Today, many companies use the internet as a distribution channel to offer consumers a variety of digital goods and services. Consumers with smartphones can shop for clothing online or download their favorite flick with the click of a button. Many consumers have replaced file cabinets with the "cloud" (1) to safeguard and access their data. The rapid development of the digital economy has created significant challenges with respect to the taxation of cross-border transactions involving digital goods and services. This article provides a summary of the evolving international landscape and an introduction to certain technical U.S. federal tax issues associated with the digital economy.
Recent Changes in International Tax Rules
In recent years, policymakers and legislators from across the world have taken a number of steps to address the challenges of taxing the digital economy. In some cases, countries have enacted legislation unilaterally, and, in other cases, the rule changes are the result of collective effort. For example, in 2013, the Organisation for Economic Co-operation and Development (OECD) published an action, "Addressing the Tax Challenges of the Digital Economy" (Action One), as part of the "Action Plan on Base Erosion and Profit Shifting" (2) (BEPS Action Plan) that focused specifically on digital business models. Action One recognized several issues that presented base erosion and profit shifting (BEPS) concerns. These issues included 1) a company's ability to have a significant digital presence in the economy of another country without being liable to tax due to the lack of nexus under existing international rules; 2) the attribution of value created from the generation of marketable location-relevant data through the use of digital goods and services; 3) mechanisms for properly characterizing income derived from new business models and applying related source rules; and 4) ensuring the effective collection of indirect taxes with respect to cross-border offerings of digital goods and services. (3) The BEPS Action Plan recognized the need to form a dedicated task force on the digital economy. (4) In response, the OECD Committee on Fiscal Affairs established the Task Force on the Digital Economy (TFDE) to examine these issues and develop detailed options to address them. (5)
In 2014, the TFDE, with the OECD, released an interim report on Action One, where the TFDE recognized a number of specific challenges (6) linked to the digital economy, potential direct tax and indirect tax options, (7) and identified the steps it would take in tackling these issues. The TFDE agreed to employ a framework based upon the basic tax principles of neutrality, efficiency, certainty, fairness, flexibility, and proportionality. (8)
Subsequently, in 2015, the TFDE released its final report on Action One, where the TFDE provided its conclusions (9) and recommendations for addressing the BEPS challenges raised by the digital economy. (10) Significantly, the TFDE did not recommend that countries adopt specific direct-tax options, such as alternatives to the existing PE threshold (i.e., significant economic presence) or the imposition of withholding taxes on certain types of digital transactions or equalisation levies, because of ongoing work being carried out under other BEPS Actions (e.g., Action Seven). (11) The TFDE noted that countries could introduce such options in their domestic laws as additional safeguards against BEPS provided they respect existing treaty obligations or bilaterally agree to include such options in their tax treaties. (12) The TFDE recommended that countries should apply the principles of the OECD's International VAT/GST Guidelines and consider introducing the collection mechanisms contained in such guidelines, particularly with respect to cross-border business-to-consumer transactions. (13) Seemingly buoyed by the recommendation, numerous countries have implemented extraterritorial VAT regimes that impose indirect taxes on remote suppliers of electronic services. (14) To this day, the OECD and TFDE continue to monitor developments in the digital economy. (15) The OECD and TFDE recently announced their intent to publish an interim report in April 2018, which will focus on identifying long-term issues and assessing the consequences of countries acting unilaterally. (16)
In recent months, there has been a growing buzz in the EU with respect to the taxation of digital companies doing business in Europe. Finance ministers from France, Germany, Italy, and Spain have supported implementing an "equalisation tax" on the "turnover generated in Europe by the digital companies." (17) Essentially, this tax would be imposed "at the source," i.e., the location where payment is made, rather than where the digital company makes the supply. (18) Subsequently, the European Commission released a communication, "A Fair and Efficient Tax System in the European Union for the Digital Single Market," where it outlined weaknesses in the international tax rules for digital transactions and recommended short-term fixes to address these problems. (19) The EU commission expressed its concerns that the current rules no longer fit the modern context, for example, where businesses rely on hard-to-value intangible assets, such as data and automation, to facilitate cross-border online trading without the need for physical presence. (20)
A number of unilateral measures taken by countries have attempted to address BEPS concerns. (21) While some of these unilateral measures (such as the diverted profits tax (22)) affect digital and nondigital companies alike, in some cases digital companies have been the express or implied targets of such legislation. Among the unilateral measures that directly target the digital economy are taxes directly on specific digital services, (23) and special characterization and sourcing rules applied to digital transactions. (24)
Taxation of Cross-Border Transactions
In determining whether and how tax should be imposed on transactions involving digital goods and services, a threshold question is what degree of nexus is required for a country to be able to tax such transactions. (25) To illustrate, if a consumer who resides in the United States downloads a mobile application that was designed by a company in Brazil that owns and operates servers in the United Kingdom, which country is entitled to tax the download? The right of each country to impose tax depends on the character of the transaction and the income derived therefrom, as determined under domestic law, but with each country's taxing jurisdiction potentially limited by the application of an income-tax treaty. Most domestic law taxing regimes apply principles that focus on either the source of the income or residence of the taxpayer.
If a provider of digital goods and services has sufficient nexus to be taxed in the source jurisdiction (often referred to as a permanent establishment (26) (PE) in that country), the person generally would be subject to tax on a net basis and be required to comply with local registration and reporting requirements. Most income tax treaties embody this principle, that the source country has jurisdiction to tax a nonresident with a local PE, but only to the extent of the business profits attributable to the PE. Even if the provider does not have a PE, the provider's income may nonetheless be subject to local withholding tax on a gross basis (an applicable treaty might reduce the rate of withholding or even exempt such income from withholding). (27) Finally, most countries have indirect taxes, such as value-added taxes, that may also apply to payments for digital goods and services.
Key Technical Considerations
* Cloud Computing, Servers, and Websites--Digital companies often use the cloud to deliver a variety of different products and services to their customers. This includes hosted software, storage, and processing hardware infrastructure, and hosted platforms that allow developers to create applications or other programs. A familiar cloud service model is software as a service (SaaS). (28) As discussed in more detail below, a key distinction is between SaaS and software itself. This is important because each gives rise to a different character of income and, therefore, might be governed by a different set of tax rules to determine how the transaction will be characterized for U.S. federal tax purposes.
SaaS solutions are typically delivered to a consumer over the internet for a fee. In most cases, the customer has restricted access to the software enabling the SaaS solution. In contrast, software as a product in and of itself can be delivered on a tangible medium, such as a CD or USB, or a customer might be able to download a copy of software from a master file that otherwise is hosted remotely. In most cases, whether software is accessed as SaaS, or on tangible media, or via download, the customer will typically have to agree to the terms of a license to use the software.
Providers in the area of electronic commerce may deploy hardware and software in one or more locations to supply digital goods and services to customers in yet another location, raising the question of whether the provider should be taxed in the jurisdiction in which its employees are located or where the hardware or software elements are located. In this context, a distinction should be made between websites and the servers that host them. Websites generally do not constitute PEs under OECD treaties because they lack a tangible physical component and, therefore, do not use a location that can constitute a "place of business." (29) In contrast, a server on which the website is stored and through which it is accessible is a piece of equipment having a physical location, which could constitute a "fixed place of business" for the company that owns and operates the server if the physical premises are at the disposal of the operator...