Digital technology is changing how businesses operate in fundamental ways, though one that may not immediately come to mind is taxation. There have, however, been a number of high-profile examples of multinational businesses apparently exploiting anomalies in the international tax system and there is a public perception that ‘digital businesses’ are at the forefront of this. This is one reason why the OECD now has a task force looking at tax and the digital economy.
There is concern that certain businesses are using the rules to avoid taxing their profits at all
The current system of bi-lateral tax treaties has its origins in the 1930s OECD model tax treaty. The objective of creating this system was to avoid the double taxation of the same profits in two different jurisdictions. But now there is concern that certain businesses are using the rules to avoid taxing their profits at all.
So, how can this happen? At the risk of oversimplifying the issues, the tax treaty network works on the basis that a state will only tax profits made if the business in question is ‘trading in’ their territory. The sales revenue generation from ‘trading with’ (i.e. selling to customers in one state from outside that state) can be subject to sales taxes such as VAT or customs duties, but the underlying profit is not taxed in the importing state.
This was a relatively straightforward concept to apply in the 1930s, but in the modern economy, vastly improved communications technology means that it is now possible to deconstruct the value chain of a business and locate the most profitable parts in low-tax jurisdictions. Tax planning of this kind has been around for 30 years or more, but it has only been with the advent of the internet and mobile communications that it has become relatively straightforward to implement for most businesses. In short, in the digital economy, it is much harder to work out who is doing what, where, and with who.
So, what changes may we see in the international tax environment, and what challenges might they create for business?
Sales tax reforms
We have already seen the EU change VAT rules such that, from 1 January 2015, businesses selling into an EU country have to apply the VAT rate of the customer’s territory, not the supplier’s. This will create extra compliance burdens and systems costs for business.
Trading ‘in’ vs trading ‘with’
We are likely to see changes to the ‘permanent establishment’ definition, which determines when a business is subject to profits tax in a particular territory. As business and governments adapt to these changes, we are likely to see a rise in tax disputes and the risk of double taxation.
There is likely to be a big debate about the extent to which intangible assets are generating profits, and whether taxable income should be attributed to customers’ activities, or the collection of customer data.
Businesses with large numbers of intangibles may find that governments look for new ways to tax the profits generated by intangibles, while limiting the tax relief for development costs. This becomes a particular problem for businesses which invest in many projects, but only make significant profits from a few successful ones.
While the potential changes to the global tax treaty regime are debated, there is a real risk of unilateral change, as individual countries try to prevent challenges to their tax bases – one example is the Italian e-advertising tax changes. This will create uncertainty and compliance burdens for businesses.