Reconsidering the finance function of digital companies
The technological revolution has led the OECD to attempt to redefine the concept of permanent establishments. Antonio A Weffer of Baker & McKenzie Luxembourg discusses how the related notion of the finance function is evolving in a digital cross-border setting.
Today's digital business model requires flexible and on the spot decisions of the financial department to be in the game. The new framework for ensuring digital business activities are taxed in a fair and growth-friendly way triggers multiple collateral challenges for the business community, which we are not entirely sure could even be solved by the unanimous consensus of the tax authorities.
For example, the definition of permanent establishment (PE) suggested by the OECD is based on the notion of significant economic presence (SEP) versus the allocation of taxing rights between jurisdictions. This is due to the 'consumer-centric' formulaic approach, which ignores the key drivers' functions of digital companies, such as the operational finance function.
Some relevant queries could then be raised:
Are we addressing the challenges of the significant value-added digitalised cross-border transactions?
Does the new digital PE notion fairly cover and allocate tax rights among jurisdictions?
To this end, the below will provide some background and our technical views to self-answer the above or assist you to raise further queries.
The pillars of a digital business model
A digital business model, even in its purest form of a traditional business-to-consumer (B2C) e-commerce of tangible goods, where the seller receives the order from the client and dispatches the goods to the latter without the application of sophisticated technologies, differs significantly from the average bricks-and-mortar business for a variety of valid reasons. According to Bhimani in Financial Management for Technology Start-ups (2017), the following patterns/values are often observed in digital companies:
Network value driven: The efficient management and creation of networks of suppliers, consumers and information, allowing them to break from the traditional sequenced linear value chains, resulting in multiple synergies;
Continuous innovation and experimentation: Unlike the majority of traditional business, where most of the changes occur at a certain pace and there are certain entry barriers to the market, a successful tech-based firm has to navigate and survive in a chaotic market place with multiple players on a global basis. The main competitive advantage of such a firm is its desire to successfully innovate and differentiate from the mass;
Externalisation of activities/outsourcing of core business functions: The sharing economy is a typical example of externalising core business activities related to the offered product service to the final consumer; the tech company acts as the coordinator/meeting point of its own network of suppliers and consumers and this is its main value-adding activity. Typical examples include accommodation, car rental/hiring services, e-commerce platforms or even dating sites; and
Wealth of data: A digital business de facto acts as a data collection point of its own network. The subsequent analysis and interpretation of such information, provides the business the opportunity to adapt its business model and strategy accordingly in zero time.
The finance function of digital companies
The finance function of digital companies has evolved from administrative support into a key driver of value generation. Today, frontiers with the sales/distribution efforts are very thin and thus it can no longer be treated as a low-value adding activity.
Professor Klaus Schwab, founder and executive chair of the World Economic Forum, has noted that the fourth industrial revolution (4IR) will mark the fusion of the natural, physical and digital worlds owing to the synergistic interaction of new technologies and scientific developments. It is expected to affect the way we live, work and relate to one another in an unprecedented and transformative way.
The regulation of the 4IR industries poses significant challenges at local and international levels today. Taxation is not an exception because the default disruptive nature of the 4IR activities, combined with the inelastic national and international tax frameworks – which are designed per se for the needs of bricks-and-mortar economies – will lead to the creation of novel dilemmas.
The understanding of the basic value creation mechanisms of 4IR under bricks-and-mortar business and management perspectives/concepts is a rather subjective process with conflicting results and multiple/uncertain interpretations.
Terms and notions until recently unknown to the uninitiated, including but not limited to biotechnology, artificial intelligence (AI), cloud computing, robotics, advanced wireless technologies, 3D printing, big data and the internet of things (IoT), will inevitably result in ground-breaking and disruptive business models, where finance functions lead the way of doing business.
In practice, maneuvering in a disruptive, volatile and difficult to interpret business environment, has, as a prerequisite, the implementation of a sophisticated financial management strategy.
This, in turn, requires the combination of analytical skills, immediate response to the challenges and, of course, an 'out-of-the-box' approach, since both the short-term cash survivability and the long-term value creation are more than ever dependent on instant financial decisions.
Since the price-setting mechanism is of utmost importance in price sensitive markets that require instant reaction, as those prevalent in the digital economy landscape. The finance function is de facto amalgamated with the sales/distribution function. Additionally, the effectiveness of the finance function in terms of processing payments/outward remittances is a determinant factor for selecting a digital services provider. As in the case of online market places or even gambling companies, the earlier a payment/outward remittance is processed, the more users it will attract.
Therefore, the finance function has notably evolved from a supportive/low-value adding function into a key driver of value generation, which frontiers with the sales/distribution efforts are not well defined.
OECD/G20 initiatives: Groundbreaking developments or just 'quick-fixes'?
The BEPS Action 1 package is moving toward the setting up of uniformed rules when taxing digital economy activities.
The EU is also discussing a new framework to ensure that digital business activities are taxed in a fair and growth-friendly way. Nevertheless, since the proposed directives for a general digital services tax (DST) or a lighter digital advertising tax (DAT) covering a wide spectrum of digital activities and limited to specific digital advertising activities respectively, lack the unanimous consensus of the member states, almost all member states expressed their preference to find a solution at the OECD level.
It is fully acknowledged that such initiatives require an immense amount of preparatory work and a unanimous consensus between the participants, which is indeed a lengthy process with multiple milestones, not allowing the digital companies to keep up with the technological developments and the evolution of the 4IR in general. Nevertheless, they do not address the challenges of the 4IR era by setting a unified international taxation framework for all the digitalised cross-border transactions.
Unsurprisingly, such initiatives come as a response to the unilateral efforts of various jurisdictions to introduce sales-driven digital taxes, dramatically perplexing the international tax landscape. Perhaps this is the reason why most of these initiatives follow a 'consumer-centric' doctrine similar to indirect taxes: a tax nexus and the subsequent taxing rights will exist only in cases of "businesses that generate revenue from the sale of goods and services of a type commonly sold to consumers, i.e. individuals who are purchasing items for personal use and not for commercial or professional purposes".
This reiterates the view that such initiatives merely function as quick fixes that partially address the problem, providing short-term solutions that may temporarily satisfy the popular sentiment for more taxes on digital multinational enterprises (MNEs).
On this point, a new concept of PE, based on the concept of SEP has been developed and referred to in Action 1 of the BEPS Action Plan but not included in the new definition of PE provided by Action 7. More specifically, the OECD report on addressing the tax challenges of the digital economy suggests that "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".
The EU initiatives are also heavily influenced by this concept. Much to our regret, this profound change in the PE definition was not included in Action 7, since only existing chronic PE issues were addressed, including the introduction of an 'anti-fragmentation' rule and a new definition of dependent agent PE (DAPE). As a result, since the Action 7 and the Multilateral Instrument (MLI) do not refer to this new concept of SEP, tax treaties will need to be further amended to the extent that future developments occur.
Undoubtedly, the proposed allocation of taxing rights between jurisdictions, due to the followed 'consumer-centric' formulaic approach, which grants taxing rights irrespective of physical presence, is a result of multiple compromises that effectively erodes the recently revised PE concept, leaving it intact only in cases not covered by the two-pillar approach.
Additionally, it substantially undermines the arm's-length principle (ALP), by degrading the importance of other functions performed, assets used and risks incurred, at a first glance not directly related to the sales effort and delivery of the products/services to the final client.
We regret to say that the need for the allocation of a fair portion of taxing rights to the market jurisdictions by using a consumer-centric formulaic approach weakens the applicability of the ALP. The ALP, in conjunction with the application of a well-articulated functional analysis, although with its known limitations, is the only tested and effective tool the application of which captures, or at least makes a decent attempt to capture and depict, the contributions of all the key value drivers traceable in an inter-company transaction other than the sales/delivery activities.
Thus, the application of such narrow-focused initiatives has profound implications on the uniform application of two household principles of the international tax arena, allowing the 'multi-speed' tax treatment of MNEs on the grounds of their involvement in a limited number of B2C digital activities.
It is interesting to observe how the two pillar approach will affect the remuneration of indirect sales/distribution efforts, which are mainly targeted by these initiatives.
Since the importance of the finance function in a digital business model is growing, the rest of this article examines the potential implications of the new approaches when remunerating the finance function of a digital business model.
Evaluating OECD guidance on financial transactions and low-value adding activities
On February 11 2020, the OECD published the long-awaited Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10 (FT TPG).
The FT TPG addresses a set of topics related to the treasury function, namely including the intra-group loans, the cash pooling and the hedging activities, providing insights on several existing hot-topics of the financial transactions on a standalone basis, isolated from the general picture.
Surprisingly, although it is acknowledged in section 10.39 of the FT TPG that "the management of group finances is an important and potentially complex activity", it is further stated that the "treasury function will usually be a support service to the main value-creating operation" (FT TPG, section 10.45). Unsurprisingly, Section D of Chapter VII of the 2017 OECD Transfer Pricing Guidelines for low-value adding intra-group services also shares this view. The vast majority of the finance functions may be classified as low-value adding activities, eligible for a 5% return on total cost (ROTC) remuneration, since they normally do not constitute a "core business activity" of an MNE.
Notions like agile finance and digital finance transformation are silently demoted to routine and repetitive bookkeeping and data entry functions. The well-grounded perception that the finance function, although important, is another 'supportive service', a view prevalent among traditional and stable bricks-and-mortar business models, is reiterated in the most profound way. Perhaps, for the sake of simplification, the main objective of the BEPS project is to capture the value creation drifted apart.
Taxing finance functions in a digital cross-border setting
In short, the taxation of the finance function in a digital cross-border setting faces the following two main challenges:
1) The classification of the finance function as a 'core' and value adding service, crucial for the success of the business model; and
2) The attribution of the resulting profits among the different jurisdictions.
Indeed, a robust functional analysis might be the first step in identifying and estimating the contribution of the finance function in the business model, as well its interdependencies and synergies with the other core functions. Nevertheless, the profit attribution among the different jurisdictions proves to be a tantalising exercise. Neither the location of the significant people's functions, nor the risk-taking activities play a determinant in the profit attribution among the jurisdictions.
On the one hand, a geographically dispersed finance workforce in more than one jurisdiction is becoming a norm, bearing in mind the recent developments in telecommuting, even before the coronavirus pandemic. On the other, considering the intangible nature of the digital business, the risk taking activities are dispersed throughout the value chain in different jurisdictions. A profit split method might be an appropriate method to allocate the profit among the jurisdictions.
In our view, the rewriting of international taxation rules should be more than just quick fixes. To tackle the international taxation issues of the 2020s, we should take distance from the established set of rules suited for the bricks-and-mortar economies of the 1920s.
Digitalisation of the economy changes MNEs' functions constantly, thus within the existing international taxation toolkit, the combined application of a robust functional analysis and a profit split method seems to be an appropriate method to identify, qualify and quantify the contributions of the various functions in a digital business cross-border setting prior to allocating the country's taxation rights.
Finance functions are key drivers' functions of digital companies and, therefore, should be part of the PE discussion.
The recently proposed initiatives, apart from addressing a niche category of digital transactions, de facto establish a 'multi-speed' tax treatment of MNEs in a rapidly changing landscape, which, in practice, proves the old Greek adage that "nothing is more permanent than a temporary solution".
Antonio A Weffer
Baker & McKenzie Luxembourg
Tel: +352 26 18 44 254
Antonio A Weffer is a tax principal in Baker & McKenzie Luxembourg's tax practice group and is the head of the firm's transfer pricing practice in Luxembourg.
He has more than 20 years of international tax experience, dealing with complex financial and non-financial multinational enterprises' cross-border transactions, reorganisations and M&A in numerous industries. Within Baker & McKenzie Luxembourg, he focuses his practice on transfer pricing and valuation documentation, benchmarks, and other economic compliance services for the worldwide business community. His expertise has also strengthened the global practice of Baker McKenzie's vast network dedicated to transfer pricing.
He is an active member of several international tax associations, such as the International Bureau of Fiscal Documentation (IBFD) and the Luxembourg branch of the International Fiscal Association (IFA). He is a regular contributor on international tax issues through articles, lectures in international tax programmes and as a speaker at worldwide seminars and conferences on international tax.