2013-2014 Worldwide Cloud Computing Tax Guide
Organisation for Economic Co-operation and Development
With 341 member countries and several additional countries that participate in the OECD tax work with the status of “observers,” the Organisation for Economic Co-operation and Development (OECD) provides a forum in which governments can collaborate and seek solutions to tax issues of common interest. With respect to the evolving global questions regarding the tax treatment of activity in the digital economy, the OECD has been an influential voice with a reach that extends beyond its member nations. Conclusions reached by the OECD have a direct impact on the language used in income tax treaties around the world, and developments in the OECD's analysis can in many cases affect the interpretation of existing treaties.
Although OECD guidance does not apply in all cases, the discussion contained herein is useful as a general benchmark. This chapter discusses the OECD's guidance as it relates to payment characterization and permanent establishment, as well as the OECD's base erosion and profit shifting (BEPS) action plan and its public discussion draft on BEPS action 1, entitled “Addressing the tax challenges of the digital economy.”
1 At the time of this publication, the 34 member countries are Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom and the United States.
The OECD Commentary on its Model Tax Convention includes discussion of the characterization of e-commerce transactions and activity. A summary of key aspects of the OECD guidance is provided below.
Characterization of an amount of income as a royalty versus business profits can be an important distinction. Generally, under an applicable tax treaty between two countries, business profits of an enterprise of one country are taxable in the other country if they are attributable to a permanent establishment situated therein. Royalties can be subject to tax in such a country through local withholding even in the absence of a permanent establishment. However, the withholding tax may be reduced or eliminated under the applicable income tax treaty.
A payment's characterization as a royalty generally involves the transfer of a right to use a copyright in a commercial sense (e.g., reproduces and sells the copyrighted materials). For example, a customer electronically orders and downloads digital products for the purpose of exploiting the copyright.
Depending on the facts and circumstances, payment characterization as a royalty may be more prevalent in a business-to-business transaction compared to a business-to-consumer transaction, as the end consumer typically does not obtain a commercial license. The OECD has discussed that most online transactions do not result in royalties because these transactions do not involve the use or exploitation of intellectual property. It is observed that most digital transactions involve the copying of digital files housed on a server, where a copied file is transmitted electronically to a customer. Although certain countries may characterize such a transaction as a royalty due to a formalistic approach, the OECD has focused on the transaction's substance. In many cases, the substance of a transaction shows that the use of a copyright for commercial purposes is not involved. The copying of electronic content may be considered incidental. For example, if a customer downloads a copy of a software product, the act of copying does not necessarily represent the use or exercise of a copyright right. In analyzing the true substance of the transaction, the payment may be viewed as the purchase of software. In addition, the OECD commentary indicates that even a distribution arrangement between a copyright holder and a distribution intermediary should fall within the business profits article, provided the arrangement excludes the right to modify or reproduce the underlying software.
Sale or rent
Where a customer acquires property that is limited to personal use, the transaction may be considered a sale or a rental, depending on the rights in the property acquired. This can include the purchase or rental of a digital product such as a copy of electronic data, a software program, digitized music or video games or other forms of digital content. The product could be delivered in either a tangible form or in the form of a digital signal.
Depending on the facts and circumstances, payment characterization as a sale or rent could arise in either a business-to-business or business-to-consumer transaction, depending on the contractual arrangement. Under OECD principles, income derived from the sale or rent of property should generally be characterized as business profits.
The OECD commentary generally provides that if a customer engages another party to create an item of property that the customer will own from the moment of its creation, the transaction should be characterized as the provision of a service. For example, the OECD commentary indicates that data warehousing can be characterized as the provision of a service. Data warehousing typically involves a customer storing computer data on servers owned by a third-party operator. The customer can access, upload, retrieve and manipulate data remotely, and no license is required. Under this scenario, the OECD commentary characterizes such activity as the provision of services, which should be taxable under the business profits article under the OECD Model Tax Convention.
For purposes of applying alternative treaty provisions that allow source taxation for “technical fees,” taxpayers should determine whether such a fee is involved. The term “technical fee” generally refers to any service of a technical, managerial or consultancy nature.
OECD commentary indicates that the income from a bundled contract would, in principle, be subject to reasonable apportionment so that each type of income can be treated appropriately for tax purposes. However, the predominant character of the contract may be used if the other parts of the contract are largely unimportant or ancillary. In an example, the OECD commentary contemplates a franchising arrangement whereby a franchisor provides a franchisee with know-how, varied technical assistance, financial assistance and a supply of goods. The appropriate course of action would be to break down the contract or apply a reasonable apportionment method so that each part of the contract is appropriately taxed. However, if an element of the contract constitutes the principal purpose of the contract and the other parts are merely ancillary or unimportant, it should be appropriate to follow the predominant character of the contract.
The concept of permanent establishment is important as it is the tax treaty threshold for determining whether an enterprise of one country can be subjected to tax by the other country on its business profits from activities in such other country. The term “permanent establishment” can generally be described as a “fixed place of business” through which an enterprise carries on its business. The term “fixed” generally refers to a distinct place with a certain degree of permanence, while the term “place of business” refers to any premise, facility or installation used for carrying on the business of the enterprise, whether or not it is exclusively used for that purpose. It does not matter whether an enterprise rents or owns the premise, facility or installation. Moreover, a “place of business” may exist even if an enterprise has a certain amount of space at its disposal for business activities. It is also important to note that an agency permanent establishment may exist if an enterprise relies on a dependent agent who acts on its behalf in conducting its business.
It is possible for a principal2 to be considered to have a permanent establishment in a foreign country if the principal operates its business through a server in a foreign country, even in the absence of local employees of the principal. The OECD commentary provides that a server could constitute a permanent establishment if the server performs core functions of the business and meets the following conditions: (i) the server must be fixed (both in time and geographically), (ii) the business of the principal must be carried on through the server and (iii) the server must be at the disposal of the principal (e.g., owned/leased and operated/maintained by the principal).
Although the OECD has not reached a broad consensus on permanent establishment, the OECD's technical advisory group (TAG) in 2001 has posited the following as it relates to e-commerce transactions:
- A website cannot, in itself, constitute a PE.
- Website hosting arrangements typically do not result in a PE for the enterprise that carries on business through the hosted website.
- Except in very unusual circumstances, an internet service provider will not be deemed to constitute a PE for the enterprises to which it provides services.
- A place where computer equipment, such as a server, is located may in certain circumstances constitute a PE if the functions performed at that place go beyond what is preparatory or auxiliary.
2 See the definition provided in the introduction to this guide.
Base erosion and profit shifting (BEPS)
On 19 July 2013, the OECD issued its “Action Plan on Base Erosion and Profit Shifting” (the Plan). For purposes of the work on the Plan, the OECD invited G20 countries that are not OECD members to participate on an equal footing; these additional countries include China and India, among others. In the OECD's view, gaps in the interaction of domestic tax rules of various countries, the application of bilateral tax treaties to multijurisdictional arrangements, and the rise of the digital economy with the resulting relocation of core business functions have led to weaknesses in the international tax system. The Plan acknowledges that, in many circumstances, existing domestic law and treaties yield the correct result, but states that, without coordinated action in the areas that give rise to policy concerns, countries that wish to protect their tax bases may resort to unilateral action that could result in a resurgence of double taxation as well as global tax uncertainty. Thus, the Plan concludes, fundamental, consensus-based changes are needed to address double non-taxation and cases of no or low taxation where taxable income is artificially separated from the activities that generate it.
The Plan states the view that there are tax challenges that need to be addressed with respect to the digital economy, “which offers a borderless world of products, and services that too often do not fall within the tax regime of any specific country, leaving loopholes that allow profits to go untaxed.” The Plan includes the need to address the challenges of the digital economy as its first action item, although it is unclear whether this is intended to convey that this action item has a higher priority or importance than the other action items listed.
The Plan describes the digital economy as “characterized by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs.”
The Plan states that this raises questions about the character and sourcing of income and how enterprises add value and make their profits. The Plan notes that “the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.”
The OECD intends to approach the action item related to the tax challenges of the digital economy by “taking a holistic approach and considering both direct and indirect taxation.” The issues to be examined under the Plan require a thorough analysis of the different business models and include but are not limited to:
- The ability of a company to have significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules
- The attribution of value created from the generation of the marketable location-relevant data through the use of digital products and services
- The characterization of income derived from new business models
- The application of related source rules
- How to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services
The expected OECD output with respect to this action item is “a report identifying issues raised by the digital economy and possible actions to address them,” and the OECD's stated deadline for producing this report is September 2014.
BEPS action 1: addressing the tax challenges of the digital economy
On 24 March 2014, the OECD released its discussion draft “BEPS action 1: addressing the tax challenges of the digital economy.” The discussion draft provides background on the working of the digital economy, focuses on the opportunities for BEPS activity that may arise in the digital economy, and outlines some potential options to address the tax challenges raised by the digital economy.
The discussion draft provides an overview of four potential options to address the challenges of taxing the digital economy that were proposed to the OECD task force on the digital economy. The discussion draft specifically notes that while the task force has had initial discussions on several options, the options are still being developed, and it is important to receive input at this early stage.
In considering how best to evaluate the potential options, the discussion draft recommends the taxation principles developed from the 1998 Ottawa Ministerial Conference on Electronic Commerce. The framework is centered on five main principles:
- Neutrality – tax should seek to be neutral and equitable.
- Efficiency – compliance costs for taxpayers and administrative costs for tax authorities should be minimized.
- Certainty and simplicity – tax rules should be clear and simple to understand.
- Effectiveness and fairness – taxation should produce the right amount of tax at the right time.
- Flexibility – the systems for taxation should be flexible and dynamic to ensure that they keep pace with technological and commercial developments.
- Several of the potential options presented to the task force would modify the exemptions to permanent establishment status. One potential option would eliminate the exception for preparatory or auxiliary activities or limit the exception by making it subject to the overall condition that the character of the activity conducted is preparatory or auxiliary in nature.
- Another potential option focuses on establishing an alternative nexus to address situations in which businesses are conducted wholly digitally. This option would apply to an enterprise that is engaged in certain “fully dematerialised digital activities” and would treat such an enterprise as having a permanent establishment if the enterprise maintained a “significant digital presence” in the economy of another country.
- Another potential option involving the permanent-establishment threshold would involve a form of virtual permanent establishment that could exist through a virtual fixed place of business permanent establishment, a virtual agency permanent establishment or an on-site business presence permanent establishment.
The final potential option identified in the discussion draft as having been presented to the OECD task force would involve imposing a final withholding tax on certain payments for digital goods or services in the case of companies that maintain substantial economic activity in a market but have no permanent establishment under the current rules. Under this proposal, the OECD would need to consider consistency with trade obligations as well as how to address withholding in cases where the transaction is made with an individual consumer.
In the area of consumption taxes, the discussion draft identifies the need also to address indirect taxes in addressing BEPS, with a focus on the implementation of Guidelines 2 and 4 of the OECD's “Guidelines on place of taxation for B2B supplies of services and intangibles.” Guideline 2 recommends that the taxing rights be allocated to the jurisdiction where the customer has its main business establishment. In such case, the business customer would generally be required to self-assess VAT on remotely delivered services. Guideline 4 provides that when a supply is made to a business that is established in more than one jurisdiction, taxation should accrue to the jurisdiction where the customer's establishment using the service is located.
As part of this discussion, the OECD notes the need for countries to simplify consumption tax registration regimes and registration thresholds to minimize the compliance burden to businesses.
This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.