The shift from P.C. Hooft to P.C. home shopping:

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The shift from P.C. Hooft to P.C. home shopping:

A discussion of the need for adaptation of current taxation rules in the more and more digitalizing world of e-commerce.

Summary: The use of e-commerce within multinational enterprises may lead to opportunities for profit-shifting within the current taxation rules, hence should be altered to attain accurate e-commerce taxation. Companies are able to serve remote markets in countries where they don’t have legal presence; therefore it is difficult to tax earned profits. The basis for taxation for companies in another country is the permanent establishment (PE), which requires physical presence. E-commerce businesses can deliver products to customers in remote markets through websites, hence without any physical presence, which makes taxation very difficult. The OECD doesn’t address this problem as threat in the BEPS-discussion, however, there is empirical evidence that e-commerce allows profit-shifting.

A solution could be to re-determine what key-business-functions are and their remuneration. The taxation of websites is not easy within the current source-principle for taxation, but maybe we need a virtual PE-concept. Also the origin-principle might be a useful solution.

L.Y.W. (LISANNE) BÖGELS

Master thesis Economics of Taxation Groningen, 10 April 2014

Faculty of Economics and Business University of Groningen

Supervisor: Mrs. Prof Dr. I.J.J. Burgers

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LIST OF ABBREVIATIONS

BEPS Base Erosion and Profit Shifting (Action Plan)

CEN Capital Export Neutrality

CFA Committee of Fiscal Affairs, set up by the OECD

CFC Controlled Foreign Company

CIN Capital Import Neutrality

Commentary The Commentary to the OECD Model Tax Convention E-commerce Electronic Commerce

EBIT Earnings Before Interest and Taxes

EU European Union

GST Goods and Services Tax

IP Intellectual Property

LMI Local Marketing Intangible

MNE(s) Multinational Enterprise(s)

MTC OECD Model Tax Convention

OECD Organization for Economic Development and Cooperation

PE(s) Permanent Establishment(s)

SME(s) Small and Medium Enterprise(s)

TAG Technical Advisory Group

The OECD request The OECD’s request for input regarding work on tax challenges of the digital economy

U.K. United Kingdom

U.S. The United States of America

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INTRODUCTION

Most business decisions and strategies have tax implications. Tax in its turn may have significant influence on corporate strategies and therefore on business decisions. Tax motives are, however, usually not the key decision factor in setting up a business strategy or business model, as business decisions are often made on the basis of expected earnings before interest and taxes (“EBIT”). But taxation may actually have significant impact on net profit, as a few percentage points less taxation, will save a few percentage points of net profit as well and also influences cash flow, which is the basis for making Capital Budgeting decisions. Recently, a small number of very large corporate companies received the brunt of the public opinion in their attempts to structure their business in such a way that they pay the least taxes possible. This has caused a lot of damage to their corporate reputations. These companies, e.g. Starbucks, Google, Amazon and Apple did not cross any lines from a legal perspective in their pursuit for the lowest possible tax rate. However, they did cause much discussion because according to the public, they did not pay their “fair-share”, which they should contribute to the society of which they are a part, and to which they owe their big profits.

Not only the public has made many comments to the practices performed by these large companies, also governments have asked questions about companies’ strategies that reduce their effective tax rate. After several demonstrations against tax evasion in England, the British Government has set up a parliamentary committee, called the “Public Accounts Committee” that has researched the performance of the British Tax Authority and the Tax avoidance strategies used by Multinational Enterprises (“MNEs”) at the end of 2012.

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of up to 30%. This leads, according to the OECD to an unwelcome competitive advantage for these MNEs.

The Internet has caused a big shift in corporate strategies as it made possible more efficient communication all over the world. The Internet era hence led to the introduction of new business models using electronic commerce (“e-commerce”), which also made it possible to shift profits between companies of MNEs in different countries. The issue of how to tax e-commerce in general has been on the agenda of the OECD since 2000. The OECD governs tax treaties by drafting a Model Tax Convention (“MTC”) and Commentary (“the Commentary”) to it. In addition they published reports on the taxation of e-commerce and the use of permanent establishments (“PE”). These reports form the basis for changes to the Commentary that take place on a regular basis.

In 2000 for example, the OECD changed the Commentary on art. 5 MTC, about the PE-concept in such a way that a website could never constitute a PE in itself. In 2005 they made an assessment of the current treaty rules concerning the taxation of e-commerce profits through a permanent establishment. An important exception to the concept of the PE is that business activities that do not cross a threshold of preparatory or auxiliary activities cannot constitute a PE. At the time of writing the OECD focuses its attention on Base Erosion and Profit Shifting (“BEPS”). A report on this topic was published in 2013 and as well a subsequent action plan (OECD, 2014-A). Action number 1 is dealing with the challenges of the digital economy. The OECD will research if and how businesses are able to have a significant digital presence in a country without this presence causing a taxable base. The OECD does acknowledge the need for some action, but they did not discuss in detail what action is required.

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Almost 15 years after the Millennium another development, other than fully digital business, can be identified in the way business models are set up. Luxurious clothing brands and other popular brands like Apple use expensive physical shops, called “flagship-stores” to promote their products to the public. In the Netherlands for example a lot of expensive clothing brands have shops in the P.C. Hooftstraat in Amsterdam and also Apple has a famous flagship-store at the Leidseplein. Because of the high rents and operational costs in combination with reduced sales, these shops usually run at a loss. Hence they are merely used as a marketing tool, whereas online websites are starting to sell more products to customers. This might lead to a shift of profit from these physical shops, which are only used to demonstrate goods, to the website of the company. The website can be located more centralized within the business structure and could in theory be located in any tax haven that suits the MNEs preferences.

Tax systems in OECD countries are based on the source principle and the residence principle, in combination with the benefit principle. The source principle and residence principle are used to determine whether a state has the right to tax an individual or a company (the taxable subject). Only if the individual or company has a source of income in a state or is a resident within the borders of that state, the local tax authorities may tax the person. The benefit principle is relevant for determining if the taxable subject indeed should pay tax; whoever has any benefits from public goods, should contribute to the financing of these goods. The source principle and the residence principle are both part of the territoriality principle. The person or the income he or it derives should have a physical connection with the territory of the state, so the person should own or should have the authority over a house, a factory or any other physical construction before being liable to tax. If such a physical construction is present in more than one country or if there is no such construction, then a person could also be taxed on the basis that the person or the company has the center of its vital interests, in the form of work and social relationships, or its central place of management therein.

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This means that not only a physical connection of the income within the territory of a state is relevant. In addition the U.S. considers other factors that create income, hence it takes into account all value drivers. For the purpose of determining whether the U.S. may tax the income of a company, meaning that the income has its origin therein, the Internal Revenue Code uses the concept of “trade effectively connected” principle.

In e-commerce business models companies do not use facilities in a country, because they have no physical presence there. They do, however, use a market’s set of customers that they can supply to and gain profit from. States that use tax systems based on the principle of territoriality cannot tax business income derived by sales through a website as much as they could have if the income would have been accrued to a physical shop. Moreover, the states that use the principle of origin can neither tax this type of income, despite the fact that based on their domestic legislation they might be able to. This is because most tax treaties are based on the principle of territoriality and thus allocate the right to tax the business income to physical presence. This results states only being able to tax companies when a PE or a permanent representative is present in that state.

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In order to fill in the gap in existing literature on the issue of e-commerce businesses and the possible profit shifting this thesis will address a few examples of other business models that have developed as a result of e-commerce and that also create profit-shifting opportunities. Furthermore, it will identify the possibilities of profit shifting with these business models and that countries will notice in their tax revenues.

The goal of this thesis is to shed light on these not very much addressed business models that do form a part of the digital economy that is continuously developing, as the possibilities of the Internet grow larger. The taxation of e-commerce businesses is a difficult subject and the problems with its taxation do not seem to be easily solved when using the current taxation principles of the OECD. This thesis is therefore also shortly considering if it would be more accurate to develop other methods of taxation or perhaps even a new principle for foreign taxation, to achieve an appropriate taxation of the e-commerce sector. The main research question is:

Does the use of e-commerce create profit-shifting opportunities for MNEs with the current rules of taxation, and if so, how could these rules be altered to ensure that MNEs pay their fair-share in countries where they are active?

In researching this matter, the following sub-questions will be answered:

1. How have business models changed in the past few years as a result of recent developments in the e-commerce sector?

2. What are tax implications of these changes in business models? 3. Do these changes create profit-shifting opportunities?

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The thesis is structured as follows. Chapter 1 will focus on examples of developments in business models of partly e-commerce brands, for example clothing brands, and also full e-commerce businesses like Amazon that deliver physical products. It will address changes to these business models as a result of developments in the way e-commerce business is conducted. In the first chapter the focus will be most on business strategies behind these models.

Chapter 2 provides a description of the taxation motives and implications of these business models. It will look at the current taxation of e-commerce and at how e-commerce is creating taxable bases in countries, for example by constituting permanent establishments.

Chapter 3 will look at the opportunities to shift profits to tax havens in an attempt of tax avoidance using these business models. Also it is discussed here if used business models in the e-commerce sector raise particular BEPS concerns according to the OECD.

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CHAPTER 1 – Changes to business models as a result from recent

developments in the e-commerce sector.

With the introduction of the World Wide Web, or the “Internet”, for consumption by the general public in 1994, the international trade has changed. Information was since then applicable and consultable from all over the world and information could be passed on between people to the other side of the world in less than seconds. This led to big growth opportunities for companies trying to sell their products online or at least trying to gain market share over the Internet. There were a lot of companies offering their services and products online for free and that were hoping to brand awareness for their products to be able to charge rates for these products later, after the consumer got used to their product. This new upcoming of the Internet altered the business models that companies were using to generate profits. The time period around the millennium was the period in which the concept of e-commerce was developed and introduced. E-commerce relates to the type of industry where the buying and selling of products or services is conducted over electronic systems such as the Internet and other computer networks.

The first changes and developments resulting from the introduction of the Internet have been the centralization and outsourcing of business functions and more effective cooperation. Nowadays, the consequences and new business implementations because of the Internet have already matured into further developed business models. The Internet is not longer only used to promote products and services to possible future customers. In the cases where flagship-stores are used, business functions may even have reversed, as the physical shop is now sometimes used as the marketing tool to show physical products, whereas the website processes the actual sales. This online selling could be seen as the core function of the business, in which case the taxation base should maybe also be altered, because websites do not lead to a taxation base at the moment.

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fulfillment. Also in the field of marketing they recognize new business models that are using web-based marketing. Any enterprise could reach a larger audience to present their products and services to in a more efficient and cost-effective manner. This is now also an option for smaller businesses, which can enter foreign markets without the upfront investment costs and geographical barriers to entry that they were facing earlier.

Tax driven reorganizations to e-commerce businesses

The OECD requested through their website interested parties and stakeholders to comment on a discussion draft about the tax challenges of the digital economy (OECD, 2014-B). The OECD also installed a Task Force to the Digital Economy in the end of 2013, which should examine the challenges of the digital economy after a thorough analysis of various relevant business models that have been developed more recently. In this request (“the OECD request”), the OECD asked stakeholders what activities they perform in their businesses and what the impact of information and communication technology has been on these activities. The OECD hopes that the reactions on this request will provide some insights in “how technology has influenced the way and the location in which value

is created or monetized under the used business models” (OECD, 2014-B, page

108).

The BEPS Monitoring Group, in its reaction to the OECD request (OECD, 2014-B, page 20), gave an example of a concern that reorganized its European operations around ten years ago. In this reorganization, a new Swiss entity became the primary contractor for all operations in Europe. This concern was already present in Europe in different countries, where it now stripped its activities so that they became ‘limited risk distributors’ of the concern’s products, and further the industrial sites were designated sub-contracted manufacturers with specific instructions of how to operate and what prices to use. A company in France, which was the prior contractor of the concern, now became a service provider to the company in Switzerland.

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argued this claim of several millions of euros in taxes, saying that the decrease in taxable profit was simply due to the transfer of risks to the Swiss new holding company. The Swiss entity had become the owner of the licensing rights of the brand in Europe, and hence also the risks and resulting remuneration were attributed to this company. The involved Tax Commission concluded here that the “application of the arm’s length principle should not be limited to contractual

terms only, but should include a ‘realistic’ analysis of the distribution of risks and responsibilities. Rather than capturing all the profits made in France, the Commission suggested that the Swiss entity be remunerated […] for the costs it incurred plus 6%” (OECD, 2014-B, page 20).

This concern was not described as being a part of the digital economy, but it did make use of efficiencies made possible by digital communications and technological innovations. This example provides an example in which location decisions were actually driven by tax considerations:

“[These tax considerations] encourage the artificial separation of functions and their attribution to affiliates which are in fact under common control, but are treated as separate and independent for tax purposes. Functions that can be considered as high-value, such as control and direction of operations, or ownership and control of intellectual property (“IP”) rights, can be attributed to affiliates in jurisdictions that offer favorable tax regimes. Affiliates in other countries, which do not offer either low tax rates or tax preferences are designated for functions to which low rates of profit can be attributed.”

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profits could then all flow to a very strategically located headquarters or owner of intangibles in low-tax-jurisdictions.

According to the BEPS Monitoring Group, “the implications of international tax

rules are that the traditional dichotomy between residence and source taxation is no longer valid. It is no longer the case that a firm based in state A can simply supply a product to a customer in state B as a one-off passive sale. Certainly, most such firms are transnational, in the sense of having an ultimate parent in a home country, but their worldwide presence and continuous and interactive relationships with customers are key to their enhanced profitability. It is true, however, that firms which are more highly digital can more easily exploit these advantages under current tax rules, since they can have a major presence in a market without taxable presence at all, i.e. without needing a PE” (OECD, 2014-B, page 22).

Deloitte LLP UK also replied on the OECD request and mentioned some examples of altered business models as a result of the evolution of e-commerce. They address that the benefit of e-commerce is that traditional retailers can gain market share from getting online. They could offer all their products online in maybe an even bigger assortment, while in a physical store customers can look at the product and try it on, before buying the actual product online. In these circumstances, according to Deloitte, there needs to be recognition, most likely through appropriate application of transfer pricing and the arm’s length principle, that lower sales in physical stores are enabling higher online sales (OECD, 2014-B, page 31). They think it is important for the tax authorities to know what creates value in these business models, as the “network effect” of the Internet could have a lot of impact on profits. This is because the Internet is enabling more and intensive interaction between the business and the consumer. Taxation should therefore be flexible in either way to adjust to changes in business models, also to changes that we cannot foresee at the moment.

Baker & McKenzie LLP in Palo Alto divides the general discussion about business models within the digital economy into two specific business activities: remote sales and online advertising (OECD, 2014-B, page 41): “In a remote sales business,

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services available to users and hosts paid advertisements to be viewed by those users”.

They identify various business attributes that are the principle features of enterprises that are using digital technology. They address enhanced customer and supplier interaction by enterprises. This allows business to expand their commercial relationships across borders and make the communications more efficient. Customers have access to full market information about product and service offerings. This communication advantage goes in two directions; customers have easier access to products and services that a business offers, but also to the products and services of its competitors. This allows the customer to do some comparing between products and they are not only reliant on local suppliers anymore.

Digital communications allow for more efficiency and hence their goal is to achieve costs savings. The increased competitive environment drives business to lower their production costs and stimulates innovation. It will benefit consumers and also other businesses if this also reduces the cost price of products on the market. Through the Internet also firms that are only in a start-up phase are able to operate in the global market. This significantly lowers the barriers to entry into the global market, even for very small businesses.

The focus in taxing business profits should based on the value creation within businesses. Value is typically driven by labor, capital and innovation. Baker & McKenzie state here that the “point for tax policy is that the return on making

risky investments to create value and the return on commercializing a business’ valuable assets are different, and tax policy should not allow the value created by investment to be taxed in jurisdictions whose only connection to the business is commercialization” (OECD, 2014-B, page 51).

Changes in underlying business models do not have any impact on the way in which businesses are organized as a tax or legal matter. “As a legal matter, digital

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establishing physical presences outside their home jurisdictions. Mature digital economy enterprises generally establish local taxable affiliates in most major market jurisdictions. That being said, enterprises adopting digital communication models frequently exhibit business process modifications that can have an effect on the enterprises’ legal and tax structure. Communications technology allows virtually any major enterprise to centralize functions and automate business processes. As a result, major enterprises are more readily able to centralize sales, service, customer support, finance, management, legal and other similar functions in a single geographic location. (OECD, 2014-B, page 51)”

The International Bar Association in London states that business models have not necessarily changed due to more extensive use of the Internet, and that some business models at least closely resemble the pre-digital business models: “For

instance, companies that take orders electronically and ship physical goods closely resemble catalogue sellers of many decades ago, but because their catalogues are posted online, they are more readily accessible to customers all over the world. It strikes us that for these businesses, there is no need to update rules; their activities are consistent with pre-digital activities. As such, they should be already captured by rules on sales of physical goods, and the online order processing should be viewed as little different from telephone or mail order processing from ‘old’ sellers.

(OECD, 2014-B, page 64)”

The International Bar Association gives an example: “In the UK, sales of physical

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This is partly true, but touches a very difficult point to address within e-commerce. The sales that an e-commerce business makes are sales to the company that did the actual selling; hence the profits accrue to the country of which this company is a resident. But because of enhanced digital communications, businesses are able to enter other markets in other countries as well, with only the small capital costs of setting up a website there. With almost no barriers to entry, they attend other markets and hence take some market share away from the local companies in these markets. This might have a negative effect to the tax revenue of these countries.

Another application of e-commerce is that business functions could be easily split, and businesses could actively choose the country to which they will attribute their sales. If all e-commerce businesses should decide to reorganize their business models together, then why not would all these businesses suddenly attribute their sales to a company in a tax haven, whereas their customers are located all over the world? This would not trigger any taxable base at the actual location of the sale, and all the business profits will be taxed in this low tax rate jurisdiction.

The IBFD Research Staff addresses the same issue (OECD, 2014-B, page 78): “The

threshold of activity that triggers the existence of a PE within the OECD Model has traditionally been based on the physical presence of the economic actor. Where no predetermined level of physical presence is found, the taxing rights of business income are solely allocated to the state of residence of the economic actor. […] As a consequence of the digitalization of the economy, a business can serve customers and provide services across the globe without setting a foot outside its country of residence.”

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brand needs to adopt to competitors and to changings needs and desires of its possible customers.

“Following the functional allocation approach brands should be

economically owned by the entity that is responsible for the brand marketing and development. This entity should therefore be remunerated for the brand from a transfer pricing aspect. To avoid a loss of value regarding the IP, maintenance is needed. If IP is relocated to other entities than the ones that perform the maintenance in regard to the IP, the economic value of the IP should be diminishing in most cases. […] As a result transfer pricing for companies within the digital economy is linked to many uncertainties and risks of corrections by tax auditors as the transfer pricing systems are different to those used by multinational groups in other industries. Value chains and the used IP differ and therefore the OECD Transfer Pricing Guidelines offer only little support as most examples relate to other industries. If possible the OECD should offer to support companies within the digital economy regarding the structure of transfer pricing systems involving complicated value chains and high portions of IP (OECD,

2014-B, page 109).”

Partly digital e-commerce: business models using flagship-stores

The term “flagship-store” is derived from the maritime sector, in which the lead vessel of a fleet is called the “flagship”. In terms of retailing, the flagship-store is originally the first physical store location of a brand or a concern. Nowadays we use the term in a broader sense, such that it is a name for a store in a prestigious location, so that it shows that this brand is the newest, the most luxurious, or the most famous product in the world. And as these shops are commonly placed in the same expensive shopping district of city centers, they are also used to show customers the advantages of this brand instead of the competitor’s product (Farfan, 2013).

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flagship-store is to let the customer experience the product and try its features before buying it. The stores could be used to assist customers and inform them about the use of the products, rather than pushing them into a purchase. The stores will in some cases not be used to actually sell products, but rather to advice the customer.

Charles Tyrwhitt

Terence Tse is describing the business model of a small- and medium-sized formal shirt producer for men in London, called Charles Tyrwhitt, that initially only operated on a mail-order basis (Tse, 2013). This shirt producer was forced to innovate its business model as its competitors were all making use of the efficiencies that the Internet is providing these days. On one hand, the shirt producer had competitors that were large fashion houses like Marks and Spencer. These fashion houses have large market shares due to their physical stores, where the majority of their sales are generated. On the other hand, Tyrwhitt’s direct competitors, who were also focusing on niche-markets and selling their products online, were also acquiring additional market share because the growing popularity of the Internet made it possible for them to enter the global market without significant capital expenditures.

There are customers that will buy products online without trying them on or seeing them in reality. But there is also a large group of customers who want to check what they buy, before purchasing something online. This shirt producer therefore entered into a combined business model of these two possibilities: it started up one flagship-store to begin with in London, where customers could try shirts to check the quality, see what it looks like and find their size. On the other hand, as the fitting-model of the shirts was more or less similar, customers would easily repeat their purchases online in different colors and prints.

“In this way, Charles Tyrwhitt could avoid the enormous cost of establishing

shops throughout the United Kingdom (“U.K.”), but it was still able to reach out to customers nationwide” (Tse, 2013, page 689).

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“Indeed, just as in the U.K., the presence of the New York stores boosted

Charles Tyrwhitt’s Internet-based sales in the U.S. The U.S. stores provided the company with a base from which it could reach out to potential customers anywhere in North America through its remote channels. In fact, the company now makes the majority of its U.S. sales online. […] In the minds of repeat customers, the physical stores, especially the flagship-store on Jermyn Street, served as the face of a reputable brand and signaled that they could buy online with confidence”.

Expensive clothing brands, for example like Giorgio Armani and Louis Vuitton all have global coverage. They need to have access to the global market in order to maintain their status as a luxurious brand and defend their high purchase prices. Via the Internet, it is easier to acquire and maintain market share, but still most of the international luxury fashion brands make use of international flagship-stores in addition (Moore, 2011).

It is not commonly shared information that flagship-stores run at a loss. Brands will not be very proud to share that their stores are not profitable. However, the large capital investments to build up and maintain a store and finance its day-to-day operation, has led to many predictions that these stores should have negative return on their investments. If these stores are not profitable, then they should have another function within brands, as otherwise no clearly thinking business manager would keep a store like this running.

The characteristics of a flagship-store are (Kozinets et al., 2002) that they “(i) carry on a single brand of product, (ii) they are owned by the company that they promote and (iii) they operate with the intention of building a brand image rather than solely generate profit to the company”.

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these stores are usually impressive buildings at prominent locations, their goal is to stimulate the people’s interest, attract attention and appear and remain on the customer’s wish list from the moment it first enters a new market. A flagship-store in the primary shopping center of a city could be a marketing tool for promoting sales on websites. But also the effect can be noticed in other, more basic stores of the brand in the same, or other cities of the country. These other physical shops will be less of an investment and have less operating and write-off expenses, and could therefore turn out to be more profitable than the flagship-store. But they would still benefit from the attention that the flagship-store attracts.

The operational costs are high for these stores. In research to the rental and operating charges of flagship-store districts in London and New York there was a significant variance discovered in relation to other comparable commercial districts (Fernie, 1998). Also in 2013, the P.C. Hooftstaat of Amsterdam, which is the most expensive shopping center of the Netherlands, was one of the few shopping streets that had an increase in rent price, despite dropping rent prices as a result of the bad economic environment (FD, 2014).

As a result of these high rent prices, it is assumed that only a minority of all flagship-stores can be profitable. This might also be an explanation of the fact that these stores are usually directly owned by the brand and are rarely operated as a franchise (Moore, 2000). Still, these flagship-stores remain operating and are actually still opening up in not yet fully developed city centers. This implies that they must generate additional revenue to the concern that operates the brand by attracting sales through other mediums.

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This would then benefit the country where this brand is located. However, this brand is now able to penetrate all other markets in the world, without any taxable presence. The flagship-store will be a physical location, which could constitute a PE, but this PE would not generate any taxable profit, as they usually run at a loss.

This could then be the shifting of growth in e-commerce at the expense of traditional commerce, as the TAG stated as their second threat (TAG, 2004). Also this could cause a shift from domestic to international commerce, when the bulk of the profits will accrue to the location where the brand is residing. The brand is not limited in its choice of where to set up its headquarters. It could then set up its headquarters in a location that would benefit its taxation preferences and hence lower its effective tax rate.

A few other illustrative examples of e-commerce business models

Brand A – A luxurious clothing brand

There is this clothing brand that is active in the top luxury, fashion and apparel business, with a number of boutiques throughout Asia, Europe and America. The information of this example is anonymously provided by Baker & McKenzie in Amsterdam. As this is highly confidential information that was part of an advice provided by Baker & McKenzie, the name of the concern will not be stated here, and will be addressed as “brand A”.

Brand A is active in providing luxury garments through shops and also in interior design. The activities for interior design are aimed at developing a functional and aesthetically pleasing spaces for building’s users, so the customers. For the activities of selling clothes and setting up the internal atmosphere in a physical retail store, the company that exploits the store also is provided with a trademark from the owner of this intangible.

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marketing and branding tool. The company within the concern of brand A that exploits the actual flagship-store is assigned some percentage of the relative costs of the concern and as well some actual costs, like interior design services that the shop incurs itself. There will be no mark-up for these costs within the remuneration, as the performed functions do not create any internal added value. For transfer pricing purposes, the company exploiting the flagship-store qualifies as a service provider, and therefore shall run without any risk whatsoever excluding those directly connected to the functions performed. This structure shall keep the exploiting company harmless from any economic or financial risk. As no risk is attributed to this company, it is defensible that no mark-up for incurred costs needs to be attributed.

Brand B – A mid-market clothing brand

In the middle segment of the clothing market another brand operates that could be considered as a mid-market clothing brand. As the discussed information below is also not publicly available, it will be assessed here anonymously, for the purpose of being illustrative. This brand will be addressed as “brand B”.

Brand B makes use of flagship-stores. However, they do not have flagship-stores set up as separate entities that are solely present in one country. For such a mid-price brand within the clothing market, the store mix is important for sales in a specific market of country.

The flagship-stores are important for the ultimate branding, i.e. letting the customer know what the feeling of the brand will be for the season, and showing the marketing campaign and the collection ultimately. This might be the biggest investment for marketing and these stores will usually be set up at the most prominent locations (i.e. the P.C. Hooftstraat of Amsterdam). People that buy products here mostly do it for status and for showing other people that they are wealthy. Therefore, sales in these stores will not easily be taken over by the Internet, as the Internet is not giving these people the same status and attention when buying products.

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would be located in the Kalverstraat (busy shopping street for all public) instead of the P.C. Hooftstraat (exclusive luxury shopping street and an attraction for wealthy tourists). These satellites sell much more as they are set up at more crowded locations.

Brand B focuses on e-commerce and recently this focus has gotten more important. However, wholesale makes the largest margins on sales. Wholesale is set up in department stores (for example in the Bijenkorf) that supply customers with a one-stop shop for all sorts of clothing brands and other consumer goods. The last way in which customers are reached is through outlets, which should be placed distant from flagship-stores, as they are not contributing to the branding of a concern. These are the cheaper stores that do not focus on marketing, but are used as a last selling channel in which the season leftovers are sold at a discount.

Within the transfer pricing model of brand B, flagships are remunerated with a few percentage points of mark-up on their total revenue, as the shops contribute to the total business model of the brand. In total therefore, the flagship-stores that are exploited do not run an actual loss. This remuneration is despite the fact that these stores do not earn anything in absolute numbers, but contribute to the branding and marketing atmosphere that the customers notice.

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receives the benefit when applicable. This is probably the case for all comparable brands: they are usually not locally organized and only have local service providers for the benefit of the (regional) headquarters.

For tax authorities the concept for a Local Marketing Intangible (“LMI”) is an important intangible. This is, however, a difficult concept, as these intangibles are usually not accounted for in any contract. This something that could be transferred outside a contractual agreement, and could therefore be compared to goodwill for example. There have been many processes and court proceedings to the determination of the value of a LMI, also between independent parties, and this shows that the assessment of value of LMIs is difficult. It is suggested (Bakker, 2009, page 125) that either the OECD should consider providing more clarity on the identification and remuneration of LMIs or they should require that assets that meet accounting criteria should all be compensated by an arm’s length remuneration. The LMI could raise some taxable base in the country where some physical or maybe also digital presence is used for marketing purposes.

Amazon – a full e-commerce concern

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The BEPS monitoring group, as a reaction the OECD request, called an example on Amazon. The digital economy has caused businesses to reorganize their structures based on possible tax savings. Amazon is a single firm and operating under one name in its relationship with the customers. Amazon is only generating sales through its website and has no physical selling location in any country. The customers that go to Amazon’s website, do however, go to the respective Amazon website in their country. For example visitors in the Netherlands are directed to www.amazon.nl, and customers in the UK are directed to www.amazon.co.uk. They cannot chose the website of their choice, and hence Amazon is able to offer country specific products and sales in each country. The sales are hence virtually located in the country of the buyer. Other functions of Amazon, like website operation, customer support, order fulfillment and warehousing are split in separate entities.

Amazon books its sales to Amazon SARL in Luxembourg. Under the current taxation and treaty rules, the actual selling is not an activity that causes any taxable presence at the location of the customers, because this function is attributed to an affiliate company (OECD, 2014-B, page 19). Amazon is using warehouses for its sales in the UK, but in the UK warehousing is not seen as causing any taxable presence in the form of a PE, because warehousing activities are excluded form the PE-concept. Amazon clearly has some activity in the UK, as in the other locations were its customers are located, however this does not necessarily lead to any taxation there. This construction is working because of a separation of business functions in different physical and virtual locations, with functions and hence remunerations attributed to affiliated companies that are located in countries chosen for their beneficial tax regimes.

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eliminated thanks to this innovation. In doing this, Amazon will track your buying behavior and will set up systems to anticipate what you might buy in the future, and send it already, before you even decide if you want to buy it. Amazon wants to start sending products for free to build goodwill, but also products that people should pay for.

This last type of products might get rejected by the customer, which will cost Amazon delivery and processing costs, but Amazon believes that in the end this will deem more profitable than waiting for the customer to actually buy the product. For a brand as Amazon, marketing is very important. The brand logo of Amazon contains a smiling face underlining the words of Amazon, which automatically causes the customer to smile as well. As Amazon sees it, hopefully this “smirk” on the box lets customers know that Amazon has been thinking about them and hopes customers will be persuaded in accepting the product, because they would not want to hurt Amazon.

The OECD Discussion Draft on the difficulties of e-commerce business.

The OECD has noted in many publications already that the digital economy poses challenges on international taxation. They characterize the digital economy as “an unparalleled reliance on intangible models capturing value from externalities

generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs” (OECD, 2014-C, page 5). It is stated here that the

digital economy has raised some questions as to “how enterprises in the digital

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The OECD is recognizing a few trends. First of all there has been a great diversification in personal devices that are connected to the Internet. Furthermore the software that is used on these mobile devices is becoming a commodity, as more and more software is developed and supplied. As the request for software is also growing, so is the competition between software suppliers. Also services are more provided over the Internet, for example in the case of cloud-based processes. Regular websites are seen as a software application providing services over the Internet, for example when a website now makes a sale instead of the sale in a physical shop.

In recent years the upcoming of virtual currencies has developed more, which means “digital units of exchange that are not backed by government-issued legal tender” (OECD, 2014-C, page 15), for example like the Bitcoin. These currencies might raise some policy issues as they are not government controlled and they can be traded anonymously, so it is hard to control these transactions.

Furthermore, there is an upcoming of robots that have already changed and will continue to alter manufacturing processes. These robots will lower labor and production costs, as they are far more efficient and make less mistakes than more traditional production. In addition to robots, also 3D-printing makes manufacturing more efficient, in particular the transportation costs to production, as 3D-printing enables production near the customer.

The abovementioned developments are all full technological developments resulting from the digitalizing economy. These developments are therefore not applicable on the case for the luxury fashion industry, which basically is still tangible, although sales can conducted over the Internet.

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These improvements in communication also enable companies to choose the optimal locations for their processes and operations, despite the distance it will cause between this part of the concern and other parts. This will create more efficient operations and could help reduce production costs.

Where a company needs labor for its operations, then the location of a specific business unit within a concern will depend substantially on the location where these key people want to perform their jobs. Another important decision factor is required infrastructure. The concern also has to some extent be located somehow close to the client, as the client’s experience with the supplied product is important for the revenue it can generate. Therefore, companies can now locate their separate business units in optimal locations where key markets of users are for example (OECD, 2014-C, page 17).

Interim conclusion

E-commerce has caused companies to develop into more centralization and outsourcing of business functions, as well as more effective cooperation between different business entities. Where before the Internet was used as a marketing tool to support the physical sales, we are now increasingly noticing that physical marketing is contributing to the sales that a website is conducting almost fully independent. Companies are now able to enter remote markets through the Internet, even when they are only in a start-up phase. This might lead to the need of more accurate identification of core business functions to companies as well as where these functions are located. However, it is hard to say if companies have really altered the legal structure of their organization as a result of the Internet developments. Also if companies did alter their business models to adapt to developments in the e-commerce sector, then these changes do not necessarily represent tax avoidance or evasion incentives.

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CHAPTER 2 – Tax implications of changes in business models

Taxation of business profits

If a company is present in a state and derives income therein, the country that hosts this company will want to levy tax on this income. Under the domestic tax rules of most countries the tax authority of country is in the first place able to levy tax based on the “residence principle”, meaning that a company needs to be a resident of a country to become liable to tax. Where a company is residing is very generally speaking based on the place of where its effective management is situated. Resident taxpayers are usually taxed on their worldwide income, hence regardless from which country the income is derived. On the other hand a country may also levy tax on business profits generated by non-resident companies if this income has some sort of nexus to the country. This form of taxation is based on the “source principle”, and allows countries to tax income that has its source in their country.

This may lead to double taxation if the country of residence of this company levies tax on the worldwide income, hence also on the income derived in the source country. This double taxation is in most cases alleviated by a tax treaty, which contains rules on the attribution of the total income to both countries. Under most of these treaties, the source country of income is allowed to levy tax on the source income if the presence in this country exceeds a certain threshold, and hence constitutes a permanent establishment. If there is a PE in a country, the income attributable to this PE may be taxed by the source country and is then exempted or credited from the tax payable in the home country on this company. The basic definition of a PE in the OECD Model Tax Convention, which is the basis for tax treaties conducted between OECD member countries, is “a fixed place of

business through which the business of an enterprise is wholly or partly carried on”

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at the disposal of the enterprise for the purposes of these business activities. The treaty definition of a PE provides however an exemption, that is if the place is used to carry on certain activities of a preparatory or auxiliary character, the place will be deemed not to constitute a PE notwithstanding the basic definition. The basic definition is furthermore extended with the definition of a an agent, which is a person that represent the company in that other country and has authority and habitually exercises the authority to conclude contracts in the name of the company. Independent agents are exempted from this rule.

International taxation principles and policies

As mentioned, underlying the tax systems of most states are the principles of source, residence, benefit and ability to pay. For allocating the tax burden within MNEs between different countries, economists use two main principles: “the benefit principle”, which is used as the basis for source taxations, and the “ability-to-pay principle” used as the basis for residence taxation (Kobetsky, 2011, page 25).

“Under the benefit principle, a taxpayer in an equitable tax system should

contribute taxes in accordance with the benefit the taxpayer receives from government programs.”

The benefit principle is not easy to apply. It is not easy, if not impossible, to measure the amount of benefit a taxpayer receives from government programs, such as education or infrastructure, for one part because different taxpayers receive different and also indirect benefits from these activities. Furthermore, when applying this principle, also the income-redistribution function of the government is foregone. This function is however the basis of the ability-to-pay principle. The ability-to-pay principle will, however, not be discussed here. The League of Nations was in the first place commissioned to develop theoretical principles for international taxation. They came up with an economic principle to approach both source taxation and residence taxation:

“Taking the field of taxation as a whole, the reason why tax authorities

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be considered as a part of a broader principle of economic interest or ‘economic allegiance’, as against the doctrine of political allegiance. A part of the total sum paid according to the ability of a person ought to reach the competing authorities according to his economic interest under each authority. The ideal solution is that the individual’s whole faculty should be taxed, but that it should be taxed only once, and that the liability should be divided among the tax districts according to his relative interest in each. The individual has certain economic interests in the place of his permanent residence or domicile, as well as in the place or places where his property is situated or from which his income is derived.” (EFC, 1923, page 20)

Early publications by the OECD on e-commerce

The following could have been a quote published in the light of recent attempts by the OECD to counter harmful tax avoidance by MNEs. However, these structures are not at all new, as the quote actually comes from a speech by the President of the United States, J.F. Kennedy in 1961:

“Recently more and more enterprises organized abroad by American firms

have arranged their corporate structures aided by artificial arrangements between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights, the shifting of management fees, and similar practices […] in order to reduce sharply or eliminate their tax liabilities both at home and abroad.” (Saint-Amans, 2013)

This shows that corporations were already trying to reduce their effective tax rates in the ’60s and they have tried so until today. Hence the OECD is continuously working on taxation aspects of e-commerce and has published already a comprehensive set of reports and technical papers that evaluate and assess the taxation of e-commerce in the OECD member countries.

The first piece of documentation on e-commerce was published in 1998, and was a report by the Committee on Fiscal Affairs (“CFA”) set up by the OECD to implement the conditions that were agreed by the OECD countries in this report. The report was called: “Electronic Commerce: Taxation Framework Conditions – A

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was published before the total impact of the Internet on the global commerce could be fully assessed. In this report e-commerce is expected to have the potential of becoming one the great developments of the 21st_Century.

E-commerce has the potential of creating growth, but governments and also tax authorities play an important role in facilitating a fiscal climate in which e-commerce can develop and will be taxed in a predictable manner. The Committee concludes that the current principles of international taxation could and should be applied to e-commerce as well.

These principles of international taxation dictate amongst others that taxation should be neutral and equitable between forms of e-commerce businesses and regular businesses. This is because business decisions should be made based on economic motives rather than tax motives. Efficiency should be maximized and therefore compliance costs should be minimized. There should be certainty and

simplicity for the taxpayer; hence taxation rules should be transparent.

Furthermore, taxation should be effective and fair, thus taxation should produce the right amount of tax at the right time. Companies are in fact allowed to keep their tax rate low, when no evasion or avoidance occurs. Taxation should also be

flexible to make sure that it is possible to adjust rules to adapt to technological

and commercial developments in ways concerns conduct their businesses. Indeed this flexibility will cause a challenge for tax authorities, especially when broad taxation principles need to be implemented in multiple countries in a rapidly changing environment. Another challenge in a changing and digitalizing environment is the use and remuneration of intangible property, especially in international relations.

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Tax authorities recognize at this point that e-commerce will make new ways of undertaking businesses possible and this will change the way these concerns interact with the wider community and customer base, and therefore some clarification on the current international taxation rules is required before they can be applied to e-commerce. The OECD will for this matter consult businesses and its member countries, in order to be able to adapt to the continuously changing environment. There should be clarification on how the concepts in the existing MTC should be applied in taxation of e-commerce, for example in determining taxing rights, such as derived by the concept of the PE and the attribution of income hereto, the classification of income as intangible property, royalties and services. Furthermore, it should be considered how the possibility of harmful tax competition between countries in particular for e-commerce should be avoided.

In 2000 the CFA generated another report (CFA, 2000) in which they further clarified the application of the PE-concept in the definition of e-commerce and propose changes to the Commentary on this matter. The CFA reached consensus on various issues concerning the application of the PE-concept in the e-commerce business:

“This consensus includes the important views that a website cannot, in itself,

constitute a PE, that a website hosting arrangement typically does not result in a PE for the enterprise that carries on business through that website and that an Internet Service Provider will not, except very unusual circumstances, constitute a dependent agent of another enterprise so as to constitute a PE of that enterprise.” (CFA, 2000, page 3)

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the fact that they have a PE in a country. This clarity would then be reached by establishing that a website cannot, in itself, constitute a PE. According to the OECD, an Internet website is a combination of software and electronic data, and hence does not constitute tangible property by itself and cannot form a “fixed place of business” that is required to constitute a PE.

They also make an important distinction here between a website and the server on which the website is stored, because these two activities can be performed by different enterprises. Usually a server is owned or leased by a company, which is located with a company at the physical location of this server. The company owning the website, can rent digital space on this server with a digital connection. In contrast to a website, a server can under some circumstances constitute a PE.

In 2004 the Technical Advisory Group of the OECD (“TAG”) produced a report on e-commerce that describes new business models that have come up as a result to the more extensive use of Internet during these years. They explain the treaty rules for taxing business profits as they were in 2004 and make a critical evaluation as to whether these rules are appropriate for the taxation of e-commerce (TAG, 2004).

The upcoming of new business models is a result of the possibility for concerns to streamline their core functions and communicate more efficient. This has lead to the development of business models including for example outsourcing of manufacturing or internal services, online marketing, more efficient deliveries because of tracking systems, the centralization of financial and administrative services and the upcoming of trade in digital products (such as software, games, music, videos, news, e-books etc.).

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conditions should be met to cause a negative effect on the tax revenues for some countries:

1. “The growth of e-commerce would have to be very important.

2. A substantial part of that growth of e-commerce would have to be at the expense of traditional commerce.

3. A substantial part of that growth would need to represent a shift from purely domestic to international commerce.

4. Residents of the affected country would not develop enterprises engaging in reciprocal e-commerce businesses; and

5. That growth and the resulting reduction of domestic traditional commerce would not be compensated by other benefits and business opportunities created by e-commerce, such as the transfer of manufacturing and service jobs” (TAG, 2004, page 27).

The OECD published another report with a tax policy study on e-commerce regarding business profits taxation (OECD, 2005) as a result to the implementations of the communications revolution that was going on at the time being. The OECD was not expecting new or very different problems in the field of transfer pricing in respect to e-commerce, but they did recognize the potential of e-commerce making some more difficult problems that already exist, more common.

The first part of this report is discussing ways in which a business model using e-commerce can be set up and what consequences these would have for transfer pricing matters. General conclusions are that the presence of a PE is not easily assumed at a location where a server of a website is present. Basically, the extent to which performed functions are automated is a guideline for the amount of profit that should be attributed to the PE, according to this report.

This report also recognized the difficulty in changing the taxation rules for PEs in e-commerce: “It may be difficult to perform such a detailed examination of the

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given the rapid growth in electronic commerce and the potential implications for preservation of existing tax bases.” (OECD, 2005, page 53)

Because MNEs use efficient communications portals and streamline their core functions in the optimal location, they perform better and could increase the total profit to a higher level than the separate companies could make (economies of scale). This makes it an even harder question of how to attribute these profits that the concern makes as a whole, to the separate companies. For taxation matters the existence of the PE and the source of income derived from third-party transactions are the most important concerns as a result of the upcoming e-commerce business.

The second part of this report is a description of the current treaty rules for taxing business profits and the treaty definition in the context of e-commerce. The OECD has reached conclusions on how this definition should be applied:

- “A website cannot, in itself, constitute a PE;

- Website hosting arrangements typically do not result in a PE for the

enterprise that carries on business through the hosted website;

- Except in very unusual circumstances, an Internet service provider will not

be deemed to constitute a PE for the enterprise to which it provides services;

- Whilst a place where computer equipment, such as a server, is located may

in certain circumstances constitute a PE, this requires that the functions at that place be such as to go beyond what is preparatory or auxiliary.”

The PE-concept in general is vulnerable to tax planning, according to the OECD in this report. As the PE-concept is the primary source for taxing business profits in a country derived by foreign enterprises, this is an interesting concept for the e-commerce business. In e-e-commerce, functions of a concern can even easier be split between countries. “To the extent that very little profits would be attributed

to functions performed through a server or website, such planning involving the location and the hosting of websites would have little consequences on tax revenues.” (OECD, 2005, page 88)

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- “Storage, display and delivery or merchandise of the enterprise; - Purchase of goods, or collecting information;

- Maintenance of goods of the enterprise for the purpose of processing

by another enterprise;

- A combination of the above activities where the overall activity

resulting from this combination is of a preparatory or auxiliary character.” (OECD, 2010)

It is argued by some member of the TAG, that these exceptions create possibilities of setting up several economic activities in a country, which combined, are substantial, but are not regarded as passing the PE-threshold. They illustrate: “for example, purchases and sales of goods could be made in a

country through the Internet by a foreign enterprise which would also rent a warehouse for the storage and eventual delivery of these goods to consumers in the same country without that enterprise being found to have a PE in the country”

(OECD, 2005, page 89).

In the case that e-commerce businesses set up in the abovementioned example are replacing traditional retailers that would be taxed in the country, this could lead to substantial tax revenue loss for countries. However, they argue here that the total effect of e-commerce would likely be that some countries lose some tax revenue, but could also gain tax revenue as a result of these structures. They also in this report state some possible alternatives for the taxation of e-commerce, but after an evaluation of the options, they concluded that none of these alternatives should be pursued at this time.

Interim conclusion

The shift from P.C. Hooft to P.C. home shopping: