Do we have the wrong tax system for thedigital economy?Alf Capito, Tax Policy Leader, EY Asia PacificJuly 2014

Key features of the digital economy as seen by the OECD taskforce

Do we have the wrong tax system for the digital economy?Page 2

Mobility

Reliance on data

Network effects

Multisided business models

Monopoly or oligopoly

Volatility

The key layers of the digital economy

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Data centers Data centers Data centers

Infrastructuresoftware

Core software

Access

Applications

User interface

Multiple software programs providing services to end users

Multiple software programs allowing the creation, combination and connection of end-user applications

Evolving world of connected devices

Core software programs allowing data collection and data storage

C2C or B2C environments B2B environmentsUsers

Bifurcation of business processes and inputs drivingglobalisation

Do we have the wrong tax system for the digital economy?

Localisation of functions and processes

People functions Assets and risks Capital

Form-over-substance versus substance-over-form

Tension between “central control” and “local independence”

Transfer pricing

Central managementand central control

PEs

Local independenceand local execution

CFC rules

Actual involvementin business processes

HQ

Supplier Entrepreneur

Production R&D Services Distribution

Customer

Warehouse

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Case StudyAllocation of functions in a global accounting firm

Do we have the wrong tax system for the digital economy?

Functions – transfer to other jurisdiction Topics

Transfer of functions asqualitative business reason

Assessment of allocation offunctions or assessment of

transactions only

Form-over-substance versussubstance-over-form

Global

Global Accounting andTax Shared Service

Centres

Thought Leadership andGlobal Marketing Accounts ReceivableGlobal Operations

Australia New Zealand

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The current state of international taxation principles specificallyconcerning the digital economy

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Changesintroducedto modelconventionand itscommentaries

Article 5 Commentaries 42.2 and 42.3:a website cannot constitute a PE, nor canthe hosting of such a website on a server

Article 12 (Royalties) Commentary 17.1:principles expressed on softwarepayments are also applicable as regardstransactions concerning other types ofdigital products

Article 12 Commentary 11.1: know-howcontract involves imparting to other partyspecial knowledge and experience whichremain unrevealed to the public

Article 5 (PE) Commentary 42.2:automated equipment may constitute aPE

Addressing Tax Challenges of the Digital Economyincorporates all BEPS themes

1. Address the Tax Challenges of the Digital Economy2. Neutralise the Effects of Hybrid Mismatch Arrangements3. Strengthen Controlled Foreign Companies Rules4. Limit Base Erosion via Interest Deductions and Other Financial Payments5. Counter Harmful Tax Practices More Effectively, Taking into Account Transparency

and Substance6. Prevent Treaty Abuse7. Prevent the Artificial Avoidance of PE Status8. Assure that Transfer Pricing Outcomes are in Line With Value Creation / Intangibles9. Assure that Transfer Pricing Outcomes are in Line With Value Creation / Risks and

Capital10. Assure that Transfer Pricing Outcomes are in Line With Value Creation / Other High-

Risk Transactions11. Establish Methodologies to Collect and Analyse Data on BEPS and the Actions to

Address It12. Require Taxpayers to Disclose Their Aggressive Tax Planning Arrangements13. Re-examine Transfer Pricing Documentation14. Make Dispute Resolution Mechanisms More Effective15. Develop a Multilateral Instrument

Coherence

Substance

Transparency

Page 7 Do we have the wrong tax system for the digital economy?

Benefits of the multilateral trading systemUnilateral action (tax base land grab) creating new tariffs

Fundamental WTO principle that open trade and an open economy unlock thebenefits of the multilateral trading system► Liberal trade policies (policies that allow the unrestricted flow of goods and

services) sharpen competition, motivate innovation and breed success► Temptation to ward off challenge of competitive imports always present

(subsidies, complicated red tape, legitimate policy objectives)London Model (1945), OECD (from 1968) and UN (from 1980) Models► Merely selling into a market without physical presence or a dependent agent

within the market is not sufficient to create a permanent establishmentallowing that country to claim a share of the enterprise’s profit

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According to the OECD, tax features of the digital economy exacerbate thepossibility of BEPS activities

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Marketjurisdiction

Principalintermediatejurisdiction

IP HoldingCointermediatejurisdiction

ForeignHoldingCo

intermediatejurisdiction

Parentjurisdiction

Ultimate parent

Holding entity

IP principal

Customer principal

Market developmentsupport Co

Direct revenues from clientsBEPS

Action 7Artificial

avoidanceof PE

BEPSAction 6Prevent

treaty abuse

BEPSAction 5

Harmful taxpractices BEPS

Actions 8–10Assure that TP

outcomes are inline with value

creation

BEPSAction 4

Limit interestdeductions

BEPSAction 9

Unusual capitalfunding

BEPSAction 3

ReinforceCFC rules

BEPSAction 2

Eliminate hybridmismatch

arrangements

Ultimate parent

IP principal

Customer principal

Market developmentsupport Co

Direct revenues from clients

Holding entity

The broader tax challenges raised by the digital economy and potentialoptions discussed by the OECD taskforce

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Where appropriate if BEPSactions were insufficient

Country-by-country reporting

Country-by-country reporting

► Modifying exemptionsunder paragraph 4of Article 5

► New nexus by reasonof significant digitalpresence

► Withholding tax ondigital transactions

► Consumptiontax option

► Virtual PE

► Nexus and abilityof significant economicimpact without beingliable to tax

► Value of marketablelocation data

► Characterization ofincome under newbusiness models

► VAT and consumptiontaxes

Will the Ottawa Conference principles really survive the forthcomingchanges?

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Neutrality

Efficiency

Certainty and simplicity

Effectiveness and fairness

Flexibility

Certainty and simplicityCurrently uncertainty prevails

74% of the largestcompanies say they feelthat tax administratorsare now challengingexisting structures dueto changes in the law orchanges in theirenforcement approach.

When asked to what extent theyforesee more double taxation fortheir company in the next twoyears, 61% of the largestcompanies expressing an opinioneither agreed or strongly agreed.

30% of large companies think the situation will be characterizedby relatively limited coordinated action and more unilateralactions by countries.`

www.ey.com/taxriskseries

Page 12 Do we have the wrong tax system for the digital economy?

Australia’s tax system already strong

► CFC rules undermining ability to create global hubs without substance► Transfer pricing rules very tight to the point of being dangerous by allowing

hypothetical reconstruction► Tight thin capitalisation rules► No IP regime or patent box concession► Interest withholding tax► General integrity rule in new treaties and GAAR

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Thank you