Hi-tech firms from Kiryat Shmona to Eilat may have to register and pay VAT and income tax in every country where they happen to have “significant” users.
On March 24, the OECD published draft proposals for tightening the taxation of multinational concerns that operate internationally in the digital economy. The problem is that some of the well-known big ones pay little or no tax anywhere under existing rules. But the OECD proposals, if adopted, could be bad for Israeli hi-tech firms, as explained below. Israel joined the OECD in 2010.
The proposals call for public comments by April 14, so a version of this article is being submitted to the OECD.
According to the OECD proposals, the digital economy has changed the way companies do business, and it is now far easier to supply services via e-commerce to consumers with minimal physical presence in the consumer countries. And if the multinational uses an offshore supply company to hold intellectual property and accept commercial risks, the profits may accrue offshore tax free. Consequently, the OECD was asked by onshore member countries to look into ways of tackling so-called “base erosion profit shifting” (BEPS), and the digital economy is one area the OECD is looking into as part of its BEPS action plan. The plan should be fully developed by the end of 2015.
All this is due to the development of information and communication technology (ICT) of many types, including personal computing devices, cloud computing, software development, use of data regarding consumers, the Internet of things (putting your fridge and other devices on the Internet), advanced robotics, 3-D printing, online and credit-card payments and much more.
The proposals include some interesting statistics. In 2012, business to consumer (B2C) e-commerce sales were estimated to exceed $1 trillion, and business-to-business (B2B) e-commerce was estimated at $12.4t. The major OECD exporters of ICT services in 2012 were India ($13.5 billion), Ireland ($12.7b.), the US ($8.0b.), Germany ($7.3b.) and the UK ($7.0b.). Israel is in 10th place at $2.7b.).
Aims of the OECD proposals
The stated aims of the OECD proposals are neutrality, efficiency, certainty, simplicity, effectiveness, fairness and flexibility.
What is proposed?
First, the OECD task force proposes as a “potential option” that an enterprise engaged in “fully dematerialized activities” would have a taxable permanent establishment if it maintained a “significant digital presence” in the economy of another country.
A “fully dematerialized activity” would include: digital goods or service core activity; no physical element other than servers and websites and commercialization of location-relevant data; contracts concluded exclusively by Internet or phone; online electronic or credit-card payments; relationships only via websites; vast majority of profits from digital goods or services; residence and location disregarded by the customer; use via computer, mobile device or other IT tools.
A “significant digital presence” in a country would include, for example: significant number of customer contracts signed remotely; digital goods or services widely used or consumed in the country; substantial payments from clients for digital goods or services; or an existing branch offering related functions such as marketing and consulting.
Second, the OECD task force a proposes to treat as a permanent establishment a significant business in a country using personal data obtained by regular and systematic monitoring of Internet users in that country using “multi-sided business models” (that link different activities).
Third, the OECD Task Force mentions the possibility of a “virtual permanent establishment” in a country. There are three alternatives: (1) a virtual fixed place of business – a website in a country; (2) a virtual agency – contracts habitually concluded through technological means in a country; (3) on-site business presence – at the customer’s location.
Fourth, it is proposed to make financial institutions withhold tax from credit-card and electronic payments.
Fifth, it is proposed to scrap VAT exemptions for imports of low-value goods.
Sixth, it is proposed to simplify VAT registration procedures.
The task force is clearly hesitant. Based on practical experience, the proposed “options” won’t work and fresh options are called for (see below).
First, initiative and innovation will be stifled.
Hi-tech firms from Kiryat Shmona to Eilat may have to register and pay VAT and income tax in every country where they happen to have “significant” users, even if they have nothing physical in those countries.
It is unclear how many is “significant.”
If the Internet makes it easy to reach overseas markets from the home country, why penalize those companies with tax and bureaucracy? This is bad for the start-up nation (Israel), and the Israeli government should strongly oppose the OECD proposals.
Second, there is no mention of extending the rules for avoiding double taxation (foreign tax credit or exemption). Not every multinational avoids tax everywhere.
Third, the rules discriminate against companies in the digital sector. No mention is made of other sectors.
Fourth, this will be little more than a catand- mouse game. It will be easy to change a few things in the business model of a multinational to avoid meeting the new taxation “options,” – for example, by adding a small physical element.
Fifth, there is no estimate of the expected improvement in tax revenues.
Sixth, the “options” appear to contravene free-trade principles as administered by the World Trade Organization.
Seventh, the tried-and-tested principle is that a company from one country should only pay tax in another country if it does business IN that other country – not WITH that other country. The case for breaking that principle is not clearly stated. It is not enough to say that business is conducted differently – that was also the case when the fax machine and PC were first introduced.
Eighth, it is unclear how much income should be allocated to a particular country.
What about the value of technology provided and management time and resources devoted outside that country? Further proposals are apparently still in the pipeline.
The secret of success is in paragraph 102 of the draft proposals: “First, skills and talent remain a critical resource in the digital economy… managers, developers, software architects and designers… remain instrumental.”
Instead of seeking to impose tax where the machines are, tax should be imposed where “mind and management” is exercised by humans.
This is generally referred to as “effective management” and should be easy to apply.
This is because effective management is an existing accepted principle for determining the fiscal residency of a company in cases of doubt, according to the OECD model tax convention.
Moreover, many countries around the world apply a similar related principle known as “central management and control,” including the UK and Canada, and the US is said to be considering following suit. Israel also applies this concept, where it is referred to as “control or management.”
How would it work? The existing effective “management test” would be combined with existing transfer-pricing principles (which take into account functions, assets and risks) to allocate fairly profits and taxing rights between supply-and-demand countries for digital services and goods. The focus should simply be on the human element, not the machinery.
This should avoid the need for start-ups and others to register for income-tax purposes in every country where they have users.
What about VAT? If the OECD is smart enough to propose recently an international one-stop information-exchange facility between banks of different countries, it should also be possible to devise an international one-stop VAT reporting facility for international business concerns.
Since VAT is really a tax on consumers, a dispensation might be granted for paying VAT on B2B transactions as in the EU in most cases. This should avoid the need for start-ups and others to register for VAT purposes in every country where they have users.
What should a hi-tech company do now?
Hi-tech companies should monitor developments and review whether to increase the human element in the countries where they enjoy the greatest demand.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
email@example.com Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.