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The digitalization of the Economy: Tax Implications (1)

The digitalization of the economy has had a huge impact on how the global economy functions.

The world’s markets are ever more integrated and the nature of the services provided is changing the way activities are carried out and value is created.

Needless to say that the digitalization process and the new business models are challenging the current international tax framework which was designed early in the 20th century.

In view of this, the tax aspects of the digitalization of the economy came to the attention of governments and academia who started working on how to adjust the current domestic and international tax framework to the digital era.

Indeed, since most digital business do not need physical presence, assets or workforce in a given country in order to generate profits and value, the main tax challenge of the digital era relates to identifying the most appropriate ways to adapt the current criteria for the allocation of taxing rights between source and resident jurisdictions to the current digital business models.

One of the most important actions taken to tackle the tax implications of the digitalization of the economy is the OECD 2015 BEPS Package Action 1 Report that tackles “the Tax Challenges of the Digital Economy” which is part of the larger BEPS (Base Erosion and Profit Shifting) Project launched in 2013 by the OECD and the G20.

The 2015 OECD Report 1 identifies a series of features of the digitalization that are relevant from a tax perspective and that should be addressed in order to tackle tax distortions by digitalization:

  1. identifying whether a digital business has a significant economic presence in a given country (nexus approach);
  2. attributing value to the data collected by digital businesses from end-users (e.g. users’ data used by social networking businesses to sell advertisement on their websites);
  3. characterizing correctly the payments made by a resident payer to a non-resident digital business (since in most cases it is difficult to understand whether a payment made over an e-commerce transaction has to be regarded as a royalty paid to a non-resident or, conversely, as a business profit made by the non-resident business through its permanent establishment).

The 2018 OECD Interim Report on the Digitalization of the Economy

Although these challenges had been so identified, the 2015 Report contained no recommendation to the OECD member countries to take any substantial action in order to address the digitization challenge.

After years of monitoring the impact the digital economy is having on the international tax system, in 2018 the OECD published the OECD Interim Report on the “Tax Challenges arising from digitalization” which contains insightful information on the progress made on the implementation of the BEPS Package with particular regard to the digital economy.

According to the 2018 Interim Report, the impact that the ongoing implementation of the BEPS Package is having on the taxation of the value created by the digital economy is two-fold:

  • on the one hand, the ongoing signature and enforcement of the Multilateral Instrument (MLI) provided for by Action 15 of the BEPS Package, which is aimed at implementing anti-avoidance, anti-treaty-abuse and other treaty-related BEPS Package actions, is likely to bring about an in-depth restructure of the international tax framework that will help governments tackle the challenges arising from taxing fairly the “digital value”;
  • on the other hand, the measures of the BEPS Package taken to tackle tax avoidance like preventing the artificial avoidance of Permanent Establishments status (BEPS Package Action 7), ensuring that Transfer Pricing outcomes are in line with value creation (BEPS Package Actions 8-10), strengthening Controlled Foreign Companies (CFC) rules (BEPS Package Action 3) , among others, is having a great impact on countries’ domestic tax legislation as well as on digital businesses’ (like Amazon, eBay and Facebook) tax strategies, which are taking action in order to ensure that their business models and corporate structures are compliant with the ongoing implementation of the BEPS Package provisions.

Although among the countries there is no consensus over the interim measures that should be taken in order to tax the “digital value”, it seems reasonable to believe that the implementation of the BEPS Package over time will effectively help tackle the problem with taxing highly-digitalized business. Indeed, distortions might be eliminated by allowing countries to restore both source and residence taxation in many cases where cross-boarder income would otherwise go untaxed or taxed at very low rate as well as help countries tax domestic and multinational enterprises’ profits similarly.