Broader direct tax challenges
In our 23rd article in a series of articles on the tax challenges of the digital economy, we shall be providing you hereunder with a brief overview on the third and last category of the main policy challenges raised by the digital economy i.e. the characterization of income derived from new business models.
New business models raise new questions about how to characterize certain transactions and payments, both for domestic law and also for tax treaty purposes. For example cloud computing has developed significantly over the past years and the character of payments for cloud computing is not specifically addressed in the commentary to the OECD MC.
The question for tax treaty purposes is often whether such payments should be treated as royalties (particularly under treaties in which the definition of royalties includes payments for commercials, industrial or specific equipment where rentals of space on the cloud service provider’s servers is being provided), fees for technical services (under treaties that contain specific provisions in that respect) or business profits.
Under most double tax treaties, business profits would only be taxable in a country if there is sufficient physical presence leading to a permanent establishment and only those profits which would be attributable to such a PE would be taxed. On the other hand, other income such as for example royalties may be subject to a withholding tax in the country of the payer, depending on the terms of the applicable treaty. Thus whether a transaction is characterized as business profits or as any other type of income such as for example royalties, can result in a different treatment for tax treaty purposes. Thus the need to clarify the application of existing tax rules to some new business models.
In addition, issues of characterization have broader implications for the allocation of taxing rights for direct tax purposes. If a new type of business is able to generate business profits without a physical presence that would give rise to the level of a PE, the characterization of such income will have an effect on how such profits are allocated between the source and the residence jurisdiction. If characterized as business profits, the source jurisdiction will be able to tax such income in one way while if the income is characterized as royalties, the source country may be able to tax such income by means of a reduced withholding tax depending on the application of the relevant tax treaty.
In our next article, we shall be focusing our attention on the options to address the broader direct tax challenges of the digital economy.