Different states and governments have slightly different definitions of what their state’s Nexus Rules are, and when a business meets the threshold of being taxed by that state or government (such as value of sales or a certain amount of transactions done within a particular timeframe).
Companies with large international presence that have both strong physical presences often outsource quite a number of their operations to different geographic locations. Through digital means, they can essentially make a large economic presence on the other side of the world, while being headquartered in a completely different country.
The question that arises is how are taxing rights allocated between different jurisdictions? An example scenario mentioned in a report by the OECD illustrates the issue:
“…some highly digitalised business models may solicit substantial contributions to, and active utilisation of, a web-based platform by a jurisdiction’s residents, generating substantial value for a business but, under the current tax rules, that jurisdiction may not have a taxing right over any of that business’s income. Some of these business models may facilitate large numbers of transactions between persons within the same country, similarly generating value for the business without creating any taxing right for the user or market jurisdiction – notwithstanding the highly localised impact of the utilisation of the platform. This “remote” participation in the domestic economy enabled by digital means but without a taxable physical presence is often seen as the key issue in the digital tax debate.”
Businesses that with arrangement similar to this example are often classified as “scale without mass”, meaning they have the ability to scale their business growth, without the consequences (good or bad) of having a large physical presence.
Businesses that rely heavily on intangible assets
Intangible assets are things of value that don’t actually have no “physical” form. An example is patent of an invention of a new product, copyright, license, trademark, among others. Traditionally, a factor in determining the jurisdiction of a business also played heavily on the assets that business has. With the digitalization of economies, a large growth of intangible assets such as market awareness, consumer relationships, brand presence and sentiment, etc. are all valuable assets but there may be multiple jurisdictions that may or may not have taxing rights over the benefits accruing to the owner.
Potential solutions to digital economy challenges
In determining a solution for the above discussed challenges, the OECD suggested three options:
• The “user participation” proposal
• The “marketing intangibles proposal”
• The “significant economic presence” proposal
The “user participation” proposal
It is evident that the value of a business often depends on the participation of the business’s users, especially for large digital companies. This is often referred to as a “network effect” in that a company becomes more and more valuable the more active users it has.
An example of this is social media platforms such as Facebook. Would the platform be as valuable if your friends and family weren’t using it?
Currently, this added value to a business is not taken into account under current tax rules and regulations. Current regulations focus mainly on the physical activities of a business in determining where profits should be allocated, and which governments have taxation rights.
This proposal suggests that allocation of the added value derived from large and active user bases be allocated according to the activities of active users based on their geographical location. Should a particular geographical location have a highly engaged user base, that government may have jurisdiction of the value brought to the business from those users.
Because of the ability to grow a large user base in nearly any part of the world without having an actual physical location, this proposal would not require a company to have a physical location present in a jurisdiction before such jurisdiction exercise its taxing rights over the applicable income. If the user base is large enough in that area, then value is provided to the company and is derived from a large audience of that governing jurisdiction.
The “marketing intangibles” proposal
Companies today, as mentioned by the OECD, “…can essentially ‘reach into’ a jurisdiction, either remotely or through a limited local presence, to develop a user/customer base and other marketing intangibles.” Based on this capability provided to businesses from innovative technology, the marketing intangibles proposal suggests that marketing intangibles and associated risks would be allocated to the market jurisdiction in which they reside.
The “significant economic presence” proposal
This proposal suggests that when a non-resident business has a noticeable presence, making a significant impact to the economy and a large awareness to consumers, it will have established a taxable presence. According to the OECD report, the main deciding factor will be the “revenue generated on a sustained basis.”
In addition, the proposal suggests that it would only work without the defined Nexus rules. In place of following the Nexus rules, the following factors would be taken into consideration when determining jurisdiction :
1. A solid user base – does the company have a strong user base in that geographic location?
2. The amount of digital content that comes from the jurisdiction – Are users in that geographic location active, providing large amounts of intangible asset growth for a digital company? How much of the company’s content is catered to cultures and individuals of certain areas internationally?
3. The amount of billing and collections in the local currency or local form of payment – How much of the billing and collections from a company’s user base is coming from each geographic location?
4. Is a website in the local language maintained consistently? – The presence of a website in the local language suggests a focus on, and highly valued geographic location. This suggests which geographic area has jurisdiction for taxation laws and profit sharing.
5. The responsibility of goods delivered to consumers including after sales services, repairs or maintenance – How much work is being done upon the “final delivery” of a good or service is being done in each geographic presence? This includes customer service and maintenance of a digital company’s user base.
6. Are there sustained marketing and sales activities to attract local customers? – This goes along with the geographic presence. A company that focuses marketing efforts heavily in one location, suggests that they are growing their intangible assets, brand awareness, and user base in that area as well.
Based on a business’s presence and response to the above questions, it should be easier to determine the jurisdictions that have taxing rights and how the profit should be allocated.
Conclusion
It seems as though an economic cycle where drastic change occurs happens just about every 10 to 20 years. Economic changes like the industrial revolution, the dotcom economic boom, and the current digitization the economy are the reasons why tax laws and fiscal framework needs to be updated regularly. The idea is not to find out how to tax businesses and make them grow slower due to higher taxation costs, but rather to properly tax a business to support the related government jurisdictions that are providing value to that business.
With the drastically different laws and regulations of each country, state, city or province, it makes it a difficult task to find a common ground where all parties are credited with the proper value provided to large digital companies. Naturally, as large companies seek to reduce their expenses and increase their profits, digital technology has enabled large enterprises to take advantage of different tax laws.
As the growth and transformation of the digitalization of economies progresses, it’s apparent that the future holds potential major changes to how local governments define jurisdiction and are able to tax the income of digital-based companies. It’s also apparent that physical presence of a company or product is becoming less and less of a factor in deciding what laws that company abides by. Rather, the digitalization of economies suggests that laws and jurisdictions will be based on the presence of a company’s intangible assets and local active user base.
Funke Oladoke and Victor Adegite Adeloye
Funke Oladoke is an associate director and Victor Adegite is a senior manager KPMG Advisory Services, Lagos Nigeria. The authors can be contacted at: [email protected] and [email protected] respectively
