, was to address the double non-taxation of profits. So far, the package has been effective in securing tax revenues for countries, following widespread consensus between OECD member states, as well as third countries. However, regarding the digital economy, only time will prove whether the proposed measures are suitable for the emerging business landscape in the new era. In approaching this area, the BEPS project faces two main challenges, in form of determining where value creation takes places and in the context of determining a digital nexus in order to allocate profits and losses. No consensus has been reached regarding these matters, as trends shift from taxing the traditional physical structures toward profit allocation through significant people functions, assets and business risks. This development hints at a more fundamental issue of residence versus source taxation.⁵ Due to the BEPS project, the following action points have been adopted and implemented in practice and will be discussed next. Action 6 of the BEPS project introduces the principal purpose test (hereinafter referred to as PPT).

This test aims to prevent tax avoidance and targets the nature of business decisions and their actual objective. Tax authorities make use of the PPT in order to identify artificial business arrangements, aimed solely at reducing the tax base. This test could provide aid in the pursuit of taxing the digital economy, as it focuses on whether an economic activity is genuine or not.

With the help of BEPS action 7 (“Prevent the Artificial Avoidance of PE Status”), which brought changes to the scope of a PE by broadening it, tax authorities will be able to levy taxes on parts of the tax base attributable to digitized business models, through the principle of the dependent agent.

Further, actions 8 to 10 of the BEPS project focused on the alignment of the profits with the contribution of a certain member within a multinational enterprise. This was achieved through analysing business operations according to the arm´s length principle in order to identify value creation and assigning returns from intangibles to people performing different functions and assuming risks. The aforementioned development represents a step forward towards effectively identifying ways to tax digital business models, as intangibles play a significant, if not even crucial role therein.

Despite a comprehensive examination of today´s business landscape, the Report on Action 1 fails to provide clear recommendations regarding how to

4 A.M. Bal., (Mis)guided by the Value Creation Principle - Can -new Concepts Solve Old Problems?, Bulletin for International Taxation, 2018, Vol. 72, no. 11, 22.10.2018

5 Chris Morgan, Manal Corwin, Brett Weaver, Matt McNeill, The OECD Taskforce on the Digital Economy, October 2017

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proceed with specific measures, because it fails to clearly define the concept of digital economy. Although problems were identified, scenarios developed and clustered into several key categories and suggestions made (i.e. new digital nexus standard, withholding tax on payments performed for digital goods and services, consumption taxes), consensus is pending.

2.2.2. EU proposals

The European Union has released in 2018 a “fair taxation of the digital economy” package⁶. The package consists of two proposals to tax the digital revenue of companies, namely the Digital Services Tax (DST) and the digital PE. Discussions led to the conclusion of the need to develop a temporary solution for the taxation of the digital economy, followed by a testing period in order to determine its effectiveness and then proceed with a long-term solution.

The interim proposal of introducing a Digital Services Tax is designed as a 3% tax on gross revenue generated from specific digital economic activities, such as:

• Selling online advertising space

• Digital intermediary activities

• Selling data generated from user-provided information.

While the first proposal focuses on a directive of common tax for digital services performed, the second proposal revolves around the establishment of a significant digital presence, or “virtual PE”. The lack of consensus regarding the latter proposal is not surprising, as both companies established or incorporated in the EU, as well as companies in third countries that do not have bilateral tax treaties concluded with the Member State where that company has a significant digital presence, would fall under the scope. A taxable 'digital presence' or a virtual permanent establishment in a Member State would be determined if at least one of the following criteria are met in a taxable year for an enterprise:

• its annual revenue was higher than €7 million;

• it had over 100.000 users in a Member State;

• more than 3.000 business contracts for digital services had been concluded between the company and business users.⁷

The EU Commission also proposed certain taxable items, such as profits from data users (i.e. advertising placement), profits from services connecting users (i.e. online marketplace platforms) and profits from other digital services (i.e. subscriptions to streaming services), which would be taxable

6 European Commission, Fair Taxation of the Digital Economy 7 European Commission, Fair Taxation of the Digital Economy

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where a digital nexus were to be determined.⁸ However, any new taxation measure has to comply with existing rules before being implemented. We will look at those rules and fundamental principles in the next chapter, as we will discuss why these measures could pose a challenge for legislators.⁹

2.2.3. Digital nexus and the issues of the “virtual PE” concept

As mentioned above, a virtual PE would require a digital nexus in order to establish a company´s presence for tax purposes in a country and represents a measure that has been discussed at both OECD and EU level. It is feared by most, that imposing such a measure through a digital PE standard could lead to disparity between different jurisdictions, as well as to tax uncertainty, eventually leading to infringement of the successful OECD measures applied so far, themselves. ¹⁰

The attempt to drastically modify taxation rules in favour of covering the scope of digital economy should end where a company engaged in digital activities has a physical presence in the country other than the one where it resides for tax purposes, where it sells goods or provides services. In such situations, the question becomes a transfer pricing related issue.

As opposed to the recently introduced dependent agent concept (or DAPE), the virtual PE concept does not enjoy a high level of popularity among countries. Should no consensus be reached in this respect in the near future, a recommendation to adopt the virtual PE standard would create issues related to tax treaty law, as some countries would not be willing to adapt the new concept, thus leading to double taxation risks and tax uncertainty in general. It will also be interesting to observe a potential shift of the place of taxation in the context of an established balance between source and residence taxation, should the digital nexus standard be recommended.

2.2.4. (Indirect) Digital Services Tax on consumer markets

The withholding mechanism is used to levy tax from the gross amount of a payment generating income. Applied in the context of the digital economy, it is feared that it might result in double taxation and additional tax burden for the taxpayer. Similarly, a gross basis tax such as the Digital Services Tax (DST) targeting revenues is also likely to result in additional tax liabilities.

However, mitigation is possible, should the countries imposing the DST also enable a credit.

The DST (indirect, withholding tax) proposed by the EU, would be collected by the Member States where the users are located. It would apply to companies with an annual worldwide revenue of EUR 750 million,

8 Marcin Szczepanski, European Parliament, Corporate Taxation of a significant digital presence, December 2018

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respectively EUR 50 million of EU revenues. The scope of this measure is estimated to cover up to 150 companies. Furthermore, the DST is defined as an interim measure, without being clear what “interim” actually means regarding the timespan. ¹¹ Although having a different name, the OECD also approaches this consumer tax in its BEPS Action 1 Final Report.

2.2.5. Digital VAT

In the case of the value added tax, which is a consumption tax, there are two principles on which it can be based, namely the origin and the destination principles. The former charges the transaction partly within the state in which it is created or where the transaction originates, while the latter charges the part of the transaction within the state where it is destined for consumption.

For example, when goods leave country A, these are taxed there as export goods. If the goods are destined for consumption in country B, these are taxed in that country accordingly. However, this is an oversimplified mechanism, which in practice rarely takes place in this form. Normally, transactions, which generate most of the revenue streams, can cross through several countries until reaching their destination. For this purpose, the EU has harmonized the VAT mechanism through the Directive, allowing certain simplification measures to be applied for intra-Community supplies and purchases of goods. Additional issues arise with respect to services performed, as these are more difficult to classify for VAT purposes correctly between origin and destination. The classification depends on whether the services are being performed in an origin-based jurisdiction, or in a destination-based jurisdiction. It is therefore easy to comprehend how the digital economy could amplify these challenges, as these emerging business models operate with increasingly less physical presence for the sale of goods and services. The outcome of these challenges results in no or very low VAT being levied due to exemptions or complexity of enforcing the tax.¹²

Two major reforms of the VAT system were announced by the EU Commission in the last couple of years, namely the Digital VAT Package and the Definitive VAT system, affecting almost everyone who is participating in the EU trade.¹³ For the purpose of this thesis, we will only address the former VAT package further.

A wide range of business to consumer transactions in E-commerce are covered by the Digital VAT, which is due to be implemented by the Member States in their national legislation by 2019 or 2021, depending on the applicable provisions.

11 A.M. Bal., (Mis)guided by the Value Creation Principle - Can -new Concepts Solve Old Problems?, Bulletin for International Taxation, 2018, Vol. 72, no. 11, 22.10.2018

13 A.M. Bal., The Changing Landscape of the EU: Digital VAT Package and Definitive VAT System, European Taxation, 2019, Vol. 59, no. 11, 2.01.2019

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Supplies of electronic services to EU customers are taxed at their destination, namely in the country where the customer is located, under the existing VAT rules.¹⁴ In order to facilitate tax collection and compliance, business-to- business transactions involving electronic services are subject to the reverse charge mechanism, which means that the customer has to self-assess VAT.¹⁵ In addition, the One-Stop Shop is a simplification scheme, which is optional for businesses that perform electronic services supplies to non-taxable consumers (B2C).¹⁶

Given this brief summary, it is fair to say that the aim of the package is to simplify and facilitate cross-border transactions, as much as possible given the circumstances and challenges. As a significant part of each country´s tax revenues, it is important to ensure the fair, but also efficient collection of VAT and prevent tax avoidance.¹⁷

2.3. Why does the digital economy pose a challenge for taxation purposes and of what kind?

As mentioned before, the challenge of taxing the digital economy arises from the rapidly developing business models and lack of consensus regarding how to update a complex, but outdated tax system. Going into detail, each proposed tax raises different issues, due to the need to uphold international taxing principles or treaty conventions. It follows, that a taxing measure, which is labelled appropriate, should then be analysed against these principles for compliance purposes.

The principles of equity, fairness and neutrality represent such principles of the international taxation that address a person´s ability to pay, by comparing them to other persons in comparable situations (equity and fairness), or the prerogative of a company to base its choices on economic, rather than tax- related factors (neutrality). They suggest, that taxpayers should be treated equally, should not be affected in their choice of economic activity compared to a situation without any taxes (based on the fact that companies should make decisions which lead to the best economic results without taking into consideration the aspect of taxation) and finally taxpayers should be taxed equitably, based on their different level of income. ¹⁸

A further principal of international taxation is the principle of tax certainty, which suggests that taxes should specify clearly how a taxable amount is

14 Article 58 of the VAT Directive, Council of the European Union

18 Martin Berglund, Katia Cejie, Basics of International Taxation (2nd edition, Iustus) page 19

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determined, when the obligation of paying the established amount arises (chargeability event) and how the respective payment should be performed.¹⁹ Amendments regarding the nexus standard for permanent establishments, the impositions of additional withholding taxes such as the “digital tax”, as well as the equalization levy, pose a significant challenge to the goal of achieving global consensus in accordance with the international tax rules, specifically to the goal of maintaining tax certainty and avoiding double taxation.²⁰ Challenge 1

A significant challenged is posed by the need to amend bilateral tax treaties to a large extent, in order to include adapted measures in the digital economy.

The risk of double taxation rises, particularly in the case of a virtual PE, when the concept is introduced into national legislation and not recognized by the other party of the treaty or when conflict arises between the traditional PE and the virtual one.

This can only be avoided through multilateral cooperation, in order to not hinder economic development. For this purpose, we should address the successful implementation of the multilateral instrument, or “MLI”, which was developed by the OECD and implemented in several member states (the MLI will be briefly discussed in the next chapters). A similar solution should provide an alternative to the implausible task of renegotiating all existing bilateral tax treaties.

Challenge 2

Every new European tax law has to comply with the fundamental freedoms (hereinafter referred to as “TFEU”), before being implemented. Should a new tax, although intended for purposes of covering digital goods and services with its scope, discriminate between residents and non-residents of the EU, then such a tax would represent an infringement of the fundamental freedoms. It would then need to be proven, that the respective measure is justified and proportionate, according to the ECJ test²¹, in order to be in compliance and enter into force.

For example, the introduction of any (withholding) tax levied on the gross value of payments performed toward non-resident providers of online goods and services, including the equalization levy, could constitute an infringement of the freedom of establishment. This would occur, as residents in similar situations could claim expenses directly related to the taxable activity, which they would deduct, whereas the non-resident would be restrained from doing so by the withholding tax. The same would apply in

19 The Association of International Certified Professional Accountants, Taxation of the digitalized economy, October 2018

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the cases of a virtual PE or VAT. The former would raise, like in the case of a WHT, cost deductions-related issues, which could be the result of unfair treatment compared to residents, whereas the latter would pose an issue, as the EU VAT Directive prohibits the levy of additional turnover taxes, other than the VAT.²²

Challenge 3 - How is value created?

Before diving into the analysis of the two most popular proposed measures (i.e. DST and digital PE), we will first look at why it is so difficult to tax a digital business. Regardless of economic activity and segment, every digitalized business model operates based on two key features, namely user participation and generation & use of data. Whether advertising or e- commerce, every platform needs user participation and data in order to develop, to grow.

Value creation is the OECD´s bedrock for profit allocation and the primary criteria for the allocation of taxing rights. However, with no clear definition on what value creation really is or how to quantify it, it is difficult to determine how to allocate profits for taxation purposes. Furthermore, this concept can follow both a source, as well as a destination principle. The former can be interpreted in terms of production location, where value is created and the beginning of the value chain, whereas the latter prefers the approach of a market-based taxation, where the customers are considered to be value drivers, thus taxing profits in the destination country. These alternatives depend on each country´s preference for taxation, which in turn relies heavily on the country´s economic and political situation. ²³

Other challenges²⁴

A well-known fact is that the largest high-tech companies, the most highly digitalized multinationals in the world are incorporated in the United States of America. It therefore follows, firstly, that the U.S. plays a dominant role and is a key partner in the global debate on digital economy taxation and secondly, that it will protect its interests in retaining most of the taxable base on income generated by these American companies, resident there. Any disapproval on part of the U.S. would clearly generate delays with respect to the goal of reaching international consensus. As is, the pressure of taxing digital business models arose when Europe realized the potential of revenue stream generated by these companies, operating on the European market. As these companies continued to earn more income, the need to retain taxes in Europe became a priority. Prominently, following the publication of the OECD´s Interim Report in 2018, the U.S. Treasury Secretary issued a

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statement according to which the U.S. firmly rejects the proposal to “single out digital companies” for tax purposes. This statement clearly indicates the intent of protecting some of the country´s largest contributors to job creation and economic growth.²⁵

The Tax Cuts and Jobs Act (hereinafter referred to as “TCJA”) has brought significant changes for U.S. multinational enterprises. Until 2017, these companies were only subject to tax in the U.S. after their offshore profits were repatriated. This incentive was amended, and the shift was performed to a territorial tax system in which profits are taxed where they are earned. A one-time tax for offshore holdings has also been introduced, irrespective of repatriation, eliminating the incentive of keeping profits abroad.²⁶

Repatriation of profits is therefore no longer available in the U.S. following the tax reform of 2017 and companies do not enjoy advantages for tax purposes any longer since then. Thus, it will no longer be advantageous for U.S. companies to postpone tax payments until the profits are repatriated to the United States. These anti-tax avoidance measures exonerate U.S.

companies from now on when it comes to taxes payable within the EU.²⁷ Fairness of the tax measures to be introduced represents yet another challenge. For example, the European Digital Services Tax targets a company´s turnover as a tax base and not it´s profit. Should companies that operate with different profit margins, or even at a loss, be taxed the same?

Furthermore, the proposed measure could represent a risk of double taxation, as the proposal does not contain any kind of mandatory requirement of tax relief among the Member States. As such, companies that will already have been taxed in the residence state could risk paying tax in the source state, where users are active, for the same income and not be allowed any kind of credit or deduction of business expenses by the residence country.

2.4. Interim conclusion

We have discussed which parties are involved in developing new tax measures, which challenges they face and how they intend to solve them.

Both the OECD and the European Union have been active in engaging consultations in order to develop appropriate measures. These measures have been proposed in different forms, namely as equalization levy, consumption tax, withholding tax and income tax on business profits through a permanent establishment. All of these measures face challenges regarding jurisdiction to tax, type of income subject to tax and method of taxation.

26 Federal Reserve, U.S. Corporations´Repatriation of Offshore Profits, 4 September 2018,

27 Krister Andersson, United States/European Union/International - Should We Use Value Creation or Destination as a Basis for Taxing Digital Businesses? – Krister Andersson’s Comments on the 2018 Klaus Vogel Lecture Given by Professor Michael Devereux, Bulletin for International Taxation, 2018 (Volume 72), No.

12, 14 November 2018

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3. The debate

The jurisdiction to tax is determined by states in connection with either the person or the income. The residence principle establishes tax liability on income based on the person´s residence, irrespective of the income´s source.

This basic principle applies to both individuals, as well as companies and determines tax liability based on either whereabouts of the individual or place of management or registration of a company in a specific country. For every of the aforementioned cases and according to the international tax framework (i.e. OECD Model), the residence is determined based on a facts and circumstances test. This translates into place of habitual abode, nationality, permanent home and centre of vital interests in the case of individuals and for companies into:

• the place of effective management, meaning where most important management decisions are met for a company.

In contrast, the source principle generates taxation rights for the country where the taxable income is generated. This principle triggers tax liability only for that particular income which has a connection to that state. Both principles are connected by fundamental principles of income taxation, namely by the benefit and ability-to-pay principles, which require an assessment of a person´s global income in order to justify the tax liability. As their names suggest, these principles should ensure that a person is subject to a proportionate tax burden and that the country from which the person derives benefits receives its fair share of tax revenue in exchange for the secured advantages (i.e. infrastructure).²⁸

The destination-based principle for tax purposes represents a concept, which opposes the origin-based principle of taxation and is a result of the attempt to address the current economic reality more accurately. It is mentioned more and more often in specialized articles and revolves around the idea of taxing a company based on its profit value drivers, such as consumers. It follows that the destination-based principle is synonymous to the consumer market- based principle.

3.1. Source versus residency based taxation

Proposed measures so far are counterproductive for the already established trend on behalf of the OECD for residence-based taxation; shift intended to tax companies on the markets where they sell goods or perform services.

When concerning oneself with the issue of fair taxation of the digital economy, the need to address the traditional allocation rules between residence and source taxation seems inevitable, at least to some degree, which is difficult to determine precisely at the moment. This is a scenario, which inevitably leaves one stakeholder dissatisfied. Whether it is the side

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where digital business models reside and are incorporated or the one where these companies activate on the market in order to sell their goods and services. Despite consensus being reached in the area of transfer pricing, regarding principles of value creation, arm´s length and functions performed by people, countries may see the challenge of developing new tax measures for the digital economy as an opportunity to re-balance the taxing rights between them. In order to reach global consensus, multilateral collaboration, cooperation and tax debates must be conducted. In addition, the digital economy should be acknowledged as the new structure which has already began to shape the future and will continue to do so until it becomes the status quo. As a result, a further logical conclusion is that countries should aim to develop long-term solution, rather than temporary ones. As stated in the OECD´s BEPS Action 1 report from 2015, the digital economy cannot be ring-fenced, because it “is” the economy.²⁹

Data is the cornerstone of digital economy. However, data itself in its raw form cannot generate value, instead it can fuel the engine, which drives the digital economy once it is managed and leveraged in order to improve a company´s position in terms of innovation, customer experience and competitiveness. It therefore follows, that the collection, process and analysis of data generates insights, which can be translated into profit drivers.

Ensuring this data management process is therefore key and is performed by individuals. One can conclude, that in order to understand value generation in the digital era, a comparison between data as a valuable resource and raw materials can be performed. As in the case of raw materials, an enterprise needs skilled individuals who are able to transform those materials into profit-generating finished goods. This is an oversimplified example of converting inputs into outputs for profit purposes. Going forward with this logic, as well as acknowledging the aim of the income tax system of taxing these profits, one can realize that potential loopholes or new, uncharted territory in terms of taxation measures. These should be closed in order to enable the fair taxation of profits not yet covered by the scope of the system, rather than to experience a shift of the taxing rights toward the input jurisdiction.³⁰

Data is gathered through user participation. Without user participation, any digital services platform would not grow. Acknowledging user participation as an allocation key for taxing rights, entails the taxation of profits by the jurisdiction where the users are located. However, this method implies several challenges, all linked to the difficulty of accurately determining how to measure such value, given the varying behaviour of the users.

This shift of taxation rights can be observed in OECD´s Interim report regarding the significant digital presence standard. The digital nexus is a

29 OECD BEPS Project, Addressing the Tax Challenges of the Digital Economy, Action 1, 2015, Final Report 30 A.M. Bal., (Mis)guided by the Value Creation Principle - Can -new Concepts Solve Old Problems?, Bulletin for International Taxation, 2018, Vol. 72, no. 11, 22.10.2018

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market-based source concept, which relies on the economic activity of non- resident companies and where it is performed. Together with the market jurisdiction concept, customers play a significant role in a company´s wellbeing, other than the role of merely buying the company´s product, such as a marketing role for example.³¹This is especially important in cases where companies offer their services for free, such as social media platforms.

Despite enjoying the service without using any monetary means of payment, the customers contribute to the offering company´s growth with personal information and online behaviour by accepting their online activity to be tracked based on criteria, which is relevant for the company´s interests. Such business models flourished under the consent of the customer, who in turn is able to enjoy the many benefits offered by the company. In this context, the EU´s interim proposal for a fair taxation of the digital economy, takes the shape of the Digital Services Tax, which would be levied on sales of data obtained through gathering of user-provided information, as well as on sales of online advertising space.

3.2. Digital nexus versus Digital Services Tax 3.2.1. Virtual PE

The current permanent establishment standard found under article 5 of the OECD Model Tax Convention requires a physical presence in order to allocate taxing rights. In order to determine an obligation for a non-resident to pay income tax in another state, the PE rule sets out several requirements and the test approach consists of the following steps:

• (1) the determination of significant people functions, and the allocation of risks and assets based on a functional analysis, and allocation of free capital and debt; and

• (2) the determination of the profit to be allocated to the PE based on the functional analysis and by applying the arm’s length principle.³² The first paragraph of article 5 entails: For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.³³

The “fixed place of business” requirement no longer applies to modern digital business models, which enable a company to achieve a significant economic presence on a market without actually being physically present on that

33 OECD Model Tax Convention on Income and Capital, Condensed Version, 2017

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market. The EU proposal therefore aims to address this issue by extending the scope of the PE to businesses that have a significant digital presence. The proposed “virtual PE” raises two main questions: where to tax? - with respect to the significant digital presence and what to tax? - with respect to value creation.

Regarding the first question, Action 1 of the BEPS Project suggests taking into account factors such as revenue, users and other relevant digital factors in order to determine a significant economic presence for digital business models. The EU proposal states that a significant economic presence is deemed to exist if at least one of the following requirements is met:

• (1) if the revenues from providing digital services to users in a Member State jurisdiction exceed the EUR 7 million threshold (revenue-based factor);

• (2) if the number of users of a digital service in a Member State exceeds 100,000 in a taxable year (user-based factor); or

• (3) if the number of business contracts for digital services that are concluded between the company and its users located in the Member State exceed 3,000 (user-based factor).³⁴

The revenue requirement addresses sales generated by residents of a Member State, users are measured in relation to the volume of digital contracts and digital factors are deemed services performed through a digital platform, local domain name or local payment options.

The new PE standard would represent an extension of the existing PE concept of article 5. The significant economic presence test could be performed either as a qualitative test, which would take into account all relevant facts and circumstances (i.e. domain name, payment options), or as a quantitative test, which implies regarding solely revenue and user-based factors. In contrast to the view of the OECD, which has made its preference for extensive functional analysis known, the EU would opt for the quantitative test. It is debatable if such an option would achieve a fair allocation of taxing rights and if it would be enough to prevent business restructurings solely for the purpose of tax avoidance. According to scholars, it is very likely that a combination of the quantitative and qualitative test would be necessary, in order to address all digital business models depending on the nature of their economic activity.

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Regarding what to tax, the EU suggest the profit allocation be performed by judging whether the profits deriving from a company in a Member State would be generated in the same way by a:

separate and independent enterprise performing the same or similar activities under the same or similar conditions, in particular in its dealings with other parts of the enterprise, taking into account the functions performed, assets used and risks assumed, through a digital interface. ³⁵

The profits attributable to the Member State would be the ones earned under the above-mentioned conditions. By recommending that the profit attribution should be based on a functional analysis, the EU would be in line with the OECD Transfer Pricing Guidelines. ³⁶ Although not specifically included in the EU proposal, the Authorized OECD Approach (“AOA”) seems to be in line with its provisions regarding the attribution of assets and risks to such a significant economic presence.

The AOA and the Transfer Pricing Guidelines (“TPG”) found under Actions 8-10 of the BEPS Project, place special emphasis on the significant people functions and risk control functions. Limitations have been introduce, which only allow profit allocation to those jurisdiction in which a significant presence is deemed. Therefore, the introduction of a customer/ user-based source taxation as provided by the EU´s virtual PE requirements would require significant revisions of the TPG and AOA in order to prevent double taxation. The new nexus standard with an emphasis on the location of users, as opposed to the location of an enterprise´s functions, risks and assets, would have significant implications, especially when considering enterprises with disparities between the location of its customers and the location of its value creation. ³⁷

The Dependent Agent Permanent Establishment (“DAPE”) standard recommended by BEPS Action 7 has only been adopted by a minority of countries participating in the BEPS Action 15 Multilateral Instrument (“MLI”). Paragraphs 278, 279 and 280 of the Final BEPS Action 1 report mention the revenue, user-based and digital factors used in order to determine the new digital nexus standard. In the event of the introduction of a virtual PE, many questions remain unanswered regarding the compatibility of the EU provisions with the existing bilateral tax treaties. This would raise questions regarding the hierarchy of norms between treaty law and EU law, with the fundamental rights included in the EU treaties, the TFEU, supporting

36 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2017 37 Chris Morgan, Manal Corwin, Brett Weaver, Matt McNeill, The OECD Taskforce on the Digital Economy, October 2017