Date posted: 21/05/2019 8 min read

Tax in throes of catching up with digital age

What was originally a narrow discussion on how to tax digital services has morphed into a wide-ranging one on how countries carve up tax revenues on international business profits.

In brief

  • The international tax system is finally adjusting to the digital age
  • Changes may not favour commodity export-based economies such as New Zealand’s
  • Government wants to proceed with go-it-alone digital services tax (DST), but CA ANZ says we should focus on collaboration with other small trading nations at OECD

Tax, as well as time, has caught up with the bricks and mortar-based business model.

Like traditional businesses adapting to online commerce, the international tax system is finally having to adjust to the digital age. And possibly in ways that may not be favourable for commodity export-based economies such as New Zealand’s.

Taxation based on source, and bricks and mortar – known as permanent establishment (PE) – has served the global economy well since the 1920s, but it is becoming out dated as a basis of tax allocation.

The PE model relies on a fixed place of business, or people carrying out activities in a jurisdiction as a basis for taxation.

This way of working is being challenged by the evolving industries, including digital services companies, based as they are on scale without physical mass and with a heavy reliance on intangible assets, data and user participation rather than actual purchases.

And crucially their value is created by activities in jurisdictions or markets where they have no PE.

What’s happening

There are a number of options being considered as countries scramble to work out how to re-slice and share the international tax pie in a non-PE world. 

At the moment OECD discussions are proceeding under the innocuous banner of digital taxation, but their scope and intent is much more far reaching.

Crucially for commodity exporters such as New Zealand, what was originally a narrow discussion on how to tax digital services, has morphed into a wide-ranging one on how countries carve up tax revenues on international business profits.

The OECD has called for public input into the tax challenges of digitalisation that flowed out of discussions on how to counteract multinationals exploiting gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. 

At the moment the organisation is considering a number of options including possibly heading down the path of allocating a right to levy taxes based on brand values and marketing intangibles in offshore markets – a customer-centric approach to update the current PE one.

"The New Zealand Government also needs to stop and think whether the risks of going-it-alone outweigh the estimated $30-80 million in revenue a DST would bring in."
John Cuthbertson, NZ Tax Lead

The dangers of this line of thinking to commodity exporter nations are obvious, with companies like Fonterra and Zespri facing paying some of their taxes in their markets, shifting part of our tax base offshore.

Three proposals are being considered at the OECD:

  • A “user participation” proposal to tax digital service providers such as social media platforms, online marketplaces and search engines which is favoured by the UK. This is the proposal many see as the state of play.
  • A “marketing intangibles option” is the US’s preferred option, and the preferred option overall. This proposal has a much wider scope and addresses situations where multinationals can “reach into” other jurisdictions remotely, or through a local hub, to develop marketing networks and customer bases. For example, a large exporter based in New Zealand would be deemed to “reach into” China by advertising heavily in that market, and as a result has a large customer base there without needing physical staff or buildings in China. The scope of this proposal is important when taking into account recent research which suggests intangibles make up 87% of a business’s value – up from just 17% in the 1970s (based on the US stock market). 
  • A G24 developing countries option based on the concept of “significant economic presence”. This view says technological advances which enable heavy involvement in a jurisdiction without physical presence have rendered existing profit allocation rules ineffective. However, it is not clear how this approach would work in practice and a number of factors could be considered when deciding whether an organisation had a ‘purposeful and sustained interaction’ in a jurisdiction. 

Some governments, including New Zealand’s, have decided to have a look at going it alone ahead of an OECD decision. In February, the New Zealand Government announced it would consult on the design of changes to tax rules which allowed digital services multinationals to do business in New Zealand without paying income tax. A discussion document is due out in May. 

The Government said it preferred to keep working with the OECD, but wanted to proceed with its own form of a digital services tax (DST), at least as an interim measure till the OECD reached agreement.

The OECD may not reach a quick decision, if at all, given the size of the stakes, the number of countries involved, the different types of economies and the inherent complexity of the issue. 

As well as New Zealand, India, France, Spain, Italy, Korea, Austria, Australia and the EU have at one time or another indicated an interest in enacting DSTs. 

Cold feet

Some of these countries are getting cold feet. Ireland for example saw a risk of the OECD proposals extending to tangible goods and, along with Germany, signalled concerns that proceeding with a form of digital taxation outside of the OECD group may risk retaliation from other jurisdictions in the form of tariffs or levies. As a result, both nations focused solely on a multilateral response. Part and parcel of DSTs are the risks of double taxation and breaching trade agreements and World Trade Organisation rules.

Australia and the EU have now also seen the dangers and pulled back from go-it-alone digital services taxes.

The New Zealand Government also needs to stop and think whether the risks of going-it-alone outweigh the estimated $30-80 million in revenue a DST would bring in. It currently looks to be a case of a clear and present danger with large ramifications versus what is a relatively small amount of money.

New Zealand should focus on the main event – the OECD discussions.

Our time would be better spent developing and executing a strategy for NZ Inc in OECD discussions. We should be looking to collaborate with like-minded, similarly impacted, small trading nations, presenting a uniform strong voice at OECD deliberations to ensure we get a good result for the country.

Over two hundred submissions were made to the OECD during public consultation on the tax challenges of digitalisation. 

Two interesting themes were apparent across these submissions. Firstly, almost all submitters called for international agencies to adopt a multilateral approach, with some submitters going as far as to call for any unilateral digital services taxes to be revoked once an OECD consensus is reached. Secondly, the observation was made by many that focusing on digital services companies does not reflect the increasingly globalised business environment and due to the difficulties in defining digital service providers risks penalising one area of business for practices which are now common across all industries. Others were concerned this limited scope would also create additional compliance and administration burdens. 

These themes are not new. Inland Revenue made the same observations back in 2001 when the ‘tax challenges of e-commerce’ were first being addressed. Robin Oliver, then the GM of Inland Revenue’s Policy Advice Division said: “First, e-commerce should not receive special tax treatment. By this I mean that e-commerce should be treated neither more favourably nor less favourably than other forms of commerce. It is the neutrality of treatment principle. Second, there is a need to achieve an international consensus on the application of tax rules, with the aim to adapt the current principles, without changing the core rules.”

The Government may be well advised to keep these old principles in mind. 

I recently returned from the Global Accounting Alliance Tax Directors Meeting in Hong Kong and China. Discussions at the meeting noted that there are a range of challenges with each of the approaches before the OECD, least of all that different countries will favour a different approach. 

While China has to date been silent on their position, over 50% of their economy is now digital and support for the US model is quickly gathering momentum. These discussions are fast tracking the international taxing rights debate and smaller nations such as New Zealand need to be sure our voices are heard before the momentum gets away from us. 

The costs of failure will be borne by all New Zealanders.

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