Digital Permanent Establishments

Contents

Management Summary

Contents

List of Figures

List of Tables

List of Abbreviations

1 Introduction
1.1 Research Questions
1.2 Objectives
1.3 Material and Methodology
1.4 Applied Definitions
1.5 Delimitation
1.6 Outline

2 Digital Economy and digitalized Business Models
2.1 Definition and Characteristics of the Digital Economy
2.1.1 Definition of the Digital Economy
2.1.2 Characteristics of the Digital Economy
2.2 Digitalized Business Models
2.3 The Value Creation Process
2.3.1 Global Value Chains in Transfer Pricing
2.3.2 Value Creation Process in a digital(ized) Company
2.3.3 The Value Chain
2.3.4 The Value Network
2.3.5 The Value Shop
2.4 Interim Conclusion

3 Overview of Initiatives of International Organizations and unilateral Actions undertaken by Countries
3.1 Initiatives of International Organizations
3.1.1 OECD Initiatives
3.1.2 EU Initiatives
3.2 Unilateral Measures by selected Countries
3.3 Interim Conclusion

4 The Concept of Permanent Establishment
4.1 Traditional Definitions (pre-BEPS)
4.2 BEPS Action 7 – Amendments with regard to PE Definitions
4.2.1 Preparatory and Auxiliary Activities
4.2.2 Dependent Agent PE
4.3 Attribution of Profits to a PE
4.4 Interim Conclusion

5 A new PE Nexus based on non-physical Economic Presence and its Impact (post-BEPS Action 7)
5.1 OECD Proposals on Corporate Taxation of a Significant Economic Presence to trigger a digital PE
5.1.1 Public Consultation Document
5.1.1.1 User Contribution
5.1.1.2 Marketing Intangibles
5.1.1.3 Significant Economic Presence
5.1.2 OECD Work Plan
5.1.3 Unified Approach under Pillar One
5.1.3.1 Scope
5.1.3.2 A new Nexus Rule for the Taxpayers in the Scope
5.1.3.3 Expected Impact Analysis
5.1.3.4 Analysis of comments given by different stakeholders
5.2 EU proposal on corporate taxation of a Digital Service Tax and Significant Digital Presence
5.2.1 Short-term measure: Digital Services Tax
5.2.2 Long-term measure: Significant Digital Presence
5.3 Interim Conclusion

6 Court Cases 66
6.1 Court Case India
6.2 Interim conclusion

7 Challenges, Recommendations and possible Solutions with regard to MNEs operating in Switzerland
7.1 Challenges
7.2 Recommendations
7.3 Possible Solutions
7.3.1 Stay with the Status-quo (post-BEPS Action 7 / pre-BEPS Action 1) – BEPS 1.0
7.3.2 Planning and anticipating taking into consideration possible amendments proposed by the OECD
7.4 Interim Conclusion

8 Final Conclusion and Outlook
8.1 Final Conclusion
8.2 Outlook

Bibliography

Appendix A: Article 5 of the OECD MTC 2017

Appendix B: Article 5 of the UN MTC 2017

Management Summary

The OECD/G20 as well as the Inclusive Framework on BEPS are currently aiming to find an international tax consensus for a long-term solution, which could have a signifi- cant impact on the international corporate tax and transfer pricing landscape. The on- going tax challenges raised by the digital economy emphasize the fundamental tax pol- icy issues. The new proposal by the OECD and EU would alter the current permanent establishment (“PE”) concept in a significant way and thus have a strong influence on cross-border transactions of multinational enterprises (“MNEs”). These developments, which relate mostly to the terms nexus and profit allocation under international tax law, may affect many MNEs respectively their businesses. The outcomes may reshape the international allocation of profits (and losses) mechanism, and, moreover, the (re-)allo- cation of those profits (and losses) between the residence jurisdictions and the source or market/user jurisdictions. While big user/consumer markets are often located in emerging states, which are pushing for a bigger stake in global tax revenues, Switzer- land as a relatively small country with stark export activities seems to be strongly af- fected.

Objectives

The key objectives of this Master Thesis is to outline the impact respectively chal- lenges of the proposed new digital PE concept, notably on Swiss headquartered MNEs and to derive recommendations and potential solutions for these enterprises from a consulting standpoint.

Challenges

While the traditional PE concept is relatively old, the application is more complex as businesses become increasingly digitalized and countries around the globe are intro- ducing unilateral measures. Swiss MNEs thus should thoroughly evaluate their intra- group structures and ensure their business models are in line with their transfer pricing documentation to mitigate any tax and transfer pricing exposure.

There are several challenges that Swiss MNEs face. The following seem to be the most crucial ones:

- Lack of clarity on the practical application of PE rules as well as the specific definitions;
- Departure from long established tax and transfer pricing principles as well as from recently introduced transfer pricing related BEPS Actions, such as Actions 8-10;
- Uncertainty about potential material impact on MNEs, especially for Switzerland having a large number of MNEs with centralized business models; and
- Various unilateral measures taken by some countries, especially developing countries like India.

Recommendations

MNEs with operations in Switzerland can react to these challenges in the following way:

- Thorough PE examination;
- Analysis of unilateral actions;
- Business model and value chain analysis;
- Analysis of sector activity;
- Specific thresholds assessment;
- Simulation of potential impact;
- Discussions with international advisors;
- Clarifications with Swiss Federal Tax Administration (“FTA”) and/or State Secre- tariat for International Finance (“SIF”); and
- Lobbying work with peers or other MNEs.

Solutions

The two potential solutions proposed in this Thesis, either staying with the status-quo or planning and anticipating, taking into consideration possible amendments proposed by the OECD and the actions taken by the various countries. However, these solutions starkly depend, amongst other reasons, on the specific business operations of an MNE.

What is clear is that the PE concept remains one of the most critical topics, which has the potential to significantly change the international tax and transfer pricing landscape.

List of Figures

Figure 1 OECD/G20 15 Action Plans

Figure 2 OECD/G20 - Five BEPS objectives

Figure 3 Selection of relevant reports and guidelines taken into account

Figure 4 Chronological overview of specific published OECD Action 1 documents

Figure 5 Three common key factors in digitalized business models

Figure 6 Intensity of user participation

Figure 7 Types of PEs: Practical viewpoint of PE definitions under UN MTC

Figure 8 BEPS Action 1 developments during 2019

Figure 9 Two pillar approach outlined by the OECD in February and May 2019

Figure 10 Key features of the Unified Approach under Pillar One

Figure 11 Unified Approach: Two Pillars

List of Tables

Table 1 Top 100 global companies by market capitalization (as of 31 March 2019)

Table 2 High-level categorization of country views into three groups

Table 3 Overview of unilateral actions by selected countries (as of 12.11.2019)

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

The debate on base erosion and profit shifting (“BEPS”)¹ by multinational enterprises (“MNEs”) has become a significant topic on the agenda of the Organization for Eco- nomic Co-operation and Development (“OECD”)² and the G20³ and resulted in 15 ac- tions to prevent and counter BEPS.⁴ In 2015, the OECD released final reports of these 15 BEPS actions, which serve many countries as guidance for local legislation, setting regulatory frameworks and imply challenges to MNEs that require increasingly a coor- dinated and cross-divisional approach.⁵ The following graphic 1 illustrates the 15 BEPS actions, which are based on three core principles, namely coherence, substance and transparency, followed by figure 2, which outlines the five BEPS objectives⁶

Abbildung in dieser Leseprobe nicht enthalten

Figure 1 OECD/G20 15 Action Plans⁷

The first and last Actions (Action 1 and Action 15) are overarching, meaning that they involve all three core principles. Action 1⁸ of these final reports deals with the chal- lenges of the digital economy, which show the gaining importance of digital business models in taxation and transfer pricing.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2 OECD/G20 - Five BEPS objectives⁹

The BEPS project was initiated, amongst other reasons, to counteract certain tax plan- ning strategies and structures implemented by some MNEs.¹⁰ Especially highly digital ones like the big five digital giants Alphabet¹¹ (Google), Amazon¹², Apple¹³, Facebook¹⁴ and Microsoft¹⁵, raises the desire of certain tax jurisdictions to enhance the tax reve- nues.¹⁶

The influence of digital based technology firms by market capitalization is illustrated in the following Table 1, highlighted by five technology firms in the top ten.

Abbildung in dieser Leseprobe nicht enthalten

Table 1 Top 100 global companies by market capitalization (as of 31 March 2019)¹⁷

Cross-border technology transactions has grown exponentially with many MNEs rely- ing more and more on the virtual presence in a jurisdiction than on traditional busi- nesses.¹⁸ MNEs operating with a global business setup are able to generate revenues from delivering goods and rendering services in a country without having a physical presence there. With such business models, the question becomes as to who has the right to tax: is it the country in which the MNE has a legal presence (i.e. the residence country), the country whose resources are being used respectively value is being ex- ploited or consumed (i.e. source country), or any other state where users/consumers are situated or data is generated.¹⁹

In light of these developments, the concept of permanent establishment (“PE”) and the attribution of business profits become crucial. Whether there exist a PE in a country is one of the most critical international tax and transfer pricing issues, and, with the re- cently outlined proposals of the OECD “Unified Approach” (see Chapter 5.1.3), be- comes even more critical, keeping not only academics and business practitioners busy, but also many courts around the globe.²⁰

The focus of this analysis clearly lies on the OECD initiatives because of their global reach and relevance for Swiss headquartered companies, especially in connection with international tax and transfer pricing issues. Because of their relatively stark influence on many Swiss based MNEs, the outcomes by the European Union (“EU”) ²¹ are also described where necessary.

1.1 Research Questions

The following main research questions will be answered in this Master Thesis:

- Is there a need for the introduction of a digital PE?
- How is the digital economy defined and how is value generated within a digital company or a company that applies digitalized business models according to the definitions by the OECD?
- What are the challenges and recommendations based on the analysis on MNEs based in Switzerland?
- What are potential solutions to deal with these challenges?

In order to answer this core research questions, each chapter of this Thesis will answer sub-questions, which in turn are important steps in answering the key questions. The sub-questions are listed below:

- Chapter 2: What is the digital economy and how do MNEs conduct their busi- nesses within these confines? How is value generated within a digital com- pany?
- Chapter 3: What are the concepts respectively proposals by the different inter- national organizations and countries?
- Chapter 4: What is the traditional concept respectively what are the various definitions of a (digital) permanent establishment?
- Chapter 5: What is the content of the OECD proposal with regard to tax chal- lenges arising from the digitalization in the context of PEs?
- Chapter 6: Are there actual court cases / case law available to substantiate the relevance of the vital topic?
- Chapter 7: What are the challenges and consequences of the introduction of a digital PE concept for a Swiss based MNE and what they need to do to tackle with these challenges. In addition to these recommendations, what are possible solutions for them?
- Chapter 8: What are the conclusions with regard to Swiss based MNEs having cross-border intra-group operations?

1.2 Objectives

The objectives of this Thesis is to outline the impact of the proposed new digital PE concept on Swiss headquartered companies and to derive recommendations for these companies from a consulting standpoint.

The focus of this Master Thesis lays clearly on the rules and proposals enacted by the OECD. However, proposals by other important organizations will be outlined where necessary. For instance, the EU proposals on “Digital Service Tax(es)” (“DST”) and “Significant Economic Presence” (“SEP”) are shortly described under Chapter 5.2 due to their importance for Swiss headquartered MNEs. Nevertheless, this is only punctu- ally done because the OECD seems to be by far the most significant organization for Switzerland and often for Swiss headquartered companies, especially with regard to international tax and transfer pricing regulations. In the context of the recently pub- lished papers by the OECD concerning taxation of the digital economy, the locus point is really the new nexus under “Pillar One”, as outlined in Chapter 5 of this Thesis and the comparison with the status quo of the PE regulation.

1.3 Material and Methodology

The research on which this study is based consists mainly of desk research as well as literature provided by practitioners, such as international consulting companies. The most recent reports and studies by the various supranational organizations, in particu- lar the OECD and the EU, as well as tax and finance authorities will be taken into con- sideration. Given the relative novelty of this topic, not much specific academic literature is yet available or expected to be available in due course, which leads to a shift in the research focus towards published papers of the various supranational organizations and authorities.

The methodology is mainly the evaluation, analysis and assessment of various docu- ments, including publicly available papers, practical papers describing approaches by MNEs, academic articles as well as interviews and discussions with practitioners, con- sultants and academic persons.

1.4 Applied Definitions

The following definitions and explanations thereto are applied and shorty explained to ensure clarity:

- Traditionally, “residence” based taxation relates to the “home” tax jurisdiction, whereas “source” based taxation relates to the “host” tax jurisdiction. However, under the new proposals made by the OECD, there could be many different types of tax jurisdictions, namely the “residence”, the “source”, as well as “mar- ket/user” tax jurisdictions. Due to simplicity reasons and if not clearly outlined in this Master Thesis, the source tax jurisdiction and the market/user tax jurisdic- tion(s) are applied equally.
- The terms “digital economy”, “digitalized economy” or “digitalization of the econ- omy” are interchangeably used due to the fact that the OECD published papers with these different terms.
- The OECD has several sub-bodies, which are, amongst others, the Task Force on the Digital Economy (“TFDE”) or the Secretariat. Where not differently out- lined, these sub-bodies are subsumed under respectively designated as OECD so that the reader is not confused by the various bodies or terms.
- The Inclusive Framework of the OECD/G20 consists of 135 member states, in- cluding OECD member states or jurisdictions and other non-OECD members (as of 4 November 2019)²².
- The term “digital permanent establishment” means a PE in the context of the outlined documents and discussions by the OECD and EU so far and is there- fore currently often only a virtual term respectively a proposed concept how members of the Inclusive Framework or the EU could find a solution for the fu- ture taxation of PEs. Moreover, there exists various similar terms with regard to a taxable presence in context of a digital PE, for instance “significant digital economy”, “significant digital presence” or “virtual PE”, which differ often only marginal and thus needs to be taken into consideration.
- Permanent Establishment in the context of direct tax has to be clearly distin- guished from the term Fixed Establishment (“FE”) in conjunction with Value Added Taxes (“VAT”). In this Thesis, only the concept of PE is applied and ana- lyzed and hence relevant.
- Intra-group operations encompasses transactions between intra-group entities as well as business dealings between the head office(s) and a PE, between an intra-group subsidiary and a PE or between a PE and another PE.

If there are other important definitions to clarify or in case of deviations of the above- mentioned definitions in this Master Thesis, this would directly be mentioned and ex- plained in the respective chapter.

The following illustration gives an overview of important documents used in this Master Thesis. The focus clearly lies on OECD papers.

Abbildung in dieser Leseprobe nicht enthalten

Figure 3 Selection of relevant reports and guidelines taken into account

1.5 Delimitation

Taking into account the complexity and broad scope of the tax challenges arising from the digital economy, the analysis will be limited to the issues concerning the PE nexus for digital activities.

This Thesis will not intend to give a final definition of the concept of the digital econ- omy, as the term is not conclusively described by legal sources. Furthermore, this pa- per will not analyze in-depth on the various taxation possibilities arising from a digital PE, but focusing on direct taxation methods of business profits. With regard to the re- cently published OECD “Unified Approach” (see Chapter 5.1.3), the assessment is based on “Pillar One”, especially on the new nexus approach and scope.

1.6 Outline

The following Chapter 2 focuses on the digital economy and digitalized business mod- els. Chapter 3 gives an overview of the digital economy initiatives and concepts by dif- ferent supranational organizations, namely the OECD as well as the EU, and selected countries, which introduces or intend to introduce unilateral measures. In C hapter 4, the concept of the PE will be discussed. The topic of Chapter 5 is the OECD proposal on the corporate taxation of a significant digital presence and gives the latest outcomes of proposals by the OECD around the new nexus and scope related to PEs. Chapter 6 presents court cases available so far. The main purpose of this Thesis is outlined in Chapter 7 by answering the core research questions, after which some recommenda­ tions as well as solutions are given as well as outlining the consequences of the intro­ duction of a digital PE concept for MNEs with operations in Switzerland. A final conclu­ sion with a short outlook is given in Chapter 8.

2 Digital Economy and digitalized Business Models

The digital economy poses many challenges to tax authorities worldwide. LuxLeaks²³, Panama Papers²⁴ and Paradise Papers²⁵ as well as EU investigations²⁶ on major MNEs, including digital technology giants, shed light on a wide range of tax evasion schemes used by large businesses triggering a heated public debate on the need for fair taxation.²⁷

Digitalization has changed the manner in which traditional (so-called “brick and mor- tar”) companies operate their businesses. The massive quantities of available data gathered from digital platforms, sensors and smart phones is accompanied by mount- ing storage capacity and computational power as well as more sophisticated algo- rithms.²⁸ Due to the rapid technological progress, a lot of new business models evolved.²⁹ The OECD illustrates this in their Action 1 Final Report of 2015 (hereafter “Action 1 Final Report”)³⁰ by listing the various form of information and communication technology. From the emergence of the personal computing devices, over telecommu- nication networks, software, content, use of data, cloud-based processes, to the emerging and potential future developments such as the internet of things (“IoT”), vir- tual currencies (e.g., bitcoins), advanced robotics, 3D printing, the sharing economy and collaborative production, access to government data, to the reinforced protection of personal data.³¹

The following timeline gives a short overview of selected papers that the OECD has published since 2013 and hence accentuates the significance of the topic relating to in- ternational taxation. Besides these papers, several policy notes and informational up- dates were published and, to a certain extent, to be taken into consideration.

Abbildung in dieser Leseprobe nicht enthalten

Figure 4 Chronological overview of specific published OECD Action 1 documents

Illustration 4 shows only the published reports of the OECD, whereas other interna- tional organizations, such as the EU, released also several papers in the context of the taxation of the digital economy, which could also be of high importance for Swiss head- quartered MNEs. In addition, the OECD published several policy notes in 2019 that laid the grounds for the Inclusive Framework³² to come to a potential agreement on the way forward.³³ If necessary, this Thesis will also present parts of the significant devel- opments and outcomes by the EU, as this seems to be the second most important or- ganizations for Swiss based MNEs.

This Chapter 2 aims to give a definition of the digital economy and deals with the ques- tion of what the digital economy is and how international companies conduct their busi- nesses within these confines. Subsequently, the value generation process of MNEs in the context of digital businesses is outlined, followed by a short interim conclusion.

2.1 Definition and Characteristics of the Digital Economy

The definition and characterization of the digital economy, as laid down by the OECD, is described in the next two sub-chapters.

2.1.1 Definition of the Digital Economy

There is no international agreed definition on the notion “digital economy” but accord- ing to the International Monetary Fund (“IMF”), the digital economy is sometimes de- fined “narrowly as online platforms, and activities that owe their existence to such plat- forms, yet, in a broad sense, all activities that use digitized data are part of the digital economy: in modern economies, the entire economy.”³⁴

Compared to the IMF definition, the OECD gives the following definition of the digital economy:

“The digital economy is the result of the widespread and transformative process brought on by Information and Communication Technology (ICT). All sectors, ranging from retail, financial services to education and broadcasting and media have been transformed by ICT technologies. So much so, that the digital economy is increasingly becoming the economy itself. It would therefore be difficult, if not impossible, to ring fence the digital economy from the rest of the economy for tax purposes.” ³⁵

Therefore, the OECD clearly states that the digital economy encompasses not only the digital industry sector (i.e. technology companies) but also the whole economy.

As outlined in Chapter 1.4, the terms “digital economy”, “digitized economy” and “digi- talized economy” are interchangeably applied in this Thesis.

2.1.2 Characteristics of the Digital Economy

The Action 1 Final Report addresses BEPS in the digital economy:

“W hile the digital economy does not create unique BEPS issues, some of its features exacerbate existing ones. These ones have been taken into account during the work on the definition of permanent establishment, transfer pricing and CFC rules. It is ex- pected that these measures will successfully address BEPS issues in the digital econ- omy once implemented.” ³⁶

The OECD in the Interim Report of 2018 (hereinafter “Interim Report”) stated the fol- lowing five defining characteristics of the digital markets. However, these characteris- tics are not exclusive to the digital economy and can be attributed to the non-digital markets too:³⁷

Direct network effect(s) are defined as the utility from the consumption of a good or service that is dependent on the number of other end-users consuming the same good or service, also called the direct network effect or consumption externality. The larger the network, the larger the end-user utility. The most obvious examples are social me- dia and online messaging services.³⁸

Indirect network effect(s) occur when a specific group of end-users (advertisers on a social network) benefit from interacting with another group of end-users (users of a so- cial network) in the context of multi-sided markets, for example an online platform.³⁹

Economies of scale arise if the marginal costs of the distributed or sold products or ser- vices are very low. The fixed costs (e.g., initial investments) for producing a software program might be relatively high whereas the distribution and selling of it are low.⁴⁰

Switching costs and lock-in effects come into play if a user has different electronic de- vices but these devices rely on different operating system. As a result, clients may be locked-in to a particular operation system once they acquired a specific device. This is described as an effect resulting from taking into consideration psychological as well monetary switching costs, which customers incur if they switch from one system to an- other. For instance, changing from one social media platform to another entails the transfer of a wide range of personal data and contacts.⁴¹

Complementary is described as the increasing utility derived from using a device (e.g., laptop) together with another device (e.g., smartphone) or several other devices when it is used with corresponding software programs, i.e. operation systems, applications or games.⁴²

2.2 Digitalized Business Models

According to the OECD, three key factors are most frequently observed in digitalized business models, namely:⁴³

Abbildung in dieser Leseprobe nicht enthalten

Figure 5 Three common key factors in digitalized business models⁴⁴

Cross-jurisdictional scale without mass: Firstly, the digitalization has created highly integrated and connected businesses in many sectors and allowed highly digitalized enterprises to reach international customers in jurisdictions without establishing a, or any significant, physical presence. Therefore, these MNEs are able to achieve opera- tional local scale without local mass (referred to as cross-jurisdictional “scale without mass”).⁴⁵

Reliance upon intangible assets, including intellectual property (“IP”) rights: The second key feature refers to the heavy reliance on intangible assets, including IP, and the growing investments in intangible assets in order to create or enhance value.⁴⁶

Given that IPs are highly mobile, MNEs are able to transfer intangible rights within a group to an associate company in a low-tax jurisdiction.⁴⁷

Data and user participation: Third and lastly, the users that actively or passively par-ticipate in the digital activities determine to a certain extent the value that is generated via their contributions (e.g., via content sharing on a social platform) or sole member- ships (e.g., only visiting a webpage). This can especially be observe and analyzed by social networks, where without data, network effects and user-generated content, the businesses would not exist in the way they operate today. However, user participation is not the decisive factor with regard to the degree of digitalization: for instance, cloud computing can be considered as highly digitalized business even if the user participa- tion is rather limited.⁴⁸

Data and user participation seems to be the most prevalent factor(s) in the OECD In- terim Report 2018.⁴⁹ With regard to data, the OECD lists the data value cycle in five several interconnected phases, which are data origination, d ata collection leading to big data, data analytics, knowledge base as well as data-driven decision-making.⁵⁰

Some MNEs monetize customer data directly by selling targeted online advertisement to customers on a different market side; others use collected data mostly to enhance their operations, product design or marketing activities.⁵¹

In conjunction with user participation, the OECD makes a clear differentiation be- tween two broad categories, namely active user participation and passive user partici- pation.⁵² On the one hand, active user participation involves an explicit action.⁵³ Active user participation is further divided into low (e.g., film and music streaming or e-com- merce websites), medium (e.g., uploading photos and videos on social networks like Instagram) and high (e.g., adding friend to a platform, creating communities and net- working) user action.⁵⁴ On the other hand, a passive user participation is characterized by the lack of direct activity, although it is likely to have involved at least some active steps (e.g., downloading an app).⁵⁵ Data collection is a by-product of the Internet and is collected without the direct involvement of the user or active transmission of the data, such as the use of cookies to capture browsing activity.⁵⁶

The following figure 6 from the OECD illustrates how the degree of user participation intensity of different types of businesses might be classified and that the intensity of user participation is not necessarily correlating with the degree of digitalization.⁵⁷ Cloud computing as an example can be considered as a more highly digitalized business that involves a more limited user participation intensity.⁵⁸

Abbildung in dieser Leseprobe nicht enthalten

Figure 6 Intensity of user participation⁵⁹

As a consequence, not all highly digitalized businesses are completely based on data and user participation and thus other characteristics such as scale without mass, amongst others, are also of relevance (e.g., cloud computing).⁶⁰

2.3 The Value Creation Process

The growth of global value chains⁶¹ can be observed by the more interconnected econ- omies and by the increasing specialization in specific activities and stages of value chains rather than industries.⁶² The digital economy has accelerated and changed the spread of global value chains in which MNEs integrate their global operations.⁶³ For this reason, the global value chain analysis in transfer pricing is shortly outlined, fol- lowed by the three value creation processes described by the OECD in the context of the digital economy.

2.3.1 Global Value Chains in Transfer Pricing

Global value chains stimulated the economic growth in various parts of the world in the past twenty years.⁶⁴ In addition, global value chains, together with cross-border trade and investments, are the engines of growth in a global economy.⁶⁵ The increasing im- portance of global value chains related to transfer pricing (“TP”) can be clearly ob- served by the recent introduction of a mandatory value chain analysis⁶⁶ in certain coun- tries like China, where such an analysis includes the transaction flows within a group is a mandatory requirement to be compliant in the TP local file⁶⁷ (if certain thresholds⁶⁸ are surpassed).⁶⁹ A value chain analysis is a management tool used to evaluate activi- ties of an international group such as Research & Development (“R&D”), procurement, production, sales, marketing or after-sale services.⁷⁰ Its goal is to measure the im- portance of these functions in terms of the overall group value creation and reveals a group’s competitive advantages.⁷¹ Furthermore, the OECD mentioned the concept of the value chain analysis in their BEPS Actions 8-10 Report (hereinafter “Actions 8-10 Report”)⁷² and thus is part of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereinafter “TP Guidelines”) ⁷³. The analysis is especially important with regard to highly integrated business operations in the context of the transactional profit split method (“TPSM”)⁷⁴.⁷⁵

2.3.2 Value Creation Process in a digital(ized) Company

The OECD presents three different value creation concepts to point out how the digital- ization impacts the value creation process, namely the value chain, the value network and the value shop.

2.3.3 The Value Chain

Developed by Michael Porter (1985)⁷⁶, the value chain concept describes how value is being created by converting inputs into outputs through discrete but related, sequential activities in a way a vertically integrated company works.⁷⁷ The final goods may be pro- duced by the company itself or acquired.⁷⁸ The value chain comprises of five primary activities, which are inbound logistics, operations, outbound logistics, marketing and sales as well as service, and four secondary or supportive activities, which are infra- structure, human resource management, technology development and procurement.⁷⁹

For example, for a reseller (e.g., Alibaba, Amazon retail or Carrefour), inbound and outbound logistics are the most critical elements, whereas for a manufacturer like Huawei or Siemens, operations is usually the most significant activity.⁸⁰ However, in any business, all the different primary activities will be present to some extent and con- tribute to the business competitive advantage.⁸¹

Practical examples of this value creation process are businesses selling physical goods through an online platform or digitalized products and/or content through an online platform⁸²:

Businesses selling physical (tangible) goods through an online platform: These busi- nesses could produce or create their own physical goods for sale (e.g., H&M sells its clothing line through its shops and website), or could buy products from unrelated par- ties for the purpose of resale (for instance, Walmart acts as reseller for tangible prod- ucts).⁸³

Businesses selling digitalized (intangible) goods or content through an online platform: These businesses either can produce their own digitalized content through the Internet, like Netflix, or could act as reseller for digitalized products, like Apple merchandises soundtrack rights through the iTunes stores.⁸⁴

In addition to the value chain, which models a linear value creation concept, Stabell and Fjeldstad (1998)⁸⁵ identify two alternative models, namely the value network and the value shop, which are described in the subsequent two chapters.

2.3.4 The Value Network

The second value creation concept is the value network, which plays an important role in analyzing businesses where mediating technology is present and plays a central part.⁸⁶ The value network applies to more highly digitalized firms, and, in particular to platform-based businesses such as multi-sided platforms⁸⁷.⁸⁸ Although value networks already existed in the traditional, non-digital world, like employment agencies or banks that mediating between investors and borrowers, the internet has greatly expanded the role of mediating technology, especially in the form of social networks that bring indi- viduals together.⁸⁹ The linking may be direct, as in the case of social network, or indi- rect, as in retail banking or insurance, where a group of customers is linked through a common pool of funds.⁹⁰ The basic value network is comprised of three primary activi- ties, which are network promotion and contract management, service provisioning as well as network infrastructure operation, and the same four support activities presented in the preceding value chain concept, which represent the effectiveness for the deter- mination of the profit margin.⁹¹ As in the case of the value chain concept, the way of how businesses carry out each activity is to a large degree a reflection of its product(s) or service(s).⁹² However, in contrast to the sequential ordering of activities in the value chain, activities in a value network are performed concurrently.⁹³ Subscription fees (e.g., LinkedIn Premium), pay-as-you-go fees when services are consumed (as in the case of Airbnb or BlaBlaCar), or advertising revenue from targeted advertising services (e.g., Facebook, Twitter, Instagramm or Weibo) are generated as revenue in value net- works.⁹⁴

Practical examples of the value network concept are businesses providing an online marketplace for the sale of goods and services and businesses providing online ser- vices:⁹⁵

Businesses providing an online marketplace for the sale of goods and services (e-com- merce intermediary): These businesses typically act as intermediate party and connect suppliers of goods or services with potential clients. For instance, eBay as provider of online platforms, where suppliers can list their products and clients can buy them. In a similar way, Booking.com provides a platform that connects accommodation seekers with accommodations. Likewise, firms involved in the so-called sharing economy, such as Uber and Airbnb, could fall under this category.⁹⁶

Businesses providing online services (service intermediary): This category contains businesses that are engaged in online advertising such as social network (e.g., Face- book or LinkedIn) or search engine (e.g., Google or Bing), online payment services (e.g., Paypal or Transferwise) or online gaming (e.g., GvC Holdings).⁹⁷

2.3.5 The Value Shop

In contrast to the value network concept, the value shop focuses on single-sided mar- kets, where interactions take place with one specific type of user or customer.⁹⁸ This concept is of significance for companies where a relative intensive use of technology is necessary to solve a customer-oriented request or problem.⁹⁹ Intensive technology is the combination of hardware, software and knowledge used to change a specific out- come and the type of problem to be solved (the consumer demand determines the in- tensity of the shop’s activities).¹⁰⁰ The OECD defines customer problems in the context of the value shop as difference between an existing state and an aspired state.¹⁰¹ For instance, an existing state would be a non-digitalized business operation, whereas a digitalized, cloud-based operation the aspired state.¹⁰² Between these two states is the problem-solving and thus value creation process, where the intensive technology is the means to the solution.¹⁰³ The OECD clearly states that the value shop is often the re- sult of a strong information asymmetry between the business and its customers and that the asymmetry constitutes the reason why there is a customer demand respec- tively why the customer approaches the business.¹⁰⁴ The value shop comprises five primary activities, which are problem-finding and acquisition, problem-solving, choice (choosing among alternative solutions to the problem), execution as well as control and evaluation, and the same four support activities outlined in the value chain.¹⁰⁵

Practical examples of the value shop concept are businesses providing online solu- tions: ¹⁰⁶ This category mainly encompasses cloud computing firms that provide infra- structure-as-a-service (“IaaS”), platform-as-a-service (“PaaS”) or software-as-a-service (“SaaS”).¹⁰⁷ For instance, Microsoft Azure or Alibaba are providers of such services.¹⁰⁸ Other examples are vertically-integrated professional service companies like Siemens or GE.¹⁰⁹

2.4 Interim Conclusion

The digital economy is expanding at a tremendous pace and new business models are emerging and rapidly evolving due to, amongst others, IoT, virtual currencies, ad- vanced robotics, 3D printing, artificial intelligence (“AI”), the sharing economy and other technological advancements. In addition, the digitalization is changing the way work is organized and could be a decisive factor for entrepreneurial initiatives since it lowers the transaction costs of business and providing greater flexibility, which enhances the productivity.¹¹⁰ With many established digital companies having multiple business lines, the differentiation between multi-sided platforms and other digitalized businesses be- comes more and more challenging.¹¹¹ Soon, a fully digitalized economy disrupting fun- damental principles of the international tax system could emerge.¹¹²

With digitalization allowing business activities to spread across the globe, it is more and more complex to identify the location of value creation and to decide on how to al- locate profits.¹¹³ The OECD’s Action 1 project tries to find a consensus-based solution to tax the digital economy, which is most likely to affect all MNE’s businesses and not just the ones that are belonging to the “digital” industry sector (technology companies). Consequently, all international groups need to take Action 1 seriously so that their businesses will be in compliance with international tax and TP rules.

The OECD identifies three main key features or challenges of digital business models, which are scale without mass, reliance on intangibles and user participation. In addi- tion, the OECD lies the focus primarily towards user participation and data with regard to these three key features that are frequently observed in digitalized business models.

The three elaborated concepts of value creation by the OECD, namely the value chain, the value network and the value shop are clearly outlined and a good starting point for classifying businesses with regard to the value creation process. The strongest case for value creation in the market can be made for value network, covering online adver- tising and intermediation services, which takes into consideration the role of data and user participation.¹¹⁴ Nevertheless, digital companies having multiple business lines, the differentiation between multi-sided platforms and other digitalized businesses be- comes more and more challenging.¹¹⁵ Furthermore, there is no strong consensus within the OECD on whether or not user contribution shall be taken into consideration as determinant factor on how value is created for taxation purposes.¹¹⁶

Summing up, the definitions are very difficult to ring-fence for the various forms of MNE’s businesses, especially when there are several highly digitalized business lines or models in place. In addition, international organizations have clearly some differ- ences in the understanding of the value creation process in the context of the digital economy, which makes it even more complex. Therefore, it is questionable whether the proposals of the different international organizations and institutions thereof cur- rently published capture all the relevant aspects of the digital economy in relation to in- ternational taxation and transfer pricing. However, it is obvious that the jurisdiction of the user will contribute to a relative large extent to the profits, and that there is no ne- cessity to have a physical presence in that jurisdiction for the MNE.¹¹⁷

[...]

---

¹ The BEPS project started with the G20 leaders declaration in Los Cabos, Mexico, in 2012, see OECD, 2012, http://www.oecd.org/ctp/exchange-of-tax-information/G20_Progress_Report_June_2012.pdf (ac- cessed 15 Aug. 2019), and initiated with the Action Plan on BEPS by the OECD in 2013, see OECD, 2013, https://www.oecd.org/ctp/BEPSActionPlan.pdf (accessed 15 Aug. 2019).

² The OECD currently consists of 36 member states, which are Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Latvia, Lithuania, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States, see OECD, 2019, https://www.oecd.org/about/members-and-partners/ (accessed 15 Nov. 2019).

³ The G20 is a group of 19 countries, which are Argentina, Australia, Brazil, Canada, China, France, Ger- many, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom (UK) and Northern Ireland, the United States of America (US), as well as the European Union (EU), see G20, 2019, https://g20.org/en/summit/about/ (accessed 15 Nov. 2019).

⁴ For more information, see http://www.oecd.org/tax/beps/beps-actions/ (accessed 15 Sep. 2019).

⁵ See OECD, 2015, https://www.oecd.org/ctp/beps-2015-final-reports.htm (accessed 15 Sep. 2019).

⁶ See OECD, 2015, https://www.oecd.org/ctp/BEPS-FAQsEnglish.pdf. (accessed 9 Sep. 2019).

⁷ See OECD, 2015, https://www.oecd.org/ctp/beps-2015-final-reports.htm. (accessed 15 Sep. 2019).

⁸ See OECD, 2015, Addressing the Tax Challenges of the Digital Economy – Action 1: 2015 Final Report, (“Action 1 Final Report”), accessible under https://doi.org/10.1787/9789264241046-en (accessed 15 Aug. 2019).

⁹ Brülisauer & Huber, 2019, p. 4.

¹⁰ See OECD, 2019, Bitesize BEPS, https://www.oecd.org/tax/beps/bitesize-beps/ (accessed 15 Sep. 2019).

¹¹ For more information on this company, as well as on the way it generates revenues, see its annual re- ports, e.g., Alphabet, 2018, https://abc.xyz/investor/static/pdf/20180204_alpha- bet_10K.pdf?cache=11336e3 (accessed 15 Sep. 2019).

¹² For more information on this company, as well as on the way it generates revenues, see its annual re- ports, e.g., Amazon, 2017, http://www.annualreports.com/HostedData/AnnualReportAr- chive/a/NASDAQ_AMZN_2017.PDF (accessed 15 Sep. 2019).

¹³ For more information on this company, as well as on the way it generates revenues, see its annual re- ports, e.g., Apple, 2018, http://www.annualreports.com/HostedData/AnnualRe- ports/PDF/NASDAQ_AAPL_2018.pdf (accessed 15 Sep. 2019).

¹⁴ For more information on this company, as well as on the way it generates revenues, see its annual re- ports, e.g., Facebook, 2017, http://www.annualreports.com/HostedData/AnnualReportAr- chive/f/NASDAQ_FB_2017.pdf (accessed 15 Sep. 2019).

¹⁵ For more information on this company, as well as on the way it generates revenues, see its annual re- ports, e.g., Microsoft, 2018, http://www.annualreports.com/HostedData/AnnualReportAr-chive/f/NASDAQ_FB_2017.pdf (accessed 15 Sep. 2019).

¹⁶ Eden & Treidler, 2019, INSIGHT: Taxing the Digital Economy - Pillar One Is Not BEPS 2 (Part 2), p. 2, https://news.bloombergtax.com/daily-tax-report/insight-taxing-the-digital-economy-pillar-one-is-not-beps-2- part-1 (accessed 18 Nov. 2019).

¹⁷ PricewaterhouseCoopers (“PwC”), 2019, Global Top 100 companies by market capitalization, p. 19, https://www.pwc.com/gx/en/audit-services/publications/assets/global-top-100-companies-2019.pdf (ac- cessed Sept. 15 2019).

¹⁸ Ernst & Young (“EY”), 2019, You and the Taxman, p. 19, https://www.ey.com/Publication/vwLUAs-sets/EY-you-and-the-taxman-issue-3-2019/$FILE/EY-you-and-the-taxman-issue-3-2019.pdf (accessed 15 Nov. 2019).

¹⁹ Ibid.

²⁰ EY, 2019, You and the Taxman, supra note 18, p. 19.

²¹ The EU currently consists of 28 member states, which are Austria, Belgium, Bulgaria, Croatia, Cyprus, Czechia, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and UK. See EU, 2019, https://europa.eu/european-union/about-eu/countries_en (accessed 15 Nov. 2019).

²² See OECD, 2019, p. 1, http://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf (ac- cessed 4 Nov. 2019).

²³ See for example International Consortium of Investigative Journalists (“ICIJ”), 2019, https://www.icij.org/investigations/luxembourg-leaks/ (accessed 19 Oct. 2019).

²⁴ See for example ICIJ, 2019, https://www.icij.org/investigations/panama-papers/ (accessed 19 Oct. 2019).

²⁵ See for example ICIJ, 2019, https://www.icij.org/investigations/paradise-papers/ (accessed 19 Oct. 2019).

²⁶ See for example Eyes on Europe, 2017, https://www.eyes-on-europe.eu/the-european-union-and-the- gafa-issue/ (accessed 15 Nov. 2019).

²⁷ Hadzhieva, 2019, p. 16.

²⁸ Bughin, J., Manyika, J. & Woetzel, J., 2016, https://www.mckinsey.com/~/media/McKinsey/Busi- ness%20Functions/McKinsey%20Analytics/Our%20Insights/The%20age%20of%20analytics%20Compet- ing%20in%20a%20data%20driven%20world/MGI-The-Age-of-Analytics-Full-report.ashx (accessed 16 Aug. 2019).

²⁹ Ibid.

³⁰ OECD, 2015, Action 1 Final Report, supra note 8.

³¹ Ibid., pp. 36-46.

³² The Inclusive Framework on BEPS is primarily concerned with evaluating the implementation of the minimum standards agreed in the BEPS project and implemented through the MLI. The objective of the review is to achieve a global level playing field in terms of tax competitiveness. See for example State Secretariat for International Finance [“SIF”], 2019, Inclusive Framework on BEPS, https://www.sif.ad- min.ch/sif/en/home/multilateral/gremien/inclusive-framework-on-beps.html (accessed 24 Oct. 2019).

³³ See for example OECD, 2019, Addressing the Tax Challenges of the Digitalisation of the Economy – Policy Note, https://www.oecd.org/tax/beps/policy-note-beps-inclusive-framework-addressing-tax-chal-lenges-digitalisation.pdf (accessed 15 Sept. 2019).

³⁴ International Monetary Fund (“IMF”), 2018, p. 7, https://www.imf.org/~/media/Files/Publica- tions/PP/2018/022818MeasuringDigitalEconomy.ashx (accessed 15 Sept. 2019).

³⁵ OECD, 2019, supra 10.

³⁶ Ibid.

³⁷ OECD, 2018, Interim Report 2018, p. 25, https://doi.org/10.1787/9789264293083-en (accessed 15 Aug. 2019).

³⁸ Ibid. p. 26.

³⁹ Ibid.

⁴⁰ Ibid.

⁴¹ Ibid.

⁴² OECD, 2018, Interim Report 2018, supra note 37, p. 24.

⁴³ Ibid.

⁴⁴ Ibid.

⁴⁵ Ibid.

⁴⁶ Ibid.

⁴⁷ OECD, 2015, Action 1 Final Report, supra note 8, p. 65.

⁴⁸ OECD, 2018, Interim Report 2018, supra note 37, pp. 24-25.

⁴⁹ See ibid., pp. 53-59.

⁵⁰ Ibid., p. 53.

⁵¹ Ibid.

⁵² Ibid., p. 55.

⁵³ Ibid.

⁵⁴ Ibid.

⁵⁵ Ibid.

⁵⁶ Ibid., p. 56.

⁵⁷ OECD, 2018, Interim Report 2018, supra note 37, pp. 57-58.

⁵⁸ Ibid.

⁵⁹ Ibid., p. 58.

⁶⁰ Ibid.

⁶¹ The concept of global value chains was introduced in the early 2000s. For more information see OECD, 2013, Mapping Global Value Chains, p. 7, https://doi.org/10.1787/5k3v1trgnbr4-en (accessed 15 Aug. 2019).

⁶² OECD, 2013, Interconnected economies: benefiting from global value chains, p. 5, https://www.oecd.org/sti/ind/interconnected-economies-GVCs-synthesis.pdf (accessed 15 Aug. 2019).

⁶³ OECD, 2019, Meeting of the OECD Council at Ministerial Level, p. 12, http://www.oecd.org/officialdocu- ments/publicdisplaydocumentpdf/?cote=C/MIN(2019)2/FINAL&docLanguage=En (accessed 15 Oct. 2019).

⁶⁴ Owen & Tavares, 2018, p. 7, http://www3.weforum.org/docs/WP_Global_Value_Chain_Policy_Se- ries_Taxation_report_2018.pdf (accessed 15 Oct. 2019).

⁶⁵ Ibid., p. 4.

⁶⁶ The value chain analysis consists typically of five steps, which are analyzing the industry, analyzing the company, mapping the value chain and its core drivers, drawing the value chain, and feedback. See Baumgartner, 2018.

⁶⁷ The local file is one of the three transfer pricing documents proposed and described by the OECD TP Guidelines 2017, see OECD, 2017, TP Guidelines 2017, p. 233, https://doi.org/10.1787/tpg-2017-en (ac- cessed 15 Aug. 2019).

⁶⁸ The thresholds for the preparation of a local file in China are dependent on the types of related-party transactions, which are RMB 200 million for tangible assets transfers, RMB 100 million for financial asset transfers, 100 million for intangible asset transfers, RMB 40 million for other related-party transactions in total. See KPMG, 2019, BEPS Action 13: Country implementation summary, https://home.kpmg/content/dam/kpmg/xx/pdf/2019/04/tnf-beps-action-13-april15-2019.pdf (accessed 15 Sept. 2019).

⁶⁹ See for example RSM, 2018, https://www.rsm.global/singapore/insights/our-expert-insights/compliance-chinas-latest-transfer-pricing-documentation-requirements (accessed 15 Oct. 2019).

⁷⁰ Jurevicius, 2013, https://www.strategicmanagementinsight.com/tools/value-chain-analysis.html (ac- cessed 15 Sept. 2019).

⁷¹ Ibid.

⁷² See OECD, 2015, Actions 8-10 Final Report, p. 59-60, https://doi.org/10.1787/9789264241244-en (ac- cessed 15 Aug. 2019).

⁷³ OECD, 2017, TP Guidelines 2017, https://doi.org/10.1787/tpg-2017-en (accessed 15 Aug. 2019).

⁷⁴ The transactional profit split method is one of the five common TP methods stated by the OECD TP Guidelines, see OECD, 2017, TP Guidelines 2017, paras. 2.114-2.155, pp. 133-145.

⁷⁵ See OECD, 2015, Actions 8-10 Final Report, supra note 72.

⁷⁶ Porter, 1985, as cited in OECD, Interim Report 2018, p. 35.

⁷⁷ OECD, 2018, Interim Report 2018, pp. 36-37.

⁷⁸ Ibid., p. 43.

⁷⁹ Ibid., pp. 36-37.

⁸⁰ Ibid.

⁸¹ Ibid.

⁸² Chand & Spinosa, 2018, p. 478.

⁸³ Chand & Spinosa, 2018, p. 477.

⁸⁴ Ibid.

⁸⁵ Stabell & Fjeldstad, 1998, as cited in OECD, Interim Report, 2018, p. 35.

⁸⁶ OECD, 2018, Interim Report 2018, supra note 37, p. 38.

⁸⁷ A multi-sided platform is described as a platform that is multi-sided if there are indirect network external- ities affecting the price structures across market sides; see Rochet & Tirole, 2003, 2006, as cited in OECD, Interim Report, 2018, p. 30. The platform allows for direct interactions between end-users on dif- ferent market sides, and end-users on each market side have to affiliate themselves with the platform (im- plying non-zero switching costs); see Hagiu and Wright, 2015a, 2015b, as cited in OECD, Interim Report 2018, p. 30.

⁸⁸ Interim Report, 2018, supra note 37, p. 38.

⁸⁹ Ibid.

⁹⁰ Ibid.

⁹¹ Interim Report, 2018, supra note 37, p. 39.

⁹² Ibid.

⁹³ Ibid.

⁹⁴ Ibid.

⁹⁵ Chand & Spinosa, 2018, p. 478.

⁹⁶ Ibid., p. 477.

⁹⁷ Ibid.

⁹⁸ Interim Report, 2018, supra note 37, p. 40.

⁹⁹ Ibid.

¹⁰⁰ Ibid.

¹⁰¹ Ibid.

¹⁰² Ibid.

¹⁰³ Ibid.

¹⁰⁴ Ibid.

¹⁰⁵ Ibid.

¹⁰⁶ Chand & Spinosa, 2018, p. 477.

¹⁰⁷ Ibid., p. 477-478.

¹⁰⁸ Ibid.

¹⁰⁹ Interim Report, 2018, supra note 37, p. 41 and p. 43.

¹¹⁰ OECD, 2017, Key Issues for digital transformation in the G20, p. 20, https://www.oecd.org/g20/key-is-sues-for-digital-transformation-in-the-g20.pdf (accessed 15 Nov. 2019).

¹¹¹ Hadzhieva, 2019, p. 99.

¹¹² See OECD Observer, 2016, http://oecdobserver.org/news/fullstory.php/aid/5600/Tax_challenges,_dis- ruption_and_the_digital_economy.html (accessed 15 Oct. 2019).

¹¹³ Hadzhieva, 2019, p. 99.

¹¹⁴ Ibid., p. 20.

¹¹⁵ Ibid., p. 10.

¹¹⁶ Ibid., p. 13.

¹¹⁷ Brodd, 2018, p. 36, http://lup.lub.lu.se/luur/download?func=downloadFile&recordOId=8965959&file- OId=8968349 (accessed 15 Aug. 2019).