Transfer Pricing Times: Taxation of the Digital Economy

In this edition: The UK Treasury, the OECD and the European Commission released a series of papers on corporate tax and the digital economy; The U.S. Chamber of Commerce released its comments regarding tax reform under Public Law No. 115-7; The Hong Kong Inland Revenue Department launched a Country-by-Country reporting portal; and Korean politicians pressured the National Tax Service to initiate a transfer pricing investigation of General Motors Korea.

View our transfer pricing times articles.

Taxation of the Digital Economy

A series of papers recently released by the UK Treasury, the OECD and the European Commission have focused attention on the challenges of taxing the digital economy and the potential reforms that may lay ahead. While the digital economy is an important area of focus for many stakeholders, it is also clear that international consensus is lacking on whether it warrants separate consideration and what form any necessary changes might take.

On March 13, 2018, the UK Treasury issued an updated position paper on corporate tax and the digital economy, in which it set out its belief that there is a misalignment between where digital businesses are taxed and where they create value. It presents its view that the participation and engagement of users is an important aspect of value creation for certain digital business models and that the international corporate tax framework should reflect the value of user participation. The UK Treasury has also expressed concern that in the absence of tax reform that addresses the specific issues raised by the digital economy, there is a need to consider interim measures such as revenue-based taxes.

On March 16, 2018, the OECD/G20 Inclusive Framework on BEPS issued its Interim Report on the Tax Challenges Arising from Digitalization. Though it contains few firm recommendations, it does examine the changes to value creation and to business models brought about by digitalization. It also identifies characteristics that are frequently observed in certain highly digitalized business models.

The Interim Report identifies three categories of countries based upon the view that they take towards the need for specific measures to address the taxation challenges raised by the digital economy:

  • The first group includes countries which take the view that the digital economy raises unique concerns related to the alignment of profits and value creation as a result of the specific features of digital economy (including user-generated value), which are not adequately addressed within the existing international tax framework for multinational businesses. This group of countries believes the existing rule around nexus and profit allocation does not properly align profit allocation and value creation for certain digital economy business models, and a more refined analysis of relevant business models should perhaps give way to targeted changes that address nexus and profit allocation concerns for those models. This group is generally supportive of the broad principals underlying the existing international tax framework, and do not believe that the digital economy requires a wide-ranging change to that framework.
  • The second group includes countries which believe that digitalization and other changes driven by globalization challenge the effectiveness of the existing international tax framework for multinational businesses. This group of countries does not think the ineffectiveness of the existing framework is specific to the digital economy, but rather that global economic changes have created circumstances where multinationals can be “heavily involved in the economic life of a market jurisdiction” without having any taxable presence. These countries think this is evidence of the inadequacy of the current international tax framework, which has been created by the increasing importance of highly mobile business drivers and by the increased ability of businesses to participate in a market with little or no physical presence. This group is supportive of broader changes to the international tax framework to address these issues.
  • The third group includes countries which take the view that the existing international tax framework (inclusive of changes that have occurred as a result of the BEPS project) is largely adequate and do not see a need for a significant reform to international tax rules to address concerns raised by the digital economy. 

While there is significant disagreement among countries, as highlighted above, a broad group of countries support further exploration around the issue. The Interim Report is described by the OECD as laying the ground for progress towards a long-term multilateral solution in the next phase of work.

The OECD report notes that, while agreeing to work towards a long-term solution by 2020, some countries believe that there is a strong imperative to act quickly and are in favor of the introduction of interim measures, such as excise taxes on the supply of certain e-services. Other countries oppose such measures, and have raised concerns about the unintended impacts such measures might have on investment, innovation, growth and overall economic welfare, among others. The OECD report identifies design considerations for interim measures (discussed at a high level within the report) which should be taken into account to mitigate the risk of adverse outcomes.

U.S. Treasury Secretary, Steven Mnuchin issued a statement in response to the OECD report, saying “The U.S. firmly opposes proposals to single out digital companies. Some of these companies are among the greatest contributors to U.S. job creation and economic growth. Imposing new and redundant tax burdens would inhibit growth and ultimately harm workers and consumers. I fully support international cooperation to address broader tax challenges arising from the modern economy and to put the international tax system on a more sustainable footing.”

The European Commission proposed new rules on taxing digital business activities in a paper released on March 21, 2018. The Commission’s preferred long-term solution aims to reform corporate tax rules so that profits are registered and taxed where businesses have significant interaction with users through digital channels, so as to enable member states to tax profits generated in their territory, even if a company does not have a physical presence there. A digital platform will be deemed to have a taxable digital presence or virtual permanent establishment in an EU member state if it exceeds €7 million in annual revenues or has more than 100,000 users in a member state, or if more than 3,000 business contracts for digital services are created between the company and business users in a taxable year. The measure proposes changes in the allocation of profits between member states and could eventually be integrated into the scope of the proposed Common Consolidated Corporate Tax Base.

A second proposal responds to the calls from several EU member states for an interim tax to cover the main digital activities that currently escape tax in the EU. This tax would apply to revenues created from activities where users play a major role in value creation and which are the hardest to capture under current tax rules, including revenues created from selling online advertising space, digital intermediary activities which allow users to interact with other users and which can facilitate the sale of goods and services between them, and from the sale of data generated from user-provided information. Tax revenues would be collected by the member states where the users are located, and will only apply to companies with total annual worldwide revenues of €750 million and EU revenues of €50 million, to help ensure that smaller start-ups and scale-up businesses remain unburdened.

The European Commission’s legislative proposals are to be submitted to the Council for adoption and to the European Parliament for consultation. However, all EU member states must approve the proposals before they would become law and not all member states are in favor of the proposals.

The position paper released by the UK treasury is available here.

The OECD’s Interim Report is available here.

The rules proposed by the European Commission is available here.

U.S. Chamber of Commerce Comments on Tax Reform Law

Given the speed with which tax reform legislation was written and passed, it should be no surprise that practitioners and businesses are finding many circumstances where the current law is less than clear or where it may yield outcomes than are undesirable and potentially unintended. On March 7, 2018, the U.S. Chamber of Commerce (“USCC”) released its comments regarding tax reform under Public Law No. 115-7. These comments covered a wide variety of comments across various provisions of the legislation, including provisions most related to transfer pricing and international tax matters. Among these were requests to clarify and revise Foreign Derived Intangible Income (“FDII”), Base Erosion Anti-Abuse Tax (“BEAT”) and Global Intangible Low Income (“GILTI”) provisions in the interest of U.S. businesses. 
Some of the key recommendations are discussed below:

  • Revision of the BEAT provisions to exclude research and experimentation (“R&E”) reimbursements from inclusions as base erosion payments when those R&E payments are associated with intellectual property (“IP”) that will be owned (and taxed) in the U.S. The USCC is concerned that the current law inadvertently discourages companies from bringing IP to the U.S. As a result, U.S.-based IP ownership and associated royalties from foreign affiliates could decrease, leading to a decrease in U.S. tax revenue. Excluding R&E costs from the BEAT provisions would give companies incentives to adopt a U.S.-based IP ownership model, increasing the tax base for the royalties paid by foreign affiliates to the U.S. IP owner. The USCC’s position is that the tax revenues associated with the royalty payments would provide an offset for the exemption of the R&E reimbursements.
  • Clarification of the BEAT provisions to ensure that only the markup component associated with intragroup payments that qualify under the services cost method (“SCM”) are included as base erosion payments. The SCM is a specified transfer pricing method which allows “covered services” to be charged out at cost with no markup. Per the BEAT provisions, payments for services that are eligible for the SCM are excluded from the definition of base erosion payments. The USCC recommends the BEAT provisions be revised to indicate that the cost component associated with intragroup payments that qualify under the SCM are not classified as base erosion payments, even if a markup was charged on these payments.  
  • Clarification on the definition of property and services deemed to be for foreign use when determining FDII. The USCC’s preference in cases where property is sold for mixed use (i.e., domestic and foreign use) or services are split between domestic and foreign use is that the taxpayer be permitted to get FDII benefit with respect to the portion of sales or services that qualify as foreign. This could be achieved by the direct tracing of income and implementing a de minimis rule.
  • Clarification on the allocation of interest and stewardship expenses to GILTI to avoid circumstances where a taxpayer has a foreign tax rate of 13.125% or higher, but the taxpayer nonetheless finds themselves subject to additional tax through a GILTI inclusion due to the effects of such allocation on foreign tax credit limitations. 

Additional information on the USCC’s comments is available here.

Hong Kong Launches Country-by-Country Reporting Portal

On March 5, 2018, the Hong Kong Inland Revenue Department (“IRD”) launched the “CbC reporting portal”, a platform created to facilitate Country-by-Country (“CbC”) reporting by enabling the designated “Reporting Entity” to submit notifications and CbC returns.

Hong Kong’s ultimate parent entity (“HK UPE”) of the group is required to file the CbC return from January 1, 2018 onwards. Every entity in Hong Kong is required to submit a notification containing information relevant for determining the obligation for filing a CbC return within three (3) months after the end of the relevant financial year. However, for groups with more than one entity in Hong Kong, only one notification is required.

The HK UPE can now also file CbC returns for accounting periods commencing between January 1, 2016 and December 1, 2017 via the portal voluntarily. HK UPEs intending to make such filings are required to register via the portal, and they are required to use an “e-Cert (Organizational) with AEOI Functions” for authentication.

The CbC reporting portal can be accessed here.

Korean Politicians Pressure Tax Authority to Investigate General Motors Korea Transfer Pricing

National Tax Service (“NTS”) is currently under pressure to launch a transfer pricing investigation into the pricing of related party transactions of General Motors Korea (“GM Korea”).

An analysis released by Representative Ji Sang-Wook from Bareun Future Party in Korea, a South Korean political party, finds that GM Korea may, in the view of the author, be exporting vehicles produced at the company’s Gunsan plant in North Jeolla Province at artificially low prices to affiliates, and that the non-arm’s length intercompany pricing was the key reason for GM Korea’s net losses of 1.9 trillion won (approx. USD 1.7 billion) between 2014 and 2016, which eventually lead to the shutdown of the Gunsan plant.  

Political figures, influenced by public opinion, are now urging the NTS to initiate a transfer pricing investigation of the pricing of GM Korea’s sales to affiliates.

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