It’s apparent that there is a lot more cross border business than we had decades ago, but also the way we use the internet and the digital economy to manufacture, market, sell and deliver our products or services has been completely revolutionized over the last two decades.
Contrast that to the international tax principles and laws that governments rely on to tax cross border activity, these have been the same for over fifty years. The purpose of the OECD Taxation of the Digital Economy initiative is to address this huge gap between the current world of global commerce and the relatively ancient framework for taxation of cross border activity.
The two main factors that govern the taxation of cross border activities is:
1) Who has the right to tax?
2) How to allocate profits amongst various jurisdictions?
The existing international tax principles inherent in most tax legislation worldwide allow a jurisdiction to tax a business enterprise when said business has physical presence in a country. This is the basis for the OECD model treaty Permanent Establishment provision as well as the U.S. tax principal of being “Engaged in a Trade or Business” in the U.S.
With the digital commerce platform, businesses can generate millions of dollars in revenue without ever “stepping foot” into a country. Furthermore, businesses can generate millions of dollars of market value by curating an audience in a country without ever “stepping foot” into that country. Under the current taxation of cross border activities regime, this ability to generate revenue and create valuable assets in a country without any physical nexus to a country allows businesses to avoid paying any taxes to that country on the income and wealth generated in that country.
For example, a company like LinkedIn may have a millions of users in France. However, it may not have any physical presence in France, and therefore under the current regime France would not have any right to tax LinkedIn for the value it created in curating the French based users.
The existing transfer pricing framework based on U.S. and OECD guidelines allocates profits based on the location of the functions, risks and assets of a multinational enterprise. This analysis typically allocates these three factors and therefore the profits associated with them to countries where there is some sort of physical substance or activity.
With a digital commerce platform companies, such as LinkedIn in my above example, may have significant assets that relate to the foreign market, however, the substance that created that asset may be based in the U.S. so that asset and the profit associated with that asset are allocated to the U.S.
As digital commerce continues to become an overall bigger piece of the global economy, these concerns translate into bigger and bigger dollar amounts for tax authorities worldwide. Many countries have proposed legislation that would impose a Digital Service Tax (DST) on digital commerce within their jurisdiction. These unilateral actions may result in double taxation to Multi-National Enterprises.
The OECD’s Taxation of the Digital Economy initiative was undertaken in an effort to create a workable framework and universal consensus on how to approach these issues.