- Businesses engaged in cross-border transactions face a changing tax landscape, including new definitions for nexus and new approaches to sourcing and allocating taxable income.
- These developments will have far-reaching effects throughout the international business community—many companies will be affected, not just the digital behemoths.
- Business lawyers must understand the context for these changes and the wide-ranging implications for their firms.
Innovation Is Driving Tax Policy Change
Innovation in internet and related communication technology has spawned new ways for firms to tap into the marketplace. Business models built on digital platforms can generate significant income from remote markets through network connections without a significant physical presence in the form of facilities or personnel. The sharing economy, cloud computing, streaming services, electronic marketplaces, advertising, and software services provide examples of activities that can target remote markets from operational bases that could be anywhere. Moreover, these activities are now common components in many business models.
The permanent establishment (PE) concept, which is based on physical presence within the taxing jurisdiction, is no longer considered an effective tool for allocating taxing authority by some countries. As the value chain for providing goods and services continues to expand across jurisdictional boundaries, governments have struggled to address their ability to capture taxes on an appropriate share of economic income from firms tapping their markets without a PE within their borders.
Legal techniques designed to shift income from high-tax to low-tax jurisdictions have also presented tax administration challenges. Anti-avoidance rules designed to prevent shifting profits through contracts and legal relationships have long been part of the international tax regime. Transfer pricing rules based on arm’s-length principles have emerged as effective tools to address income allocation for transactions involving traditional goods and services. However, as technological change has shifted more value into intangibles and information, some claim those rules have been strained to appropriately measure and assess value creation and the locus of economic benefits.
Government Responses: Sovereignty Versus Coordination
The Organization for Economic Cooperation and Development (OECD) has become the leading international organization devoting efforts toward study and policy development for a coordinated response to the changing tax environment. Although sovereign states maintain their own power to impose taxes, coordinated approaches offer advantages, including more efficient compliance and the avoidance of double-taxing or double-nontaxing income.
Beginning with a 2013 report on base erosion and profit shifting (BEPS), the OECD identified the jurisdiction to tax digital goods and services as one part of a multipronged action plan to address the changing tax environment. However, the complexities of the digital landscape and differences in policy commitments among state participants have contributed to disagreements based on sovereign interests of member states. For example, if rules change to allow market states to tax more of the income generated by the digital economy, states that previously taxed that income—including those where intellectual property, capital, and management skills are located—stand to lose portions of their current tax base.
The OECD continues to work on a coordinated solution, targeting early 2020 as the date for achieving high-level political agreement. In the meantime, sovereign governments are working independently on solutions that will address their own desires for revenue. The EU launched a coordinated digital tax proposal of its own in 2015, which targeted large businesses utilizing digital platforms. However, EU countries have also failed to reach an agreement on a coordinated approach for member nations. Some EU countries (and in some cases, states within those countries) have resolved to forge ahead with digital tax proposals of their own, including the United Kingdom, Spain, France, and Italy. Outside the EU, other countries are modifying their tax laws to address their conception of the value proposition inherent in the digital environment, including the role of their consumers in generating income. Tax claims based on providing support for markets, rather than support for firms based on physical presence, are expanding.
So far, these country-specific approaches have taken four primary forms: (1) changing the PE threshold; (2) withholding taxes involving payments for digital goods and services; (3) so-called turnover taxes on gross receipts from firms offering digital goods and services; and (4) specific taxes targeting large multinational enterprises with digital activities.
The OECD will be taking these approaches into account in its quest to find a coordinated approach, with a targeted completion date scheduled for mid-2020. OECD leadership has professed a goal of developing a neutral system that does not significantly change the current allocation of taxes, but one wonders how that goal can be reconciled to the desire of sovereign states to assert their independent interests.
Implications for Business Advisors
Modifying the PE concept will likely have the most far-reaching effects on (even small) firms conducting business abroad. If the PE concept is modified to permit a significant digital or online presence, income tax possibilities become magnified. India, the Slovak Republic, and Israel have all started down this path. Still unresolved is the manner of solving competing claims for allocating income among different states.
Most firms engaged in cross-border businesses have experience with withholding taxes; however, if the withholding tax base is potentially expanded beyond traditional categories of interest, dividends, and royalties to include certain kinds of digital and technical services, there will not only be new compliance challenges, but also changes to the economics of delivering those services. Although business customers in a market state may bear some of the compliance burdens, firms dealing directly with consumers may face special compliance challenges as rules emerge to shift the locus of collection and payment responsibilities.
When tax obligations are based on reaching minimum thresholds (such as gross receipts or the number of transactions within a jurisdiction), business planners and tax policymakers must both carefully think through the significance of legal structures for delivering products and services to foreign markets. Can the tax be mitigated by changing the locus for providing goods or services? Does that structural change make good business sense? How will those tax implications affect pricing policies?
Concerns about double taxation in this regime are well-founded, particularly when states use different approaches. These tax changes are likely to enhance the possibilities of conflict with taxing authorities of multiple states. Such problems are akin to those experienced on a subnational level in the United States, where U.S. states adopt different income allocation approaches. Bilateral tax treaties and the foreign tax credit regime both are designed to address the double-taxation concern. Treaty protections will require new scrutiny, and some of these taxes will also present U.S. taxpayers with challenges in obtaining a foreign tax credit to offset taxes imposed elsewhere. A creditable tax must have a predominant character as an income tax in the United States; gross receipts taxes may not be able to satisfy these requirements.
Finally, IT departments must become more involved with their counterparts in the tax department. These new tax regimes will require information that current accounting and information systems may not be designed to produce. Geolocation technologies may prove increasingly important in determining how and where digital goods and services are delivered. Moreover, the collection and retention of this information for tax compliance will also implicate cross-border responsibilities involving privacy and security, which present their own legal and economic challenges.
In short, business lawyers must pay attention to developments in this area if they are to effectively identify and manage the risks that accompany participation in international markets.