Appendix
USCIB believes that (i) the OECD’s existing discussions relating to digital transactions, as set forth in the
Commentary on Article 12 of the OECD Model Tax Convention (the “Commentary”) and the Treaty
Characterisation TAG Report, already provide a robust framework for the treatment of new business models in the digital economy, and (ii) the existing guidance should clarify the application of established principles to such new business models.
I.
Background
1.
The Action Plan on Base Erosion and Profit Shifting (the “Action Plan”) emphasizes the need for the examination of “the characterisation of income derived from new business models” in the
“digital economy.”
2.
While the Action Plan does not specifically define what “new business models” are contemplated and does not explain precisely what is meant by the term “digital economy,” both the Action Plan and the OECD Secretary-General Report to the G20 Leaders (the “G20 Report”) do allude to certain aspects of the economy that are enabled by the use of the Internet.
3.
The Action Plan indicates that one issue to be examined is “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 under current international rules”. Similarly, the G20 Report refers to “the ability to provide goods and services cross-border without a physical presence” as an issue relating to the digital economy that should be addressed; as it cautions, “the growing importance of the service component of the economy, and of digital products that often can be delivered over the Internet, has made it much easier for businesses to locate many productive activities in geographic locations that are distant from the physical location of their customers.”
4.
Second, the G20 Report states, “The spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs.
This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes.”
5.
However, the Action Plan also states, “This Action Plan is focused on addressing BEPS. While actions to address BEPS will restore both source and residence taxation in a number of cases where cross-border income would otherwise go untaxed or would be taxed at very low rates, these actions are not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income.”
6.
This Appendix, focusing on the characterization of income from the digital economy, reviews the existing OECD guidance and concludes that such guidance already provides a robust framework for the characterization of income from such arrangements. Specifically, this Appendix focuses on the question of whether income from various e-commerce transactions constitutes a royalty
(Article 12 of the Model Tax Convention) or business profits (Article 7 of the Model Tax
Convention).
7.
This Appendix focuses on situations where it is assumed that the e-commerce in question does not give rise to a permanent establishment in the country of the customer.
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II.
Commentary to Article 12: Distinguishing business profits from conventional royalties
8.
The Commentary was substantially amended in 1992 to describe the principles by which payments for computer software may be classified as royalties (a matter that the Commentary describes as “difficult” but “of considerable importance in view of the rapid development of computer technology in recent years and the extent of transfers of such technology across national borders”). These principles were further refined in 2000, 1 2003, and 2008, when the Commentary was significantly updated to confirm, inter alia, that grants of rights to distribute software products (without rights to reproduce the software) to a distribution intermediary did not give rise to royalties.
2
9.
Although Article 12(3) of the Model Tax Convention treats a royalty as business profits to the extent that the royalty arises through a permanent establishment in the relevant country and the right or property in respect of which the royalty is paid is effectively connected with such permanent establishment, this provision does not apply where the e-commerce activity in question does not give rise to a permanent establishment.
10.
In accordance with the copyright law of most OECD member countries, the Commentary recognizes a distinction between the copyright in a software program and software which incorporates a copy of the copyrighted program.
3
11.
Payments made for the acquisition of partial copyright rights represent a royalty where the consideration is “for the granting of rights to use the program in a manner that would, without such license, constitute an infringement of copyright.” 4 Payments also may be characterized as royalties to the extent that they represent consideration for “the use of, or the right to use, secret formulas or for information concerning industrial, commercial or scientific experience which cannot be separately copyrighted.” 5
12.
On the other hand, where the payment is “essentially” for something other than the use of, or right to use, copyright rights and the use of copyright is limited to rights required to enable downloading, storage and operation on the customer’s device, such limited use of copyright is disregarded for purposes of characterizing the payment under the Commentary and thus should not affect the issue of whether the payment constitutes a royalty.
6 Conversely, “transactions where the essential consideration for the payment is the granting of the right to use a copyright in a digital product that is electronically downloaded for that purpose will give rise to royalties.” 7
1 Commentary at Art. 12, § 12.
2 2008 Update to the OECD Model Tax Convention (July 18, 2008) at § 14.4.
3 Commentary at Art. 12, § 12.2.
4 Commentary at Art. 12, § 13.1.
5 Commentary at Art. 12, § 14.3. In contrast, payments for the transfer of the full ownership of the rights in the copyright cannot represent a royalty.
6 Commentary at Art. 12, § 17.2.
7 Commentary at Art. 12, § 17.4.
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13.
To illustrate, in many cases payments are made for the acquisition of rights that are limited to those necessary to enable the user to operate the program (e.g., a user’s right to download a program onto his hard drive). In these situations, the essential consideration of the transaction is the effective operation of the program by the user, and not for his or her exploitation of the underlying copyright rights. As a result, such payments merely represent payments for copies, and thus are business profits governed by Article 7.
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14.
Similarly, arrangements between software copyright holders and distribution intermediaries frequently will grant the latter the right to distribute copies of a software program without the right to reproduce the program. That is, the rights acquired in relation to the copyrighted program are limited to those needed for the intermediary to distribute the software program. The existing guidance recognizes that, in these situations, the distributors are paying for the acquisition of copies of the software program and not for the exploitation of the underlying copyright rights. As a result, the rights attributable to the act of distribution are disregarded for purposes of characterizing the transaction for tax purposes, 9 and corresponding payments are dealt with as business profits under Article 7. Moreover, this result is the same “regardless of whether the copies being distributed are delivered on tangible media or are distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation.” 10 In other words, the method of transferring the computer program to the transferee is not relevant.
11
15.
If the software payments are made under “mixed contracts,” the consideration may be broken down, where necessary, on the basis of information contained in the contract or by means of a reasonable apportionment.
12
16.
The Commentary expressly contemplates that the principles governing payments for the acquisition of computer software should extend broadly to other digital commerce transactions:
“The principles expressed above as regards software payments are also applicable as regards transactions concerning other types of digital products such as images, sounds or text. The development of e-commerce has multiplied the number of such transactions. In deciding whether or not payments arising in these transactions constitute royalties, the main question to be addressed is the identification of that for which the payment is essentially made.” 13
(Emphasis added) For example, consider the case for transactions that permit the customer
(which could an individual or an enterprise) to download digital products for his or her own use or enjoyment. In this situation, the payment is essentially for the acquisition of data transmitted in the form of digital signal and does not constitute royalties within the meaning of Article 12.
To the extent that the act of copying the digital signal to a computer or other device involves the use of copyrights by the customer pursuant to relevant copyright law or contractual arrangements,
8 Commentary at Art. 12, § 14.
9 Commentary at Art. 12, § 14.4.
10 Id.
11 Commentary at Art. 12, § 14.1.
12 Commentary at Art. 12, § 17.
13 Commentary at Art. 12, § 17.1.
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“such copying is merely the means by which the digital signal is captured and stored.” 14 This limited use of copyrights is not significant for income characterization purposes because the essential consideration for the payment is the acquisition of data transmitted in the form of digital signal, and not for the use of copyrights. In addition, the Commentary provides that there is no basis for classifying such payment as royalties if, under the relevant law or contractual arrangement, the creation of a copy is regarded as the use of copyright by the provider rather than the user.
17.
In focusing on the essential purpose for which the payment is made, as opposed to the means or technology through which the software or digital product is delivered, the Commentary recognizes and adopts a principle of neutrality between different types of digital and non-digital business models.
18.
The principles of the Commentary can be applied to the new digital business models described above. First, the same key tests contained in the Commentary for determining whether a payment constitutes a royalty or business profits should be applied to a situation where a user does not physically acquire or download software, but rather accesses software, other digital products, or services provided over the Internet. For example, regardless of whether a customer accesses software through download from a server or by running the software application on the server, the same factors–i.e., whether the provider receives payments for the acquisition of copyright rights
(beyond those rights that are necessary to enable a user to operate software) and whether all of the rights in the copyright are acquired–govern whether the provider receives business profits, royalties or gain from sales. Moreover, this result is supported by the Commentary, which contemplates the application of the same income characterization principles for a broad spectrum of digital business models and focuses on “the identification of that for which the payment is essentially made”, as well as by the 2001 Treaty Characterisation TAG Report (discussed below).
Treaty Characterisation TAG Report
19.
In 2001, the Treaty Characterisation TAG Report gave significant consideration to a variety of ecommerce situations, including numerous “cloud computing” arrangements (although the term was not used back then). In addition to the existing Commentary, as discussed above, USCIB believes that the Treaty Characterisation TAG Report provides useful guidance in applying the existing principles of the Commentary to new digital commerce business models.
20.
Payments “for the use of, or the right to use, industrial, commercial or scientific equipment”:
Under the 1977 Model Convention (but not the current model convention) and certain bilateral treaties, payments “for the use of, or the right to use, industrial, commercial or scientific equipment” constitute royalties.
15 The Treaty Characterisation TAG Report concluded that certain factors listed in section 7701(e), generally used to distinguish rental from service contracts, could be used to determine whether a payment was “for the use of, or the right to use, industrial, commercial or scientific equipment.” Such nonexclusive list of factors includes:
14 Commentary at Art. 12, § 14.3.
15 Commentary at Art. 12, § 9 (“Whilst the definition of the term ‘royalties’ in the 1963 Draft Convention and the
1977 Model Convention included payments ‘for the use of, or the right to use, industrial, commercial or scientific equipment’, the reference to these payments was subsequently deleted from the definition.”).
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a.
Whether the customer is in physical possession of the property; b.
Whether the customer controls the property; c.
Whether the customer has a significant economic or possessory interest in the property; d.
Whether the provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract; e.
Whether the provider uses the property concurrently to provide significant services to entities unrelated to the service recipient; and f.
Whether the total payment substantially exceeds the rental value of the computer equipment for the contract period.
16
21.
The Treaty Characterisation TAG Report concluded that the section 7701(e) factors, as applied to
“application service provider transactions [described infra ], generally should give rise to services income as opposed to rental payments.” In a typical transaction, the ASP obtains a license to use a software application that automates a particular back-office business function for a customer
(e.g., delivery of goods or services used in the customer’s business) and hosts the software application on computer servers owned and operated by the ASP.
17 The customer can only use the software remotely on the ASP’s server and does not have possession or control of a software copy. Because the customer typically may not have possession or control over the software or the equipment, will access the software concurrently with other customers, and may pay a fee based on the volume of transactions processed by the software, the arrangement generally is expected to constitute a services contract and not a contract for the use of equipment.
18 Accordingly, the arrangement is not expected to give rise to royalties under Article 12.
22.
Payments for “technical fees”: In certain alternative treaty provisions, source taxation of
“technical fees” is permitted.
19 Technical fees are generally defined as “payments of any kind to any person, other than to an employee of the person making the payments, in consideration for any service of a technical, managerial or consultancy nature.” 20
23.
The Treaty Characterisation TAG Report clarified that the mere use of technology in providing a service does not automatically color that service with a “technical, managerial or consultancy” nature. The report stated, “ The fact that technology is used in providing a service is not indicative of whether the service is of a technical nature. Similarly, the delivery of a service via technological means does not make the service technical. This is especially important in the ecommerce environment as the technology underlying the internet is often used to provide services
16 Treaty Characterisation TAG Report at § 28.
17 Treaty Characterisation TAG Report at Annex 2, Category 14.
18 Treaty Characterisation TAG Report at § 30. Based on similar reasoning, the Treaty Characterisation TAG
Report concluded that a data warehousing transaction (described infra) generally is expected to constitute a services contract and not a contract for the use of equipment. Treaty Characterisation TAG Report at § 31.
19 Treaty Characterisation TAG Report at § 36.
20 Treaty Characterisation TAG Report at § 37.
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that are not, themselves, technical ( e.g.
offering on-line gambling services through the internet).” 21 (Emphasis added)
24.
Similarly, the provision of the use of, or access to, data and software does not constitute a technical service. The Treaty Characterisation TAG Report stated, “The service of making such data and software, or functionality of that data or software, available for a fee is not, however, a service of a technical nature. The fact that the development of the necessary data and software might itself require substantial technical skills is irrelevant as the service provided to the client is not the development of that data and software (which may well be done by someone other than the supplier) but rather the service of making the data and software available to that client. For example, the mere provision of access to a troubleshooting database would not require more than having available such a database and the necessary software to access it. A payment relating to the provision of such access would not, therefore, relate to a service of a technical nature.” 22
25.
The conclusion of the Treaty Characterisation TAG Report – i.e., that the delivery of goods and services through the Internet does not in itself give rise to a “technical service” – is thus based on the fundamental premise that the characterization of income from providing goods or services is not affected by the technological means through which such goods and services are provided.
26.
Annex 2. Moreover, Annex 2 of the Treaty Characterisation TAG Report included detailed descriptions and high-level analyses of several e-commerce business models and concluded that these arrangements generally should give rise to business profits falling under Article 7, subject
(where applicable) to the considerations described above where the applicable treaty has a clause for payments “for the use of, or the right to use, industrial, commercial or scientific equipment” or “technical fees.” Such arrangements described and analyzed in Annex 2 are listed below: a.
Category 6: Single-use software or other digital product. In one variation of this transaction, the customer receives a onetime right to use software stored on a remote server. b.
Category 7: Application Hosting-Separate License. In one variation of this transaction, the user has a perpetual license to use a software product and pays a host to load the software onto host servers, such that the user can access, execute and operate the software product remotely. The host also provides technical support to protect against failures of the system. c.
Category 8: Application Hosting-Bundled Contract. In one variation of this transaction, the user enters into a contract (renewable annually for an additional fee) that allows it to access, execute and operate a software application remotely on a host server. The host provider, which is also the copyright owner with respect to the software application, provides technical support for the hardware and software. d.
Category 9: Application Service Provider (“ASP”). See supra.
21 Treaty Characterisation TAG Report at § 40.
22 Treaty Characterisation TAG Report at § 42.
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e.
Category 10: ASP License Fees. The ASP in Category 9 pays (pursuant to a one-year contract) the provider of the software application a fee which is a percentage of the revenue collected from customers. f.
Category 13: Data warehousing. The customer’s computer data is stored on computer servers owned and operated by the provider and can be accessed, uploaded, retrieved, and manipulated remotely by the customer. g.
Category 14: Customer support over a computer network. The provider provides the customer with online technical support (including installation advice and troubleshooting information), which can take the form of online technical documentation, a trouble-shooting database, and/or communications (e.g. by e-mail) with human technicians.
23 h.
Category 15: Data retrieval. The provider makes a repository of information available for customers to search and retrieve. i.
Category 16: Delivery of exclusive or other high-value data. The provider makes a repository of high-value information (e.g., special industry or investment reports) available for customers to search and retrieve. j.
Category 17: Advertisers pay to have their “banner ads” (i.e., small graphic images) embedded in a web page of a web site; these banner ads, when clicked by the user, load the web page specified by the advertiser. The advertiser may be paid according to the number of clicks on the ad or the number of times an ad is displayed to a user. k.
Category 18: Electronic access to professional advice (e.g., consultancy). A professional service provider advises customers through a remote means of communication, such as email or video conferencing.
24
27.
The Treaty Characterisation TAG Report’s analyses of the application of certain alternative treaty clauses to such e-commerce arrangements as ASPs, data warehousing, and database access, as well as its more general analyses of cloud computing arrangements contained in Annex 2, demonstrate that the Treaty Characterisation TAG Report has already closely considered the tax treatment of many modern e-commerce business arrangements in 2001.
23 Treaty Characterisation TAG Report at Annex 2, Category 14 at § 26 (“Whilst the provision of online advice through communications with technicians may require the application of special skill and knowledge and might therefore constitute services of a technical nature, the mere provision of access to a troubleshooting database would not require more than having available such a database and the necessary software to access it. The part of the payment relating to the provision of such access would not, therefore, relate to a service of a technical nature.”).
24 Treaty Characterisation TAG Report at Annex 2, Category 18 at § 32 (“As these transactions involve the provision of technical, managerial or consultancy services, the Group also addressed the issue of whether these could be considered as services ‘of a technical nature’ under the alternative provisions on technical fees that have been previously referred to. The Group concluded that to the extent that the services were rendered by someone acting as a consultant, they would constitute services of a consultancy nature so as to fall within the definition quoted in paragraph 37 of section 3.”).
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28.
An important premise of the Treaty Characterisation TAG Report is that the analysis of ecommerce arrangements relies on existing, generally applicable principles. For example, the report characterizes its conclusions as being “fully consistent with the views, which the [TAG] has unanimously endorsed, that are expressed in paragraphs 14 to 14.2 of the Commentary on
Article 12 as regards software payments.” Based on these principles, modern digital commerce business arrangements are typically expected to result in business profits under Article 7.
29.
Many of these e-commerce business transactions are carried on today as “cloud computing” business models, although the term cloud computing was not used in the Treaty Characterisation
TAG Report back in 2001.
30.
The United States National Institute of Standards and Technology (NIST) defines cloud computing as a “model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.” It is a general term for anything that involves delivering hosted services over the internet. There are three broad categories of cloud computing services: IaaS
(Infrastructure as a Service), PaaS (Platform as a Service), and SaaS (Software as a Service).
31.
According to NIST, in an IaaS business model “[t]he customer obtains processing, storage, networks, and other fundamental computing resources where the customer can run its own software, including operating systems and applications. The customer has control over operating systems, storage, and deployed applications; and may be given limited control of select networking components (e.g., host firewalls).” The customer can be charged for storage
(gigabytes per month) or computing power per hour. According to NIST, PaaS “[p]rovides the customer with software applications running in the cloud. The applications are accessible from many of the customer’s devices (e.g., all its employees’ computers). Access may be through the internet or a special program installed on the various customer devices. The customer generally does not manage or control the underlying network, servers, operating systems, storage, or even individual application capabilities, with the possible exception of any special customer-specific software installed in the cloud.” PaaS may provide certain software components on which the customer can build its applications or to develop and distribute content to end users. For example, the customer might build web pages on top of web-publishing software that populate instances of a database with information derived from the webpages. Finally, according to NIST,
SaaS “[a]llows the customer to deploy on the cloud application it has created or acquired using programming languages, libraries, services, and tools supported by the provider. As with PaaS, the customer does not manage or control the network, servers, operating systems, or storage, but it has control over the applications.” SaaS can involve services from web-based email to inventory management. Some applications, such as email or word processing, are provided to customers who do not have to own any servers or applications, and only need a device to access the web. SaaS providers are sometimes referred to as Application Service Providers (ASPs).
32.
Cloud computing providers must engage in a number of activities and make significant investments before a cloud service can be provided. There would be investment in data centers
(which can cost hundreds of millions of euros) to house the computing, storage and networking capacity needed to offer cloud services. Software licenses must be obtained and in some cases other intellectual property must be acquired from other vendors, as well. R&D activity would be required to set up the data center to provide the cloud services the vendor chooses to offer and to provide secure computing environments. Marketing and sales activity would be required to obtain customers. Customer support would be necessary, and operating and managing the data center would, of course, be critical. Administrative effort would be required to coordinate the
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cloud service business. Billing systems must be implemented to measure usage of cloud services and bill customers, if appropriate. If cloud services are offered on a global basis, data centers are often established in several geographic locations. Disaster recovery is a critical aspect of cloud computing to ensure maximum “up-time” of computing services, which requires excellent engineering, redundant capacity and significant testing.
33.
In one example of cloud computing, photographers load their digital photos on-line to manage, manipulate, and print. The vendor provides the applications and storage necessary to do so. The printing might be done by the photographer on her own printer or by a commercial printing company. In another example, instead of purchasing bookkeeping software that was loaded on an office personal computer, a small business might pay a monthly fee to access accounting software on-line. The bookkeeper could be a contractor working remotely from the small business.
34.
Although terms such as cloud computing and SaaS were not used in the Treaty Characterisation
TAG Report, the business models of providing service and access to hosted software applications, digital products, and servers were considered and addressed in 2001.
III.
Conclusions
35.
Many of the digital and e-commerce business models of 2013 are not actually “new” business models, and in fact have been discussed in OECD guidance dating as far back as 2001. In particular, as discussed above, the Treaty Characterisation TAG Report established substantive tax principles for analyzing many arrangements involving the delivery of goods and services over the Internet.
36.
The international tax system needs a principled framework for analyzing transactions that does not disrupt economic choices and adversely affect technological innovation. By contrast, an ad hoc formulation of specific rules for selected transactions would inevitably result in “winners” and “losers” between different arrangements with similar economic effects (e.g., providing software applications through download versus allowing customers to run the same software applications on the provider’s server), thus violating the principle of neutrality between economically similar transactions. Moreover, the boundaries of a separate regime for digital and e-commerce business models would be difficult to demarcate, as most (if not all) major companies today, including those that are not commonly perceived as being technologically oriented, engage in some type of e-commerce—whether it be through the coordination of “bricks and mortar” goods and services through Internet technology, or the enhancement of such goods and services through software applications available online.
37.
The principles of the Commentary address the characterization of income as royalties, business profits, or other types of income, as applicable, based on the core features of the relevant economic transaction (e.g., whether intellectual property rights have been transferred (and if so, whether such transfer is complete or partial), the extent to which a customer acquires full ownership of intellectual property rights or property, etc.). The principles of the Commentary are adequate to analyze and are already addressing most of the new digital commerce business models.
38.
The Commentary makes clear that the characterization of income from providing goods or services is not affected by the technological means through which such goods and services are
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provided. For example, the method of transferring a computer program to a transferee (e.g., whether it is acquired via a computer disk or a modem download) is not relevant to the analysis of whether a payment constitutes a royalty, 25 and the principles applicable to software payments are also applicable to other types of digital products (e.g., images, sound, and text).
26 Although technological developments may necessitate a reexamination of existing income characterization principles, the principle of neutrality between the taxation of digital and non-digital transactions, and between different forms of digital transactions, should remain an integral part of the approach to income characterization for e-commerce or digital commerce business transactions.
39.
To the extent that existing guidance does not specifically and adequately address a type of new digital commerce business model, existing principles should be, if needed, appropriately adjusted rather than discarded. In addition, the Treaty Characterisation TAG Report has considered in detail the use of the Internet to deliver goods and services for over a decade. The robust analytical framework developed by the Treaty Characterisation TAG Report is compatible with the Commentary and should be adopted. In any event, as explained above, the Action Plan specifically contemplates that actions to address BEPS “are not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income.”
25 Commentary at Art. 12, § 14.1.
26 Commentary at Art. 12, § 17.1.
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