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The impact of BEPS on the digital economy

Channing Flynn and Stephen Bates discuss the specific issues related to profit shifting in the fast-changing digital economy.

Digital economy taxation remains one of the most uncertain tax aspects of multinational business today. This is despite two years of work by the OECD on its Base Erosion and Profit Shifting Project (BEPS) Action 1: Addressing the Tax Challenges of the Digital Economy, and its recent work on related matters, such as indirect taxation, and also despite the public embrace of BEPS by national tax authorities that are rewriting their own policies and rules.

In fact, much of the OECD's work on the digital economy lies ahead of it – delegated to its Task Force on the Digital Economy (TFDE) for completion in 2020. In the meantime, countries are implementing diverse national digital economy tax policies that reinterpret, and may even digress from, the new BEPS guidelines. In parallel, disruptive technologies and digital business models such as the sharing economy continue to evolve at a breathtaking pace that is exacerbating policymakers' challenges.

With more and more companies and industries deploying new digital business models that disrupt traditional trade flows and strain existing tax regimes around the world, the OECD viewed its digital economy tax work as critical to the global economy – so much so that it was designated Action 1 of the BEPS 15-point Action Plan, which included the proclamation that "the digital economy is the economy itself". Digital business was also implicated in the other 14 BEPS Actions: Action 1 guidance actually draws on Action 7 work on permanent establishment (PE), for example, and on other BEPS action items addressing controlled foreign corporations and harmful tax practices.

Now, with at least four more years of deliberation to come on some of the most difficult digital economy tax questions, tax uncertainty is among the biggest obstacles to doing business with the speed and agility necessary in today's hypercompetitive global market. The current level of digital tax uncertainty acts as a drag on innovation, growth and profitability as it saps companies' 'digital confidence'. Think of digital confidence as the cross-functional grasp of the digital business catalysts of today and tomorrow, along with their tax, legal and policy implications. Digital confidence increases business foresight, from understanding the costs of doing business to predicting returns on investment and managing risk.

Companies now need to find the right framework to act with digital confidence in an uncertain environment (see table). From the financial services sector to life sciences and the technology industry itself, examples presented in this article illustrate the potential business impacts of BEPS. They are presented in the context of EY's Digital Confidence Framework.

Digital confidence amid tax uncertainty

EY Digital Confidence Framework

Grow 

 Optimise

 Protect

Digital enterprise strategy

Digital

incubation and innovation

Digital

experience transformation

Digital

supply

chain and operations enablement

Digital

risk manage-ment, cyber-security, compliance, governance and audit

Companies across sectors need new strategies, business models and operating models purpose-built for a digital world.

Companies require cross-border agility in activating and managing their innovation processes and their portfolios of product, service, experience and business model innovations.

Customers are driving iterative and ongoing transformation in companies’ digitally enabled products and services.

Disruptive technologies enable new ways of manufacturing and distributing products and services, and new ways of running back- and middle-office operations.

Companies must master global tax compliance as one of the key risks in the regulatory and security mix of requirements.

Key OECD and BEPS tax changes in 2015

The BEPS conclusion that the digital economy is the economy itself has digital tax implications for companies from all industries. Meanwhile, inconsistent national interpretations and implementations create global tax uncertainty.

The tax treatment of intellectual property (IP) will be subject to modifications in two key areas: the transfer pricing of intangible assets and risks, and the nexus provisions allowed under national IP tax incentives.1 2

OECD guidelines to align all VAT and GST collection in the country of consumption are among myriad national and international changes to consumption taxes, requiring far greater attention by companies to pricing, digital interfaces and more.

The modified definition of permanent establishment regarding preparatory or auxiliary activities, plus anti-fragmentation rules, affects essential supply chain activities, including warehousing.

OECD-developed country-by-country (CbC) information exchanges give national authorities a greater cross-border view of companies’ tax profiles.

Some issues delegated to the TFDE report in 2020

The OECD sees tax policy challenges evolving as the digital economy continues to develop, and these will be addressed in the 2020 report. Basics such as revenue characterisation are also up for further analysis.

The 2020 report is expected to incorporate new considerations from the next waves of digital business innovation, such as the sharing economy, 3D printing and others.

One proposal would tax value created by or attributable to individuals’ data, which is increasingly used to define content, marketing, services and the digital experience.

Further analysis will be carried out on physical versus ‘virtual’ nexus.

An ‘equalisation levy’ has been proposed on digital businesses operating in a country without being physically present.

1 EY Tax Alert: Ireland announces improvements to IP regime. http://goo.gl/iRr2CI

EY Tax Alert: US proposed major changes to model tax treaty to counter base erosion. http://goo.gl/FfIC37


Tax directors need to anticipate evolving tax policy

As the OECD group responsible for addressing BEPS Action 1, the TFDE acted on the basis that technology is transforming how business is done globally and in every sector – how goods and services are sold, where companies base their operations and how they connect with their customers.

This transformation was seen as creating difficulties for governments' tax authorities and sapping their national treasuries. For example, the mobility of intangibles puts pressure on the accurate administration of direct taxes on corporate income, while the mobility of customers puts pressure on the efficient collection of indirect taxes on sales. Another example is the ability of multinational companies to conduct substantial sales into a market from a remote location, with minimal personnel in-country. Such mobility engendered growing government complaints that multinationals' organisational structures resulted in zero-tax, 'stateless' income – particularly when IP held in one country was globally commercialised in products and services.

A fundamental BEPS outcome is that "once the new measures become applicable, it is expected that profits will be reported where the economic activities that generate them are carried out and where value is created", as the OECD states in the Action 1 final report. Tax authorities will look to the development, enhancement, maintenance, protection and exploitation (DEMPE) functions surrounding IP within an organisation to analyse the global attribution of profits. This will challenge corporate tax directors to document the value drivers proactively throughout their global value chains.

Four recommendations are underscored in the Action 1 report:

  • Modify the list of exceptions to the definition of PE regarding preparatory or auxiliary activities as they relate to a digital environment, and introduce new anti-fragmentation rules to deny benefits from these exceptions through the fragmentation of certain business activities;

  • Modify the definition of a PE to address artificial arrangements through certain "conclusion of contracts" arrangements;

  • Make a correlative update to the transfer pricing guidelines; and

  • Make changes to the CFC rules addressing identified challenges of the digital economy.

The Action 1 report also reinforced recommendations developed outside of the BEPS process, such as a recent OECD regulation applying VAT and GST in the country of consumption and standard country-by-country tax reporting for greater global tax transparency.

The Action 1 recommendations were characterised as a first step in a long process of rewriting global tax policy for the digital era. A key BEPS project focus has been seeking better global alignment of companies' profit attribution with the people functions of their business. Now, the TFDE will continue looking at the broader challenges of the digital economy, which include the possibility of a tax on nexus implications of digital activity, a withholding tax on sales of digital goods and services, characterisation of income from new business models, and the value created by, and attributed to, individuals' data – all of which are expected to be addressed in a supplementary report to be released by 2020. (A detailed mandate for this work will be developed in 2016.)

Governments, meanwhile, are moving ahead, with a multitude of new VATs and GSTs (including, specifically, on digital services and low-value e-commerce transactions) and even with provisions that would establish 'virtual PEs' based on certain levels of digital activity in their country.

Framing digital confidence

As more people and businesses interconnect worldwide, as machines talk to machines in the "internet of things" and as the power of big data drives new business development, every enterprise needs a digital operating model. To attain digital confidence, companies must take a holistic approach to developing that model, strategically analysing tax along with other areas such as law, operations, technology and transactions across the five components of the model:

  • Digital enterprise strategy;

  • Digital incubation and innovation;

  • Digital experience transformation;

  • Digital supply chain and operations enablement; and

  • Digital risk management, cybersecurity, compliance, governance and audit.

Digital enterprise strategy

Companies need to identify and deal with digital tax issues as early as possible in their business development processes, or risk creating unintended PEs, tax costs, compliance burdens, penalties, interest and reputation risks. This is a continuous engagement that recognises the value of agility in business as well as the benefits of 'getting it right' the first time when identifying opportunities, markets, pricing and profitability. It also recognises that, in the immediate wake of the final BEPS release, the level of uncertainty in these areas is driving risk to unprecedented levels.

For example, the financial services sector has seen a sharp increase in R&D related to new technologies. Many banks are investing in redeveloping core systems to allow mobile access and are now increasingly offering niche applications as a way of targeting new customers. The creation of new IP and new mobile banking solutions may impact the bank's domestic and international tax profile, including its existing transfer pricing.

In this example, tax directors at financial services firms can provide critical up-front insight into the BEPS theme of allocating profits in line with DEMPE oversight functions and their respective weight in value creation. By establishing profit split percentages in a given value chain, tax directors can provide a risk evaluation of the taxpayer's overall transfer pricing system, quantify the benefits of various planning scenarios (IP planning, financing, restructuring, among others) and shore up documentation and tax compliance.

Digital incubation and innovation

Today, digital conveniences such as apps sit at the core of modern society and the global economy. As more data is being collected, stored and exchanged electronically, new opportunities arise, but so do new risks and responsibilities, including data privacy, data security and complex new relationships among the many players involved. The Action 1 report acknowledges this new reality, in projecting more work to come on individuals' data, its potential value and taxation, to be completed by the TFDE in 2020.

In one example that confounds classic cross-border models, a global cruise-line recently wanted to "improve enjoyment" by providing guests on board its ships with digital mobile experiences. The internal IT team developed a next-generation commerce platform with rich, relevant and personalised content offerings operated from data servers on land, with the intent of increasing on-board spending. In addition to maintaining high levels of network and information security, as well as implementing measures to protect data privacy and intellectual property, the cruise line had to contend with the tax implications of cross-border and high-seas sales activity by citizens from multiple countries.

This example underscores how tax departments need to extract meaning from large volumes of data to meet their increasing direct and indirect tax obligations under BEPS. In particular, companies must understand the characterisation of new income sources, products and services. Forward-looking corporate tax directors may even want to be prepared to analyse value created from individuals' data to determine the potential impact of a concept that would tax user-generated data.

Digital experience transformation

The digital revolution is changing the relationship that insurance companies have with their customers, the markets where they provide their services and the nature of the services they provide. For example, technology tools allow customers to bypass brokers and buy products directly from insurance providers. Consequently, insurance companies have developed digital infrastructure to replace certain processes that were once carried out by local personnel. And the ability to use remote servers to run complex underwriting algorithms means that contracts can be accepted by increasingly sophisticated software programmes.

In the post-BEPS world, tax departments within the insurance industry should consider the impact of this increased cross-border activity, how individual countries interpret this digital activity, and whether it may someday constitute a 'virtual PE'.

Digital supply chain and operations enablement

In another case, a US-based insurer wanted to start providing warranty and indemnity insurance policies for a fast-growing global technology company. To calculate the correct tax, the company needed to obtain confirmation of the tax treatment of the insurance policies in 33 countries. This example illustrates the complexity of determining VAT, GST, stamp duty or insurance premium tax amounts to price the policies correctly. Most expect this complexity will only increase with the current wave of countries imposing new or modified VAT and GST. Adding to the challenge is the need to ensure remittance of the correct insurance taxes to the country where the risk is located.

Digital risk management, cybersecurity, compliance, governance and audit

Every company in every sector has to be aware of the OECD's new CbC and master file reporting requirements, which are due as early as 2017 for 2016 financial data in countries adopting their use. The CbC initiative calls for comprehensive global operational reporting by companies (including coverage of all locations, legal entities and branches of operation), to be shared among relevant countries via government information exchange mechanisms. Digitally enabled themselves, the standardised CbC reports are expected to usher in a new era of tax transparency, as underscored in the Action 1 report.

Tax directors should continually assess the systems and documentation needed, as well as their colleagues' buy-in to the importance of averting reputational risk.

Building digital confidence

While it is hard to declare a 'bottom line' figure for the impact of BEPS, one can begin to extrapolate from the OECD's declaration that governments worldwide are losing between $100 billion and $240 billion each year in tax revenue due to BEPS – or 4% to 10% of global corporate income tax revenue. The BEPS Project aims to redress these losses. Multinational companies also see the growing compliance costs in developments such as CbC tax reporting, the escalating information technology systems requirements for multiplying VAT and GST registrations and collection, as well as the potential business losses as tax uncertainty hinders new business development, and the potential reputational risk if found to be non-compliant.

Tax directors need to work closely with their counterparts across the enterprise to mitigate these negative impacts, align their company with the ongoing pace, complexity and volume of change in new multilateral and national taxation, and establish a digital framework to manage it all. Day-to-day operational issues will emerge. It could be that new product pricing should include a VAT cost not previously charged, for example, or that the leaders of a software development team need to work from an office in the jurisdiction of the IP owner.

Strategically, the stage must be set for success through a series of milestones: Action 1 implementation; the 2016 release of the TFDE's new mandate for further digital tax policy development; and then the task force's 2020 report on those policies. To achieve this, tax directors should:

  • Actively track changes in digital economy taxation worldwide;

  • Command a seat at the business strategy table; and

  • Engage with national and international tax policymakers to facilitate rational digital economy tax policy.

Going forward, new frameworks, tools and analysis will be needed to re-evaluate the operating model throughout your global value chain, holding it up to OECD guidelines and their national interpretations in areas including IP alignment, CbC and master file reporting, possible risks of risks of stateless income, double taxation, and the costly proliferation of PEs. Specifically, companies should take the following steps:

  • Document the location of DEMPE oversight functions and ensure they align with attribution of IP profits;

  • Convince your company's business lines to include VAT costs as they develop product pricing;

  • Alert the IT department to the risk that adding or changing data centres around the world could create new PEs in your global value chain; and

  • Establish a dedicated committee to vet any short-term decisions affecting the development of IP and plans for global commercialisation.

All businesses want to operate with digital confidence. Given the current environment and heightened uncertainty in digital economy taxation, tax leaders can increase their level of confidence by initiating up-front and continuous planning across the enterprise – within a very deliberate framework that incorporates taxation as a matter of course.

EY would like to thank Jess Martin and Todd Scherzer for their contribution to this chapter

Flynn-Channing

 

Channing Flynn

EY

Tel: +1 408 947 5435

channing.flynn@ey.com

Channing Flynn is a partner in EY's international tax services practice. Based in both San Jose, California, and San Francisco, he is also the global technology tax sector leader within EY's global technology center, headquartered in the Silicon Valley of Northern California. Channing leads experienced hire recruiting efforts for the firm's West Region International Tax and Transfer Pricing practice.

Channing has been with EY for more than 19 years, serving a wide variety of clients in cross-border tax planning, including restructurings, mergers and acquisitions, supply chain management and transition, transfer pricing, international tax planning, US GAAP presentation of tax matters, intellectual property alignment and IRS audit and procedural issues. In addition, Channing has worked on a range of US inbound taxation issues. His clients range from start-up companies to Fortune 100 multinationals, as well as a full range of non-US multinationals operating in the US and globally.


Bates-Stephen

 

Stephen Bates

EY

Tel: +1 415 894 8190

stephen.bates@ey.com

Stephen Bates is a principal in the national tax department, based in San Francisco. Before joining EY, Stephen was a principal at another Big 4 firm and an international tax associate at Weil, Gotshal & Manges.

Stephen provides tax advice to multinational corporations on transactional and controversy matters including transfer pricing, intellectual property planning, international restructuring and supply chain management. He advises large multinationals in a variety of industries, including the software, semiconductor, pharmaceutical, consumer products, manufacturing, and services sectors.


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