By Andreas Papagavriel
The digital transformation of the global economy and the shift towards a user-based digital market that has been primarily driven by the evolution of the internet and the increasing interconnectedness that it facilitates between people and multinational enterprises (MNEs) create significant tax challenges for all jurisdictions and for international taxation.
The tax challenges relating to the digitalisation of the economy and in particular the fact that many MNEs have reduced their effective tax rate significantly (via the exploitation of the existing ‘nexus’ rules through targeted international tax planning) by shifting profits to low (or no) tax jurisdictions, rather than paying their share of taxes in the jurisdictions where value is created, have been a key aspect of the Base Erosion and Profit Shifting (BEPS) Action Plan implemented by the Organisation for Economic Cooperation and Development (OECD).
The main challenge that the OECD aims to address is the one that relates to the existing “nexus” rules that allocate the right to tax the profits of non-resident enterprises to the jurisdiction where these profits are sourced and where physical presence exists (i.e. through the creation of a permanent establishment). The profit allocation as per the existing “nexus” rules is based on the arm’s length principle and the authorised OECD approach by focusing on the concept of “significant people functions” which looks at the functions performed, assets owned and risks assumed by the non-resident enterprise.
Until recently, the existing “nexus” rules were perceived by many international tax experts as the most appropriate method to allocate taxing rights to the jurisdictions where the physical and economic substance is created. However, they are now rendered as obsolete, since they are not effective when it comes to the allocation of taxing rights for the profits that arise as a result of the value created from the exploitation of data and user participation, which are the main characteristics of the new highly digitalised business models.
Further to the OECD BEPS Action Plan and the need to address the aforementioned tax challenges relating to the digital economy, the EU Commission issued several proposals for directives on a revenue-based “digital services tax” and the introduction of a digital permanent establishment (PE) concept (also referred to as “virtual PE”).
Despite the fact that the Economic and Financial Affairs Council of the EU (Ecofin) did not reach an agreement on the “digital services tax”, member states like France and the UK have recently introduced new domestic legislation which provides for a “digital services tax”. While such an initiative may be a step in the right direction, it creates further challenges. Unilateral tax measures facilitated by the application of a revenue-based “digital services tax” will result in double taxation for MNEs, which cannot be relieved under the existing provisions of double tax treaties.
In order to address the aforementioned issue and ensure that the sustainability of the international framework for the taxation of cross-border activities is not undermined, it is imperative to reach consensus at an international level. This is also stressed in the programme of work recently published by the OECD/G20, as part of an initiative to develop a solution to the tax challenges arising from the digitalisation of the economy. According to the programme, the aim of the OECD/G20 is to develop a consensus-based solution by the end of 2020, which will be based on the revision of the existing profit allocation and nexus rules and the design of a system to ensure that MNEs pay a minimum level of tax, in an attempt to prevent base erosion and profit shifting.
Andreas Papagavriel is supervisor of tax advisory services at Baker Tilly Klitou and Partners Ltd, Nicosia