New Tax Planning for Your Digital Business

Two recent developments in the news should get you thinking about what if….

Domestically, the U.S. Internet Tax Freedom Act (“ITFA”) will expire on December 11, 2014, unless Congress passes another extension.   ITFA, enacted in 1998 to encourage the growth of internet access and e-commerce, has already been extended three times, the last time in 2007.  It essentially prohibits any new direct taxation by state and local governments on internet access, multiple taxes on internet transactions (can’t be taxed twice by different jurisdictions) and discriminatory taxes (same tax rate must apply for both online and its physical counterpart) on online transactions.  A permanent ITFA was passed by the House in July, 2014, but has been held up in the Senate, politics being what it is.  ITFA was due to expire November 1, 2014, just prior to Election Day, but was kindly extended by Congress to December 11 for obvious reasons. 

So what if it is not extended or made permanent:

1)    Consumers and businesses alike would be hit by higher taxes in its usage and access to the internet.
2)    Higher taxes may restrict the ability of (moderate to lower income) consumers to access the internet, thereby reducing e-business sales and profits, affecting the nationwide economy.  Dissemination of information on the internet would suffer as well from lack of access.
3)    Services, such as e-mail, may be subject to taxes, taking a bigger bite of everyone’s budget.

Although it is likely to be extended, e-businesses need to be prepared for the possibility of higher taxes, going forward.

Internationally, on October 29, 2014, the OECD and G20 countries endorsed a new standard for the automatic intergovernmental exchange of financial and tax information, which will usher a new era of international financial transparency, beginning in 2017.  As one of the policies to prevent “artificial” “base erosion and profit shifting” (BEPS), the standard follows the US model of adopting information exchange treaties to identify all financial transactions of its citizens globally, where foreign governments become the willing enforcement mechanism for U.S. tax law.   See http://www.oecd.org/ctp/beps-2014-deliverables-explanatory-statement.pdf.  and recent press release by oecd.

…, [I]t is also recognised that the business models and key features of the digital economy exacerbate BEPS risks and therefore must be addressed. It is expected that the other actions will address these risks but at the same time a number of specific issues have been identified which must be taken into account when doing the work (permanent establishment issues, importance of intangibles and use of data and possible need to adapt CFC rules and transfer pricing rules to the digital economy). A number of broader direct tax challenges have also been analysed, such as the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus and further work will be carried out to evaluate their scope and urgency and potential options to address them. Finally, challenges in the area of indirect taxes in relation to business to consumer transactions have also been identified and will be addressed by 2015.  OECD, BEPS report, p. 8 (see above).

And Ireland has bowed to international pressure to eliminate the “Double Irish” corporate tax loophole, which allows an Irish-registered subsidiary to send royalty payments for intellectual property to another that resides for tax purposes in a country with no corporate income taxes (such as Bermuda).

So, what should the ordinary e-business do to simplify business and minimize compliance problems?

    First, you can’t hide.  As an “ultimate beneficial owner” (“UBO”), you should forget any hope of confidentiality of your ownership interests in any legal entity.  While American corporate laws do not require reporting of ownership to local Secretaries of State, tax laws do.  Under the OECD/G20 standard, you can’t hide behind a foreign holding company.  

    Second, develop strategies for workforce deployment and outsourcing.  Learn about “form vs. substance” and the principles of what constitutes a taxable nexus.  Anticipate that transferring intellectual property to a tax-favored holding company might not work unless it is in the same jurisdiction as your innovative employees who create the IP.  This principle will encourage smaller companies to outsource new product development since outsourcers normally assign IP rights across borders without much tax complexity. 

    Third, refocus on transfer pricing and be reasonable.  The new rules invite governments to tax more.  As governments get more active in adopting a new template for country-by-country reporting and challenging transfer pricing, businesses can consider collective action through trade associations to define standards for transfer pricing levels.  (Of course, exchanging of pricing information smells of concerted monopolism, so this would need some care to avoid crossing the line into anti-competitive conduct).

    Fourth, ask your portfolio companies what they are doing and how they are adapting.     

    Finally, rethink your game plan for tax compliance and eventual tax audit.  Maybe your internal analysis on allocation of value-creation and taxable revenue streams could be programmed into a software model that you could sell on the market.  After all, compliance costs for everyone will only increase, and you could recover your investment. 

Every pain enables someone to gain.  No pain, no gain.