Digital and tax: location, location, location

June 19, 2015

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A couple of weeks ago, I wrote about the challenges of adapting the international tax regime to the digital age. One of the biggest issues that will have to be tackled is around the location of income.

As I previously said, the current tax regime dates largely from the 1920s when trade was physical and transport was slow. At that time, it was relatively unusual for companies to trade over large geographical distances, because it could be difficult and time-consuming to communicate with customers who were based elsewhere, and even more challenging to get their goods from A to B.

Today, digital business is rather different. Essential business activities can take place in an entirely different jurisdiction to customers, and it’s become much less clear where some key business activities are carried out. This is partly the result of the technology itself, and partly because it’s becoming the norm to separate the business chain into components, located in different places.

One important factor in determining which territory has the right to tax income is to look at where the contract is made. The internet has brought the ability to carry out contract acceptance through a server, which in the pre-cloud days was hosted by the company and managed by its people.

The first problem is that while it’s relatively easy to identify where digital things are happening physically (by looking for the server), the location of the digital source isn’t necessarily the same as the person controlling it. It’s not unusual for a server to be located in one country and customers in many others; but at some point, there will be some human intervention to make sure that it’s running as it should, and how relevant is that to assessing tax? The EU, incidentally, tackled this question when looking at VAT on business to consumer (B2C) digital transactions, by focussing on the location of the customer.

An even bigger complication, though, is the cloud. If you buy into the idea that it’s important where your server is located, then a virtual cloud server creates problems. What if a business opts not to have a physical server of its own, but instead makes use of cloud technology through either Software or Infrastructure as a Service (SaaS or IaaS)? Where is the contract made then?

The problem is partly that ‘virtual’ is a misnomer; the server is still real and so is each transaction – it’s only virtual in the sense that it could happen virtually anywhere. And this is why the OECD has identified cloud technology as an area needing guidance in its Digital Economy paper.

But where does this leave us in terms of tax? Do we need to force digital activities into a particular place, or do we accept that we can no longer use location for permanent establishment and transfer pricing purposes as we have been used to doing?

John Steveni | Communications Tax Leader
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