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Undesirable Google Digital Tax & Tax War.docx
National Tax Newspaper of Korea (2019)
  • Sung-Soo Han

As a part of BEPS Project, OECD published 15 Action plans to equip government with domestic and international instruments to address tax avoidance, ensuring that profits are taxed where economic activities generating the profits are performed and where value is created. As the anti-avoidance system should be made by the government, where each government introduces a reasonable legal system corresponding to the purport of BEPS Project, there would be no controversial issues between governments. However, it is thought from empirical perspective that the international community will have to get over many difficulties derived from unavoidable disputes (“tax war”) between states. 

Currently digital service tax is becoming a controversial issue all over the world. Especially European Commission (“EC”) proposed a new rule for digital service business. EU’s digital tax is going to be applied to the revenue derived from each state at a rate of 3%.In case where EU imposes 3% of digital service tax on digital service companies, they are subject to taxation and requirement which is more burdensome than EU companies. Thus, it is directly against the non-discrimination principle Paragraph 1, Article 24 of the OECD Model Tax Convention. Also EU’s proposal wouldn’t be reasonable from the standpoint of “principle of matching costs with revenues.” EU’s proposal can force even a deficit company to pay tax only to EU. 

Digital service companies which EU is targeting are mostly the U.S. enterprises and thus the possibility of tax war between EU and the US is increasing. The international community should find out a reasonable solution which can be agreed upon by member states in order to avoid such an unnecessary tax war between states.  

The reason why EU could not help making such a proposal is that the current OECD e-commerce rule has a limitation in preventing the tax avoidance activities of digital business MNEs. The e-commerce PE issue has been discussed since 1996. The OECD determined to treat servers as PEs, rather than web pages and inserted the related rules in the Commentary on Article 5 of the OECDModel Tax Convention. However, several authors have criticized this new category of PE since it is inaccurate in linking a geographical place with activities that produce income and it is easy to manipulate.  

The OECD studied the “virtual PE” theory as an alternative nexus that would apply to electronic commerce operations. Then, the PE definition was extended to include concept such as “virtual fixed place of business”, “virtual agency” and “on-site business presence.”  But the OECDconcluded that it would not be appropriate to dramatically change the PEconcept to include such notions and there did not seem to be actual evidence that the communications efficiencies of the Internet had caused any significant decrease to the tax revenues of capital importing countries.  

The discussions of e-commerce virtual PE could not give OECD member states a satisfactory solution. In the meantime, Google UK triggered a controversial issue in relation to its business activities in UK and the e-commerce issue is now spreading all over the digital business. Therefore, the European Commission ("EC") proposed new rules to ensure that digital business activities are taxed in a fair and growth-friendly way in the EU on 21 March 2018.  

Under the current e-commerce rule, the place where that server is located could constitute a permanent establishment of the enterprise. According to Commentaries 125 and 127, Article 5 of 2017 OECD Model Tax Convention, a server becomes a permanent establishment regardless of whether or not there is a person who manages the server.

A digital service company can shift its server easily from one place to another place. Also, as a server can be operated by remote control, it is possible not to have a server manager in the country where a server is located. Thus, it is not reasonable to determine a PE only based on the location of a server from the standpoint of business functions and risk burdens.  

Commentary 127 treats a server in the same way as automatic pumping equipment in order to justify a server PE. But a server is quite different from automatic pumping equipment in terms of taxation approach. Thus, it is very inappropriate to justify a serve PE in such a way.  

The business activities of a digital service company consist of “R&D activity” and “Sales activity” widely. A server is just a by-product of R&D activity. Thus, it would be appropriate that its whole business income should be allocated between R&D activity entities and sales activity entities on a reasonable basis considering their functions and risk burdens. A server is currently being used as a PE conduit for tax avoidance because the current OECD commentaries relating to electronic commerce acknowledge it. Accordingly the current Commentaries shall be revised. This thesis contains detailed case analyses on this matter.  

Every tax treaty has a PE rule. Article 5 of OECD Model Tax Convention does not treat the activities of ‘preparatory or auxiliary character’ as a PE which is a taxable entity. The reason why a tax treaty has a PE rule is to ascertain whether or not foreign enterprises’ certain activities in a specific state come under a PE activity within that state and thus can be a taxable entity. A liaison office is not a taxable entity. If a liaison office performs business activities which are not preparatory or auxiliary character, it becomes a taxable and the tax authority issues a business ID number by authority to collect a corporate tax, etc.  

What if a sale supporting subsidiary ‘X’ exercises an authority to conclude a contract for a foreign parent company? Should we treat this subsidiary in the same way as a liaison office? The answer is probably not. In that case, it would be reasonable for the tax authority to make an additional TP adjustment against X using a TP approach since it has already a business ID number. Thus, additional issuance of a business ID number (for PE) to X’s office would be redundant.  

Likewise, in case where the business activities of a digital service company lead to a PE issue, transfer pricing approach is more reasonable rather than a PE approach because a digital business MNE already has a subsidiary (taxable entity) in a state in issue and to secure reasonable taxing rights is available under this approach. This thesis contains detailed case analyses on this matter. 

A server can always be used as a “PE conduit” for tax avoidance by MNEs under the current OECD e-commerce rule. And such a PE issue can occur only when a digital MNE has a 100% subsidiary or a branch which provides sales support activity, etc. (a kind of disguised activity). If the activity of a subsidiary or a branch leads to a PE issue, it is reasonable to use the above transfer pricing approach and thus the current PE approach rule on a digital business MNE shall be substantially revised.  

If a PE conduit were a joint venture, it would be possible to use a 50% ownership threshold because such a planning is not possible unless a parent company has a majority ownership.  

R&D activities are very important to MNEs. MNEs which require a technology for their business cannot survive in the market without R&D activities. Thus, most of MNEs actively get involved in R&D activities. A patent is an output of R&D activities. MNEs often shift their patent into tax heaven areas in order to save related taxes. For that purpose, they conclude a contract between related parties for migration of a patent. Contracting activity is just a paper work.  

Is this kind of IP immigration reasonable from the standpoint of international taxation and equity? The answer would be no. Thus, it would be desirable for the international community to prevent this kind of transaction between related parties. If a subsidiary in a tax heaven state were a joint venture, it would be possible to use a 50% ownership threshold because such a planning is not possible unless X has a majority ownership. This thesis contains detailed case analyses on this matter.  

In addition to the digital service tax, it is expected that transfer pricing (“TP”) would become another controversial issue under the BEPS project. Since transfer pricing affects the taxing right of each government, there is a high possibility that each tax authority will try to unreasonably its taxing right based on unreasonable approaches as always.  

A TP very often leads to a functional, legal and statistical analysis issue and the analysis process makes the TP issue more complex because transfer pricing is not an exact science.  

As the functional analysis is performed by the pure business fact analysis against a tested party, it is less controversial. The legal issue is also less controversial. On the other hand, the statistical approach very often leads to a controversial issue. 

The statistical analysis performed by MNEs is a non-standardized process. The OECD TP guidelines and domestic TP rules of each state do not have a detailed rule concerning the statistical analysis. Thus, it very often leads to a controversial issue between MNEs and tax authorities.  

The statistical analysis should go through several steps. The problem is that it can be a controversial issue between MNEs and related tax authorities since there is no detailed rule concerning the statistical analysis. Thus, standardized rules concerning statistical al analysis are urgently required in order to eliminate an unnecessary tax dispute.  

In the past, MNEs generally performed a statistical analysis using the local data base of a tested party since the local tax authority tended to request the use of local data base. One of principal reasons for such request is because it was not easy for tax auditors to verify the data base of another state. However, the situation has been changed with the introduction of BEPS Project. Under the BEPS Project system, MNEs should submit their BEPS reports to all related tax authorities.  

MNEs are now filing their BEPS Project report in a various way. A certain MNE files its BEPS Project report using “local data base” and another MNE files its BES Project report using “global data base.” Therefore, there could be a substantial difference between “local data” and “global data” in terms of analysis result (interquartile profit ratio).  

MNEs (or their professional firms) generally perform a statistical analysis by manual work. In case where MNEs perform a statistical analysis by manual work, they should invest substantial time on their analysis work.  

Analysis work consists of several steps as follows: 1) selection of SIC, 2) download of necessary data, 3) selection of proper data, 4) application of elimination criteria and selection of comparable companies, 5) capital adjustment on selected comparable companies, 6) review of capital adjustment result, 7) drawing up of appendix. Especially steps 3), 4), 5) and 7) require substantial time.  

When it comes to 5) capital adjustment which especially requires a lot of time, MNEs use the excel sheet templet for it and the excel sheet work requires a lot of time. In addition, the accuracy of analysis is not guaranteed in case where there are many comparable companies which require a capital adjustment.  

Where a MNE uses “global data base”, the number of comparable companies naturally increases compared to “local data base” because the area of data base is broad. Thus, the number of a comparable company increases and capital adjustment work becomes more and more difficult and complex. Also, the accuracy of capital adjustment is not guaranteed because manual work on many comparable companies necessarily causes errors.  

If a MNE should perform the statistical analysis whenever tax authorities tackle the statistical analysis result, it would be a big burden. Tax authorities should also spend a lot of time in order to review the appropriateness of analysis result.  

The inserted table clearly shows a difference between automatic data analysis work and manual data analysis work in relation to the steps 3), 4), 5) and 7). 

In case of automatic analysis, a MNE spends substantial time only on the selection of proper data (comparable companies). Once the proper data is selected, the steps 4), 5) and 7) are performed automatically. An analysis worker just clicks buttons or inserts figures on the screen in order to fulfill a necessary step. Once the analysis work is finished, the appendix which contains the details of analysis work is made automatically.  

Let’s assume that a MNE uses an automatic analysis tool above and submit its analysis result to related tax authorities by an electronic system and tax authorities have the same automatic analysis tool. Further assume that a MNE chose 50% ownership and 3% R&D expense/net sales. However, a certain tax authority argues that a MNE should have chosen 70% ownership and 5% R&D expense/net sales.  

In that case, it is possible for a MNE and tax authority to efficiently review the submitted file. Both parties can discuss the issue by a conference call. Once tax authority changes elimination criteria chosen by a MNE using an automatic analysis tool, tax authority can immediately confirm an analysis result under the changed elimination criteria. Thus, both parties can discuss the issue efficiently within a very short time. Likewise, where disputes between tax authorities take place, they can discuss the issue efficiently.  

In case where a MNE performs a TP analysis by using an automatic analysis tool, the analysis process is stored within an automatic analysis tool and can be easily confirmed anytime.  

Let's assume that a MNE performed a TP analysis by an automatic analysis tool and submitted it to tax authority in December 2018, and then tax authority performs a tax audit on this MNE 5 years later, that is, in the year 2023. In that case, tax authority can easily confirm the analysis process (and its result) which was done in December 2018 5 years later. The analysis result made in the year 2018 is stored in the computer (automatic analysis tool) and is not changed.  

On the other hand, the manual analysis work by an excel sheet is very complex and thus it is very difficult for tax authority to confirm its details and errors. Thus, there is a high possibility of dispute between taxpayers and tax authorities and both parties must consume a lot time to resolve the dispute.  

What is more, in case where tax authorities receive a unified electronic data from all MNEs, it is possible to efficiently manage cross-border transactions by comparing and analyzing the submitted data. 
Thus, the international community needs to actively discuss the introduction of automatic analysis system in order to increase the transparency and reasonableness of cross-border transactions and eliminate the unnecessary tax disputes.
  • Google digital tax & tax war
Publication Date
Winter January 25, 2019
Citation Information
Sung-Soo Han. "Undesirable Google Digital Tax & Tax War.docx" National Tax Newspaper of Korea (2019)
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