Equalisation Levy – creating inequality for SME?

This article is based on a legislative enactment.  It is divided into following portions

Citation of the Enactment

Entering the subject

Take away points

Purpose of article-:

Situation before Enactment

Source of Enactment

Purpose of article-:

Situation before Enactment

Source of Enactment

Position vis-avis ITA

Impact on SME

Citation of the Enactment

1. It is a levy proposed by the Finance Bill, 2016.

2. One is aware that, the service tax has also been levied vide the Finance Act, 1994 [ chapter V]

3. If the finance Bill, 2016 gets approval of parliament in the current format, one will have to say that, the equalisation levy has been levied vide the Finance Act, 2016 [chapter VIII] [the FA, 2016]

Entering the subject

4 It is a levy emerging from source based taxation at the rate of 6%.

5 Government has chosen this route because, under the current regime, it cannot reach to google / yahoo etc.

6 Especially from view point of a SME, it is in the nature of levy on availing / importing some digital services like digital advertisement.

7 Additionally, if an assessee fails to pay [deduct and pay] the 6%, 100% of the amount on which the 6% was payable will be added to income chargeable to tax u/s 40(a) like that of addition on account of non payment of TDS.

8 To put in very simple terms, if a person wants flash an advertisement on google / yahoo, he will have to pay this levy. For the moment, lets not go into individual assessment of Google / Yahoo in specific.

9 Taxguru.in is carrying an article by CA. Rockey at https://taxguru.in/income-tax/levy-equalisation-levy.html which elaborate the details

Take away points

10 Benefit DTAA u/s 90 / 90A of ITA may not be available.

11 The provisions of this chapter may be challenged for its constitutional validity on the criteria of extra-territorial nexus theory. Refer GVK Inds. Ltd & Anr vs The Income Tax Officer & Anr on 1 March, 2011 a constitutional bench decision of Supreme Court of 5 judges.

12 A failure in paying the levy will attract all the consequences as that of non- payment of TDS u/s 40(a).

13 Whether the provisions will be beneficial or otherwise is considered under the head Impact on SME.

Purpose of article-:

14 To study the source from which the levy has emerged. [source of enactment]

15 To assess impact on SME

Situation before Enactment

16 One is encouraged to read the decision of ITO vs. Right Florists Pvt Ltd (ITAT Kolkata) T.A. No.: 1336/ Kol/2011 dated April 12, 2013. The facts and ratio of the case will give the background to understand the reason for the levy.

17 Right Florist paid money to Google Ireland for flashing an advertisement when a person searches for florist or related requirement.

18 The only issue was whether Right Florist should have deducted TDS u/s 195 before making for availing this online advertisement services.

19 On facts and as per law, it was held that, Google Ireland does not have a PE in India and thus its income is not chargeable to tax in India.

20 Consequently, it is not necessary to deduct any TDS.

21 This is a case based more on facts and not posing substantial question of law.

22 What is very important and crucial is understanding of following factors elaborated by the learned bench

• How an online advertisement works. [Pages 3 to 7, 23, 27]

• Commentary of OECD on electronic commerce [Page 14]

• Whether online advertisement services can be covered by article 12 of the treaty. [Page 22]

• Requirement for Human interface [Page 27]

• Application of concept of PE to the above facts [Page 13 to 17]

• what is primary meaning of a PE and whether a search engine like Google or Yahoo can be said to have a PE, within its primary meaning, in India. [Page 13]

23. Refer following paragraphs of the above judgement 

12. Let us first examine as to what is primary meaning of a PE and whether a search engine like Google or Yahoo can be said to have a PE,within its primary meaning, in India. It is important to bear in mind the fact that the concept of PE evolved because in traditional commerce, physical presence was required in the source country if any significant level of business was to be carried on, but, with the development of internet,correlation between the size of business and extent of physical presence in the source country has virtually vanished. In that sense, the traditional concept of PE, which was conceived at a point of time when internet and e-commerce was not even on the radar, does not really fit into the modern day world in which virtual presence through internet , in certain respects, is as effective as physical presence for carrying on businesses. At a policy level, taxation may infringe neutrality when it is dependent on the form of presence, i.e. physical presence vis-a-vis virtual presence, traditional commerce vis-à-vis e-commerce, direct presence vis-à-vis presence through a dependent agent. A search engine’s presence in a location, other than the location of its effective place of management, is only on the internet or by way of a website, which is not a form of physical presence. As to whether an website can be PE or not, we find guidance from High Powered Committee Report which, while recognizing the need to make form of presence tax neutral but realizing the limitations of the scope of existing principles and rules, has also observed that, “The Committee, therefore, supports the view that the concept of PE should be abandoned and a serious attempt should be made within OECD or the UN to find an alternative to the concept of PE”. Clearly, conventional PE tests fails in this virtual world even when a reasonable level of commercial activity is crossed by foreign enterprise. It isa policy decision that Government has to take as to whether it wants to reconcile to the fact that conventional PE model has outlived its utility as an instrument of invoking taxing rights upon reaching a reasonable level of commercial activity and that it does fringe neutrality as to the form of commercial presence i.e. physical presence or virtual presence, or whether it wants to take suitable remedial measures to protect its revenue base. Any inertia in this exercise can only be at the cost of tax certainty.

13. In the light of the above discussions, even as per the High Power Committee, a website per se, which is the only form of Google’s presence in India – so far as test of primary meaning i.e. basic rule PE is concerned, cannot be a permanent establishment under the domestic law. We are in considered agreement with the views of the HPC on this issue.

14. This view further finds support from the Commentary on OECD Model Convention, which, inter alia, observes as follows:

Source of Enactment

24. OECD alongwith G20 countries have started an ambitious project namely “Base Erosion and Profit Shifting Project”. It has published its final report on various topics in October 2015. One of the topic being “Addressing the Tax Challenges of the Digital Economy – ACTION 1: 2015”

25. The OECD has recommended in Base erosion and Profit Shifting (BEPS) project under Action Plan 1 several options to tackle the direct tax challenges including –

(i). modifying the existing PE rule to include an enterprise which maintains a significant digital presence in another country’s economy; or

(ii). creation of a PE when the enterprise maintains a website on a server of another enterprise located in a jurisdiction and carries on business through that website; or

(iii). Impose a final Withholding tax (WHT) on certain payments for digital goods or services provided by a foreign e-commerce provided ; or

(iv). Imposition of Equalisation levy on consideration for certain digital transactions.

26. The Indian revenue authorities have adopted the last approach by imposing Equalisation Levy on the resident Indian or non-resident having a PE in India who have to make payments to non-residents in the advertisement space above a threshold limit.

27. Apparently, IRS has chosen a simpler one whereby a recipient will have to pay tax on income of the service provider. The reason is obvious being “Modifying PE rules or creation of PE based on website / server means amending DTAA with respective countries”.

28. Refer Chapter 7 of the report provides the details. The same are given in Appendix. The most important paragraphs are re-produced herein-below.

7.6.4. Introducing an “equalisation levy” 

302. To avoid some of the difficulties arising from creating new profit attribution rules for purposes of a nexus based on significant economic presence, an “equalisation levy” could be considered as an alternative way to address the broader direct tax challenges of the digital economy. This approach has been used by some countries in order to ensure equal treatment of foreign and domestic suppliers. For example, in the area of insurance, some countries have adopted equalisation levies in the form of excise taxes based on the amount of gross premiums paid to offshore suppliers. Such taxes are intended to address a disparity in tax treatment between domestic corporations engaged in insurance activities and wholly taxable on the related profits, and foreign corporations that are able to sell insurance without being subject to income tax on those profits, neither in the state from where the premiums are collected nor in state of residence. As discussed below, an equalisation levy could be structured in a variety of ways depending on its ultimate policy objective. In general, an equalisation levy would be intended to serve as a way to tax a non-resident enterprise’s significant economic presence in a country. In order to provide clarity, certainty and equity to all stakeholders, and to avoid undue burden on small and medium-sized businesses, therefore, the equalisation levy would be applied only in cases where it is determined that a non-resident enterprise has a significant economic presence. 

7.6.4.1. Scope of the levy 

303. If the policy priority is to tax remote sales transactions with customers in a market jurisdiction, one possibility is to apply the levy to all transactions concluded remotely with in-country customers. To target the scope of the levy more closely to the situation in which a business establishes and maintains a purposeful and sustained interaction with users or customers in a specific country via an online presence, the levy would be applied only where the business maintains a significant economic presence as described above. 

304. An alternative would be to limit the scope to transactions involving the conclusion through automated systems of a contract for the sale (or exchange) of goods and services between two or more parties effectuated through a digital platform. Although this would create an incentive to choose non-digital means of conducting transactions, it would also focus more closely on the specific types of transactions that have generated concern. There is no rule, however, that prevents a broader scope of application. Indeed, focusing too narrowly on specific types of transactions may limit the flexibility of the levy to accommodate future developments, which would limit its ultimate effectiveness in addressing the tax disparity between foreign and domestic suppliers of products through an online presence. The levy would be imposed on the gross value of the goods or services provided to in-country customers and users, paid by in-country customers and users, and collected by the foreign enterprise via a simplified registration regime, or collected by a local intermediary.

305. Alternatively, if the policy priority is to tax the value considered to be directly contributed by customers and users, then a levy could be imposed on data and other contributions gathered from in-country customers and users. For that purpose, a number of options could be available. One option would be to impose a charge based on the average number of MAU in the country. As noted above, however, measuring MAU accurately may prove to be challenging. Moreover, the number of MAU of a foreign enterprise may not be directly related to in-country revenue generated by a foreign enterprise. Setting an appropriate rate for a levy measured by active users would also be challenging, as the average value of each user to a non-resident enterprise may vary widely. Another option would be to base the levy on the volume of data collected from in-country customers and users. Similar to MAU, however, data may also vary widely in value depending on its content and the purpose for which it was gathered, and it would be challenging to identify a reliable direct connection between the in-country revenue and the data collected from in-country customers and users. 

7.6.4.2. Potential trade and other issues 

306. As is the case with the imposition of a gross-basis final withholding tax, a levy that applied only to non-resident enterprises would be likely to raise substantial questions both with respect to trade agreements and with respect to EU law. In order to address these questions, potential solutions that would ensure equal treatment of domestic and non-resident enterprises would need to be explored, as discussed above in section 7.6.3.3. Depending on the structure of the levy, one option that could be considered would be to impose the tax on both domestic and foreign entities. If this approach were to be taken, however, presumably consideration would also need to be given to ways to mitigate the potential impact of applying both the corporate income tax and the levy to domestic entities and foreign entities taxable under existing corporate income tax rules. 

7.6.4.3. Relationship with corporate income tax

307. Imposing an equalisation levy raises risks that the same income would be subject to both corporate income tax and the levy. This could arise either in the situation in which a foreign entity is subject to the levy at source and to corporate income tax in its country of residence or in the situation in which an entity is subject to both corporate income tax and the levy in the country of source. In the case of a foreign entity, for example, if the income is subject to corporate income tax in the country of residence of the enterprise, the levy would be unlikely to be creditable against that tax. To address these potential concerns, it would be necessary to structure the levy to apply only to situations in which the income would otherwise be untaxed or subject only to a very low rate of tax.

308. Another approach could be to allow a taxpayer subject to both CIT and the levy to credit the levy against its domestic corporate income tax. Such an approach would ensure that foreign entities with no nexus for corporate income tax purposes would be subject only to the levy in the source country, while the tax burden of entities subject to corporate tax would effectively be limited to the greater of the corporate income tax or the levy. 

Position vis-à-vis ITA

29 It appears that, India has chosen to apply para 307 above. Parliament needs to clear the air about non-applicability of DTAA.

30 It is necessary to co-relate the provisions with provisions of ITA. This levy will be collected as per procedural law under the ITA like service tax is collected as per the excise Act.

31 Additionally, there is an amendment to section 40 on the same lines of dis-allowance of 100% of the amount on which equalisation levy is chargeable. The amendment proposes insertion of clause(ib) which reads as follows

“(ib) any consideration paid or payable to a non-resident for a specified service on which equalisation levy is deductible under the provisions of Chapter VIII of the Finance Act, 2016, andsuch levy has not been deducted or after deduction, has not been paid on or before the due date specified in sub-section (1) of section 139:Provided that where in respect of any such consideration, the equalisation levy has been deducted in any subsequent year or has been deducted during the previous year but paid after the due date specified in sub-section (1) of section 139, such sum shall be allowed as a deduction in computing the income of the previous year in which such levy has been paid;”.

32 Thus an assessee who is availing online advertisement or such services will have to pay it irrespective of whether it can be recovered from foreign party or not.

33 Paying 6% is always better than 30%

Impact on SME

34 The question whether online advertisement services or such other digital services will fall under the category “fess for technical, consultancy, managerial services” is of debate.

35 In general, there is a consensus that, online advertisement does not fulfil the criteria of “make available” but all treaties do not have it.

36 It is so because, both the things i.e. the manner in which the business in conducted and the law governing the transaction are moving targets.

37 This levy is not there till the amount payable is upto Rs. 1 lac. But in today’s era, whether exempting Rs. 1 lac is sufficient itself is an issue even for a SME

38 In a nutshell, it will be beneficial when make available clause is not there. It will create an additional charge in case where make available clause is available. Refer the example in Appendix for elaboration.

Appendix to an article on equalisation levy

Extract from Memorandum to Finance Bill, 2016 Relevant portion of final report of OECD on action plan – 1Example

Extract from Memorandum to Finance Bill, 2016

With the expansion of information and communication technology, the supply and procurement of digital goods and services have undergone exponential expansion everywhere, including India. The digital economy is growing at ten per cent per year, significantly faster than the global economy as a whole.

Currently in the digital domain, business may be conducted without regard to national boundaries and may dissolve the link between an income-producing activity and a specific location. From a certain perspective, business in digital domain doesn’t seem to occur in any physical location but instead takes place in the nebulous world of “cyberspace.” Persons carrying business in digital domain could be located anywhere in the world. Entrepreneurs across the world have been quick to evolve their business to take advantage of these changes. It has also made it possible for the businesses to conduct themselves in ways that did not exist earlier, and given rise to new business models that rely more on digital and telecommunication network, do not require physical presence, and derives substantial value from data collected and transmitted from such networks.

These new business models have created new tax challenges. The typical direct tax issues relating to e-commerce are the difficulties of characterizing the nature of payment and establishing a nexus or link between a taxable transaction, activity and a taxing jurisdiction, the difficulty of locating the transaction, activity and identifying the taxpayer for income tax purposes. The digital business fundamentally challenges physical presence-based permanent establishment rules. If permanent establishment (PE) principles are to remain effective in the new economy, the fundamental PE components developed for the old economy i.e. place of business, location, and permanency must be reconciled with the new digital reality.

Further, in order to reduce burden of small players in the digital domain, it is also provided that no such levy shall be made if the aggregate amount of consideration for specified services received or receivable by a non-resident from a person resident in India or from a non-resident having a permanent establishment in India does not exceed one lakh rupees in any previous year.

To provide certainty and to avoid interpretational issues, it is also proposed to define certain terms and expressions used therein. Further it also proposes to provide for the procedure to be adopted for collection and recovery of equalisation levy.

In order to provide for the administrative mechanism of the equalisation levy, it also proposes to provide for statutory authorities and also prescribes the duties and powers of the authorities to administer the equalisation levy. In order to ensure effective compliance, it also proposes to provide for interest; penalty and prosecution in case of defaults with sufficient safeguards.

Further, it also proposes to confer the power on the Central Government to make rules for the purposes of carrying out the provisions of this Chapter and further provides that every rule made under this Chapter shall be laid before each House of Parliament.

In order to avoid double taxation, it is proposed to provide exemption under section 10 of the Act for any income arising from providing specified services on which equalisation levy is chargeable.

In order to ensure compliance with the provisions this Chapter, it is further proposed to provide that the expenses incurred by the assessee towards specified services chargeable under this Chapter shall not be allowed as deduction in case of failure of the asseseee to deduct and deposit the equalisation levy to the credit of Central government.This Chapter will take effect from the date appointed in the notification to be issued by the Central Government.

Example Let’s take following example whereby we will try to compute the impact of equalisation levy. Effective tax rate is computed after taking into consideration section 115A, 206AA, relevant treaty provisions. The small difference for grossing up of tax rate is ignored.

SME can convince foreign entity for TDS set off

Equalisation levy	Before	Before	After
Make available clause	Yes	No	N.A.
Effective Tax Rate	0%	15%	6%
Benefit of set-off TDS available to foreign entity	Yes	Yes	No
SME can convince foreign entity for TDS set off	N.A.	Yes	N.A.
Figures are in	Lacs	Lacs	Lacs
Consideration paid / payable	100	100	100
Income tax / equalisation levy payable	0	15	6
Cost to the SME	100	100	106

SME cannot convince foreign entity for TDS set off and has to take the hit of TDS.

Equalisation levy	Before	Before	After
Make available	Yes	No	N.A.
Effective Tax Rate	0%	15%	6%
Benefit of set-off TDS available to foreign entity	Yes	Yes	No
SME can convince foreign entity for TDS set off	N.A.	No	N.A.
Figures are in	Lacs	Lacs	Lacs
Consideration paid / payable for online advertisement	100	100	100
Income tax / equalisation levy payable	0	15	6
Cost to the SME	100	115	106

Chapter 7 of final report of OECD on action plan – 1 – Broader direct tax challenges raised by the digital economy and the options to address them

This chapter discusses the challenges that the digital economy raises for direct taxation, with respect to nexus, the tax treatment of data, and characterisation of payments made under new business models, as well as certain administrative challenges faced by tax administrations in applying the current rules. The chapter then provides an overview of potential options that have been discussed by the Task Force on the Digital Economy to address these challenges.

7.1. The digital economy and the challenges for policy makers

243 The spread of the digital economy brings about many benefits, for example in terms of growth, employment and well-being more generally. At the same time it gives rise to a number of challenges for policy makers. These challenges extend well beyond domestic and international tax policy and touch upon areas such as international privacy law and data protection, as well as accounting and regulation.

244 From a strategic tax policy perspective, the uptake of digital technologies may potentially constrain the options available to policymakers in relation to the overall tax mix. For decades, companies have contributed to public expenses via a broad range of taxes in addition to corporate income tax. These taxes include employment taxes, environmental taxes, property and land taxes. The development of digital technologies has the potential to enable economic actors to operate in ways that avoid, remove, or significantly reduce, their tax liability within these bases. This may increase the pressure on a smaller number of taxpayers to compensate for the related loss of revenues. It also highlights the importance of designing corporate income and consumption tax systems that promote growth and investment, while reducing inequality and establishing a level playing field among economic actors.

245 The following sections examine a number of the tax challenges raised by the digital economy in relation to corporate income tax.

7.2. An overview of the tax challenges raised by the digital economy

246 The evolution of business models in general, and the growth of the digital economy in particular, have resulted in non-resident companies operating in a market jurisdiction in a fundamentally different manner today than at the time international tax rules were designed. For example, while a non-resident company has always been able to sell into a jurisdiction without a physical presence there, advances in information and communication technology (ICT) have dramatically expanded the scale at which such activity is now possible. In addition, traditionally for companies to expand opportunities in a market jurisdiction, a local physical presence in the form of manufacturing, marketing, and distribution was very often required. These in-country operations would have engaged operations such as procurement, inventory management, local marketing, branding and other activities that earned a local return subject to tax in the market country. Advances in business practices, coupled with advances in ICT and liberalisation of trade policy, have allowed businesses to centrally manage many functions that previously required local presence, rendering the traditional model of doing business in market economies obsolete. The fact that existing thresholds for taxation rely on physical presence is partly due to the need in many traditional  businesses for a local physical presence in order to conduct substantial sales of goods and services into a market jurisdiction. It is also due in part to the need to ensure that the source country has the administrative capability of enforcing its taxing rights over a non-resident enterprise. The fact that less physical presence is required in market economies in typical business structures today – an effect that can be amplified in certain types of businesses in the ICT sector – therefore raises challenges for international taxation.

247 Other elements of the digital economy have also raised challenges for policy makers. As noted above, growing reliance in certain new business models on data may raise tax challenges both in terms of characterisation of and attribution of value from data, and in terms of the changing ways in which users and customers interact with businesses. Further, new revenue streams adopted in particular due to the spread of multi sided business models or the use of massive computing power and broadband connection trigger questions regarding the appropriate characterisation of certain transactions and payments for tax purposes. Finally, digital technologies make it easier to do business across jurisdictions, as well as enabling consumers to access products and services from anywhere in the world, generating challenges in terms of collecting the appropriate amounts of consumption tax.

248 In general terms, in the area of direct taxation, the main policy challenges raised by the digital economy fall into three broad categories: Nexus: The continual increase in the potential of digital technologies and the reduced need in many cases for extensive physical presence in order to carry on business, combined with the increasing role of network effects generated by customer interactions, can raise questions as to whether the current rules to determine nexus with a jurisdiction for tax purposes are appropriate. Data: The growth in sophistication of information technologies has permitted companies in the digital economy to gather and use information across borders to an unprecedented degree. This raises the issues of how to attribute value created from the generation of data through digital products and services, and of how to characterise for tax purposes a person or entity’s supply of data in a transaction, for example, as a free supply of a good, as a barter transaction, or some other way. Characterisation: The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation of payments made in the context of new business models, particularly in relation to cloud computing.

249 These challenges raise questions as to whether the current international tax framework continues to be appropriate to deal with the changes brought about by the digital economy and the business models that it makes possible, and also relate to the allocation of taxing rights between source and residence jurisdictions. These challenges also raise questions regarding the paradigm used to determine where economic activities are carried out and value is created for tax purposes, which is based on an analysis of the functions performed, assets used and risks assumed. At the same time, when these challenges create opportunities for achieving double non-taxation, for example due to the lack of nexus in the market country under current rules coupled with lack of taxation in the jurisdiction of the income recipient and of that of the ultimate parent company, they also generate BEPS issues.

250 Although the challenges related to corporate income tax (nexus, data and character) are distinct in nature, they may overlap with each other. For example, the characterization of payments may trigger taxation in the jurisdiction where the payor is resident or established and hence overlap with the issue of nexus. Similarly, the collection of data from users located in a jurisdiction may trigger questions regarding whether it should give rise to nexus with that jurisdiction, and if so, whether and how the income generated from the use of these data should be attributed to that nexus. It also raises questions regarding how income from transactions involving data should be characterised for tax purposes.

251 The digital economy also creates challenges for value added tax (VAT) systems, particularly where goods, services and intangibles are acquired by private consumers from suppliers abroad. This is partly due to the absence of an effective international framework to ensure VAT collection in the jurisdiction of consumption. For economic actors, and in particular small and medium enterprises (SMEs), the absence of an international standard for charging, collecting and remitting the tax to a potentially large number of tax authorities, creates difficulties and high compliance costs. From a government viewpoint, there is a risk of loss of revenue and trade distortion, as well as the challenge of managing tax liabilities generated by a high volume of low value transactions, which can create a significant administrative burden but marginal revenues

252. In addition to these policy challenges, which are further discussed below, the Task Force on the Digital Economy (TFDE) has also identified a number of administrative issues raised by the digital economy. These latter issues are outlined in the box at the endof this chapter.

Nexus and the ability to have a significant presence without being liable to tax

253 Advances in digital technology have not changed the fundamental nature of the core activities that businesses carry out as part of a businesss model to generate profits. To generate income, businesses still need to source and acquire inputs, create or add value, and sell to customers. To support their sales activities, businesses have always needed to carry out activities such as market research, marketing and advertising, and customer support. Digital technology has, however, had significant impact on how these activities are carried out, for example by enhancing the ability to carry out activities remotely, increasing the speed at which information can be processed, analysed and utilised, and, because distance forms less of a barrier to trade, expanding the number of potential customers that can be targeted and reached. Digital infrastructure and the investments that support it can be leveraged today in many businesses to access far more customers than before. As a result, certain processes previously carried out by local personnel can now be performed cross-border by automated equipment, changing the nature and scope of activities to be performed by staff. Thus, the growth of a customer base in a country does not always need the level of local infrastructure and personnel that would have been needed in a “predigital” age.

254 This increases the flexibility of businesses to choose where substantial business activities take place, or to move existing functions to a new location, even if those locations may be removed both from the ultimate market jurisdiction and from the jurisdictions in which other related business functions may take place. As a result, it is increasingly possible for a business’s personnel, IT infrastructure (e.g. servers), and customers each to be spread among multiple jurisdictions, away from the market jurisdiction. Advances in computing power have also meant that certain functions, including decision-making capabilities, can now be carried out by increasingly sophisticated software programmes and algorithms. For example, contracts can in some cases be automatically accepted by software programmes, so that no intervention of local staff is necessary. As discussed below, this is also true in relation to functions such as data collection, which can be done automatically, without direct intervention of the employees of the enterprise.

255 Despite this increased flexibility, in many cases large multinational enterprises (MNEs) will indeed have a taxable presence in the country where their customers are located. As noted in Chapter 4, there are often compelling reasons for businesses to ensure that core resources are placed as close as possible to key markets. This may be because the enterprise wants to ensure a high quality of service and have a direct relationship with key clients. It may also be because minimising latency is essential in certain types of business, or because in certain industries regulatory constraints limit choices about where to locate key infrastructure, capital, and personnel. It is therefore important not to overstate the issue of nexus. evertheless, the fact that it is possible to generate a large quantity of sales without a taxable presence should not be understated either and it raises questions about whether the current rules continue to be appropriate in the digital economy.

256 These questions relate in particular to the definition of permanent establishment(PE) for treaty purposes, and the related profit attribution rules. It had already been recognised in the past that the concept of PE referred not only to a substantial physical presence in the country concerned, but also to situations where the non-resident carried on business in the country concerned via a dependent agent (hence the rules contained in paragraphs 5 and 6 of Article 5 of the OECD Model Tax Convention). As nowadays it is possible to be heavily involved in the economic life of another country without having a fixed place of business or a dependent agent therein, concerns are raised regarding whether the existing definition of PE remains consistent with the underlying principles on which it was based. For example, the ability to conclude contracts remotely through technological means, with no involvement of individual employees or dependent agents, raises questions about whether the focus of the existing rules on conclusion of contracts by persons other than agents of an independent status remains appropriate in all cases

257 These concerns are exacerbated in some instances by the fact that in certain business models, customers are more frequently entering into ongoing relationships with providers of services that extend beyond the point of sale. This ongoing interaction with customers generates network effects that can increase the value of a particular business to other potential customers. For example, in the case of a retail business operated via a website that provides a platform for customers to review and tag products, the interactions of those customers with the website can increase the value of the website to other customers, by enabling them to make more informed choices about products and to find products more relevant to their interests.

258 Similarly, users of a participative networked platform contribute user-created content, with the result that the value of the platform to existing users is enhanced as new users join and contribute. In most cases, the users are not directly remunerated for the content they contribute, although the business may monetise that content via advertising revenues (as described in relation to multi-sided business models below), subscription sales, or licensing of content to third parties. Alternatively, the value generated by user contributions may be reflected in the value of business itself, which is monetised via the sale price when the business is sold by its owners. Concerns that the changing nature of customer and user interaction allows greater participation in the economic life of countries without physical presence are further exacerbated in markets in which customer choices compounded by network effects have resulted in a monopoly or oligopoly.

259 These various developments must be understood in light of their relationship to more traditional ways of doing business. For example, while having a market in a country is clearly valuable to a seller, this condition by itself has not created a taxing right in the area of direct taxation to this point. It is also true that data about markets and about customers has always been a source of value for businesses as illustrated by phenomena such as frequent flyer programmes, loyalty programmes, the creation and sale of customer lists, and marketing surveys (in which customers participate for no remuneration), to name a few. The traditional economy also benefited from “network” effects in ways that are perhaps less obvious than the network effect present in social networks. Sellers of fax machines, for example, were dependent on a sufficiently broad supplier of purchasers in order to ensure that their product had value. The digital economy has, however, enabled access to markets with less reliance on physical presence than in the past. In addition, the digital economy has enabled collection and analysis of data at unprecedented levels, and has enhanced the impact of customer and user participation in the market, as well as the degree of network effects. It has been suggested that the lower marginal costs in digital businesses coupled with increased network effects generated by higher levels of user participation may justify a change in tax policy. See, e.g. Crémer (2015); Pistone and Hongler (2015). In considering policy changes to reflect customer interactions to the imposition of income tax, however, potential impact on traditional ways of doing business must be taken into account in order to maintain coherence in cross border tax policy. In addition, consideration should be given both to solutions based on income tax and to solutions focused on indirect taxes.

260 Another specific issue raised by the changing ways in which businesses are conducted is whether certain activities that were previously considered preparatory or auxiliary (and hence benefit from the exceptions to the definition of PE) may be increasingly significant components of businesses in the digital economy. For example, as indicated in Chapter 6, if proximity to customers and the need for quick delivery to clients are key components of the business model of an online seller of physical products, the maintenance of a local warehouse could constitute a core activity of that seller. Similarly, where the success of a high-frequency trading company depends so heavily on the ability to be faster than competitors that the server must be located close to the relevant exchange, questions may be raised regarding whether the automated processes carried out by that server can be considered mere preparatory or auxiliary activities.

261 Although it is true that tax treaties do not permit the taxation of business profits of a non-resident enterprise in the absence of a PE to which these profits are attributable, theissue of nexus goes beyond questions of PE under tax treaties. In fact, even in the absence of the limitations imposed by tax treaties, it appears that many jurisdictions would not in any case consider this nexus to exist under their domestic laws. For example, many jurisdictions would not tax income derived by a non-resident enterprise from remote sales to customers located in that jurisdiction unless the enterprise maintained some degree of physical presence in that jurisdiction. As a result, the issue of nexus also relates to the domestic rules for the taxation of non-resident enterprises.

7.4. Data and the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services

262 Digital technologies enable the collection, storage and use of data, and also enable data to be gathered remotely and from a greater distance from the market than previously. Data can be gathered directly from users, consumers or other sources of information, or indirectly via third parties. Data can also be gathered through a range of transactional relationships with users, or based on other explicit or implicit forms of agreement with users. Companies collect data through different methods. These can be proactive, requesting or requiring users to provide data and using data analytics, or primarily reactive, with the quantity and nature of the information provided largely within the control of users e.g. social networking and cloud computing. As set out in Chapter 3, data gathered from various sources is often a primary input into the process of value creation in the digital economy. Leveraging data can create value for businesses in a variety of ways, including by allowing businesses to segment populations in order to tailor offerings, to improve the development of products and services, to better understand variability in performance, and to improve decision making. The expanding role of data raises questions about whether current nexus rules continue to be appropriate or whether any profits attributable to the remote gathering of data by an enterprise should be taxable in the State from which the data is gathered, as well as questions about whether data is being appropriately characterised and valued for tax purposes. As noted above, the issue of data collection is not new, although the ability to collect and categorise data has increased exponentially in large part due to computing power and the growth of the internet. As a result, addressing the growing role of data would require consideration of potential impact on more traditional business models as well.

263 While it is clear that many businesses have developed ways to collect, analyse, and ultimately monetise data, it may be challenging for purposes of an analysis of functions, assets, and risks, to assign an objective value to the raw data itself, as distinct from the processes used to collect, analyse, and use that data. For accounting purposes, the value of data collected by a business, like other self-created intangibles, would generally not appear on the balance sheet of the business, and would therefore not generally be relevant for determining profits for tax purposes. Although data purchased from another related or unrelated business would be treated as an asset in the hands of the buyer (and its subsequent sale would generate tax consequences), outright sale of data is only one of many ways in which collection and analysis of data can be monetised. For example, as with other user contributions, the value of data may be reflected in the value of the business itself, and may be monetised when the business is sold. Even where data itself is sold, the value of that data may vary widely depending on the capacity of the purchaser to analyse and make use of that data. The issue of valuing data as an asset is further complicated by existing legal questions about the ownership of personal data, and the ability of users to control whether businesses can access and utilise user data by using digital services anonymously,or by deleting data stored in local caches. Many jurisdictions have passed data protection and privacy legislation to ensure that the personal data of consumers is closely protected. Under most such legislation, this information is considered to be the property of the individual from which it is derived, rather than an asset owned by a company or a public good. Economic literature analysing intangibles, in contrast, has tended to embrace modern business realities and value also assets whose ownership may not be protected by legalrules (Corrado et al., 2012).

264 The value of data, and the difficulties associated with determining that value, is also relevant for tax purposes in the cross-border context and triggers questions regarding whether the remote collection of data should give rise to nexus for tax purposes even in the absence of a physical presence, and if so (or in the case of an existing taxable presence) what impact this would have on the application of transfer pricing and profit attribution principles, which in turn require an analysis of the functions performed, assets used and risks assumed. The fact that the value of data can impact tax results places pressure on the valuation of data. Further, the fact that the value of data can impact tax results if attributable to a PE or if held by a local subsidiary and sold to a foreign enterprise, but not if collected directly by a foreign enterprise with no PE, places pressure on the nexus issues and raises questions regarding the location of data collection. This distinction between the taxation of those with a PE and those without a PE was, of course, present in the traditional economy as well.

265 In addition, data, including location-specific data, may be collected from customers or devices in one country using technology developed in a second country. It may then be processed in the second country and used to improve product offerings or target advertisements to customers in the first country. Determining whether profit is attributable to each of these functions and the appropriate allocation of that profit between the first country and the second country raises tax challenges. These challenges may be exacerbated by the fact that in practice a range of data may be gathered from different sources and for different purposes by businesses and combined in various ways to create value, making tracing the source of data challenging. This data may be stored and processed using cloud computing, making the determination of the location where the processing takes place similarly challenging.

266 Additional challenges are presented by the increasing prominence in the digital economy of multi-sided business models. A key feature of two-sided business models is that the ability of a company to attract one group of customers often depends on the company’s ability to attract a second group of customers or users. For example, a company may develop valuable services, which it offers to companies and individuals for free or at a price below the cost of providing the service, in order to build a user base and to collect data from those companies and individuals. This data can then be used by the business to generate revenues by selling services to a second group of customers interested in the data itself or in access to the first group. For example, in the context of internet advertising data collected from a group of users or customers can be used to offer a second group of customers the opportunity to tailor advertisements based on those data. Where the two groups of customers are spread among multiple countries, challenges arise regarding the issue of nexus mentioned above and in determining the appropriate allocation of profits among those countries. Questions may also arise about the appropriate characterisation of transactions involving data, including assessing the extent to which data and transactions based on data exchange can be considered free goods or barter transactions, and how they should be treated for tax and accounting purposes. However, as discussed more generally above, the location of advertising customers and the location of users are frequently aligned in practice, such that the value of the user data is reflected in the advertising revenue generated in a country. The scale of this challenge may, in addition, be mitigated by the fact that advertising will frequently require a local presence to attract advertisers.

267 The changing relationship of businesses with users/customers in the digital economy may raise other challenges as well. The current tax rules for allocating income among different parts of the same MNE require an analysis of functions performed, assets used,and risks assumed. This raises questions in relation to some digital economy business models where part of the value creation may lie in the contributions of users or customers in a jurisdiction. As noted above, the increased importance of users/customers therefore relates to the core question of how to determine where economic activities are carried out and value is created for income tax purposes.

7.5. Characterisation of income derived from new business models

268 Products and services can be provided to customers in new ways through digital technology. The digital economy has enabled monetisation in new ways, as discussed in Chapters 3 and 4, and this raises questions regarding both the rationale behind existing categorisations of income and consistency of treatment of similar types of transactions.

269 Prior work by the Treaty Characterisation Technical Advisory Group (TAG), discussed further in Annex A examined many characterisation issues related to e-commerce.Although this work remains relevant, new business models raise new questions about how to characterise certain transactions and payments for domestic and tax treaty law purposes.1 For example, although the TAG considered the treatment of application hosting, cloud computing has developed significantly since that work, and the character of payments for cloud computing is not specifically addressed in the existing Commentary to the OECD Model Tax Convention. The question for tax treaty purposes is often whether such payments should be treated as royalties (particularly under treaties in which the definition of royalties includes payments for rentals of commercial, industrial, or scientific equipment), fees for technical services (under treaties that contain specific provisions in that respect), or business profits.More specifically, questions arise regarding whether infrastructure-as-a-service transactions should be treated as services (and hence payments characterised as business profits for treaty purposes), as rentals of space on the cloud service provider’s servers by others (and hence be characterised as royalties for purposes of treaties that include in the definition of royalties payments for rentals of commercial, industrial, or scientific equipment), or as the provision of technical services. The same questions arise regarding payments for software-as-a-service or platform-as-a-service transactions.

270 In the future, development and increasing use of 3D printing may also raise character questions. For example, if direct manufacturing for delivery evolves into a license of designs for remote printing directly by purchasers, questions may arise as to whether Box 7.1. Administrative challenges in the digital economy There is a pressing need to consider how investment in skills, technologies and data management can help tax administrations keep up with the ways in which technology is transforming business operations. The border less nature of digital economy produces specific administrative issues around identification of businesses, determination of the extent of activities, information collection and verification, and identification of customers. These issues are outlined below, while possible ways to address them are outlined in the later sections of this chapter. Further, operational work is underway within the Forum on Tax Administration to develop a strong voluntary compliance culture and expand the use of modern technology for self-service delivery purposes (OECD, 2014).

Identification: While global business structures in the digital economy involve traditional identification challenges, these challenges are magnified in the digital  economy. For example, the market jurisdiction may not require registration or other identification when overseas businesses sell remotely to customers in the jurisdiction, or may have issues with implementing registration requirements, as it is often difficult for tax authorities to know that activities are taking place, to identify remote sellers and to ensure compliance with domestic rules. Difficulties in identifying remote  sellers may also make ultimate collection of tax difficult.

• Determining the extent of activities: Even if the identity and role of the parties involved can be determined, it may be impossible to ascertain the extent of sales or other activities without information from the offshore seller, as there may be no sales or other accounting records held in the local jurisdiction or otherwise accessible by the local revenue authority. It may be possible to obtain this information from third parties such as the customers or payment intermediaries, but this may be dependent on privacy or financial regulation laws.

• Information collection and verification: To verify local activity, the market jurisdiction’s tax administration may need to seek information from parties that have no operations in the jurisdiction and are not subject to regulation therein. While exchange of information can be a very useful tool where the proper legal basis is in place, this is predicated on knowledge of where the offshore entity is tax resident and information retained or accessible by the reciprocating tax authority. This can create challenges for a market jurisdiction revenue authority seeking to independently verify any information provided by the offshore entity.

• Identification of customers: There are in principle a number of ways in which a business can identify the country of residence of its client and/or the country in which consumption occurs. These could include freight forwarders or other customs documentation or tracking of Internet Protocol (IP) and card billing addresses. However, this could be burdensome for the business and would not work where customers are able to disguise their location.and under what circumstances payments by purchasers may be classified as royalties ratherthan as business profits, or may be treated as fees for technical services.

271 Under most tax treaties, business profits would be taxable in a country only if attributable to a PE located therein. In contrast, certain other types of income, such as royalties, may be subject to withholding tax in the country of the payer, depending on the terms of any applicable treaty. Whether a transaction is characterised as business profits or as another type of income, therefore, can result in a different treatment for tax treaty purposes. There is therefore a need to clarify the application of existing rules to some new business models.

272 At the same time, when considering questions regarding the characterisation of income derived from new business models it may be necessary to examine the rationale behind existing rules, in order to determine whether those rules produce appropriate results in the digital economy and whether differences in treatment of substantially similar transactions are justified in policy terms. In this respect, further clarity may be needed regarding the tax treaty characterisation of certain payments under new business models, especially cloud computing payments (including payments for infrastructure-as-a-service, software-as-a-service, and platform-as-a-service transactions). In addition, issues of characterisation have broader implications for the allocation of taxing rights for direct tax purposes. For example, if a new type of business is able to interact extensively with customers in a market jurisdiction and generate business profits without physical presence that would rise to the level of a PE, and it were determined that the market jurisdiction should be able to tax such income on a net basis, modifying the PE threshold and associated profit attribution rules could permit such taxation. Source taxation could also be ensured by creating a new category of income that is subject to withholding tax. As a result, the issue of characterisation has significant implications for the issue of nexus.

7.6. Developing options to address the broader direct tax challenges of the digital economy

273 In the context of its work, the TFDE received and discussed several proposals for potential options to address the broader direct tax challenges raised by the digital economy, including novel work carried out by academics (Bloch, 2015; Bourreau, 2015; Brauner,2015; Crémer, 2015; Hongler, 2015). As there is a substantial overlap between the challenges related to nexus, data, and characterisation, it was considered that rather than attempting to individually target them, any potential option should instead focus more generally on the ability of businesses in the digital economy to (i) derive sales income from a country without a physical presence, and (ii) use the contributions of users in the value chain (including through collection and monitoring of data), and monetise these contributions by selling the data to third parties, by selling targeted ads, by selling the business itself, or in any other way.

274 The options analysed by the TFDE in 2014 included modifications to the exceptions from PE status, alternatives to the existing PE threshold, the imposition of a withholding tax on certain types of digital transactions, and the introduction of a tax on bandwidth use.

275 With respect to the exceptions from PE status, work in the context of Action 7of the BEPS Project (preventing the artificial avoidance of PE status) analysed whether activities that may previously have been preparatory or auxiliary should continue to benefit from exceptions (contained in Article 5(4) of the OECD Model Tax Convention)to the permanent establishment definition where they have become core components of a business. As a result of this work, these exceptions have been modified to ensure that they are available only for activities that are of a preparatory or auxiliary nature.

276 The technical details of the other three options have been developed further and are presented below. Like the challenges they are intended to address, the impact of these options overlaps in a number of respects. They have therefore been conceived in a way that allows them to be either combined into a single option or chosen individually. More specifically, elements of the three potential options could be combined into a new concept of nexus for net-basis taxation (a “significant economic presence”), with the intent to reflect situations where an enterprise leverages digital technology to participate in the economic life of a country in a regular and sustained manner without having a physical presence in that country. In this context, the application of a withholding tax on digital transactions could be considered as a tool to enforce compliance with net taxation based on this potential new nexus, while an equalisation levy could be considered as an alternative to overcome the difficulties raised by the attribution of income to the new nexus

7.6.1. A new nexus based on the concept of significant economic presence

277 This option would create a taxable presence in a country when a non-resident enterprise has a significant economic presence in a country on the basis of factors that evidence a purposeful and sustained interaction with the economy of that country via technology and other automated tools. These factors would be combined with a factor based on the revenue derived from remote transactions into the country, in order to ensure that only cases of significant economic presence are covered, limit compliance costs of the taxpayers,and provide certainty for cross-border activities. The following sections describe the details of such an option, together with potential approaches for attributing income to the new nexus.

7.6.1.1. Revenue-based factor 

278  a general matter, revenue that is generated on a sustained basis from a country could be considered to be one of the clearest potential indicators of the existence of a significant economic presence. This is based on the assumption that even in multi-sided business models, and particularly those dependent on network effects, the two markets are likely to be strongly interrelated, and as a result are likely to be situated in the same country. To the extent that the country of the users and country of the paying customers are aligned, the value of an enterprise’s users and user data would generally be reflected in the enterprise’s revenue in a country. In other words, because user data serves to enhance the value of the services an enterprise offers, a strong user network (and the attendant user data) is likely to result in enterprises either selling more or enterprises charging more for its core products/services, or both. Under such circumstances, the revenues earned from customers in a country are a potential factor for establishing nexus in the form of a significant economic presence in the country concerned. Revenues will not be sufficient in isolation to establish nexus but they could be considered a basic factor that, when combined with other factors, could potentially be used to establish nexus in the form of a significant economic presence in the country concerned. In addition, the use of revenue asa basic factor could limit the compliance costs of taxpayers and provides a high degree oftax certainty for cross-border activities. In developing a revenue factor, consideration was given to the following technical issues:

• Transactions covered. One approach that could be considered in defining a basic revenue factor is to include only revenues generated from digital transactions concluded with in-country customers through an enterprise’s digital platform.Specifically, these transactions would involve the conclusion of a contract for the sale(or exchange) of goods and services between two or more parties effectuated through a digital platform where the contract conclusion primarily relies on automated systems. Such an approach could however create incentives for particular ways of doing business with remote customers. For example, such an approach would treat remote digital transactions differently from mail-order transactions (e.g. catalogue shopping) and telephone transactions (e.g. sale through call centres). Although in practice the latter transactions are less likely to enable a business to generate a significant amount of revenue, all three ways of transacting enable businesses toengage in sales transactions without physical presence in the country of the customer.In addition, businesses may leverage digital technology to reach a broader range of customers in another country without entering into digital transactions (e.g. website displaying the products but routing the customers to a call centre to perform the final purchase). Accordingly, to ensure that taxpayers in similar situations carrying out similar transactions will be subject to similar levels of taxation, it may be preferable to define the factor so as to include all revenue generated by transactions concluded by the non-resident enterprise remotely with in-country customers. Potential adverse effects associated with such a broad scope would in any case be addressed by the application of the other factors (see further below at 7.6.1.4).

• Level of the threshold. The core element of the revenue factor could be the gross revenues generated from remote transactions concluded with customers in the country concerned. This amount should be framed in absolute terms and in local currency, in order to minimise the risk of manipulation. A key objective in settingthe level of threshold would be to set it at a high enough level to minimise the administrative burden for tax administrations as well as the compliance burden on and level of uncertainty for the taxpayer, while ensuring that nexus is less likely to be created in cases in which minimal tax revenue would be collected.The size of the country’s market might also be a relevant factor in setting the level of the revenue threshold. Given the relative mobility and flexibility in choosing the location of automated functions related to revenue-generating activities in the digital economy, the factor could be applied on a related-group basis rather than on a separate-entity basis to prevent any risk of artificial fragmentation of distance selling activities with customers of the same country among a variety of foreign affiliated entities. This aggregation rule could be introduced as are buttable presumption, with the taxpayer being able to demonstrate that it did not artificially fragment the distance selling activities in order to manipulate the revenue threshold.

• Administration of the threshold. An accurate application of the revenue threshold would depend on the ability of the country to identify and measure remote sales activities of the non-resident enterprise. One possible approach to address this challenge could be to introduce a mandatory registration system for enterprises that meet the factors giving rise to a significant economic presence. On the other hand,it could be difficult for tax authorities to know when activities are taking place and at what scale, to identify remote sellers, and ultimately to ensure compliance.Similarly, in the case of transactions concluded and fulfilled entirely online, it maybe difficult for enterprises to identify with certainty the country of residence of clients. In this respect, regimes introduced to ensure compliance with VAT/GST rules by non-resident suppliers could prove extremely useful (see also Chapter 8for additional details).

7.6.1.2. Digital factors

279 In the case of “brick and mortar” businesses, the ability to reach significant numbers of customers in a country generally depends on a variety of factors, including a store’s location, local marketing and promotion, payment options, and sales and customer service employees. In the digital economy, the ability to establish and maintain a purposeful and sustained interaction with users or customers in a specific country via an online presence depends on analogous factors. A range of digital factors based on the current development of the digital economy could be used as part of a test for significant economic presence,including the following:

• A local domain name. A non-resident enterprise targeting customers or users in a country will generally obtain the digital equivalent of a local “address” where the non resident enterprise establishes its store front, typically taking the form of a localized or specialised domain name. For example, while an enterprise’s “home” domain name might be “.com”, the enterprise’s site targeting one country would likely use a domain name reflecting that, in order to make it more likely that a local user would find the local site. This is reinforced by the need of enterprises to protect their trademarks by purchasing related domain names, including a local country domain name. In summary, while it is possible for an enterprise to do business in a country without a local domain name, the choice to do so carries reputational risk from potential domain“squatting” and trademark infringement from not protecting the enterprise’s business name, trademarks and trade names across various domains. Accordingly, MNEs doing substantial cross-border business would very likely operate in a country via a local domain name. Whether local domain names will remain the predominant method for accessing markets, however, is uncertain. In the near future, merchants selling camera equipment globally may, for example, use a generic “.camera” domain name, thus reducing the relevance of country specific domain name.
• A local digital platform. Non-resident enterprises frequently establish “local”websites or other digital platforms in order to present the goods or services being offered in the light that most appeals to the local users or customers, taking into account language and cultural norms in particular. Local websites or digital platforms could include features intended to facilitate interaction by local users and customers with the site’s content, services and functions. Such features include language, local marketing such as targeted discounts and promotions, and local terms of service for users and customers that reflect the commercial and legal context of the local environment. Although some enterprises may elect to only operate only in one language and not attempt to undertake local marketing or promotional efforts,establishing a local platform is often critical to attracting meaningful numbers of local users and customers. Note, however, that local platforms do not necessarily  correspond to political boundary lines.
• Local payment options. A non-resident enterprise that maintains a purposeful and sustained interaction with the economy of a country will frequently ensure that local customers have a seamless purchasing experience with prices reflected in local currency, taxes, duties and fees already calculated, with the option of using a local form of payment to complete the purchase. Integration of local forms of payment in to a site’s commercial features is a complicated technical, commercial, and legal exercise requiring substantial resources, and an enterprise would normally not undertake such an investment unless it purposefully participates in the country’s economic life.While this factor may be less relevant in countries that share a common currency, it generally is a critical commercial requirement in countries that have stringent banking regulations, currency controls, or low penetration of international credit cards.

7.6.1.3. User-based factors

280 Given the importance of network effects in the digital economy, the user base and the associated data input may also be important indicators of a purposeful and sustained interaction with the economy of that another country. A range of factors based on users could be used to reflect the level of participation in the economic life of a country, namely:

• Monthly active users (MAU). One factor reflecting the level of penetration in a country’s economy is the number of “monthly active users” (MAU) on the digital platform that are habitually resident in a given country in a taxable year. The term MAU refers to registered user who logged in and visited a company’s digital platform in the 30-day period ending on the date of measurement. A factor based on MAU presents the advantage of measuring the customer/user base in a given country both in terms of size and level of engagement. Given that little material is publicly available on the process of defining and identifying MAU, more detailed metrics would need to be developed in consultation with businesses and IT experts for the purpose of using this factor, such as how to identify a unique “user” or what level of engagement is required for a user to be considered “active”. Reliability andvercity of the information would also need to be ensured, to address fraudulent accounts, multiple accounts, false information volunteered by users, and “bot”-produced data, to name a few.
• Online contract conclusion. Another factor indicating the level of participation of an enterprise in the economic life of a country is the regular conclusion of contracts. This is the focus of the existing “dependent agent” PE test contained in Article 5 of the OECD Model which, in broad terms, requires that this contract conclusion be carried out in the country by a person acting on behalf of the non resident enterprise. In the digital economy, contracts can frequently be concluded with customers via a digital platform without the need for the intervention of local personnel or dependent agents. For example, online platforms providing free services to their users often specify on their websites that by accessing or using the products and services of the company the user agrees to the “Terms of Service” and each use of the platform results in the conclusion of a legally binding agreement.The number of contracts concluded through a digital platform with customers or users that are habitually resident in the country in any taxable year could therefore be considered an important factor.
• Data collected. Another factor which could be considered to reflect an enterprise’s level of participation in the economic life of a country is the volume of digital content collected through a digital platform from users and customers habitually resident in that country in a taxable year. The focus would be on the origin of the data collected, irrespective of where that data is subsequently stored and processed (e.g. data warehouse). The range of data captured by the threshold would not be confined to personal data, but would cover also, e.g. user created content, product reviews, and search histories. This core element could be coupled with proportionality tests, such as whether the volume of digital content collected exceeds a percentage of the enterprise’s overall stored digital content. Information on data collected is increasingly available, reliable and up-to-date, especially if the factor is focusing on data collected that is effectively stored by the non-resident enterprise on a server. At the same time, businesses may not necessarily maintain separate and comprehensive track records of the volume of data collected and stored on a country-by-country basis. In addition, the volume of data collected (and stored) from users in a country may not necessarily reflect an effective contribution to the profits generated by the non-resident enterprise, as the value of raw data is rather uncertain and particularly volatile.

7.6.1.4. Possible combinations of the revenue factor with the other factors

281 For purposes of this potential option, total revenue in excess of the revenue threshold would be an indicator of the existence of a significant economic presence.

282 Total revenue, however, may not by itself suffice to evidence a non-resident enterprise’s regular and sustained participation in the economic life of a country. To be an appropriate measure of participation in the economic life of a country, the revenue factor could be combined with other factors, such as the digital and/or user-based factors that indicate a purposeful and sustained interaction with the economy of the country concerned. In other words, a link would have to be created between the revenue-generating activity of the non-resident enterprise and its significant economic presence in the country. The choice of which factors should be combined with the revenue factor to ascertain whether a significant economic presence should be deemed to exist is likely to be driven by the unique features and economic attributes of each market(e.g. size, local language, currency restrictions, banking system).

283 This concept may be illustrated by an example. If a non-resident enterprise generates gross revenues above the threshold from transactions with in-country customers concluded electronically through a localised digital platform where the customer is required to create a personalised account and utilise the local payment options offered on the site to execute the purchase, it could be considered that there is a link between the revenue generated from that country and the digital and/or user-based factors evidencing a significant economic presence in that country. In contrast, it would be more difficult to find such a link where a non-resident enterprise generates gross revenues above the threshold from transactions with in-country customers through in-person negotiation taking place outside of the market jurisdiction, if the enterprise only maintains a passive website that provides product information with no functionalities permitting transactions or intensive interaction with users (including data collection).

7.6.2. Determining the income attributable to the significant economic presence

284 Attribution of profits is a key consideration in developing a nexus based on significant economic presence. The option outlined in 7.6.1 above would establish nexus for taxation in cases where an enterprise has no physical presence in the country concerned.Consideration must therefore be given to what changes to profit attribution rules would need to be made if the significant economic presence option were adopted, while ensuring parity to the extent possible between enterprises that are subject to tax due to physical presence in the market country (i.e. local subsidiary or traditional PE) and those that are taxable only due to the application of the option.

7.6.2.1. Existing rules and principles

285 A significant economic presence associated with little or no physical presence in terms of tangible assets and/or personnel in the other country is not likely to involve the carrying on of any functions of the enterprise in the traditional sense. Unless significant adjustments are made to the existing rules, therefore, it would not be possible to allocate any meaningful income to the new nexus.

286 Several adjustments to existing principles were considered during the course of the work, including allocating business functions handled remotely through automated systems to the significant economic presence, as well as treating customers and users as performing certain functions on behalf of an enterprise under certain circumstances. Other substantial departures from existing rules, such as replacing a functional analysis with an analysis based on game theory that would allocate profits by analogy with a bargaining process within a joint venture, were also considered (see Pellefigue, 2015). All such potential adjustments, however, would require substantial departures from existing standards for allocating profits within a MNE operating in multiple jurisdictions, which are currently based on an analysis of the functions, assets and risks of the enterprises concerned. It was concluded, therefore, that, unless there is a substantial rewrite of the rules for the attribution of profits, alternative methods would need to be considered.

7.6.2.2. Methods based on fractional apportionment

287 Another approach considered would be to apportion the profits of the whole enterprise to the digital presence either on the basis of a predetermined formula, or on the basis of variable allocation factors determined on a case-by-case basis. In the context of a significant economic presence, the implementation of a method based on fractional apportionment would require the performance of three successive steps: (1) the definition of the tax base to be divided, (2) the determination of the allocation keys to divide that tax base, and (3) the weighting of these allocation keys.

288 It is important to note that the domestic laws of most countries use profit attribution methods based on the separate accounts of the PE, rather than fractional apportionment. In addition, fractional apportionment methods would be a departure from current international standards. Furthermore, pursuing such an approach in the case of application of the new nexus would produce very different tax results depending on whether business was conducted through a “traditional” permanent establishment, a separate subsidiary or the new nexus. Given those constraints, fractional apportionment methods were not pursued further.

7.6.2.3. Modified deemed profit methods

289 The use of empirical presumption methods such as “deemed profit” systems is sometimes a way to avoid profit computations based on the taxpayer’s accounts in situations where a high proportion of expenses associated with revenues are incurred overseas, making it difficult from a practical perspective to audit locally. Deemed profits methods have been used, for example, in the insurance industry, by applying a coefficient based on the ratio of profit to gross premiums of resident insurance companies to gross premiums received from policy holders in the source country.

290 In the context of a nexus based on significant economic presence, one possible approach would thus be to regard the presence to be equivalent to a physical presence from which the non-resident enterprise is operating a commercial business and determine the deemed net income by applying a ratio of presumed expenses to the non-resident enterprise’s revenue derived from transactions concluded with in-country customers, hence aligning it to one of the key factors of the option as described above. Determining an appropriate ratio would depend on a number of factors, including the industry concerned, the degree of integration of the particular enterprise, and the type of product and service provided. On possible approach would thus be to classify taxpayers by industry and apply an industry specific profit percentage. A more refined approach would be to divide taxpayers within a given industry into additional classes based on relevant factors (e.g. capital equipment,turnover, employees), with a specific profit percentage within each band. The determination of the latter percentage would require an extensive analysis of actual profit margins of domestic taxpayers operating in the same specific class of industry or type of business.

291 Deemed profit methods are generally perceived as relatively easy to administer and raise revenue. However, for large MNE groups with complex structures operating in many lines of business, applying multiple industry-specific presumptive profit margins to the same significant economic presence presents several practical challenges. Another challenge relates to the comparability of digital and traditional business models when considering the applicability of such deemed profit margins. Many digital business models have a different cost structure than traditional business models, such that adjustments to margins found in this context are very likely to be required. In addition, application of deemed profit methods in this context may be considered as a substantial departure from current international standards, resulting in a tax liability even where there are no actual profits generated through the significant economic presence. One possible way to mitigate this negative impact would be to create a rebuttable presumption limited to situations where the foreign taxpayer is able to demonstrate that its overall activity (or specific line of business related to the activity of the significant economic presence if it can be ring-fenced from other business activities of the enterprise) is in a loss-making position at the end of the fiscal year.

7.6.3. A withholding tax on digital transactions

292 A withholding tax on payments by residents (and local PEs) of a country for goods and services purchased online from non-resident providers has also been considered. This with holding tax could in theory be imposed as a standalone gross-basis final with holding tax on certain payments made to non-resident providers of goods and services ordered online or, alternatively, as a primary collection mechanism and enforcement tool to support the application of the nexus option described above, i.e. net-basis taxation. Both approaches raise similar technical issues with respect to the scope of transactions covered and the collection of the ensuing tax liability. In addition, the application of a standalone final with holding tax raises specific challenges regarding trade obligations and EU law.

7.6.3.1. Scope of transactions covered

293 The scope of transactions covered by the tax must be clearly defined, so that taxpayers and withholding agents will know when the tax applies, and to ensure that tax administrations will be able to ensure compliance. The scope should also be defined as simply as possible in order to avoid unnecessary complexity and classification disputes.The need for clarity and simplicity, however, must be balanced against a need to ensure that similar types of transactions will be taxed similarly, in order to avoid creating incentives for or against particular ways of structuring them.

294 For this purpose, although listing specific types of transactions covered would provide  degree of clarity, it would also likely result in disputes over the character of transactions,particularly as technology continues to advance. Such an approach also could lead to differences in treatment for tax purposes between economically equivalent transactions depending on their form. For this reason, a more general definition of covered transactions appears more appropriate. The tax could be applied, for example, to transactions for goodsor services ordered online (i.e. digital sales transactions), or to all sales operations concluded remotely with non-residents. The latter would have the advantage of flexibility, and would ensure tax neutrality between similar ways of doing business, and may reduce disputes over characterisation. In addition, if withholding is used as a tool to support net-basis taxation, abroad scope covering all distance selling would be more consistent with the sales threshold discussed above in the context of a nexus based on significant economic presence.

7.6.3.2. Collection of the tax

295 In practice, the liability to pay a withholding tax on outbound payments is often shifted from the non-resident enterprise to a local collecting agent, such as the customer or a third-party payment processing intermediary. For such a mechanism to function efficiently, the agent responsible for withholding must have access to information about the covered transactions sufficient to know when the tax will apply, and must be reasonably expected to comply with its obligation to withhold.

296 In the case of B2B transactions, businesses resident in the source country may reasonably be expected to comply with the withholding obligation. In the case of B2C transactions, however, requiring withholding from the pay or would be more challenging as private consumers have little experience nor incentive to declare and pay the tax due.Moreover, enforcing the collection of small amounts of withholding from large numbers of private consumers would involve considerable costs and administrative challenges.

297 One possible solution would be to require intermediaries processing the payment to withhold on the payment in a B2C context. As a practical matter, however, this present several technical issues. For example, an intermediary would generally not have access to transaction-identifying information enabling it to determine its character and hence the amount of tax due. In practice, it would only see a value without any description of the underlying transaction, in which case it would not be able to determine with sufficient certainty when it was required to withhold. The task of the intermediary could be facilitated if the collection regime is supplemented by a mandatory registration system for non-resident enterprises whereby all remote sellers of goods and services must design a tea dedicated bank account for all payments received from local customers. In the latter situation, intermediaries may be required to withhold the tax only for payments made to these specific bank accounts. However, the application of this approach may pose challenges in imposing compliance obligations on intermediaries that are situated in third-countries with no connection to the jurisdiction of the customer, thereby creating opportunities for tax avoidance strategies.

7.6.3.3. Negative impact of gross-basis taxation and relationship with trade and other obligations

298 The initial development and hosting of the technology required to provide products and services online typically requires substantial up-front investment of resources,including labour and capital. After initial creation of the technology, however, providing products and services online frequently requires only limited marginal costs for businesses.Where this is the case, it has been argued that payments made in consideration for digital goods or services share common features with royalties and fees for technical services,i.e. that gross revenue is a reliable proxy for net income. In many businesses, however,providing products and services online will require ongoing expenditures for continued product development (including maintenance of products and addition of new features),marketing, and ongoing customer support due to rapid product cycles as technology and competition evolve. Where this is the case, imposition of withholding tax on gross revenues will be an imperfect proxy for tax on net income. One potential way to reduce the negative impact of gross-basis taxation would be to fix the rate at a relatively low amount that would reflect typical profit margins. Such margins could be determined, for example, on the basis of a statistical analysis of actual profit margins of local domestic taxpayers operating in the same specific class of industry or type of business.

299 Assuming that domestic suppliers of similar products are subject to net-basis taxation,the imposition of a standalone gross-basis final withholding tax on foreign suppliers for remote sales of goods and services is likely to raise substantial conflicts with trade obligations and EU law. Trade obligations may differ substantially depending on whether a particular digital transaction is treated as involving a product, in which case the General Agreement on Tariffs and Trade (GATT) would apply, or a service, in which case the General Agreement on Trade in Services (GATS) would apply. Both agreements generally require foreign suppliers ofgoods (in the case of GATT) and services (in the case of GATS) to be taxed no less favourably than domestic suppliers. However, GATS provides broad exceptions for the application of provisions of tax treaties and for the imposition of direct tax provisions aimed at ensuring the equitable or effective imposition of direct taxes. In contrast, GATT contains no exceptions to national treatment obligations, and simply prohibits parties from subjecting imported products to taxes in excess of those that would apply to similar products produced domestically. Thus,at least to the extent GATT applies (i.e. to goods delivered physically, and to digital products considered “goods” for trade purposes), consideration would need to be given to ways to preserve national treatment.

300 In addition, for some countries EU law imposes comparable obligations – i.e. non discrimination between resident and non-resident businesses – that would not permit the application to non-resident suppliers of a gross-basis final withholding tax, even if the rate is fixed at a very low amount.

301 Given the above issues, a more viable approach could be to use this mechanism asa back-up mechanism to enforce net-basis taxation on the basis of a significant economic presence nexus, rather than as a standalone option. Whether the withholding tax is used as a gross basis payments tax or a collection mechanism for net basis income tax, remittance of the tax by local businesses would both ensure compliance and facilitate identification of the covered remote sales. One approach in this regard would be to establish a registration system for taxpayers that agree to file tax returns and pay tax on their net income, coupled with a credit system enabling taxpayers to pay any tax due on net income in addition to the tax withheld, or for taxpayers that are in a loss position on a net basis at the end of the fiscal year to claim a tax refund. However, such a system would need to take into account that taxpayers may have an incentive not to file a return where their net tax liability would be greater than the amount of withholding tax payable.

7.6.4. Introducing an “equalisation levy”

302 To avoid some of the difficulties arising from creating new profit attribution rules for purposes of a nexus based on significant economic presence, an “equalisation levy”could be considered as an alternative way to address the broader direct tax challenges of the digital economy. This approach has been used by some countries in order to ensure equal treatment of foreign and domestic suppliers. For example, in the area of insurance, some countries have adopted equalisation levies in the form of excise taxes based on the amount of gross premiums paid to offshore suppliers. Such taxes are intended to address a disparity in tax treatment between domestic corporations engaged in insurance activities and wholly taxable on the related profits, and foreign corporations that are able to sell insurance without being subject to income tax on those profits, neither in the state from where the premiums are collected nor in state of residence. As discussed below, an equalisation levy could be structured in a variety of ways depending on its ultimate policy objective. In general, an equalisation levy would be intended to serve as a way to tax a non-resident enterprise’s significant economic presence in a country. In order to provide clarity, certainty and equity to all stakeholders, and to avoid undue burden on small and medium-sized businesses,therefore, the equalisation levy would be applied only in cases where it is determined that anon-resident enterprise has a significant economic presence.

7.6.4.1. Scope of the levy

303 If the policy priority is to tax remote sales transactions with customers in a market jurisdiction, one possibility is to apply the levy to all transactions concluded remotely within-country customers. To target the scope of the levy more closely to the situation in which a business establishes and maintains a purposeful and sustained interaction with users or customers in a specific country via an online presence, the levy would be applied only where the business maintains a significant economic presence as described above.

304 An alternative would be to limit the scope to transactions involving the conclusion through automated systems of a contract for the sale (or exchange) of goods and services between two or more parties effectuated through a digital platform. Although this would create an incentive to choose non-digital means of conducting transactions, it would also focus more closely on the specific types of transactions that have generated concern. There is no rule, however, that prevents a broader scope of application. Indeed, focusing too narrowly on specific types of transactions may limit the flexibility of the levy to accommodate future developments, which would limit its ultimate effectiveness in addressing the tax disparity between foreign and domestic suppliers of products through an online presence. The levy would be imposed on the gross value of the goods or services provided to in-country customers and users, paid by in-country customers and users, and collected by the foreign enterprise via a simplified registration regime, or collected by a local intermediary.

305 Alternatively, if the policy priority is to tax the value considered to be directly contributed by customers and users, then a levy could be imposed on data and other contributions gathered from in-country customers and users. For that purpose, a number of options could be available. One option would be to impose a charge based on the average number of MAU in the country. As noted above, however, measuring MAU accurately may prove to be challenging. Moreover, the number of MAU of a foreign enterprise may not be directly related to in-country revenue generated by a foreign enterprise. Setting an appropriate rate for a levy measured by active users would also be challenging, as the average value of each user to a non-resident enterprise may vary widely. Another option would be to base the levy on the volume of data collected from in-country customers and users. Similar to MAU, however, data may also vary widely in value depending on its content and the purpose for which it was gathered, and it would be challenging to identify a reliable direct connection between the in-country revenue and the data collected from in-country customers and users.

7.6.4.2. Potential trade and other issues

306 As is the case with the imposition of a gross-basis final withholding tax, a levy that applied only to non-resident enterprises would be likely to raise substantial questions both with respect to trade agreements and with respect to EU law. In order to address these questions, potential solutions that would ensure equal treatment of domestic and non-resident enterprises would need to be explored, as discussed above in section 7.6.3.3.Depending on the structure of the levy, one option that could be considered would be to impose the tax on both domestic and foreign entities. If this approach were to be taken,however, presumably consideration would also need to be given to ways to mitigate the potential impact of applying both the corporate income tax and the levy to domestic entities and foreign entities taxable under existing corporate income tax rules.

7.6.4.3. Relationship with corporate income tax

307 Imposing an equalisation levy raises risks that the same income would be subject to both corporate income tax and the levy. This could arise either in the situation in which a foreign entity is subject to the levy at source and to corporate income tax in its country of residence or in the situation in which an entity is subject to both corporate income tax and the levy in the country of source. In the case of a foreign entity, for example, if the income is subject to corporate income tax in the country of residence of the enterprise, the levy would be unlikely to be creditable against that tax. To address these potential concerns, it would be necessary to structure the levy to apply only to situations in which the income would otherwise be untaxed or subject only to a very low rate of tax.

308 Another approach could be to allow a taxpayer subject to both CIT and the levy to credit the levy against its domestic corporate income tax. Such an approach would ensure that foreign entities with no nexus for corporate income tax purposes would be subject only to the levy in the source country, while the tax burden of entities subject to corporate tax would effectively be limited to the greater of the corporate income tax or the levy.

( Author CA. Yogesh S. Limaye can be reached at [email protected])

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