Once again, we find ourselves faced with a proposal attempting to target and provide special tax rules for income generated in the digital economy. As was the case in the previous year’s budget proposal, the Administration’s Fiscal Year 2016 Revenue Proposals (the “Green Book”) contains proposed measures aimed at income generated by “digital goods and services.” While it may be easy to dismiss this specific provision as unlikely to be implemented given the current political climate, the reality is that it would be unwise to ignore the momentum that is building, both domestically and internationally, for provisions to be enacted that apply specifically to digital goods and services, as well as the exploitation of personal data. Therefore, it is worth taking a few minutes to consider where things may be headed and whether or not you may be ensnarled as the tax law in this area continues to develop.

Included in the Green Book is a proposed new category of Subpart F income, foreign base company digital income, which is described as including “income of a CFC from the lease or sale of a digital copyrighted article or from the provision of a digital service, in cases where the CFC uses intangible property developed by a related party (including property developed pursuant to a cost haring arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income.” [1] As appropriate, an exception is provided if the customer is located in the CFC’s country of organization. As this is only in the form of a proposal, little background is given, and the breadth and reach of the operative terms requires further clarification to say the least. However, a couple of points are worth mentioning. In connection with a sale of a copyrighted article, although not entirely clear, it would seem that the application of the provision hinges, in part, on the medium of the delivery of the article. [2] A sale by a CFC of a disc containing the software would seem to be treated differently than a transfer of the software via the Internet. It is a bit puzzling why substantively similar transactions should be treated differently. Further, it is unclear why the administration would want to encourage the economically wasteful intermediate step of embedding software on a disc. [3] In the non-digital goods space, a CFC is able to acquire/cost-share IP from or with a related party and sell a product, regardless of the relative value of the IP to the product, without triggering Subpart F income on the sale. This is the case even if the CFC contracts out the manufacturing to a third party, such that the CFC may not contribute anything substantial to the actual physical creation of the tangible embodiment of the product.

Turning to digital services, it should be noted that formal guidance is still lacking as to proper characterization of certain cloud-based offerings. This uncertainty has been around for some time, and it would be helpful for Congress to first provide some guidance, including whether authority under Section 7701(e) will or should be followed.

The concerns for players in the digital economy space are not limited to U.S. proposals. Countries and multinational organizations (such as the OECD) are struggling to apply laws developed under a brick-and-mortar economy to the digital economy. [4] More frequent discussions are occurring centering on establishing jurisdiction to tax based on “significant digital presence” or other market-based approaches. Bilateral tax treaties still currently act to blunt such approaches, although the longevity of such protection is uncertain. In addition, the United States does not have tax treaties with all jurisdictions, especially with many Latin American countries where tax authorities have already imposed local tax (via withholding) on technical services provided to persons in the local market, even where all of the actual services are performed outside of the country.

Taxing authorities are also wising up to the notion that “if it is free, you are the product” and considering ways in which to capture revenue attributable to the use and exploitation of its citizens’ data by the data aggregators.  For example, in 2013, France had proposed an Internet based tax on the collection of personal data. [5] Although the provision was not formally adopted, the author understands that France is awaiting direction from OECD under its base erosion and profit-shifting project, which, in its recent preliminary release on the subject, included discussions of a potential bandwidth tax to address such concerns. [See Tax Challenges Raised by the Digital Economy]. Although the OECD mentions that the digital economy should not be ringed-fenced with its own special set of rules, one gets the impression that tax authorities are moving in that direction.

The good news is that most of the provisions discussed above have not been enacted. Taxpayers still have the opportunity to provide input and raise concerns. Although some may be of the dismissive of the U.S. proposals, since tax reform has been trumpeted for years without any substantive action, proposals targeting the digital economy are being offered on a more frequent basis. The focus on the taxation of digitized or dematerialized offerings is intensifying, and it is very possible that a consensus will be reached that may have a drastic impact on a taxpayer’s way of doing business and worldwide effective tax rate. Taxpayers that ignore this movement do so at their own peril.

Notes:
[1] Green Book at 33-34.

[2] Since a copyrighted article is generally defined as a computer program (which is inherently digital) under Treas. Reg. Section 1.861-18(c)(3), the descriptive use of the word “digital” would seem to imply that medium employed to transfer the copyrighted article is an important aspect of the provision. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986 as amended, and the Treasury Regulations promulgated thereunder.

[3] Moreover, if Section 954(c)(6) continues to be extended, it may lead to structures that avoid the Subpart F taint of this new category, but potentially lead to an increase in local country tax. If profits are ultimately repatriated (with foreign tax credits), the net result is a ceding of the U.S. tax base to foreign countries.

[4] The European Union recently changed the way in which VAT was applied by requiring VAT to be determined by the location of the customer.

[5] See http://www.nytimes.com/2013/01/21/business/global/21iht-datatax21.html?_r=0