OECD Updates

1. Valuation of intangibles in the area of Transfer Pricing is a contentious issue and is subject to debate. The OECD met with business commentators on the valuation of intangibles for transfer pricing purposes for a seamless and consistent application of the valuation techniques. The objective is to make sure that the Transfer Pricing valuation is done in accordance with the arms length principle. The meeting is reported here.

2. The Global Forum of Transparency has added Ghana, Georgia and Nigeria to its member list (see here). OECD reports that the pressure has been kept up on the global fight against tax evasion. The updates are available here.

Tax Information Exchange Agreements

Exchange of information between the tax authorities of states can be done through Double Taxation Avoidance Agreements (DTAAs) and Tax Information Exchange Agreements (TIEAs).

Tax Information Exchange Agreements (“TIEAs”) are generally bilateral agreements under which territories agree to co-operate in tax matters through exchange of information. The OECD Global Forum Working Group on Effective Exchange of Information (“the Working Group”) is the organization behind the development of the TIEAs. Various low tax jurisdictions such as Bermuda, the Cayman Islands, Cyprus, the Isle of Man, Malta, Mauritius, and the Netherlands Antilles form a part of the Working Group. The mandate of the Working Group was to develop a legal instrument that could be used to establish effective exchange of information.

TIEAs are intended for use with countries where DTAAs are not considered appropriate. They are entered into with jurisdictions which levy very low or no tax at all. Thus, it enables the tax authorities to exchange information on specific points. The corresponding article in a DTAA is modeled similar to Article 26 of the OECD Model Convention on Income and Capital.

Governed by the terms of the agreement, the requesting party generally would furnish the following information:

• the identity of the taxpayer/person under examination or investigation;
• the period for which information is requested;
• the tax purpose for which the information is sought;
• Grounds for believing that information is held in requested state;
• Name and address of person believed to be in possession of requested information;
• Statement that request is in conformity of law and administrative practice of applicant state;
• Statement that request is in conformity of law and administrative practice of applicant state;

This information would be then processed and the requested party would proceed to provide for:

• information held by banks, other financial institutions, and any person acting in an agency or fiduciary capacity including nominees and trustees, as well as;
• full information regarding the ownership of companies, partnerships, trusts, foundations and other entities and all persons in an ownership chain, including settlers, trustees, beneficiaries, founders, members of foundation council and so on, as the case may be.

It is clear that TIEAs are a positive step towards tax transparency and to bring to book, the probable offenders. As per the terms of the agreement/s, the requesting state is not required to state a ‘probable cause’ to get the relevant information. The terms used in these treaties run along the lines of the country requesting the information claiming that they believe the information to be relevant to their tax investigation. This means that the scope for seeking information is not limited, and can be sought in a variety of causes.

On the other hand, there may be a violation of the privacy of individuals as their information would be open to access by the government. Also, there is a limitation on the lines that there is no automatic exchange of information. The request document is supposed to contain a lot of information, including the purpose for which the information is sought and exhaustion of local remedies. This may then be a stumbling block to the free access of information.

Similarly, the old argument of the non-existence of an independent tribunal raises concern as to the impartial adjudicator. Though the agreement provides for a Mutual Agreement Procedure (MAP), the absence of a time limit for the conclusion of the same raises concerns. It is argued that the information may be provided too late, be outdated or worse, help the person/tax evader cover his tracks.

However, the major limitation stems from the simple fact that most low-tax jurisdictions do not maintain any financial records, nor have any norms to identify shareholders or KYC (Know Your Client) norms. The absence of information with the jurisdiction itself gives it a valid reason to avoid providing relevant information, if at all provide any information. Therefore, there may not be any information to share at all!

As is seen from the limited practice of these treaties across various jurisdictions, The Model TIEA is a slow, largely ineffectual, resource-intensive process that seems unlikely to be used much more in the future than it has been in the past, despite the increased number of haven jurisdictions adopting it. At the same time, it would be completely unfair to rubbish these treaties as a mere hogwash since these are the first steps towards tax transparency across jurisdictions.

Under the Indian laws, these agreements (TIEAs) are duly executed by the Government of India under the provisions of section 90(c) of the Income Tax Act, 1961 and are notified thereunder.

The text of the agreement as drafted by the Working Group of the OECD is available here.

OECD Updates

The OECD has come out with a report for "Tackling Aggressive Tax Planning through Improved Transparency and Disclosure".
The report provides a toolkit for those concerned with aggressive tax planning and recommends a careful review of the different approaches to inform both tax policy and compliance. The report concludes that disclosure initiatives can help fill the gap between the creation/promotion of aggressive tax planning schemes and their identification by the authorities, therefore enabling governments to proceed immediately to an assessment of the issue and its resolution. Such early detection and resolution benefits both the taxpayer and governments, including in terms of fewer routine audits, increased transparency and a positive impact on compliance culture in general.

The report is available here.

OECD Updates

The OECD has come up with the following:

1. The Transfer Pricing of Intangibles: Scope of the OECD Project on 25th January, 2011. The document can be found here. The cases in India relating to Intangibles have been very limited in number till now.

2. The Global Forum on Transparency and Exchange of Information for Tax purposes, hosted by the OECD have found that the tax laws in some jurisdictions do not meet Global Standards.

The jurisdictions are: Barbados, the Seychelles, San Marino, Trinidad and Tobago, Australia, Denmark, Ireland, Norway and Mauritius

A synopsis of the findings are available here.

Fall in Tax Collection in OECD Countries

Tax revenues fell in cash terms during 2009 in most OECD countries, driven downward by declining economic activity and tax cuts aimed at cushioning the effects of the recession that followed the financial crisis. Access the report here.

However, this was not reflected in the Indian tax collection scenario. Access the Economic Times coverage here.

Defining ‘Permanent Establishment’ in Electronic Commerce

The changing face of technology has also changed the way businesses function across jurisdictions. Transactions originate off the shore of the receiving country, yet the utilization occurs in the latter, or even in a third country. Section 9 of the Income Tax Act, 1961 in India seeks to tax such offshore transactions. However, the allocation of the right to tax is guided through the principles of the Double Taxation Avoidance Agreements (DTAA’s).

The Organization for Economic Co-Operation and Development (the “OECD”), has produced a Model Tax Convention on Income and on Capital (the “OECD Model Treaty”) which serves as a guide to treaties across jurisdictions.

Article 5 of the OECD Model Treaty defines a permanent establishment (“PE”). A PE is a concept used to determine the right of one treaty country to tax the profits of a resident of an enterprise of the other treaty country. Such profits that are attributable to the PE are subjected to tax.

To assist persons in understanding and applying the OECD Model Treaty, the OECD also publishes commentary (the “OECD Commentary”) on the model treaty. One issue specifically addressed in the OECD Commentary on Article 5 is the extent to which engaging in electronic commerce may result in a PE (See Paragraphs 42.1 to 42.10 of the OECD Commentary on Article 5, available here).

Electronic commerce is the ability to perform transactions involving the exchange of goods or services between two or more parties, using electronic tools and techniques, which includes physical telecommunications networks, cable television, mobile, and cellular networks.

The OECD Commentary states that a web site does not itself involve any tangible property, and thus, cannot constitute a PE. However, if there exists a physical location and the requirement of the equipment being fixed is met, then the tangible property may constitute a PE.

This distinction between a web site and the server on which the web site is stored and used is important since the enterprise that operates the server may be different from the enterprise that carries on business through the web site. A server is generally owned and controlled by an unrelated Internet service provider (“ISP”). A contract for such hosting services does not typically result in the server and its location being at the disposal of the enterprise carrying on a business through the web site.

Consequently, the enterprise does not have any physical presence at the location where the server is located. This is because the web site is not tangible and the server is not at the disposal of the enterprise. The OECD Commentary notes that it would be very unusual for the ISP to be deemed to constitute a PE of the enterprise carrying on a business through a web site hosted on the ISP’s servers. Generally, the ISP will lack authority to conclude contracts in the name of the enterprise conducting the web site business (and will not regularly conclude such contracts) and will constitute an independent agent acting in the ordinary course of its business. The result may be different if the enterprise carrying on business through a web site has the server at its disposal because, for example, it owns (or leases) and operates the server. In such a case, the place where the server is located may constitute a PE. The argument that a server constitutes permanent establishment has been relied upon in certain negotiations for taxation in India.^[i]

Policy Comments: The basis of the PE principle rested on the concept in the pre-digital age whereby accessing a market would require a business to establish in a host state in some form. This can now be achieved by sending bits of information via web into the host state, including exchange of payment.^[ii] The erosion of PE as a tax treaty principle has been advocated by Arvid Skaar in his book ‘Permanent Establishment: The Erosion of a Tax Treaty Principle, 1st Indian reprint, Wolters Kluver India, New Delhi, 2008.

It is clear that in the present day scenario, the use of PE as a method of taxing operations in the host state is not feasible. This is due to the growth of e-commerce as a tool of business. The High Powered Committee on Indian Electronic Commerce and Taxation, has suggested a ‘base erosion’ approach to tax non-residents. The salient features of the concept are:

• The concept is applied to all commerce and not just e-commerce.
• The tax is implemented through a low withholding tax on all tax-deductible payments to the foreign enterprise.
• Preferably, the withholding tax is final without option of tax on net income being given to the taxpayer or the tax administration.

However, this would involve the concept of indirect taxation, including customs and thus, might not be a viable concept.

A more practical concept to adopt would be the “proxy access to market” concept. Under this concept, there is a radical shift from the country of 'value creation' to the country in which the market is accessible. While creation of value can now be achieved by automated software functions bearing no relationship to geographic boundaries, the same can be said for businesses' market access efforts. This subtle distinction between "location of value-creation" and a "market access" vantage also shifts consideration away from the existing arguments about e-commerce taxing jurisdiction and stimulates greater scrutiny of the activities used by e-traders/service providers to market their products. This would benefit developing nations to tax offshore operations of business, channeled through e-commerce.

Adding this market access proxy approach to the current debate featuring arguments for either revision or preservation of the traditional permanent establishment principles, in many cases, adds increased complexity and justification to proposals advocating reform.

Under the current PE rules, producers are increasingly able to use the nebulous nature of the web to avoid or minimize tax liabilities. We shall discuss in detail how Google has achieved an effective tax rate of 2.4% through its business structuring. At the same time it also translates into revenue loss for the exchequer.

Post Scriptum: It is important to note that the rules discussed above apply only in the treaty context, i.e., where the enterprise operating the website and the ISP are located in countries that have concluded an income tax treaty based on the OECD Model Treaty. Entirely different rules can apply if there is no treaty to rely upon.

---

[i] Jonathan Rickman, Indian, U.S. Authorities Agree Server Constitutes PE, 32 TAX NOTES INT'L 134 (2003)

[ii] Arthur J. Cockfield, Designing Tax Policy for the Digital Biosphere: How the Internet is Changing Tax Laws, 34 CONN. L. REV. 333 (2002)