International Taxation in the Digital Economy: Challenge Accepted?

Marcel Olbert, MSc. (University of Mannheim)

Prof. Dr. Christoph Spengel (University of Mannheim and ZEW)
This version: 22 August 2016
Abstract:
The digitalization of the economy is considered a driver of innovation, economic growth,
societal change, and a major challenge for the international tax system. The OECD has labelled
and addressed this challenge in its extensive report on Action 1 in the course of the BEPS
project. This article critically depicts the OECD’s view and reform proposals on taxing
businesses in the digital economy. Further, recent literature contributions on the matter are
synthesized. While taxing profits according to value creation is detected as the new paradigm
in international taxation, this review reveals that the understanding of the digital economy and
corresponding reform proposals for taxation are premature. We show that the OECD has
systematically missed to define the paradigm of value creation and to analyze digital business
models accordingly. Considering the current challenges, the key pressure area for taxing
digital businesses in the near future is transfer pricing. Drawing from practical case studies
and research in industrial economics, accounting and management science, this article derives
a concept for value creation in digital businesses. Based on this concept, we finally propose a
framework to refine transfer pricing guidance in order to come closer to the goal of aligning
profit taxation with value creation.

1
 Contents
1. Introduction ................................................................................................................................... 3
2. The OECD-view on the Challenges of the Digital Economy ..................................................... 5
2.1. Technological Features and Business Models ..................................................................... 5
2.2. Recognized Tax Challenges .................................................................................................. 6
2.2.1. BEPS ................................................................................................................................... 6
2.2.2. Broader Challenges ............................................................................................................. 7
2.3. The New Gold Standard: Value Creation ........................................................................... 8
2.4. Transfer Pricing in the Digital Economy ............................................................................ 9
2.5. Interim Conclusion .............................................................................................................. 10
3. Proposals to Tax Companies in the Digital Economy .............................................................. 11
3.1. BEPS Action Items Affecting Taxation in the Digital Economy ..................................... 11
3.1.1. Treaty Abuse and the Avoidance of the PE Status ............................................................ 11
3.1.2. Individual Anti-Avoidance Measures ................................................................................ 11
3.1.3. Aligning Transfer Pricing Outcomes with Value Creation ............................................... 12
3.2. Adjustments of the PE Concept and Alternative Concepts of Nexus ............................. 14
3.3. Withholding Taxes .............................................................................................................. 16
3.4. Consumption-oriented Tax System and Transaction Taxes ............................................ 18
3.5. Unilateral Actions and EU-Proposals ................................................................................ 18
3.6. Interim Conclusion .............................................................................................................. 20
4. A Deeper Look at Digital Business Models, Value Creation and Tax Consequences ........... 22
4.1. Case Studies on Value Creation of Digital Business Models ........................................... 22
4.1.1. Defining Value Creation and Analyzing Business Models ............................................... 22
4.1.2. Case Study: Digital B2C Business Models ....................................................................... 23
4.1.3. Case Study: Digital B2B Business Models ....................................................................... 25
4.1.4. Case Study: Digitalization of Traditional Businesses ....................................................... 26
4.2. Evidence on Tax Sensitivity of Digital Business Models .................................................. 27
4.3. Interim Conclusion .............................................................................................................. 29
5. From Addressing to Meeting the Challenge.............................................................................. 30
5.1. Aligning Taxation with Value Creation: A Transfer Pricing Challenge ........................ 30
5.2. Developing Transfer Pricing Guidance for the Digital Economy ................................... 32
5.2.1. Scope and Definitions........................................................................................................ 33
5.2.2. Key Assets ......................................................................................................................... 33
5.2.3. Core Activities ................................................................................................................... 36
5.2.4. Transfer Pricing Methods .................................................................................................. 38
5.3. Coordinating Tax and Innovation Policy .......................................................................... 39
5.4. Interim Conclusion .............................................................................................................. 40
6. Conclusions .................................................................................................................................. 41
2
1. Introduction
The phenomenon of digitalization is considered the most important development of the
economy since the industrial revolution and one of the major drivers of growth and innovation.1
At the same time, the digital economy is associated with major challenges for the international
tax system.2 Traditional tax laws are governing new ways of conducting business but current
international tax law and its underlying principles may not have kept pace with changes in
global business practices3. With regards to digital business models, the main tax challenges in
the digital economy stem from this decreasing relevance of a physical presence in the market
of the customers, the increasing importance and mobility of intangibles and the high degree of
integration of the value chain. Although these developments are not entirely new,4 they have
triggered a political and academic discussion about how international taxation can be reformed
to provide a reasonable and stable system for taxing the profits of multinational companies in
the 21st century.5 In this vein, there have been calls for comprehensive and systematic changes
of the international tax principles by academic scholars and supranational political institutions.6
The respective literature on the digital economy examines individual aspects such as the
permanent establishment (PE) concept, the characterization of income, the determination of
transfer prices and the application of withholding or transaction taxes.7 There is a general
consensus that the digital economy cannot be “ring-fenced” for tax purposes.8 At the same time,
the proposals to tax companies in the digital economy differ widely with regard to the
underlying aims and the methods to address the challenges. The lack of consensus also stems
from the fact that there is no common definition and measurement of the relevant elements in
digital value chains that are characterized by recent technological developments and the
prevalence of online networks.
In the course of the Base Erosion and Profit Shifting (BEPS) project, the OECD has labelled
the tax challenges of the digital economy as Action 1. It has been concluded that digital business
models entail substantial opportunities for (aggressive) tax planning but also raise broader
issues for the tax system. Although the OECD depicts some of the technological foundations

1
E. Brynjolfsson & L. M. Kahin, Understanding the Digital Economy – Data, Tools, and Research, 2000, p. 1;
M. Peitz & J. Waldfogel, The Oxford Handbook of the Digital Ecnonomy, 2012, p. ix; E. Brynjolfsson & A.
McAfee, The Second Machine Age, 2015, p. 90; OECD, OECD Digital Economy Outlook 2015, 15 Jul. 2015, p. 11
available at http://www.oecd.org/internet/oecd-digital-economy-outlook-2015-9789264232440-en.htm.
2
OECD, Addressing the Tax Challenges of the Digital Economy, Action 1: 2015 Final Report, 5 Oct. 2015, p. 16,
available at http://dx.doi.org/10.1787/9789264241046-en.
3
OECD, Addressing Base Erosion and Profit Shifting, 12 Feb. 2013, p. 7, available at
http://dx.doi.org/10.1787/9789264192744-en.
4
A. Baez & Y. Brauner, Withholding Taxes in the Service of BEPS Action 1: Address the Tax Challenges of the
Digital Economy, IBFD White Papers (2015), p. 4; O. Popa, Taxation of the Digital Economy in Selected Countries
– Early Echoes of BEPS and EU Initiatives, 55 Eur. Txn. 1 (2016), p. 38, Journals IBFD.
5
M.P. Devereux & J. Vella, Are we heading towards a corporate tax system fit for the 21 st century?, OUCBT
Working Paper (2014), p. 4; A. Cockfield et al., Taxing Global Digital Commerce, 2013, p. 7.
6
Y. Brauner, BEPS: An Interim Evaluation, 6 World Tax J. 1 (2014), p. 11, Journals IBFD; European Commission,
Questions and Answers on the Action Plan for Fair and Efficient Corporate Taxation in the EU, Factsheet 17 Jun.
2015, available at http://europa.eu/rapid/press-release_MEMO-15-5175_en.htm.
7
This article focuses on the taxation of income and will not evaluate the tax challenges the digital economy poses
for indirect taxes. However, the effective collection of VAT will be considered when reviewing reform options
and drawing conclusions. Also, fundamental reform options such as a destination-based corporate tax are neglected
as the focus is on current challenges and developments for tax policy and practice.
8
OECD, supra n. 2, pp. 73, 142; European Commission, Commission Expert Group on Taxation of the Digital
Economy – Report, Brussels: 2014, p. 41.
3
and innovative business models of the digital era, the corresponding consequences and potential
issues for taxation are not thoroughly discussed. The latest report rather highlights how business
models of multinational companies in the IT or e-commerce sector can facilitate undesired
outcomes in terms of low or no taxation. Options to address the tax challenges put forward by
the OECD are characterized by mitigating BEPS risks and creating awareness for the tax
challenges,9 rather than confronting long-term tax issues caused by digital business models.
This work of the OECD has been accompanied by an extensive body of literature containing
different reform proposals. Surprisingly, scientific evidence on how the digitalization might
change the influence of tax policy on corporate decision making is scarce. In the near future,
revising the determination of transfer prices is one of the key challenge in designing an
administrable system of profit taxation with a minimum of distortive effects for digital business
models. The OECD stresses this challenge and intends to better align profit taxation with
economic activity and value creation. However, outcomes are limited,10 and there is no common
understanding of the term “value creation” in the digital economy which would be a prerequisite
for a consistent profit allocation within digital business models.
Against this background, this article aims to review the OECD’s understanding of the tax
challenges of the digital economy and present the current stage of reform proposals. This review
investigates in how far tax legislation and reform proposals for direct taxes incorporate value
creating factors of digital business models. By considering relevant literature and case studies
of exemplary digital business models, the article further intends to identify open questions for
research and suggest pragmatic policy action for the short-run. In other words, this article
examines how to close the gap between addressing and meeting the tax challenges of the digital
economy.
In order to address this question, the rest of the article is organized as follows. In section 2, we
depict the understanding of the digital economy and its tax consequences from the viewpoint
of the OECD based on the Final Report in October 2015. Reform proposals for corporate profit
taxation in the digital economy by the OECD and several scholars are summarized in section
3. In this section, we also give a brief outlook on unilateral action by states implementing rules
to tackle identified tax issues of the digital economy. The focus in section 4 is on the
organizational and economic nature of digital business models and their corresponding tax
treatment. We first elaborate on the primarily undefined notion of value creation in the digital
economy. To exemplify value drivers, we then present case studies that encompass both, newly
emerged business models as well as the digital transformation of traditional business models.
Last, a brief literature review shows that little is known regarding the tax sensitivity of such
business models. Building on these results, we identify the key practical challenge of aligning
taxation with value creation in section 5. We propose a practicable approach to meet this
challenge and argue that tax policy should be aligned with innovation policy to foster innovation
and growth. Section 6 finally concludes.

9
J. Englisch, BEPS Action 1: Digital Economy – EU Law Implications, British Tax Review (2015), p. 281.
10
For a thourough critique, see Y. Brauner, Changes? BEPS, Transfer Pricing for Intangibles, and CCAs, 2016.
4
2. The OECD-view on the Challenges of the Digital Economy
2.1. Technological Features and Business Models
Rather than producing direct tax policy action, the OECD was expected to study the
characteristics of the digital economy to provide an overview of the tax challenges within its
Action Item 1.11 In the course of the work, the OECD’s Task Force on the Digital Economy
(TFDE) also examines the technological foundations and characteristics of digital business
models in the Action 1: Deliverable 2014-Report as well as the Final Report of October 2015.12
The OECD regards the soaring diffusion and development of information and communication
technology (ICT) as the enabling factor for the digitalization of businesses in several areas.13
This development implies integration of hardware and software in the form of computing
devices that become increasingly connected by accessing the internet. While the relevance of
hardware is still eminent as the backbone of communication networks, digital business models
generate profits rather from the operation of computing devices and software applications than
from the sale of hardware.14 Further, software business models in the digital economy are
characterized by their reliance on the internet as well as open-source approaches and on-demand
implementations at the level of the end customer.15 In addition, the OECD observes that the
major players in the digital economy rely on different ways of creating, using and generating
revenue with online content. The increasing use of the internet by end customers and the
growing number of connected devices enable the collection and analysis of digitized data.
Businesses in the digital economy benefit from this data by offering customized products and
services and by generating productivity and quality gains.16 Last, the OECD names cloud
computing as a major result of the trends in ICT. Firms are able to provide traditional, on-
premise resources as services over the internet such as computing power, data warehousing or
software applications.17 Overall, the OECD concludes that these developments cause prices of
commoditized goods and services to fall. In contrast, sub-elements of those commoditized
transactions can be offered in a more individualized way through digitalization. New
opportunities at a different stage of the value chain are created in this way.18 This shift (of
innovation) elsewhere in the value chain caused by the advent and uptake of modern ICT is not
further scrutinized.
Based on the development of ICT, the Final Report includes a non-exhaustive list of potential
future developments that might influence the nature of digital business models as well as a
conceptual overview of how different layers of ICT interact. In a brief and descriptive manner,
the concepts of the internet of things, virtual currencies, advanced robotics, 3D printing, the
sharing economy and collaborative production, access to government data and the reinforced
protection of personal data are depicted.19 According to the OECD, several new business

11
Brauner, supra n. 6, p. 17; Englisch, supra n. 9, p. 281; S. S. Johnston, What’s Next for the OECD and the Digital
Economy, Tax Notes International (2014), pp. 1089-1090.
12
OECD, Addressing the Tax Challenges of the Digital Economy, Action 1 Deliverable, Paris: 2014, pp. 51-98;
OECD, supra n. 2, pp. 35-84.
13
OECD, supra n. 1, p. 11; OECD, supra n. 2, pp. 35 et sequ.
14
OECD, supra n. 2, p. 37.
15
See ibid, p. 39. Within this article, firms providing the technological infrastructure (so-called internet service
providers) do not fall under the scope of digital business models as they rely on substantial physical capital and
operate at a regional scale.
16
See ibid, p. 40.
17
See ibid.
18
See ibid, p. 36.
19
See ibid, pp. 42-48.
5
models have emerged due to the spread of ICT across all sectors entailing some key features
that might be relevant for tax purposes.20 Apart from basic definitions and statistics, these
business models are not further analyzed. However, the OECD concludes that the high degree
of connectivity implies the unprecedented mobility of intangibles, users and customers as well
as business functions. Regarding the latter, it is particularly noted that businesses can carry on
economic activity in markets with minimal need for personnel and physical operations. Further,
functions and assets can spread across multiple countries. This flexibility is limited as the core
functions including the development of intangible assets can only take place where key
personnel is located. In addition, providing high-quality digital services to end users requires a
certain degree of infrastructure in proximity to the customer market.21 The processing and
analysis of data, often provided by users, is facilitated by increased computing power and
database management tools. These technologies have become a major value driver of digital
businesses.22 Therefore, investing in research and development (R&D) seems to be a pivotal
activity for the sustainable success of a business in the digital economy. 23 According to the
OECD, network effects are an important feature of many digital business models and can either
add substantial value or even decrease the value due to congestion. Also based on externalities,
multi-sided platforms are becoming prevalent due to digitalization. By providing a platform,
the business models generate revenue from one or more groups of users whose decisions and
activities affect each other (e.g. users of a social network and corresponding advertisers). These
multi-sided business models can be highly flexible and spread across several countries. 24 A
typical result of network effects and multi-sided platforms in the digital economy is the
formation of monopolistic or oligopolistic market structures with leader firms that succeed in
generating a large user base. However, the technological developments and the decrease in
start-up costs for digital business models intensify competition and make it hard to sustain
market leadership.
2.2. Recognized Tax Challenges
2.2.1. BEPS
The description of the digital economy and the emergence of new business models 25 remains
superficial in the sense that it only lists new forms of user experiences and revenue generation.
Following this section, the OECD devotes a comprehensive chapter on corresponding BEPS
opportunities. This part of the final report does not elaborate on the way assets are used or
people perform their functions and on the corresponding tax consequences of the new digital
business models. The focus rather shifts to the advantageous use of key features of the digital
economy (such as mobility and the reliance on intangibles) and legal structures of companies
in the IT sector that are supposedly motivated by the tax planning considerations.26 The
concentration on BEPS is justified by the general notion that the specifics of the digital

20
Exemplary business models are the extensive uptake of e-commerce for all types of trade transactions, online
payment services, app stores, online advertising, the above mentioned cloud computing, high frequency trading
and participative networked platforms. See ibid, p. 64.
21
See ibid, pp. 66-68.
22
See ibid, p. 69.
23
See ibid, p. 73.
24
See ibid, pp. 70-72.
25
See ibid, chapter 4.2, pp. 54-64.
26
Substantial resources have been committed to work on the specific problems identified in the BEPS project in
the form of each Action Item. As all BEPS actions interact with each other in the digital economy, the focus should
have rather been on more general implications of the digital economy for the principles of international taxation.
See R. S. Avi-Yonah & H. Xu, Evaluating BEPS, DRAFT 1/15/16, pp. 9-10.
6
economy exacerbate BEPS although the tax planning strategies might be similar to those of
traditional businesses.27
The OECD has identified four areas of BEPS opportunities of particular relevance in the digital
economy. The first one comprises eliminating or reducing tax in the market country as the result
of either avoiding a taxable presence or minimizing the income in the market country. For cross-
border online transactions that do not require a physical presence, a tax liability is usually not
defined in domestic law. If the country of residence does not assume its taxing right, the
respective income is effectively untaxed. In the case of a taxable presence, the income can be
minimized by only allocating minimal functions, assets and risks or maximizing deductions in
the market country. This is considered problematic because the allocation of functions and
assets is often tax motivated and functions and risks are not factually exercised.28 This concept
also applies to the second BEPS opportunity of reducing tax in the country of residence in
particular if valuable (intangible) assets are transferred to affiliates in low tax regimes. Two
other BEPS opportunities are the avoidance of withholding taxes and the elimination or
reduction of tax in the intermediate country through the use of specific contractual payments
and the imposition of holding companies.29
2.2.2. Broader Challenges
While the OECD concluded in its early work that no dramatic departure from the current rules
is needed,30 today’s view is that source taxation might not be sufficiently established in the
digital economy.31 The potential reason is seen in the spread and evolution of ICT. This
evolution has expanded the scale of cross-border business activity undertaken without
substantial physical operations in the market countries. At the same time, core functions can be
centralized due to their mobility. Accordingly, the OECD identifies broader tax challenges that
can be categorized into (1) nexus for taxation, (2) the use of data and the respective attribution
of value, and (3) the characterization of payments made for digital products or related services.32
(1) Taxable Nexus
On one side, the fundamental nature of business activities with regard to a supply chain in the
digital economy has not changed. On the other side, the way of conducting these activities is
shaped by the spread of core functions across multiple jurisdictions and a potential segregation
of core activities from customer markets.33 In the eyes of the OECD, the latter phenomenon
challenges current international tax law in particular with regard to the concept of PEs. First, it
is questionable whether the preconditions of a dependent agent are still not met if contracts and
customer relationships are prepared by local staff but the ultimate contract conclusion is reached
remotely between customers and a foreign entity (paragraphs 5 and 6 of Article 6 of the OECD
Model Tax Convention (MTC)). Second, activities considered preparatory or auxiliary

27
OECD, supra n. 2, p. 78, Englisch, supra 9, p. 283; D. Fehling, Neues zu den Herausforderungen für die
Besteuerung der Digitalen Wirtschaft – Der Abschlussbericht zu Maßnahme 1 des BEPS-Aktionsplans liegt vor,
2015 IStR, p. 799.
28
OECD, supra n. 2, pp. 79-81.
29
See ibid, p. 82; Englisch, supra 9, p. 282.
30
OECD, Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce? - Final Report,
Paris: 1999, pp. 72 and 350.
31
Baez & Brauner, supra n. 4, p. 15; Englisch, supra 9, p. 282.
32
OECD, supra n. 2, p. 99. Evidently, it is important to note that those three categories overlap when discussing
the tax treatment of businesses in the digital economy.
33
OECD, supra n. 2, p. 101.
7
according to paragraph 4 of Article 5 of the OECD-MTC might constitute more important parts
of digital business models and hence trigger the PE status. Additionally, it is not clear how
network effects and user participation that are observable in the market country should be
treated for tax purposes.34
(2) Use of Data and Attribution of Value
Although customer data has always been a source of value, it is unclear if current rules
consistently attribute value to the huge amounts of data collected and used for digital
businesses. The major challenge lies in understanding how collected data is monetized and
which functions are involved to do so. Whether the remote collection of data gives rise to a
taxable nexus should depend on a thorough analysis of functions performed, assets used and
risks assumed in order to reflect the value chain of businesses leveraging data. Even if a taxable
nexus is assumed, it remains an issue of transfer pricing to allocate respective profits to the
countries where data is collected, processed and used. For the use in advertising, the OECD
recognizes that the value of data is reflected in the advertising revenue.35
(3) Characterization of Payments
Since the last elaboration of the ICT’s implications on taxation, business models have evolved
and it is a challenging task to qualify the respective payments as royalties, fees for technical
services or business profits. This challenge is particularly obvious for the concept of cloud
computing that implies a shift towards more service-oriented business models in the area of
hardware and software goods. Also, completely innovative business models such as 3D printing
may rise unprecedented character questions.36 In this respect, the OECD hints at the
interrelation of the characterization of payments and nexus as both concepts together will
determine how certain digital transactions are taxed.37
2.3. The New Gold Standard: Value Creation
The OECD clearly aims to tax profits in line with value creation and economic activity. 38
Scholars and practitioners have already acknowledged this conception as the new and prevalent
paradigm in international tax law.39 The fundamental question of how enterprises in the digital
economy add value and make their profits appeared early in the BEPS project. 40 The report on
the tax challenges of the digital economy does not give any definition or interpretation of value
creation but highlights several questions, issues and developments regarding this concept in the
digitalized world. Intangibles are seen as core contributors to value creation of companies in
the digital economy. Intangibles, along with business operations, are becoming more mobile.
Software appears to become a more important category of intangibles in many digital business
models.41 The discussion of the technological developments reveals that networks are assumed

34
See ibid, pp. 101-102; Englisch, supra 9, p. 282.
35
See ibid, p. 104.
36
See ibid, p. 105.
37
For instance, if a nexus is established in the form of a PE, business profits are taxable in the market jurisdiction
and the net principle applies. Royalties, however, would then give rise to withholding taxes and payments are thus
taxed on a gross basis in the market jurisdiction.
38
See ibid, p. 136
39
Devereux & Vella, supra n. 5, p. 13; W. Schön, Transfer Pricing Issues of BEPS in the Light of EU Law,
British Tax Review (2015), p. 419; J. Wittendorf, BEPS Actions 8-10: Birth of a New Arm’s-Length Principle,
Tax Notes International (2016), p. 331.
40
OECD, supra n. 2, pp. 16. OECD, supra n. 3, p. 25.
41
OECD, supra n. 2, pp. 65.
8
to change the concept of value creation since value increases in the mere number of network
participants.42 While the concept of data as a contributor to value creation is established, the
question of how to attribute value to the generation, storage and use of data is still unanswered
giving rise to a broader tax challenge.43 Considering the amount of data in the analysis of
functions, assets and risks as well as to measure the value of data would be a complex task due
to the variety of transactions, the diffusion of data in multi-sided business models and the
remote nature of handling data.
The goal of aligning profit taxation with value creation in the digital economy is emphasized
by the reference to the work on the revision of transfer pricing guidance within the BEPS
project. The work on the corresponding Actions 8-10 is explicitly headlined “Aligning Transfer
Pricing Outcomes with Value Creation”. Again, the final report on Actions 8-10 does not define
the notion of value creation for purposes of designing tax policy but rather presents it as a
modification of the existing arm’s length standard.44 However, the work intends to update
current practice by including the nature of integrated global value chains within a concise
revision of the current guidelines.45 Due to its technological features and globalized nature,
digital business models constitute prime examples of integrated global value chains and should
thus be directly affected by the ongoing transfer pricing policy that aims at outcomes aligned
with value creation.
2.4. Transfer Pricing in the Digital Economy
The OECD expects that the revision of the transfer pricing guidance will substantially address
the BEPS issues exacerbated by the digital economy.46 The review of BEPS opportunities and
broader challenges in the digital economy points at the allocation of assets, functions and risks
within digital business models leading to undesired tax consequences. The latter two broader
issues directly relate to transfer pricing questions. It is therefore important to specifically
consider perceived transfer pricing challenges and potential solutions for the digital economy.
At the international level, profit allocation for tax purposes resulting from intracompany
transactions depends on the functions performed, risks assumed and assets used by the involved
entities. The analysis has to be performed and justified by the taxpayers relying on the arm’s
length principle. The principle is codified in the OECD’s transfer pricing guidelines agreed on
in 1995 and last updated in 2010 as well as in Article 9 of the OECD Model Tax Convention.47
The OECD’s interpretation has been adopted in many countries’ domestic tax laws. Primarily,
profit allocation follows contractual arrangements of transactions between associated
companies. Legal ownership of intangibles is a decisive factor in determining profits stemming
from the use of IP.48 Due to the increasing globalization and segregation of value chains the
contractual separation of risks and assets, in particular intangibles, from functions has emerged

42
See ibid, pp. 71.
43
See ibid, pp. 99.
44
Wittendorf, supra n. 39, p. 331; Schön, supra n. 39, p. 420.
45
OECD, Aligning Transfer Pricing Outcomes with Value Creations, Actions 8-10: 2015 Final Reports (OECD
2015), 5 Oct. 2015, p. 11, available at http://dx.doi.org/10.1787/9789264241244-en.
46
OECD, supra n. 2, p. 12; Englisch, supra 9, pp. 282-284.
47
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD 2010),
International Organizations’ Documentation IBFD [hereinafter OECD Guidelines].
48
Wittendorf, supra n. 39, p. 332; Duff & Phelps, Guide to International Transfer Pricing, 2015, pp. 70, 73; F.
Wassermeyer & H. Baumhoff, Verrechnungspreise international verbundener Unternehmen, 2014, pp. 9, 182,
815.
9
as a prominent tool for tax planning in the area of transfer pricing.49 The OECD argues that the
technological features of the digital economy magnify this tax planning potential. In particular,
transfer prices are used to minimize income allocable to functions, assets and risks in market
jurisdictions and high tax countries.50 It is concluded that the combination of contractual
allocations of business transactions and the legal ownership of intangibles are exploited by
digital business models to justify large income allocations to entities even if they perform very
little business activity.51
In its report on the tax challenges of the digital economy, the OECD acknowledges the transfer
pricing specific challenges and refers to its BEPS Actions 8-10 reports for the development of
potential solutions. In the consolidated report on Actions 8-10, reference is made to the tax
challenges of the digital economy when describing the scope of work for guidance on the
transactional profit split method. The relevant proposals can thus be seen as a part of the
OECD’s work on the tax challenges of the digital economy and will therefore be analyzed in
section 3 of this article.
2.5. Interim Conclusion
Before the publication of the OECD’s final report, there has not been any serious study of the
changes brought by the digital economy from a tax point of view.52 The OECD acknowledges
that the key features of digital business models are potentially relevant for designing tax
regulations.53 Thus, the evaluation of tax policy regarding digital business models should
closely follow the analysis of the organizational and economic characteristics of the depicted
developments. While BEPS opportunities inherent in the digital economy are detected, the
broader challenges are only described on an abstract level. More accuracy would be needed to
determine the exact tax treatment of all transactions of a digital and multinational company.
However, it is emphasized that the developments of the digital economy challenge the current
tax system especially with regards to the paradigm of characterizing and allocating income
according to value creation.
A major part of the tax challenges of the digital economy relate to transfer pricing. Yet, the
OECD has not directly elaborated on transfer pricing specifically for transactions of digital
business models. This limitation is related to the lack of analysis regarding the evolution of
functions, assets and risks in digital business models. The analysis of the tax challenges hardly
refers to the technological developments pointed out in the first sections of the final report (see
chapter 2.1). In addition, the international tax policy community has not provided a clearly
defined and commonly acknowledged notion of the term value creation. Options to reach the
goal of better aligning the location of taxable profits with the location of economic activity and
value creation put forward by the OECD and several scholars are presented in the following
chapter.

49
Brauner, supra n. 10, p. 3.
50
OECD, supra n. 2, pp. 80-81.
51
See ibid, pp. 145, G. Kofler, The BEPS Action Plan and Transfer Pricing: The Arm’ s Length Standard under
Pressure?, British Tax Review (2013), p. 649.
52
Brauner, supra n. 6, p. 17
53
OECD, supra n. 2, p. 64.
10
3. Proposals to Tax Companies in the Digital Economy
3.1. BEPS Action Items Affecting Taxation in the Digital Economy
Consistently with the notion that the tax challenges of the digital economy are mainly an
expression of more intense BEPS activities by multinational enterprises (MNEs), the OECD
first describes how relevant outputs of the BEPS project address the identified tax challenges
before evaluating separate reform options for the digital economy. The work on BEPS aims to
combat artificial structures and profit shifting to low tax jurisdictions or non-taxation and
thereby to align taxation with the location of economic activities.54
3.1.1. Treaty Abuse and the Avoidance of the PE Status
Taxation of digital business in the market jurisdiction is expected to be fostered by the BEPS
work on the prevention of treaty abuse (Action 6) and the prevention of the artificial avoidance
of PE status (Action 7). Action 6 provides conditions to be met by companies to benefit from
treaty provisions in order to inhibit legal arrangements with the goal of treaty shopping. It is
not mentioned whether these rules might apply to companies in the digital economy specifically
or more frequently. In contrast, the TFDE considers the work on the PE status a key area of
focus for the digital economy and highlights two potential amendments. 55 First, a PE status
should be assumed if a local subsidiary (i.e. its workforce) of a company selling tangible goods
or providing services online plays a principal role in the conclusion of contracts and the parent
company routinely concludes these contracts in a formal way without any material modification
(modification of the independent agent provisions in Article 6 of the OECD-MTC). Second, the
list of exemptions from the PE status in paragraph 4 of Article 5 of the OECD-MTC is revised
to exclude activities that were previously qualified as preparatory or auxiliary but are rather
substantial for digital business models and thus should create in a PE. In this context, the OECD
highlights the use of large and sophisticated warehouses in proximity of customers purchasing
physical goods from online platforms. Additionally, a new anti-fragmentation rule targets the
prevention of a PE by the spread of multiple entities of the supply chain across various
jurisdictions. A local warehouse of an e-commerce company repeatedly serves as an example
that will regularly be affected by these amendments.56
3.1.2. Individual Anti-Avoidance Measures
In the view of the OECD, several anti-avoidance measures will address BEPS in the country of
residence and the source country of companies in the digital economy. As Action 6 on
preventing treaty abuse, the work on hybrid mismatch arrangements (Action 2) and the
limitation of base erosion via financial payments (Action 4) should limit BEPS facilitated by
tax-motivated arrangements. Again, there is no direct reference made to the specific tax
challenges of the digital economy. Measures to counter harmful tax practices more effectively
(Action 5) are attributed particular relevance for the digital economy. As many countries have
introduced preferential regimes for income stemming from intellectual property (so-called IP-
boxes) and the digital economy relies on intangibles as the key value drivers, the proposed
nexus approach is expected to ensure that taxpayers only benefit from the regimes if substantial
activity is prevalent.57 To ensure taxation in the jurisdiction of the ultimate parent, a report on
designing effective controlled foreign company rules (CFC, Action 3) has been delivered.
54
See ibid, p. 86.
55
See ibid, p. 88.
56
See ibid, pp. 12, 65, 80, 88, 134, 145, 169.
57
See ibid, p. 90; Englisch, supra 9, p. 285.
11
Depending on the specific approach to implement CFC rules, digital businesses might be
affected if key intangibles are located in low-tax jurisdictions and the respective companies
generate revenue from the remote sale of digital goods and services.58
3.1.3. Aligning Transfer Pricing Outcomes with Value Creation
Major tax challenges of the digital economy are expected to be addressed by the extensive work
on aligning transfer pricing outcomes with value creation (Actions 8-10). The revision of
transfer pricing guidelines should help to restore taxation on stateless income, to address BEPS
in market and parent jurisdiction, and to solve issues regarding the tax treatment of data.59 While
the analysis of functions, assets and risks will still be decisive for profit allocation, further
guidance aims to ensure that profit will be allocated to those group members that exercise
control over business risks rather than only contractually bear the risks and only financially
contribute to the development of intangibles.60 The revision of chapter I of the guidelines on
applying the arm’s-length principle confirms that an assembled workforce and group synergies
within MNEs are not treated as intangibles per se.61 Since these concepts might be of particular
relevance in digital business models, the OECD does not seem to pursue a more tailored
definition of intangibles for digital businesses. The use and transfer of intangibles is revised
within chapters VI and VII of the guidelines with the aim to force back the predominance of
legal ownership and to value transfers, including cost contribution agreements, according to the
economic circumstances. A definition of the term intangibles is provided for the first time. This
definition is so far expected to cover a broader range of intangibles and thus cause qualification
conflicts.62 The guidance introduces a commensurate with income (CWI) standard that may
allow tax authorities to use ex-post information for determining transfer prices in particular
when intangibles are hard to value.63 Intangibles are seen as key value contributors of digital
business models. However, the revision of the guidelines does not entail any specific
elaboration on the definition, detection and valuation of intangibles within digital business
models. Instead of a clarification, these modifications might entail higher compliance costs and
a higher risk of tax disputes for digital companies that develop and use diverse types of
intangibles across their international business but coordinate these actions centrally.
The only direct relation to the tax challenges of the digital economy is the promotion of a wider
application of the transactional profit split method.64 The OECD acknowledges that the
enforcement of the arm’s length principle in the digital economy with its digital products and
services is becoming increasingly difficult as MNEs employ global and highly integrated supply
chains. In this vein, the legal separation of MNEs’ affiliates is considered economically less
relevant in the digital economy. The OECD thus advocates for a greater reliance on value chain
analyses and the use of transactional profit split methods to properly align profits with value
creation if unique intangibles are involved in digital business models.65

58
See ibid, p. 93; Englisch, supra 9, p. 291.
59
See ibid, pp. 86, 88, 103.
60
For a detailed analysis of the new guidance, see Wittendorf, supra n. 39 and H.-K. Kroppen & S. Rasch,
Immaterielle Vermögenswerte – Neudefinition des Fremdvergleichsgrundsatzes? Die finalen Aktionspunkte 8-10
der BEPS Initiative, IWB (2015).
61
OECD, supra n. 45, pp. 46-48; Wittendorf, supra n. 39, p. 342.
62
For a discussion, see Wittendorf, supra n. 39, pp. 344-347.
63
OECD, supra n. 2, p. 91. OECD, supra n. 45, pp. 9-12.
64
OECD, supra n. 45, p. 55.
65
OECD, supra n. 2, p. 92; see also Schön, supra n. 39, p. 419.
12
Tavares and Owens (2015) argue that human capital in its specific form of knowledge-based
capital is becoming a predominant value driver of businesses particularly in the digital age.
Therefore, such capital should have substantial weight in the functional analysis of purposes of
profit allocation.66 A new paradigm for functional analysis that acknowledges the existence of
globally integrated value chains and might require an enhanced residual profit split method
(PSM) would lay the foundations for ensuring transfer pricing outcomes are in line with value
creation while yielding arm’s length results. Within the scope of this analysis, the location and
use of knowledge-based capital should influence the characterization of the value chain and the
according transfer pricing outcomes. The authors record the fact that the accumulation of
knowledge-based capital often involves key entrepreneurial risk-taking functions that are
significantly less mobile than financial capital and the beneficial ownership of assets.
Considering knowledge-based capital in the functional analysis would overcome the direct
valuation of complex economic phenomena such as the use of data and would thus provide a
suitable instrument for attributing income according to value creation in the digital economy.
As such an approach would often ignore intercompany contracts in favor of value chain
analysis, effective dispute resolution mechanisms are necessary to establish legal certainty for
taxpayers and to avoid double taxation.67
In an evaluation of the consequences of the BEPS action plan on investment activity, Schreiber
(2015) criticizes the OECD’s move towards a more frequent application of the PSM. If the
consideration of cost factors is maintained when applying the method, investment decisions
might be distorted as business functions in the digital economy are highly mobile and might be
located according to tax planning objectives.68 To mitigate distortive effects while not
abandoning existing principles of international profit taxation, the author advices the OECD to
elaborate on a PSM that is based on a revenue factor only. Despite the expected opposition in
countries with smaller customer markets, a revenue-based PSM would be desirable as it
counteracts the avoidance of taxation in market countries and decreases investment distortions,
compliance costs and the risk of double taxation.69
Pellefigue (2015) reviews the economic theories of profit drivers in the digital economy
consisting of the increased use of IT and the internet, multi-sided markets and network
externalities leading to monopolistic situations. The interaction of these digital economics
complicates the task of finding consistent transfer pricing outcomes for the traditional methods
including the PSM.70 In contrast to the arm’s length principle, analytical tools in game theory
would lead to economically more justifiable results. Pellefigue suggests a model where different
affiliates of a MNE in the digital economy engage in bargaining and consider the network
effects that the activities of each other would have on their financial situation. As a result,
subsidiaries in countries where users and customers are located would be attributed more profits
even if their assets and functions are limited from a traditional perspective.71 The author does
not claim to provide a solution to the tax challenges of the digital economy due to the
complexity of the proposed method. His point is rather in line with the literature that the status

66
R. J. S. Tavares & J. Owens, Human Capital in Value Creation and Post-BEPS Tax Policy: An Outlook, 69
Bull. Intl. Txn. 10 (2015), Journals IBFD.
67
See ibid, p. 599.
68
U. Schreiber, Investitionseffekte des BEPS Aktionsplans der OECD, zfbf (2015), p. 120.
69
See ibid, pp. 121, 123.
70
J. Pellefigue, Transfer Pricing Economics for the Digital Economy, 22 Int. Transfer Pricing J. 2 (2015), p. 99,
Journals IBFD.
71
See ibid, p. 100.
13
quo is no longer tenable and that the OECD should attach high importance to designing new
transfer pricing rules and guidance for applying such rules.
3.2. Adjustments of the PE Concept and Alternative Concepts of Nexus
In its 2014 deliverable on Action 1, the OECD had discussed several options to amend the
definition of a PE in order to address the broader tax challenges. The output has been considered
in the work on Action 7. As a result, the exceptions from PE status in Paragraph 4 of Article 5
of the OECD-MTC have been modified. In the future, only overall activities of a PE that are of
preparatory or auxiliary nature will be excepted. In case a function formerly considered as
auxiliary like logistics could constitute a PE if a well performing logistics infrastructure is
essential to the business model as it is for electronic retailing. In addition, an anti-fragmentation
rule (new Paragraph 4.1) has been introduced to complement the modification of exceptions
from PE status. This rule is directed at the opportunity of digital companies to spread their value
chain across several business entities and jurisdictions.72 The OECD mentions that these
modifications may go beyond BEPS cases but does not further evaluate the amendments of the
PE concept.
Based on initial approaches of the 2014 deliverable, the OECD also presents a new taxable
nexus based on the concept of significant economic presence. In the absence of a taxable
presence according to existing principles, such a significant economic presence could be based
on different factors comprising sales, the frequency of digital transactions and the number of
users. A combination of these factors with the main emphasis on sales could then result in a
taxable presence.73 The OECD mentions that, once such a nexus is established, the
determination of attributable income is a non-trivial task. Existing rules and principles would
not be analogously applicable without major adjustments due to the missing physical and legal
factors that determines the allocation of assets, functions and risks.74 As another departure from
current principles, the deemed profit method as an easily administrable way of profit allocation
is briefly presented. A ratio of the revenue generated within the market of the significant
presence according to the above factors would determine the profit allocated to the market
country. The approach, however, contains several shortcomings such as the required
comparability of the significant presence with traditional business operations to find appropriate
margins. Also, there could even be deemed profits in loss making situations of the digital
business model.75 Owing to these practical issues and concerns regarding the implications such
a departure from the established tax principles would have, the OECD did not further discuss
the concept of a significant economic presence when evaluating the options that deal with the
broader tax challenges.
During the OECD’s work on BEPS, Hongler and Pistone (2015) have presented an elaborated
report on how to expand the PE concept to appropriately preserve source states’ sovereignty to
tax business income in the digital age. Although the work directly relates to the BEPS project,
the authors pursue a more fundamental revision of the principles for allocating taxing rights.
The authors propose the PE as a means to allocate taxing rights that require a departure from

72
OECD, Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7: 2015 Final Report, 5
Oct. 2015, p. 29 and 39 respectively, available at http://dx.doi.org/10.1787/9789264241220-en. The option to
modify the PE thresholds as described in the 2014 deliverable on was not further considered.
73
OECD, supra n. 2, pp. 107-113.
74
Similarly, formula apportionment is not a suitable method as comparable factors to apply the formula will
generally not be available and the inherent departure from traditional profit attribution methods is not desired.
75
See ibid, pp. 112-113.
14
the concept of a fixed place of business based on physical characteristics as a response to the
digital economy’s structural changes.76 Conducting digital business in countries can justify the
creation of a PE according to both, the source and the benefit theory. On the one hand, the
source theory should encompass digital businesses if value creation occurs in a modern, less
physical sense. On the other hand, also non-physical, digital activities receive benefits from
countries such as a stable legal system, the enforcement of payments, the supply of energy or
infrastructure that are important for the business model.77 Therefore, an amendment of the PE
concept in form of an additional paragraph in the OECD-MTC is suggested. Following the
novel rule, a company operating electronic applications, databases, online marketplaces,
storage rooms or platforms for online advertising would be deemed to have a PE if a monthly
user base of 1,000 and a certain threshold revenue in the market country are surpassed. 78 Once
such a nexus would be established, neither the current transfer pricing rules for allocating assets,
functions and risks nor the alternative concept of formula apportionment would be suitable for
income allocation due to the non-physical nature of digital businesses.79 The authors advocate
the application of the transactional PSM that should be revised in order to account for the great
importance of the inherent value creation of the market itself. An upfront income allocation of
one third of a digital company’s profit to the market jurisdiction is considered to be in line with
economic principles.80 Although the collection of the tax and the distribution among several
market countries might entail practical challenges, the authors also see the upfront split and
allocation of profits as a feasible option to ensure the global enforcement of taxation.81 The
authors discuss several implementation issues such as determining the ultimate taxpayer, the
interaction with other supranational provisions and the introduction to national hard and soft
law, all requiring substantial further research efforts. As in the OECD’s final report, the term
value creation is not defined but used as the justification of the proposed approach. 82 Despite
these shortcomings, the modified PE concept is seen superior to other reform proposals as it
would preserve the Ottawa principles of taxation.83
In addition, there are frequent comments in the literature on these elaborated reform proposals
and the OECD’s work with diverging views. It is noted that the proposed changes to the
exceptions from the status of PE will only have limited impact since the concept of physical
presence will still be prevalent and certain business models (i.e. online retailers) are targeted
selectively.84 Further, several limitations of the OECD’s criteria to establish a taxable nexus
based on a significant (digital) economic rather than physical presence have been highlighted.85

76
P. Hongler & P. Pistone, Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital
Economy, IBFD White Papers (2015), pp. 10, 14.
77
See ibid, pp. 19, 22.
78
See ibid, p. 25.
79
See ibid, p. 32-33. The option of introducing a gross taxation through withholding taxes on digital transactions
is not further discussed. Instead, reference is made to Baez & Brauner, see supra n. 4, see also section 3.4 of this
article.
80
See ibid, p. 34.
81
See ibid, p. 37.
82
Accordingly, there is no explanation how the upfront allocation of one third of the profits to the market
jurisdiction would comply with the principle of taxation according to value creation.
83
See ibid, pp. 38-43.
84
D.W. Blum, Permanent Establishments and Action 1 on the Digital Economy of the OECD Base Erosion and
Profit Shitfting Initiative – The Nexus Criterion Redefined?, 69 Bull. Int. Txn. 6/7 (2015), p. 317, Journals IBFD;
Hongler & Pistone, supra n. 76, p. 13.
85
The OECD’s draft on a taxable nexus based on a digital presence as presented in the 2014 deliverable is also
harshly criticized because many aspects regarding the definitions and implementation were unsolved. As the
concept was not further pursued in the Final Report, the discussion is omitted in this article.
15
First, thresholds and conditions for establishing such a nexus would potentially ring-fence
certain cyber-physical transactions. Second, it is not clear how businesses that rely on both, a
digital and a physical presence would be treated. Third, many obstacles remain for such
proposals in terms of the interaction of a new digital nexus with existing principles in
international tax law such as the PE provisions for traditional businesses and distributive rules.86
Therefore, some scholars argue for an elaboration of a “digital service PE”. This approach
would be preferable to an alternative nexus from a systematic point of view as it is also justified
with the base erosion principle but directly relates to common practice in the OECD and UN
Model Tax Conventions.87 Others call for a more fundamental debate on how to establish
indicators in the digital economy that equally comply with the principles of economic allegiance
and inter-nation equity as the concept of the traditional PE did when originally introduced. 88
However, it is not explained how these principles can serve as determinants for the allocation
of taxable profits. Within this debate, scholars propose not to rely on any physical presence or
specific nature of transactions but solely use a certain sales volume as a threshold for creating
a taxable presence.89 At this point of time, there are no outlooks on the consequences for
existing principles and issues of implementation of such a concept.
3.3. Withholding Taxes
In order to collect taxes from digital businesses in market countries in the form of a final
withholding tax or to enforce the nexus option, the OECD discusses the opportunities and issues
of a withholding tax on digital transactions. To avoid qualification conflicts and economic
distortions, such a tax should apply to a broad range of online and remote transactions.
Collecting such a tax would be particularly challenging in business-to-consumer (B2C)
transactions. Financial intermediaries (such as banks) would either need to be granted detailed
information on the transaction or a mandatory registration system might be needed. As
withholding taxes usually follow the approach of a gross taxation of income, business models
with ongoing expenses are not appropriately taxed and withholding tax rates would need to be
low.90 Further, a gross taxation of digital transactions from remote providers would not comply
with international trade law and EU law. It is generally codified that foreign suppliers must not
be taxed less favorably than domestic suppliers. Particularly withholding taxes on transactions
involving digital goods would be problematic.91 Because of these concerns, the OECD has not

86
For a discussion of the compatibility of new PE definitions and EU law, see Englisch, supra 9, p. 285 et sequ.
87
Blum, supra n. 84, pp. 318-322, p. 321 for the „service PE“ concept. A service PE for digital transaction would
allocate significantly more income to the source country than applying a new nexus approach and traditional
transfer pricing rules. This is briefly highlighted by Baéz Moreno (2015) when comparing the OECD’s work on
the tax challenges of the Digital Economy with the UN MTC approach to tax technical services. See A. Baéz
Moreno, The Taxation of Technical Services under the United Nations Model Double Taxation Convention: A
Rushed – Yet Appropriate – Proposal for (Developing) Countries?, 7 World Tax J. 3 (2015).
88
E. E. Lopez, An Opportunistic, and yet Appropriate, Revision of the Source Threshold for the Twenty-First
Century Tax Treaties, Intertax (2015), p. 13.
89
R. Avi-Yonah, A virtual PE: International taxation and the marketplace fairness act, 2013 Public Law and
Legal Theory Research Paper Series No. 328, p. 3; M. Devereux, How we can make global companies pay their
fair share of tax, The Financial Times Online, 22 Mar. 2013, available at http://www.ft.com/intl/cms/s/0/e9fc449c-
c2f0-11e2-bbbd-00144feab7de.html#axzz47DzD2r8D.
90
Applied consistently, the credit mechanism of withholding taxes would also need to be on gross basis to avoid
unused tax credits and double taxation.
91
OECD, supra n. 2, p. 113. While the General Agreement on Trade in Services (GATS) contain several
exceptions for the taxation of services by foreign suppliers, General Agreement on Tariffs and Trade (GATT)
prohibit any such unequal treatment.
16
considered the option of a withholding tax system to address the tax challenges of the digital
economy in its final evaluation of the topic.
Alongside the BEPS project, Baez and Brauner (2015) have provided a detailed argumentation
for a broad withholding tax mechanism to encounter the under-taxation of stateless income and
allocate more tax revenue to source jurisdictions in the digital economy. The authors see the
withholding mechanism as a secondary alternative to the nexus approach but point out its merits
of a feasible way to collect taxes and allocate revenue to source states.92 The proposal comprises
a global standard withholding tax of, for instance, 10% on base-eroding payments to non-
residents for all business-to-business (B2B) transactions. Upon registration, payments not
related to digital transactions can be exempt from the withholding tax and would be taxed on a
net basis in the source country.93 This would avoid the difficult task of agreeing on a definition
of the digital economy and its related transactions. Further, the option for net taxation as well
as the possibility to credit the withholding tax in the residence jurisdiction run counter to the
objections of the OECD and in the literature that a withholding tax would have the form of an
excise tax inhibiting international trade.94 In order to follow a source rule to legitimately
allocate income, the preferred mechanism would qualify those payments liable to withholding
tax that are deductible in the country of residence or PE of the payor.95 In line with their
justification according to the base erosion approach, B2C transactions would not fall under the
scope of the withholding tax. While a withholding tax could be levied by financial
intermediaries if market countries were concerned about losing legitimate tax revenue, this loss
of revenue and the apparently minor lack of neutrality do not justify a systematic inclusion of
B2C transactions in the proposal. Similarly, C2C transaction would not be covered by the
withholding tax.96 Due to its simplicity, the proposed mechanism does not face significant
design issues and could be implemented as a new article 7(4) in the OECD MTC.97 However,
a comprehensive registration and identification system would be required and can only be
implemented under global coordination and standard setting.98 While their proposal can be
based on a source rule following the base erosion approach and contains elaborate
implementation guidance, the authors call for more work on an anti-abuse rule, accounting and
review aspects as well as a coherent taxation of B2C transactions.
A study by Finke et al. (2014) shows that the extension of source taxation by imposing
withholding taxes might be a useful instrument to combat base erosion due to the promising
features of collectability and enforceability. As a pragmatic solution to secure tax revenue in

92
Baez & Brauner, supra n. 4, pp. 6-7.
93
The withholding tax rate might be increased if the payee is located in a low tax jurisdiction. The administrative
burden for multinational enterprises is expected to be limited as a registration system would fit into the
developments of global information exchange and increasing reporting requirements. See Baez & Brauner, supra
n. 4, pp. 7, 13-14.
94
Baez & Brauner, supra n. 4, p. 25. Yet, the problem of potential double taxation in case the jurisdiction of the
only grants a tax credit on a net basis is not further addressed. For concerns regarding international trade law and
withholding taxes as quasi-consumption taxes, see OECD, supra n. 2, p. 113. Comments received with respect to
the public discussion draft on BEPS Action 1, pp. 91-96; Cockfield et al., supra n. 5, p. 470; R. L. Doernberg,
Electronic Commerce and International Tax Sharing, Tax Notes International (2015), p. 1013.
95
Baez & Brauner, supra n. 4, p. 15.
96
See ibid, p. 18.
97
See ibid, p. 23.
98
Such a registration is facilitated if market countries already pursue a consumption taxation of digital transactions
at the location of consumers by requiring non-resident suppliers to register for VAT purposes. Otherwise, the
imposition of a withholding tax on B2C and B2B transactions raises the administrative burden but might facilitate
the collection of VAT for digital transactions at destination.
17
market jurisdictions, the authors assume a fixed withholding tax rate of 10% for all cross-border
payments. The tax is fully credited on a gross-basis in the jurisdiction of the payee. To predict
the effects on the tax revenue of individual countries is a difficult task. Depending on the status
quo of the withholding tax network, the direction of bilateral flows of payments related to digital
transactions as well as the characterization of those payments, the outcomes might have
surprising and undesired results for countries considered as major market jurisdictions in the
digital economy.99 For digital transactions that do not create a taxable nexus under current rules,
in contrast, withholding taxes are considered less helpful. When there is no taxable nexus, it
will be cumbersome to determine transactions falling under the scope of the tax and the
respective withholding agents for the collection of the tax. The latter is particularly problematic
because customers can hardly be obliged to withhold taxes payable by foreign MNEs. Also,
(financial) intermediaries in digital transactions often have no legal connection to the involved
business entities and are interchanged frequently.100
3.4. Consumption-oriented Tax System and Transaction Taxes
As an alternative to complicated profit allocation mechanisms, the OECD has proposed an
equalization levy to tax profits of digital businesses based on their significant digital presence.
As one form, the levy could be collected on all remote or only digital transactions of foreign
companies with domestic customers based on the gross value of the transactions and would thus
resemble a consumption tax such as the value-added tax (VAT). As another form, the levy could
be calculated based on the amount of data or other contributions from customers in order to
account for the value creation by collecting user data. Due to probable conflicts with
supranational trade law and potential double taxation if the instrument is not introduced in a
coordinated manner,101 the OECD has not elaborated on the prospects of this concept in its
evaluation of options and future work.
There are only a few comments and proposals on introducing transaction taxes, sometimes
named “bit” tax or “Google” tax. In its 2014 version of the Action 1 deliverable, the OECD has
dedicated a small paragraph to the option of introducing a bandwidth tax that would be based
on the volume of bandwidth used by MNEs’ websites.102 The advantageousness of such a
transaction tax is probably not evaluated further as it is not clear how the technological
infrastructure relates to the value creation of digital business models and a bit tax does not fit
in the existent system of income taxation.103
3.5. Unilateral Actions and EU-Proposals
The OECD does not recommend any of the considered options due to the incomplete
elaboration on their functioning and the prospect of the implementation of BEPS measures as
well as the effective collection of VAT. However, the OECD leaves the unilateral or bilateral
implementation of such options to countries wishing to proactively limit perceived tax

99
C. Fuest et al., Eindämmung internationaler Gewinnverlagerung: Wo steht die OECD und was sind die
Alternativen?, Steuer und Wirtschaft (2015), p. 96; For a detailed simulation of introducing a globally
coordinated system of a withholding tax on interest and royalty payments of 10%, see Finke et al., Extending
Taxation of Interest and Royalty Income at Source – an Option to Limit Base Erosion and Profit Shifting?, ZEW
Discussion Papers (2014), pp. 30-32, 35.
100
Blum, supra n. 84, p. 324; C. Fuest et al., Profit Shifting and “Aggressive” Tax Planning by Multinational
Firms: Issues and Options for Reform, 5 World Tax J. 3 (2013), p. 319, Journals IBFD.
101
OECD, supra n. 2, pp. 115-117.
102
OECD, supra n. 12, pp. 146 et sequ.
103
Blum, supra n. 84, p. 324.
18
challenges of the digital economy.104 The OECD simultaneously demands consistency with
existing international tax law in the case of unilateral action. These statements in the final report
reflect the conflict of interest between those countries wishing to generate more tax revenue at
source from foreign IT companies and those pursuing a competitive landscape for domestic
digital businesses.105
Already before the publication of the reports on addressing the tax challenges of the digital
economy by the OECD, the EU and national governments contemplated tackling the issues of
taxation in the digital economy. In its report of May 2014, the EU High Level Expert Group on
Taxation of the Digital Economy expresses its support for the developing ideas and conclusions
of the OECD concerning the tax challenges of the digital economy.106 Regarding BEPS, it
encourages member states to counter harmful tax practices while respecting the Single Market
Principles.107 Within the scope of BEPS, a fundamental review of transfer pricing rules, in
particular with respect to the allocation of profits to intangibles and business risk, is seen as a
major challenge.108 Finally, the report underlines the need for elaborating on more fundamental
tax reform options to address the technological change within the digital economy. Therefore,
continuing examination on income taxation based on formula apportionment109 and research on
a destination-based income taxation system are suggested.110 The assumption of neutrality and
feasibility of the latter reform option is not uncontested in light of the unknown consequences
for tax revenue distribution and the effects on corporate decisions.111 Hence, political action
addressing the tax challenges of the digital economy on EU level will, in line with the OECD’s
work, most certainly focus on current pressure areas such as preventing low or non-taxation by
tax motivated arrangements.
Among others, Australia, France, Hungary, Israel, Italy, Luxemburg, the Netherlands, and the
United Kingdom have introduced initiatives and laws for taxing digital businesses.112 Concrete
action has been taken in Italy, the United Kingdom, Australia and Hungary. All countries apply
different methods targeted at taxing income from digital business. Italy has passed a new
transfer pricing rule that stipulates the use of other than cost-based indicators for determining
arm’s length prices for digital transactions.113 In the United Kingdom and Australia, similar
laws aim to include income of multinational companies without a domestic tax liability but with
significant economic allegiance to the domestic market. Both, the Diverted Profits Tax, with

104
OECD, supra n. 2, p. 137.
105
Fehling, supra n. 27, p. 802.
106
European Commission, Report of the EU High Level Expert Group on Taxation of the Digital Economy, 28
May 2014, Brussels, pp. 6, 41.
107
See ibid, p. 43.
108
See ibid, pp. 43-45. In this context, the Expert Group expect the most important and decisive output for the
tax challenges of the digital economy from Actions 8, 9 and 10 of the BEPS project.
109
In particular, the proposal on a Common Consolidated Corporate Tax Base (CCCTB) first published in 2011
and recently picked up in the Action Plan for Fair and Efficient Corporate
Taxation in the EU (see European Commission, supra n. 6). S See European Commission, Proposal for a
Council Directive on a Common Consolidated Corporate Tax Base (CCCTB), 11 March 2011, COM(2011)
121/4, Brussels.
110
European Commission, supra n. 106, pp. 8, 50.
111
See ibid, p. 50; B. Westberg, Taxation of the Digital Economy – An EU perspective, 54 Eur. Txn. 12 (2014),
p. 544, Journals IBFD.
112
For a recent and brief overview, see Popa, supra n. 4, pp. 38-41 and EY, Digital Tax Developments December
2016, available at http://www.ey.com/Publication/vwLUAssets/ey-digital-developments-map-direct-tax-april-
2016/$File/ey-digital-developments-map-direct-tax-april-2016.pdf.
113
G. Gallo, Italy Budget Law for 2014 – details (7 Jan. 2014), News IBFD, G. Pizzitola & C. Horwath, VAT
Registration Rule for Web Advertising Abolished, Tax Notes International (2014), p. 1097.
19
effect from 1 April 2015 in the United Kingdom, and the Tax Integrity Multinational Anti-
Avoidance Law, with effect from 1 January 2016 in Australia, particularly target large
multinational companies generating sales in these countries by running local operations such as
customer relationship management but remotely concluding contracts with customers.114 While
the British government explicitly mentions digital businesses as the main target group, 115 the
Australian authorities hint at 30 large multinational companies (that) are suspected of diverting
profits using artificial structures to avoid a taxable presence116. Hungary, in turn, opted for
levying a surtax in the publishing sector that also applies to online advertising by non-resident
and domestic providers. A tax of 5% on net sales from advertising above c. EUR 3 million is
levied and might be charged to the advertiser if there is no evidence (i.e. registration) of the
provider paying the tax.117
3.6. Interim Conclusion
Neither the OECD’s Final Report nor the academic literature produce a clear and unanimous
answer to the question of how to address the tax challenges of the digital economy. With regard
to determining and taxing corporate profits, the OECD and the EU are unlikely to propose a
departure from the current principles of assessing the functions, assets and risks of the
enterprises concerned but rather promote selective adoptions of current standards.118 Existing
concepts of international taxation and their potential adoptions are discussed separately in the
corresponding action points. Several scholars highlight that the key question for taxing
businesses in the digital economy is how to allocate profits generated by new types of business
models. Yet, the OECD’s preferred proposal to amend the exception of auxiliary and
preparatory activities from PE status will not remarkably affect income allocation in the digital
economy.119 Establishing new or alternative nexus rules might contradict the idea of not ring-
fencing the digital economy for tax purposes. Further, Hellerstein (2014) points out that new
concepts of nexus might lead to the additional problem of misalignment of the allocation of
taxing rights and the ability to enforce taxation.120 Also, the implementation of specific BEPS

114
B. Obuoforibo & Heydari, S., United Kingdom – Corporate Taxation sec. 10.6.1., Country Analyses IBFD
(accessed 29 Feb. 2016); M. Butler et al., Important International Tax Developments – Foreign Capital Gains
Withholding Tax, and Anti-Google, Netflix and Amazon Taxes, Asia-Pacific Tax Bulletin (2016), Chapter 5,
Journals IBFD; Australian Government, The Treasury, Tax Laws Amendment (Tax Integrity Multinational Anti-
Avoidance Law) Bill 2015, 2015, available at
http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/2015/Tax%20In
tegrity%20Law/Key%20Documents/PDF/EM_Tax_Integrity_Multinational_Anti-avoidance_Law.ashx, M.
Butler & M. Danby, Draft Legislation for „Anti-Google“ Tax, 22 Int. Transfer Pricing J. 6 (2015), p. 349,
Journals IBFD.
115
HM Revenue and Customs (HMRC), Government ramps up efforts to tackle digital multinational tax risks,
Press Release of 24 March 2015, available at https://www.gov.uk/government/news/government-ramps-up-
efforts-to-tackle-digital-multinational-tax-risks.
116
See the statement under the title „Closing the Digital Loophole“ on the government’s website, available at
http://www.budget.gov.au/2015-16/content/glossy/tax/html/tax-05.htm., see also Butler & Danby, supra n. 114,
p. 349.
117
L. Torma & Á. Burján, Hungary – Corporate Taxation sec. 2.3.10., Country Analyses IBFD (accessed 04
Feb. 2016).
118
OECD, supra n. 2, p. 112; Englisch, supra 9, p. 280; M. K. Singh, Taxing E-Commerce on the Basis of
Permanent Establishment: Critical Evaluation, Intertax (2015), pp. 331-333. This is why fundamental reform
proposals for taxing corporate income such as a destination based corporate income tax are not further analyzed
for the sake of this article.
119
Hongler & Pistone, supra n. 76, p. 13.
120
W. Hellerstein, Jurisdiction to Tax in the Digital Economy: Permanent and Other Establishments, 68 Bull.
Int. Txn. 6/7 (2014), pp. 348-349, Journals IBFD.
20
action points in national or supranational law faces obstacles of compatibility with EU law. 121
While the question of defining a source and justifying taxing rights comes first, the profit
allocation that is expressed in the valuation techniques of transfer pricing cannot be
circumvented in a second step.122
There is no common and concise definition of the term value creation with regard to the digital
economy. Digital business models have not been analyzed in a profound manner and it remains
unclear in how far value contributing assets and activities have developed. In the same vein,
there is no understanding of digital value chains and there are only few proposals in the
literature how to refine the transfer pricing system with a direct reference to the digital
economy. Without a common understanding of digital businesses and the process of value
creation, arriving at solutions for tax policy remains a mammoth challenge.
Still, some scholarly contributions provide insightful approaches to account for the specific
economics of digital business models such as knowledge-based capital and network effects in
transfer pricing. Although the OECD elaborates on the technological foundations and
transformative elements of the digital economy, these results do not find their way into the
discussion of the appropriate design of coordinated tax rules and guidance on the allocation of
profits in the digital economy. Such work might be continued when a more detailed mandate is
developed during 2016.123
The OECD concludes that the identified challenges will be significantly mitigated by other
BEPS actions and that domestic tax regulations targeted at the digital economy could be
introduced unilaterally if treaty obligations are met. 124 This is surprising as the OECD usually
acts as an advocate of international co-ordination and primarily serves as a platform to mitigate
cross-border conflicts in international taxation.125 Accordingly, several states are recently
amending their tax code. Due to the topicality of the developments, potential consequences for
states’ tax revenue or the not yet foreseeable.126 Since digital business models are mobile and
digital transactions are borderless, the introduction of unilateral reforms should be evaluated
critically. If tax measures are selective regarding the type of transaction and the location of
businesses, tax policy might distort corporate behavior and the location attractiveness of the
respective jurisdiction might suffer. Hungary has already experienced a loss in location
attractiveness for digital businesses.127 Thus, unilateral actions can be considered ineffective in
solving issues of double or non-taxation of profits arising from digital transactions.

121
For a detailed discussion, see Englisch, supra 9.
122
Brauner, supra n. 6, p. 17.
123
OECD, supra n. 2, p. 13, 138.
124
OECD, supra n. 2, pp. 94, 137; Fehling, supra n. 27, p. 799.
125
E.g. in its explanatory statement the OECD stresses its consensus-based approach, see OECD, Explanatory
Statement 2015 Final Reports, 2015, p. 22; H. J. Oortwijn, Dispute Resolution in Cross-Border Tax Matters, 23
Eur. Txn. 2 (2016), pp. 163-165, Journals IBFD.
126
As in Australia, income is not only taxed but the treasury also plans to apply penalties of up to 100 per cent of
the tax owed and interest, information available at http://www.budget.gov.au/2015-
16/content/glossy/tax/html/tax-05.htm; see also Butler et al., supra n. 114.
127
Popa, supra n. 4, p. 40; R. Felkai, Government Presses Ahead with Controversial Sectoral Taxation Policy
through the Introduction of an Advertisement Tax, 55 Eur. Txn. 1 (2015), pp. 37-38.
21
4. A Deeper Look at Digital Business Models, Value Creation and Tax Consequences
4.1. Case Studies on Value Creation of Digital Business Models
4.1.1. Defining Value Creation and Analyzing Business Models
The term “value creation” is predominant in the current debate in international tax policy. For
the international community’s aim to align transfer pricing with economic activity it is of
particular relevance to arrive at a common understanding and a defined notion of value creation
and value drivers.128 This section therefore suggests a conceptualization of the term value
creation and business models in the digital economy before examining value creating activities
and assets of exemplary business models in the following sections.
The digital economy is not (only) an era of new or revolutionary business models but rather
represents the evolution of existing business models, products and services.129 In their recent
comprehensive work on the economics of digital technologies, MIT’s economists Brynjolfsson
and McAfee hint at the important complementary innovations of digitalization that are reflected
in business process changes and organizational co-inventions.130 In order to address the tax
challenges of the digital economy and contribute to the goal of aligning taxation with value
creation, a deeper look at the value drivers, core characteristics and new elements of digital
business models is needed. Such an analysis reaches beyond the current discussion about the
tax consequences of legal structures and accounting policies of prominent MNEs in the IT
sector.
Generally speaking, a business creates value if the revenues exceed the corresponding costs.
Thus both, the revenue and cost side should be considered when trying to identify important
elements of a value chain. Management theory based on Porter (1985) states that businesses
create value through differentiation along the different steps of the value chain. Traditionally,
IT was seen as a supporting element of the process of differentiation.131 Through the increasing
relevance and strategic use of information,132 a modern value chain analysis in digital markets
needs to take into account the combination and integration of resources, innovative technologies
and information.133 According to Amit and Zott (2001), a digital business model depicts the
content, structure, and governance of transactions designed so as to create value through the
exploitation of business opportunities.134 In practical terms, value creation of a digital business
model can be defined as the way of generating revenue (exploitation of business opportunities)
by using data and information (content) in a specific form of products or services (structure).
This process has to be implemented by skilled personnel acting in strategic management and
operations and using appropriate assets within their organization (governance). From a
quantitative point of view, the concept of Economic Value Added (EVA) can serve as a numeric
proxy of value creation. It captures sales and related current costs,135 as well as the opportunity

128
D. D. Stewart, ‘Value Creation` Understanding Key To Transfer Pricing’s Future, Tax Notes International
(2015), p. 322.
129
D. Bonnet & G. Westermann, The best digital business models put evolution before revolution, Harvard
Business Review (2015), online 20 Jan. 2015.
130
Brynjolfsson & A. McAfee, supra n. 1, p. 102.
131
Porter, M. E, The Competitive Advantage: Creating and Sustaining Superior Performance, 1985; Porter, M.
E. & V. A. Millar, How Information Gives You Competitive Advantage, 63 Harvard Business Review 4 (1985),
pp. 149–160, R. Amit & C. Zott, Value creation in e-business, Strategic Management Journal (2001), p. 496.
132
See C. Shapiro & H. R. Varian, Information Rules: A Strategic Guide to the Network Economy, 1998.
133
Amit & Zott, supra n. 121, p. 496.
134
See ibid, p. 511
135
When calculating the EVA as a corporate performance measure, net operating profits as well as the cost of
capital after taxes are used. Yet, it is not the purpose to discuss the exact way of calculation and the merits and
22
cost of the employed assets within a business model. As a result, one should analyze at what
point (and for international tax purposes in which location) revenue is generated by sales on the
market, costs are incurred through relevant activities (performed anywhere) and assets are
employed within digital business models.
Management science provides useful frameworks for analyzing business models. These tools
can be used to examine the inherent value creation since a business model describes the
rationale of how an organization creates, delivers and captures value.136 The business model
concept generally offers a powerful tool to analyze value creation by intellectual capital in
particular.137 Osterwalder and Pigneur (2010) propose to analyze the four areas of the offer,
customers, infrastructure and financial viability of a business model. For digital business
models in particular, El Sawy and Pereira (2013) put forward the five components of value
proposition, interface, service platforms, organizing model and revenue model.138 The interface
is the means of connecting the customer and the offer which is equivalent to the value
proposition. The service platforms and the organizing model can be seen as the infrastructure
of a digital business model. In the following, this article provides a brief analysis of digital
businesses with these concepts as the framework of choice. Exemplary business models from
the B2C and B2B sectors as well as the transformation of traditional business models are
presented to draw attention to open questions regarding the tax challenges of the digital
economy.
4.1.2. Case Study: Digital B2C Business Models
Digital business models can be classified under the B2C sector if private users of the digital
goods or services are either direct and paying customers or if they contribute to the business’
offer for commercial customers. Digital B2C business models often offer extremely targeted
and individualized products and services such as advertising or platform services while creating
free online services for end users. The (paying) customers are usually commercial advertising
clients or consumers of web-based services that do not depend on the physical location of the
service provider. The business models’ infrastructure is typically composed of an online
platform and the enabling proprietary software. For running the platforms and software
applications, these business models rely on a widespread IT infrastructure with its core physical
elements at the main location of the parent company and individual parts such as data centers
located in customer markets.139 The core activities within these business models are the
development and maintenance of the IT infrastructure and its online services as well as content
management and marketing. The latter two activities in addition to user support are partly
performed by personnel at locations near to the customers. Revenue is generated, for instance,
by advertising or fees for the use of online services. The corresponding costs of the business
model stem from expenditure for the platform maintenance as well as compensation expenses
for the staff in software development, marketing and other functions.140 Prominent examples

shortcomings of the measure at this point put rather present the concept as an aid to conceptualize the term value
creation.
136
A. Osterwalder & Y. Pigneur, Business model generation: a handbook for visionaries, game changers, and
challangers, 2010, p. 14.
137
V. Beattie & S. J. Smith, Value creation and business models: Refocusing the intellectual capital debate, The
British Accounting Review (2013), p. 252.
138
O. A. El Sawy & F. Pereira, Business Modelling in the Dynamic Digital Space, 2013, pp. et sequ.
139
E.g., Google runs four datacenters across Europe in Ireland, the Netherlands, Belgium and Finland. See
https://www.google.com/about/datacenters/inside/locations/index.html.
140
See, e.g., Google Inc., Annual Report 2014, 2015, p. 23 or Xing AG, Annual Report 2014, 2015, pp. 33, 35.
23
for such B2C business models are Google Inc. with its search engine or LinkedIn Inc. and Xing
AG with their network services. Both companies run a multi-sided online platform as the core
infrastructural element of their business model.
Figure 1: A Simplified Digital B2C Business Model

From the perspective of current tax law, a significant taxable nexus is only created in the country
of residence of the parent company if this company enters into direct contractual relations with
the customers. This result is independent of the geographical markets where revenue is
generated even if some of the mentioned activities are performed at the location of the customer.
The business might employ local staff at local subsidiaries or create a PE to access customer
markets. According to current transfer pricing principles, however, the activities are typically
considered routine as they do not bear any contractual risks and elements of the IT infrastructure
are only separate parts of the larger system that might even be hosted by external providers.
Against the background of the current practice, the collection of data is also seen as a routine
activity that does not necessarily contribute to value creation and hence does not alone justify
a tax liability or another allocation of income. The value of data is rather created by processing
and analyzing the information.141 However, tax authorities become increasingly suspicious
regarding the circumvention of such a PE status.142 For taxing income, current rules attribute
the value to the entity that develops and maintains the required sophisticated software. As a
result, local subsidiaries or PEs of foreign B2C businesses do not pay large amounts of taxes as
they are compensated according to the cost-plus method as can be seen in financial accounts.143

141
Fehling, supra n. 27, p. 801; Johnston, supra n. 11, pp. 1089-1091.
142
As the current tax probe of Google in France shows, tax authorities might claim to find a foreign corporation
establishing a permanent base in the customer market, See Financial Times, Google’s Paris offices raided by
French authorities in tax probe, 2016, available at http://www.ft.com/intl/cms/s/0/90018a06-21ac-11e6-aa98-
db1e01fabc0c.html#axzz4B09NuD00.
143
For foreign companies operating in the German market, see, e.g. Google Germany GmbH, Unconsolidated
Financial Accounts 2014, 2015, p. 7; LinkedIn Germany GmbH, Unconsolidated Financial Accounts 2014,
2015, p. 3. (LinkedIn Germany is a direct competitor of Xing AG).
24
 4.1.3. Case Study: Digital B2B Business Models
Digital business models in the B2B sector offer digital goods or services for commercial clients.
Consequently, such business models can also be regarded as “enablers” of the digital economy
as they facilitate the digital transformation of their clients. The customer group comprises
enterprises across all sectors and geographic regions with access to the internet. Complex
combinations of hardware and software elements build the infrastructure of digital B2B
business models. The businesses often run a massive server landscape at their main location
while they operate through smaller complementary hardware components at the location of
their customers. These hardware components, such as data centers, can also be outsourced to
external providers. Usually, software development is the core activity that is mainly conducted
at the location of the parent company implying that the parent company typically owns the
corresponding IP. Sales is another important function which is planned and managed centrally
but carried out locally through subsidiaries and (in some cases) local partners. These local
entities further foster customer relationships to facilitate the specific individualization of the
digital offers. Revenues stem from the direct sale or the licensing of digital products or services.
If local subsidiaries enter into direct contractual relationships with customers, they compensate
their parent company for the use and sale of the digital products via royalty payments.
Corresponding costs mainly occur due to the maintenance and the development of the IT
infrastructure. Personnel expenses related to software development and sales activities
constitute the major part of expenditures.144 Practical cases of such B2B business models are
Salesforce.com as a leading provider of cloud software for marketing activities and SAP SE
with its increasing product range of cloud applications and big data analytics.
Similar to B2C business models, the primary taxable nexus is in the parent company’s
jurisdiction. Current principles in international taxation attribute most of the businesses’ value
to the development and maintenance of the IT infrastructure and digital products. Local sales
activities and the functions regarding customer support are regarded routine and compensated
via the cost-plus method.145 There might be a higher degree of taxable nexus if software is
sublicensed to local subsidiaries or directly to customers and if sales contracts are concluded
between local entities and customers. In this case, local withholding taxes might be levied and
the ultimate profit allocation again depends on transfer pricing regulations but will lead to the
similar result of low profit margins in local markets. For cloud-based services, withholding
taxes can only be levied if the underlying contract specifically defines the right to use, exploit
and adapt the software. A cloud business would create taxable nexus in the form of a PE at the
location of the hosted data, software or infrastructure if the activities carried out in this location
are not of auxiliary nature. The classification would follow the principles of a server PE as
discussed in the past.146 Cloud-based business models, however, are becoming more service-
based. Therefore, profits from cross-border cloud transactions are primarily taxed in the
residence state of the provider without establishing a PE at the location of the server or the
customer under current tax law.147

144
See, e.g., Salesforce.com., Annual Report 2015, 2016, pp. 39-41 or SAP SE, Annual Report 2015, 2016, p.
231.
145
See, e.g., Salesforce.com. Germany, Annual Report 2015, 2016, p. 6 (unconsolidated accounts of the German
subsidiary).
146
A. Bal, Tax Implications of Cloud Computing – How Real Taxes Fit into Virtual Clouds, 66 Bull. Int. Txn. 6
(2012), pp. 335-339, Journals IBFD.
147
A. Bal, The Sky’ s the Limit – Cloud-Based Services in an International Perspective, 68 Bull. Int. Txn. 9,
(2014), pp. 515-521, Journals IBFD.
25
Figure 2: A Simplified Digital B2B Business Model

4.1.4. Case Study: Digitalization of Traditional Businesses

The internet of things, advanced robotics, or 3D printing were listed as emerging future
developments of the digital economy by the OECD. However, the digital economy includes the
transformation of entire business models rather than only individual technological phenomena.
It is expected that the process of value creation changes dramatically and that new products and
business models will be established within traditional boundaries.148 If this development is
understood as a business model within the proposed framework, the offer or value proposition
is directed at the company itself. It is incorporated in the digitalization of the entire supply chain
and the digital business development. The business model thrives for increases in efficiency as
well as the generation of additional or alternative revenue streams. One major infrastructural
element is the implementation of an IT landscape that enables the digital transformation of the
traditional, primarily physical, business processes. The concept or the implementation of the
internet of things relates to such a new infrastructure.149 Another infrastructural characteristic
is the organizational implementation of the digital transformation. Recently, large multinational
companies are founding spin-off subsidiaries to centralize all activities elaborating on the digital
transformation. In particular, specific human capital is allocated to these units. Several
companies also found subsidiaries that are equipped with significant amounts of capital. These
so-called innovation hubs are used to acquire or promote high-technology ventures. This digital
know-how then ideally facilitates the transformation of the traditional business model. A major
activity within this infrastructure is the analysis of collected data on customer characteristics,
transactions, and input or output markets. Experts point out that software is becoming the
crucial infrastructural element and value driver within the digital transformation of business

148
See, e.g., German Council of Economic Experts, Annual Economic Report 2015/16, 2015, pp. 308-313.
149
For a detailed elaboration on the internet of things as a digital business model, see E. Fleisch et al.,
Geschäftsmodelle im Internet der Dinge, zfbf (2015), pp. 444-464.
26
models even if a substantial amount of hardware elements are required.150 As these forms of
digital transformation are still evolving, efficiency gains, additional revenues or other financial
outcomes are not reliably measurable. In contrast, related expenditures are already occurring in
the form of labor costs, the development and the acquisition of the IT components as well as
the purchase price of acquired companies. Practical case studies for the digitalization of
traditional businesses are provided by the German steel distributer Klöckner & Co SE with its
digitalization venture Kloeckner.i, the German healthcare company Merck KGaA with its
innovation center and Coca-Cola Enterprises Inc. with its development of digital vending
solutions.151
Figure 3: The (Simplified) Structure of Digitalizing a Traditional Business Model

From a tax perspective, a nexus is only established in the jurisdiction where the subsidiary or
innovation center is located. In the exemplary case of E-Health, it is evident that the important
functions are not the sale of applications to patients and the collection of data across the globe
because, once implemented, these activities are routine tasks. Data of patients are automatically
collected by standardized hardware devices and transmitted to central computing centers via
the Internet. Such activity is thus of auxiliary nature. Instead, the development of the software
for analytics and interpretation of the output by skilled personnel are key. Under current rules,
any additional profit arising from efficiency gains or additional revenues in any entity of a
multinational company will thus be allocated to the residence country of the company were the
presented main activities are conducted.
4.2. Evidence on Tax Sensitivity of Digital Business Models
The potential of the digital economy as a driver of social developments and economic growth
as well as its inherent challenges for the international tax system have been widely
acknowledged. Besides anecdotal and descriptive evidence on US digital companies’ effective

150
See ibid, p. 460.
151
Information available at http://www.kloeckner-i.com,
http://www.merckgroup.com/en/innovation/innovation_center/innovation_center.html;
http://www.cokesolutions.com/Vending/Pages/Site%20Pages/Overview.aspx
27
tax rates,152 there are no specific empirical studies on the interrelation between international
taxation and digital businesses models.153 This lack of evidence might be due to the shortage of
readily available data to scrutinize the degree of digitalization, the organizational structures and
the financial characteristics of digital business models as well as the topic’s novelty.
Nevertheless, studies on sales taxation and e-commerce (primarily in the USA) as well as recent
work on profit shifting and the tax-motivated use of intangibles contribute to the understanding
of the tax challenges of the digital economy.
Sales taxation is considered to have increasing distortions on economic behavior because of the
uptake of online transactions.154 Nguyen et al. (2012) find that current US legislation fails to
define taxable nexus and tax liability and thus lead to the erosion of sales tax bases as online
sellers make use of tax rate differentials.155 Correspondingly, Einav et al. (2014) confirm a
negative correlation of the number of online sales with the corresponding sales tax rate with
respect to the seller’s location based on transaction data of the E-Bay platform.156 Agrawal
(2016) further shows that an increasing access to high speed internet facilitates the tax efficient
allocation of revenues by companies in the USA and therefore intensifies states’ sales tax rate
competition.157
Different strands of literature in the area of public finance suggest that companies in the digital
sector structure their business in a tax-optimized manner. Klassen et al. (2014) show that U.S.-
based multinationals report significantly lower effective tax rates if they generate a high share
of revenue via online channels and from abroad.158 To the best of our knowledge, there are no
other studies with such a direct focus on digital forms of business and tax consequences. In the
recent past, several studies on the effect of taxes and tax incentives on the location of IP have
been published. Since IP is a key success factor of digital business models, the impact of taxes
on its location and management should be of particular interest. The literature unanimously
underlines the positive effect of unilateral tax incentives on the location of patents by
multinational firms. Early results by Ernst and Spengel (2011) confirm that tax incentives
regarding R&D input attract patent applications in European countries.159 Several other recent
studies find that a decrease in the relevant tax rate for profits derived from IP increases the
probability of patent location in the respective country.160 Griffith et al. (2014) predict a

152
European Commission, supra n. 106, p. 24, Annex 2 A and 2 B.
153
K. J. Klassen, et al., A Model of Multinational Income Shifting and an Application to Tax Planning with E-
Commerce, Journal of the American Taxation Association (2014), p. 40; Lopez supra n. 82, p. 13; Blum supra n.
79, p. 325; Cockfield et al., supra n. 5, p. 490.
154
See e.g., B. Lockwood, Tax Competition and Tax Co-ordination under Destination and Origin
Principles: A Synthesis, Journal of Public Economics (2001); S. Basu, To tax or not to tax? That is the question?
Overview of Options in Consumption Taxation of E-Commerce, The Journal of Information, Law and
Technology (2004); J.E. Ligthart, Consumption Taxation in a Digital World: A Primer, CentER Discussion
Paper (2004), advocating for the destination principles despite its practical challenges.
155
H. Nguyen et al., Tax Challenges for Electronic-Commerce Activities, The Journal of Applied Business
Research (2012), pp. 861-870.
156
L. Einav et al., Sales Taxes and Internet Commerce, American Economic Review (2014), pp. 1-26.
157
D. R. Agrawal, The Internet as a Tax Haven? The Effect of the Internet on Tax Competition, 2016.
158
Klassen et al., supra n. 153.
159
C. Ernst & C. Spengel, Taxation, R&D Tax Incentives and Patent Application in Europe, ZEW Discussion
Paper (2011).
160
See, e.g., M. Dischinger & N. Riedel, Corporate taxes and the location of intangible assets within
multinational firms, Journal of Public Economics (2011), with a focus on intangibles of European companies;
B.P. Lindsey & W.M. Wilson, Foreign or Domestic Tax Havens: The Location Decision for Intangible Property
by U.S. Firms, Discussion Paper (2015), with a focus on U.S. firms; Böhm et al., The Impact of Corporate Taxes
on R&D and Patent Holdings, Discussion Paper (2012), regarding the relocation of patents; For studies
28
decrease in patent applications of 4% for Luxemburg and 0.5% for Germany if the relevant tax
rate increased by one percentage point.161 Examining the quality as well as the number of
patents, Ernst et al. (2014) show that this effect is more pronounced for patents that are
associated with high future returns.162 These insights from research might be a first indication
that assets of digital business models are primarily located in countries that provide for a certain
degree of tax attractiveness. Nevertheless, a recent analysis of interviews with tax practitioners
reveals that such conclusions should be drawn with caution. Experts state that not all activities
related to the development of IP are observable as patent applications and R&D activities. The
resulting procedure of patent applications is often coordinated at the level of the ultimate parent
company without considering tax factors in operative decision making.163 The empirical results
of Alstadsaeter et al. (2015) confirm these practical insights. The major finding is that generous
provisions for taxing income derived from IP significantly attracts the location of patents
whereas the location of R&D activities is not sensitive to reduced tax rates on related income.
Further, the authors acknowledge that the value creation process related to business models
relying on other IP than patents is not observed in current research.
Another literature strand verifies the common perception that multinational companies engage
in tax-motivated profit shifting.164 The use of intangibles appears to be a major channel of profit
shifting hinting at the potential relevance of profit shifting behavior of companies with digital
business models.165 The magnitude of profit shifting through the use of intangibles as well as
the role of specific digital business models in profit shifting strategies has not been researched.
Besides the tax-motivated allocation of patents there is no evidence for the tax-motivated
allocation of key functions (in particular people) or profits in the digital sector as suggested by
the OECD.166
4.3. Interim Conclusion
Value creation is a currently popular but undefined criterion in international tax policy for the
digital economy. Consistent with latest academic work in several disciplines, value creation
(for tax purposes) could encompass any activity related to generating revenue by digitized
products and services based on the quantitative concept of EVA, the location of incurred current
expenses, revenue sources (markets) and the capital employed should be taken into account.
The case studies illustrate that digital business models expand internationally via slim
organizational structures. Under current tax law, digitalization leads to a convergence of core
activities and thus taxable nexus at the location of the parent company or regional hubs. In local
markets, elements of the IT infrastructure are observable and might constitute a taxable nexus

regarding the localization of patents, see, e.g., Griffith et al., Ownership of intellectual property and corporate
taxation, Journal of Public Economics (2014); Alstadsaeter et al., Patent Boxes Design, Patents Location and
Local R&D, CESifo Working Paper (2015); Bradley et. al., Cross-Country Evidence on the Preliminary Effects
of Patent Box Regimes on Patent Activity and Ownership, Tuck School of Business Working Paper (2015).
161
Griffith et al., supra n. 160, p. 20.
162
C. Ernst et al., Corporate taxation and the quality of research and development, International Tax and Public
Finance (2014).
163
M. Walpole & N. Riedel, The role of tax in choice of location of intellectual property, Discussion Paper
(2014), pp. 42-43.
164
For a review, see D. Dharmapala, What do we know about Base Erosion and Profit Shifting? A Review
of the Empirical Literature, Fiscal Studies (2014).
165
For a meta-analysis of 25 empirical studies on profit shifting, see J. H. Heckemeyer & M. Overesch,
Multinationals‘ Profit Response to Tax Differentials: Effect Size and Shifting Channels, ZEW Discussion Paper
(2013), p. 27.
166
OECD, supra n. 2, p. 80.
29
in the form of a PE. These elements of the IT infrastructure can be controlled remotely, rented
from third parties and moved across jurisdictions. Depending on the activities performed at the
location of the hardware elements, they might not contribute much to value creation in the
current interpretation by solely hosting data and providing computing power. As a result, little
profit stemming from digital business models of foreign companies is attributed to market
jurisdictions for tax purposes.167 This specific form of innovative business models and its
implied organizational consequences are not necessarily tax-driven but rather represent
outcomes of the technological development. In this sense, the focus on servers for tax purposes
might become obsolete and more evolving technological developments need to be discussed in
the future.168
Apart from indirect empirical evidence, there is no reliable scientific knowledge whether the
degree of digitalization influences tax-motivated corporate decision making. Against this
background, the OECD sees both, a risk of overstating and understating the respective tax
challenges.169 Much research and political discussion is needed to examine the effect of the
current tax system on digital business models, fiscal competition as well as the consequences
that potential reform options would imply for corporate decision making and tax revenues.170
This section’s categorization and analysis of value creation and business models in the digital
economy intends to provide a framework for addressing these open questions and derive policy
options as proposed in the following.
5. From Addressing to Meeting the Challenge
5.1. Aligning Taxation with Value Creation: A Transfer Pricing Challenge
The international community promotes the adherence to existing tax principles and the
introduction of specific anti-BEPS measures to address the tax challenges of the digital
economy.171 This approach is justifiable given the premature understanding of business models
as well as the lack of scientific knowledge on revenue losses and the effect of taxes on business
decisions in the digital economy. The recent work under the umbrella of the BEPS project has
defined and stressed the tax challenges of the digital economy. Despite the large amount of
dedicated political resources and academic contributions, there is no elaborated and commonly
accepted proposal on how these challenges could be met. The more tangible output of the BEPS
project is targeted at aggressive tax planning activities and the undesired low or no taxation of
mobile income. A more rigorous application of anti-avoidance measures (Actions 2-7) and
documentation requirements (Actions 12-13) as well as increased collaboration between tax
authorities (Actions 14-15) are not primarily designed to meet the tax challenges raised by the

167
See also the case studies in Baez & Brauner, supra n. 4, section 4 and in Hongler & Pistone, supra n. 76,
annex.
168
Singh, supra n. 118, pp. 332-333. For instance, Fog Computing technology will further question the reliance
on servers for discussing a taxable nexus. For a brief introduction to the concept, see Cisco, Fog Computing and
the Internet of Things: Extend the Cloud to Where the Things Are, White Paper (2015). For a detailed discussion
on the notion of PEs in the IT sector, see Gianni, The OECD’s Flawed and Dated Approach to Computer Services
Creating Permanent Establishments, Vanderbilt Journal of Entertainment and Technology Law (2014).
169
OECD, supra n. 8, p. 100.
170
See, e.g. Westberg, supra n. 111, p. 544; Baéz Moreno, supra n. 87, section 4; France Stratégie, Taxation and
the digital economy: A survey of theoretical models, 2015, p. 19. In this report, several theoretical studies
highlight the complexities of digital business models that should be incorporated in future studies on corporate
taxation, see, e.g. J. Crémer, Taxing network externalities, pp. 1-2 and M. Bourreau et al., Digital Platforms,
Advertising and Taxation, p. 3.
171
Fehling, supra n. 27, pp. 800-801. The primary intention is to influence and guide outcomes of other action
points to address issues of digital economy Brauner (2014), supra n. 6, pp. 15-16.
30
digital economy. The OECD’s final report on Action 1 is the first study to raise the issue of the
consistent attribution of profits among connected business entities in the digital economy. 172
Although the OECD recognizes a shift in value creation due to emerging technologies it does
not deliver a roadmap how this development should be reflected in tax policy beyond BEPS.
For the near future, the focal point in corporate profit tax policy for the digital economy is
transfer pricing. Neither the international community nor national tax politicians promote
fundamental tax reforms. International profit taxation will thus follow existing principles. These
principles include the simultaneous application of the source and the residence principle as well
as the use of transfer pricing mechanisms for international profit allocation. Consequently, the
primary task is to revise the application of transfer prices and the interpretation of the arm’s
length principle rather than to deal with individual aspects of the digital economy such as
specific e-commerce transactions by including the use of warehouses in the definition of a
PE.173 The presented case studies highlight that the latter approach is ineffective. Even if
reforms in tax law decrease the thresholds for establishing a taxable nexus or facilitate tax
collection in the digital age, the allocation and taxation of profits will not be refined unless
transfer pricing regulations are adapted to the characteristics of digital business models. This is
due to the fact that most activities performed at the locations with a new taxable nexus would
be of auxiliary or preparatory nature under current the Authorized OECD Approach. Thus profit
allocation to entities creating a (digital) taxable nexus would still be minor. Practitioners
acknowledge that changes to the interpretation of the arm’s length standard are required to
overcome the lack of a clear measure for the allocation of benefits from integration and
transitions without comparables.174
Policy makers agree that understanding the term value creation for transfer pricing of digital
business models is a long-term challenge.175 Applying current methods and benchmarks leads
to outcomes that are not compatible with a modern understanding of the digital economy as
exemplified by the recent tax audit of Google in the United Kingdom. Against this background,
digital leaders claim to pay taxes in line with current rules and suggest that income allocation
mechanisms should be evaluated with an up-to-date perspective instead of publicly denouncing
individual taxpayers.176
In its function of coordinating international tax policy and promoting global trade, the OECD
constantly revises its Transfer Pricing Guidelines in order to provide an up-to-date instrument
for multinational enterprises and tax authorities. The release of the final reports on BEPS
Actions 8-10 contain the revision of several chapters of the current guidelines with particular
relevance for the Arm’s Length Principle (chapter I) and intangibles (chapter VI). These
changes will also apply to many aspects of transactions in the digital economy. Yet, the new
guidance is viewed critically by scholars and practitioners as it introduces complicated, not

172
Brauner, supra n. 6, p. 17
173
Schreiber, supra n. 68, p. 115; Tavares & Owens, supra n. 68, p. 600; Stewart, supra n. 128, p. 322.
174
U. Andresen, Comments on Professor Schoueri’ s Lecture “Arm’ s Length: Beyond the Guidelines of the
OECD”, 69 Bull. Int. Txn. 12, p. 720, Journals IBFD.
175
Stewart, supra n. 128, p. 322.
176
The Economist, Going after Google, 2016, available at http://www.economist.com/news/leaders/21689546-
britains-tax-men-struck-poor-deal-real-problem-lies-flawed-international; K. McCann, Google Boss:
International tax laws should be rewritten, The Telegraph (2016), available at
http://www.telegraph.co.uk/technology/google/12151032/Google-boss-International-tax-laws-should-be-
rewritten.html; T. Bradshaw, Apple chief Tim Cook rounds on outdated US tax code, Financial Times (2015),
available at http://www.ft.com/intl/cms/s/0/c7fc1e3a-a786-11e5-955c-1e1d6de94879.html#axzz42IghrTWS.
31
properly defined mechanisms and increases legal uncertainty regarding the taxation of
international business models.177 Apart from stating that the transactional PSM should be used
more frequently,178 the report does not contain guidance on the treatment of transactions in the
digital economy. As a result, the output of Actions 8-10 is not expected to provide sufficient
guidance for real world business transactions in the digital age.179 Against this background,
several contributions by scholars and practitioners suggest that a more detailed guidance on the
multilateral analysis of global value chains within the framework of the arm’s length principle
would be a promising tool for taxing profits in the digital age.180
5.2. Developing Transfer Pricing Guidance for the Digital Economy
The arm’s length principle has generally been criticized as it cannot fully reflect highly
integrated transactions between dependent parties that jointly make use of economies of scale,
synergies or know how.181 Developing transfer pricing solutions against the background of the
BEPS project is therefore seen as a departure from the original interpretation of the arm’s length
principle relying on contractual arrangements as a starting point for analysis.182 Before using
any theoretic framework for allocating taxable profits one should acknowledge that the inherent
question is where and when profit of a multinational business ultimately arises. Since this
question is unanswered in theory, profit allocation for tax purposes (via transfer prices) can
never yield a perfect result.183 Thus any attempt to tax profits of digital businesses in line with
value creation can only lead to approximate solutions.
A pragmatic way to better align profit taxation with value creation in the digital economy would
be to develop specific guidance on transfer pricing for digital business models. Such guidance
could be implemented not only as a revision of intangibles but in the form of a specific chapter
on digital business models in the OECD’s transfer pricing guidelines. The latest work that
substantially amended the guidelines was issued in 2010 with a novel chapter on business
restructurings.184 The motivation for the additional chapter was to account for the increasing
complexity and relevance of international restructurings of business models and the inherent
transfer of risks.185 The aim was to offer guidance as to how these arrangements can be tested
against a sophisticated arm’s length standard.186 In line with this intention, an additional

177
Brauner, supra n. 10, pp. 7-14; Wittendorf, supra n. 39, p. 358; Kroppen & Rasch, supra n. 60, p. 840; C
Engelen, Ex post-Informationen und Preisanpassungsklauseln – kritische Würdigung der OECD-Ausführungen
zu schwer bewertbaren immateriellen Werten, IStR (2015), pp. 150-153.
178
OECD, supra n. 45, p. 55 et sequ.
179
Bergmann et. al, A Lesson From BEPS: Minimize Transfer-Pricing-Related Tax Risks, Tax Notes
International (2015), p. 1051; M. Herzfeld, The Economic Substance Doctrine: Lessons for BEPS, Tax Notes
International (2015), p. 505; J. Wittendorf, supra n. 39, p. 335.
180
Tavares & Owens, supra n. 68, p. 594; Schreiber, supra n. 68, p. 115.
181
For a discussion, see W. Schön, Transfer Pricing – Business Incentives, International Taxation and
Corporate Law, in: Fundamentals of Transfer Pricing in Law and Economics (2012), pp. 61-62. See also Kofler,
supra n. 51, pp. 647-648.
182
W. Schön, International Taxation of Risk, Bull. Intl. Taxn. (2014), Journals IBFD, p. 286; Schön, supra n. 39,
p. 420; Kofler, supra n. 51, p. 651.
183
Schreiber (2015) also hints at this problem while detecting a circularity in the use of transfer prices for
allocating profits according to value creation. Schreiber, supra n. 68, p. 116.
184
See OECD, supra n. 47, at ch. IX.
185
See the introductory statement on the OECD’s website, http://www.oecd.org/ctp/transfer-
pricing/transferpricingandbusinessrestructuring.htm.
186
W. Schön, International Taxation of Risk, Bull. Intl. Taxn. (2014), Journals IBFD, p. 281.
32
chapter on digital business models in the guidelines can be justified by the increasing relevance
of digital transactions in the economy and the lack of benchmarks for transfer pricing.
It is neither the aim nor is it within the scope of this article to produce a complete and thoroughly
elaborated set of rules. We rather present an idea how such guidance could be structured. We
also comment on particularities of the digital economy that should be accounted for based on
the insights from the literature and case studies presented in this article. Similar to the chapter
IX on business restructurings, the scope of the guidance should first be described in the form
of a definition of digital business models and the understanding of value creation in the digital
economy. Then, important assets employed and core activities performed should be discussed
for the sake of a functional analysis. Last, the guidance should propagate the application of
preferred transfer pricing methods.
5.2.1. Scope and Definitions
An introductory definition of digital business models and the understanding of value creation
in the digital economy is crucial for the analysis of functions, assets and risks. A commonly
accepted definition will be necessary to establish transfer pricing outcomes of digital business
models that might change the allocation of profits between the states of source (markets) and
residence (incorporation). Hongler and Pistone (2015) argue that profits should be allocated to
jurisdictions in which value creation occurs in respect of business income either on the supply
or demand side.187 In order to preserve the source theory in the digital age, the forms of value
creation on the demand side have to be analyzed in particular. In line with the definition of Amit
and Zott (2010), the value is created where content is created and transactions are designed to
generate revenue. Thus, activities related to content creation on the user market side and the
interaction with users or customers that shape the revenues streams need to be identified. The
scope of the guidance should be broad in order to address any type of business model that
creates revenue through the extensive use of digital technologies. Thus, obvious forms of digital
businesses that rely on digital products and services as well as physical goods and services that
are delivered through digital transactions would be covered. When a company employs
traditional forms of business models alongside digital transactions, the transfer pricing guidance
might apply for the respective transactions.
5.2.2. Key Assets
For digital business models, intangible assets are key value drivers 188 and can take on novel
forms other than patents or copyrights. For instance, a lot of R&D is never formalized as IP but
still adds substantial value to businesses. Also, hardly measurable categories such as
organizational capital, user-generated content and human capital related to digital capabilities
are large parts of intangibles in digital firms.189 It is particularly critical to distinguish between
assets of ordinary character that involve only little risk and those assets with a larger
contribution to value creation. According to the current work on transfer pricing intangibles, an
ordinary asset involving low risk would be an assembled workforce (if qualifying as intangible)

187
Hongler & Pistone, supra n. 76, p. 19.
188
S. White, Intangibles drive value in the digital age, Journal of Accountancy (2016), p. 21, for the full report
see CGMA, The Digital Finance Imperative: Measure and Manage what Matters Next, 2015, available at
http://www.cgma.org/Resources/Reports/Documents/the-digital-finance-imperative-report.pdf; Beattie & Smith,
supra n. 137, p. 244; R. Sydler et al., Measuring intellectual capital with financial figures: Can we predict firm
profitability?, European Management Journal (2014), p. 245.
189
Brynjolfsson & McAfee, supra n.1, pp. 119-121.
33
or only internally used software.190 However, a detailed analysis of digital business models
might reveal that these assets are more crucial for generating profits as indicated by the
presented case studies. Therefore, the work on the transfer pricing guidelines on intangibles
should be extended with regards to the development and management of the IT infrastructure
as well as the people influencing important business processes.191
Most parts of the IT infrastructure are very important tangible and intangible assets of digital
business models because products and services have embedded digital technologies that cannot
be disentangled from the underlying IT infrastructure.192 In addition, empirical studies confirm
that investment in ICT is positively associated with sales growth and profitability. 193 Hence,
there should be particular guidance on how strategic investments in hardware and other
information technology contribute to the business model. This would help to account for the
shift (of innovation) elsewhere in the value chain caused by the advent and uptake of modern
ICT as detected by the OECD. Drawing from the case studies, investments in important ICT
elements could be detected. A company in the B2C needs to invest in local platforms to store
and manage market-specific data and content. In the B2B market such investments are even
more crucial. When, for instance, cloud applications are offered to local businesses, the
proximity of servers is important due to legal regulation (data security) and the need for high-
speed access to the applications. The case studies show that a digital business model running
an online platform heavily relies on a well performing IT landscape without necessarily owning
any tangible or intangible assets when accessing foreign markets. Instead, hosting services
allow for conducting the same activities as if the infrastructure was owned. If companies do not
directly invest in the infrastructure but rely on outsourced IT services, the related costs and
control could be attributed to a local entity of the business independent of the contractual
arrangements. As shown in the exemplary case, traditional businesses make strategic
investments to foster the digitalization of their value chain. The location and the development
of the importance of such investments should be monitored for transfer pricing purposes.
As a specific type of IP, software is the backbone of any digital business model and is seen as
the crucial factor for competitive advantage in the future. 194 Guidance on the investment in
software as well as on its development and use is a non-trivial but eminent task. Today’s
software business models are not always formalized in the form of copyrights. The generation
of revenue from software is dependent on the ongoing maintenance and development. As it is
further based on service-oriented cloud transactions, protecting software from unauthorized
copying through copyrights becomes (partly) obsolete.195

190
OECD, supra n. 45, p . 100.
191
So far, this aspect has been neglected. Further, future developments in IT will emphasize the developments and
should thus be considered. See also Fehling, supra n. 27, p. 802.
192
M. Pagani, Digital Business Strategy and Value Creation: Framing the Dynamic Cycle of Control Points,
MIS Quarterly (2013), p. 619.
193
For a recent literature review, see Cardona et al., ICT and productivity: conclusions from the empirical
literature, Information Economics and Policy (2013 ). Brynjolffson and Hitt (2003) show that investment in
computerization is associated with abnormally high returns in the long term. See E. Brynjolffson & L. M. Hitt,
Computing Productivity: Firm Level Evidence, The Review of Economics and Statistics (2003). For a proposal
on how to account for the productivity of ICT in the determination of transfer prices, see Lostumbo et al., Profit
Splits Post-BEPS: Quantifying an MNE’s Intangibles, Tax Notes International (2015), p. 710.
194
E.g., see S. Russwurm, Software, die Zukunft der Industrie, in: Industrie 4.0 (ed. U. Sendler), 2013, p. 21.
195
Z. Mahmood & S. Saeed (eds.), Software Engineering Frameworks for the Cloud Computing Paradigm, pp.
260 et sequ.; M. McRoberts, Software Licensing in the Cloud Age, The International Journal of Soft Computing
and Software Engineering (2013), p. 297.
34
Database systems can be considered as an asset combining hardware and software features. The
nature and relevance of databases has dramatically changed due to the uptake of online services
and cloud computing applications. Guidance on the nature of related payments for cloud
computing transactions is needed as it is unclear how the existing principles should be applied
for this growing business segment.196 The B2B case study exemplifies that the payment of
commercial customers and sales partners could either constitute a royalty fee for the use of
cloud applications or a service fee for the provision of services through the cloud platform.
Data as another form of an intangible asset are considered a key resource in the digital economy.
The tax treatment of data has thus been subject to a controversial debate.197 There is a common
perception that the mere process of collecting data does not substantially add to value
creation.198 The processing and analyzing of data, often provided by users, is facilitated by
increased computing power, proprietary software and database management tools. This
sophisticated use of data has become a success factor of digital businesses.199 Considering the
hardware and software elements, together with related people functions, in the functional
analysis for transfer pricing can thus serve as a proxy that captures the value of data. Further, it
is important to examine in which functions the data are exploited in order to create value. In the
digital age, not only the IT or operations department exploit data but other functions such as
marketing, customer support or sales might as well engage in data collection, processing and
analysis depending on the business model.200 Taxing corporate profits based on the functional
analysis will be a less complicated and a more efficient way of taking the value of data into
account for tax purposes than any attempt to tax the use of data separately. It can be shown that
taxing profits will not influence the amount of data collected by platform providers. In contrast,
transaction-based taxes on data are expected to create economic distortions.201 The case studies
are only presented in a simplified manner. It will be impossible to distinguish how much value
for the business is associated with the data of a specific platform user as this value depends on
the scale and form of the business model. While a search engine generating revenue from
customized advertisements benefits from a high degree of personal information from a large
user base, it is less clear how the data collected from a cloud application user translate into
business profits. The functional analysis should therefore consider the location of both, the
technical collection and storage of data in regional datacenters as well as data exploitation
conducted by staff familiar with particularities of the customer markets as well as the overall
business model.
Several theoretic studies and practical reports highlight the importance of a meaningful user
base for the success of digital business models. The reason is that major (financial) benefits
arise for digital businesses relying on the use of platforms due to network externalities. 202 While
theory suggests that taxing network externalities directly can increase overall efficiency,203 such
an approach would clearly contradict existing principles. Similarly, it would be difficult to
enforce regulation that defines and measures the user base as separate intangibles since not all
196
Fehling, supra n. 27, p. 801
197
See ibid.
198
European Commission, supra n. 106, p. 47.
199
OECD, supra n. 2, p. 69.
200
White, supra n. 188, p. 21.
201
For instance, if taxation is based on the numbers of users, data will be collected more excessively from fewer
users as the profit per marginal user is decreased. F. Bloch & G. Demange, Taxation and Privacy Protection on
Internet Platforms, 2015, pp. 3-4, in: France Stratégie, supra n. 170.
202
E.g., see OECD, supra n. 1, p. 147.
203
Crémer, supra n. 170, p. 13.
35
users are customers that contribute in the same (financial) manner to a platform’s value.204
However, the user base should serve as an indicator for value contribution as the value of the
related data is indirectly reflected in financial outcomes such as advertising revenue.205 As in
the case of data, one should thus attribute substantial importance to all activities performed to
sustain and enlarge the user base.
5.2.3. Core Activities
Tavares and Owens (2015) point out that human capital is decisive in global value chains.
Global and integrated value chains are of particular predominance in the modern economy and
the arm’s length principle should account for this fact in the digital age.206 Transfer pricing
guidance should elaborate on functions performed by people in digital business models to arrive
at an updated view on the analysis of assets, functions and risks. Intangibles in digital business
models are sometimes hardly observable and highly valuable due to the ongoing development
by the respective workforce. This is the case for the development and maintenance of an online
platform’s underlying software that includes important functions of the platform, its adaption
to local customer needs or even the provision of digital goods. Accounting for the interaction
of people functions and (intangible) asset value might justify some allocation of IP rents from
their location in low tax to high tax countries where a company’s staff is located. This move
might counteract IP tax planning strategies based on the allocation of beneficial or legal
ownership. Using ex-post information as proposed by the OECD will add to this trend.
However, the current revision of the guidelines on intangibles does not specifically address
labor rents and location benefits.207 Thus, a debate whether and in how far such rents should be
allocated is necessary for the international community in order to formulate the respective
guidance. Any approach to put more weight on the location of staff would resemble the
significant functions paradigm as recently stipulated in the Authorized OECD Approach for
allocating profits to PEs. Yet, there are arguments not to put too much weight on the location
of people as those people do not bear the risk themselves and multinational firms might operate
through separate legal entities in particular for reasons of risk separation and decision
centralization.208 This discussion should influence the elaboration of transfer pricing guidance
since the case studies illustrate that digital businesses often go international through a network
of separate legal entities.
Customer orientation and all related activities are crucial for the success of digital business
models. For instance, a major task of a digital company is the ongoing reconfiguration and
integration of its customers. Accordingly, digital firms move from the product to the customer
approach.209 Transfer pricing guidance should acknowledge that digital business models are

204
For the difficulty to distinguish intangibles and customer base, see J. S. Wilkie, Intangibles and Location
Benefits (Customer Base), 68 Bull. Intl. Txn. 6/7 (2014), pp. 352-360 Journals IBFD.
205
OECD, supra n. 2, p. 104.
206
Tavares & Owens, supra n. 66, p. 594.
207
For a discussion, see M. A. Kane, Labour Rents, Arm’s Length Transfer Pricing and Intangibles: Still
Searching for a Solution to the BEPS, 69 Bull. Intl. Txn. 6/7, pp. 371-374. See also Wilkie, supra n. 204, pp.
352-360.
208
Schön, supra n. 186, p. 290.
209
Pagani, supra n. 192, p. 618. For further reference, see exemplary contributions from industry experts such as
Capgemini, Digital Transformation: A Roadmap for Billion-Dollar Organizations, 2011, p. 27 and T. Goodwin,
The Battle Is For The Customer Interface, Tech Chrunch (2015), available at
http://techcrunch.com/2015/03/03/in-the-age-of-disintermediation-the-battle-is-all-for-the-customer-interface/.
This is trend is also observable in the software industry. See A. Mädche et al., Software for People: A Paradigm
Change in the Software Industry, 2012, p. 3
36
becoming more customer-centric and should determine how this characteristic influences the
analysis of assets, functions and risks. Activities performed by local staff such as customer
support or the technical adaption of digital products and services to particularities of local
markets (e.g. language features, legal requirements, customer characteristics etc.)210 might not
be best interpreted as routine tasks from a tax perspective. The Italian government has identified
this problem and takes a first step towards determining an arm’s length price using indicators
other than cost for these types of transactions.211 In particular, potentially new forms of the sales
function of digital business models should be analyzed in order to provide specific criteria that
distinguish between important activities that contribute to customer-centric value creation and
rather supportive activities. Such guidance would closely relate to the transfer pricing
classification of the user base as mentioned earlier. Regarding the B2C case study, one could
argue that the functions of the local subsidiary in the country of the platform users and
customers are of high relevance. The business model depends on a platform tailored to the local
language and regulation as well as customer-specific configurations. Taking on this view, it is
questionable whether a cost-plus markup leads to a transfer pricing outcome in line with value
creation. In the B2B case, local staff is often involved in sales activities. In digital businesses
such as cloud computing, the sold good is of non-rival nature implying negligible marginal
costs. Therefore, the sales function is decisive for the company’s profitability and should thus
be appropriately reflected when aligning transfer prices with value creation.
The generation and provision of digital content is another core activity which can be regarded
as a core product of digital business models.212 Here, software can either be seen as a separate
form of digital content if monetized as an individual product or as a means to generate and
manage digital content. Due to the integrated and global nature of digital value chains, digital
content and products such as software are often developed jointly by several teams in different
locations that integrate users in the development.213 It should thus be discussed how the
activities performed at different locations can be compared. When software constitutes a
separate digital product as in the B2B case study, software development is often centralized.
Accordingly, a significant proportion of value is created at the respective central locations. For
the exploitation of the software, the sales function and other customer-centric, decentral
activities as described in the previous paragraph need to be considered. When a firm operates a
multi-sided platform, content might be user-generated through the upload of any type of
information. For these cases, the guidelines should elaborate on the activities of a business that
processes this information in a way to contribute to the value proposition. When a business uses
a digital platform, the inherent economic value is captured by the revenue of platform providers

210
E.g., Google’s local staff in Germany are focused on sales but also contribute to product engineering. On its
webpage, Google states „As Germany’s largest office, we do a bit of everything, from marketing and sales to
engineering and IT. We’re online sales experts, helping Germany´s largest companies and advertisers to grow
their businesses via platforms like AdWords and AdSense. Our marketing and communications teams create
German-language communications campaigns for our products.“, information available at
http://www.google.com/about/careers/locations/hamburg/.
211
Popa, supra n. 4, p. 39; L. Quaratino, New Provisions Regarding the Taxation of the Digital Economy, 54
Eur. Taxn. 5 (2014), p. 211.
212
K. C. Laudon & J. P. Laudon, Management Information Systems – Managing the Digital Firm, 2014, p. 415.
213
S. Faraj & L. Sproull, Coordination Expertise in Software Development Teams, 46 Management Science 12
(2000), p. 1554. For a literature review on the effects of user involvement in software development, see M. Bano
& D. Zowghi, User Involvement in Software Development and System Success: A Systematic Literature Review,
EASE '13 Proceedings of the 17th International Conference on Evaluation and Assessment in Software
Engineering (2013), pp. 125-130.
37
and the expected gain by using the platform of the commercial customers.214 Transfer pricing
should distinguish between these phenomena when the aim is to tax corporate profits according
to existing principles. The core activities of a platform provider comprise platform and content
maintenance and development. Commercial platform users compensate the platform provider
via fees for service or advertising and their activity should not influence the classification of
the platform provider’s activities. The analysis of the platform provider’s assets and functions
would rely the procedure proposed for the phenomena of data, user base and customer centric
applications.
5.2.4. Transfer Pricing Methods
Current policy tends to point out that the transactional PSM offers the most appropriate tools to
allocate profits arising from the use of intangibles.215 The PSM allocates the overall profit from
a group of transactions to the involved parties. First, each involved party is compensated by a
base return which is derived from a typical market return according to the routine activities
performed. The residual profit is then split across the entities based on one or several allocation
keys that can be derived from market data or a hypothetical third party transaction.216 The PSM
should be applied in particular when the underlying value chain is highly integrated and several
entrepreneurial entities make unique contributions making comparable transactions
unavailable.217 Digital businesses are characterized by their reliance on intangibles, integrated
value chains and unique structure that are not comparable market transactions. As a
consequence, the default transfer pricing method for most of the respective transactions will be
the PSM. Accordingly, the use of the PSM for digital business models should be covered in a
refinement of the transfer pricing guidance. First, such refinement should include a threshold
for activities that can be compensated on a cost basis. The current line drawn by the OECD with
regard to internal business operations such as software systems is too blurred. For the case of
digital business models where internally used software can be a key asset, the respective
guidelines should be more detailed. Second, guidance on how to use the method based on a
functional analysis would meet the practical needs.218 Again, the development of such guidance
would closely relate to ongoing work by the international community. In its work on Actions
8-10, the OECD cautiously proposes the revision of the PSM with more weight on allocative
factors. This approach is understood and criticized as a hidden convergence towards formulary
apportionment.219 The current elaborations on the transactional PSM do not entail decision rules
on how to determine the economic factors for allocating functions. 220 Obviously, the
determination and the weighting of the allocation factors for splitting the residual profit is at
the heart of transfer pricing digital business models. Reviewing the insights from chapter 4,
guidance should be developed on how to assess the technological infrastructure, software,
datacenters and activities performed by sales and customer support in terms of allocative
factors. New output by the OECD is expected in 2017 with regard to the use and technical
application of the PSM.221 Independently of these outcomes, tax authorities and taxpayers
214
Pagani, supra n. 192, pp. 625-626.
215
OECD, supra n. 47, p. 94; OECD, supra n. 45, p. 57; H.-K. Kroppen et al., Profit Split, the Future of Transfer
Pricing? Arm’s Length Principle and Formulary Apportionment Revisited from a Theoretical and a Practical
Perspective, in: Fundamentals of Transfer Pricing in Law and Economics (2012), pp. 267, 270.
216
Kroppen et al, supra n. 215, pp. 272-273.
217
Ibid, pp. 270-272.
218
See, e.g., Lostumbo, supra n. 193, 708.
219
Schreiber, supra n. 68, pp. 117-118; Tavares & Owens, supra n. 68, p. 590.
220
Kroppen & Rasch, supra n. 60, p. 838.
221
Lostumbo, supra n. 193, p. 708.
38
should take advantage of digital technologies for administrative purposes. Databases for the
application of PSM as well as the functional analysis of digital businesses or respective rulings
can help to establish commonly expected benchmarks and increase legal certainty.
5.3. Coordinating Tax and Innovation Policy
Digitalization is as seen a major driver of innovation and economic growth in modern
societies.222 On a supranational level it is agreed that the goal of designing tax systems that are
fit for the digital age should be to promote growth and investment. 223 Yet, legislators do not
seem to consider tax legislation as a potential tool of economic policy to stimulate positive
welfare effects of the digital economy. Current tax policy rather intends to mitigate unfair tax
planning opportunities of large MNEs. Innovative business models in the digital economy are
highly mobile. Location attractiveness is thus eminent for economies to benefit from the
positive spillover effects of digital and innovative businesses across all industries. Leading
researchers believe that the digital revolution is delivering an unprecedented set of tools for
bolstering growth and productivity, creating wealth, and improving the world. But we can
create a society of shared prosperity only if we update our policies, organizations, and research
to seize the opportunities and address the challenges these tools give rise to. 224 Against this
background, several supranational organizations and research institutes rank countries
according to their readiness for digitalization and innovation.225 Studies find that the quality of
locational factors such as broadband internet connection and IT-related skills of the workforce
differ widely across countries. Therefore, the enhancement of public goods required for a
prospering digital economy such as a powerful ICT infrastructure or a modern regulatory
framework covering the collection and use of private data should be on the political agenda.
Empirical research clearly confirms that firm-level investment in innovative technologies and
digitalization responds positively to a higher quality of these locational factors.226 Taxes are not
considered in these studies. Consolidating several empirical studies and theoretic arguments,
Schreiber (2015) argues that the proposed anti-BEPS measures are likely to have a negative
impact on business investment if they are designed in the form of unilateral anti-avoidance
measures.227 Broadening the tax base in the state of residence by stricter controlled foreign
company legislation or limiting the deductibility of interest or royalty payments are likely to
induce distortions in business decisions. Tax policy should thus not be neglected as a potential
instrument affecting the evolution of digital business models. Given the increasing modularity
in digital business models (in particular the software business) that leads to increased
competition,228 the design of a tax system should account for all businesses in the digital
economy equally and consistently rather than targeting monopolistic rents of large MNEs.229
Further insights from research could first, determine the tax attractiveness of a specific location
and second, estimate to what extent digital businesses make location decisions dependent on

222
See, e.g., Brynjolfsson & McAfee, supra n. 1, pp. 71, 81.
223
OECD, supra n. 2, p. 98.
224
E. Brynjolfsson et al., Open Letter on the Digital Economy, MIT Technology Review 4 (2015), p. 12.
225
See, e.g., INSEAD et. al., The Global Information Technology Report 2014, available at http://global-
indices.insead.edu/documents/GITR2014.pdf; ITU, Measuring the Information Society Report 2015, available at
http://www.itu.int/en/ITU-D/Statistics/Documents/publications/misr2015/MISR2015-w5.pdf.
226
See Cardona et al., supra n. 193.
227
Schreiber, supra n. 68, pp. 102-127
228
El Sawy/Pereira, supra n. 138, pp. 2, 4, 8, 20.
229
The OECD states that the tendency towards a monopolistic or oligopolistic market position is potentially
relevant from a tax-perspective. Yet, there is no further elaboration on how this characteristic should be reflected
in the tax treatment. See OECD, supra n. 2, pp. 73, 143.
39
the tax attractiveness. Based on the results, tax policy could entail effective instruments to
attract digital business and should thus be aligned with future innovation policy.230
As reviewed in chapter 3.6, unilateral measures are ineffective and it is questionable whether
the new legislation in the UK and Australia have their intended effect of mitigating base erosion
without negatively influencing digital business. Yet, other states might follow these initiatives
or introduce alternative concepts such as the digital presence in Israel and a tax on digital
advertising in India.231 This trend might lead to legal uncertainty and a higher compliance
burden for taxpayers as well as the collision with treaty principles.232 Further, theory and
empirical research suggest that investment in intangible assets, and thus most probably
investment in digital business models as a very mobile form of businesses, will certainly be
sensible to unfavorable domestic tax policy.233 Although the OECD pursues a quick
implementation of measures to address the perceived tax challenges,234 any action should be
evaluated in a coordinated way to ensure the competitiveness of the respective jurisdictions and
an unhindered development of the international digital economy.235
5.4. Interim Conclusion
The elaboration of the proposed guidance directly relates to the work on Action 1 of the
OECD’s BEPS project. This report has focused on the technological features of the digital
economy and could thus serve as a starting point for drafting transfer pricing guidelines for
digital business models. Further empirical and applied research are the precondition to
achieving the stated goal of aligning taxation with value creation.236 First, a common definition
and starting point for the analysis of value drivers would be needed. Insights from management
science and industrial economics suggest that novel and less physical elements should be
considered for this purpose. Promoting specific transfer pricing guidance would not ring-fence
the digital economy for tax purposes but directly address its novel characteristics when applying
the arm’s length principle. While designing tax policy for the digital economy, policy makers
should carefully consider the impact of taxes on corporate decisions. In the future, businesses
may see tax policy as another economic factor when evaluation location decisions for digital
ventures.

230
Cockfield et al., supra n. 5, pp. 497-498, supra n. 201, p. 19. The report advocates for targeted subsidies and
tax breaks to promote digitalization within the economy.
231
For instance, the Italian Government is considering to follow the British approach of introducing a tax rule
targeting revenues of digital MNEs sourced domestically, see EY, Italy considers introduction of tax on digital
activities, Global Tax Alert 27 April 2014, pp. 1-2. For recent developments in Israel, see Y. Rosensweig, Tax
Authorities Publish Draft Circular on Internet Activity of Foreign Companies, 22 Int. Transfer Pricing J. 4
(2015), p. 261; see also EY, Confusion reigns in new world of digital taxation, 2016, available at
http://taxinsights.ey.com/archive/archive-articles/confusion-reigns-in-new-world-of-digital-taxation.aspx.
232
Fehling, supra n. 27, p. 802; L. Cerioni, The New “Google Tax”: The “Beginning of the End” for Tax Residence
as a Connecting Factor for Tax Jurisdiction?, 55 Eur. Taxn. 5 (2015), p. 194, Journals IBFD.
233
Schreiber, supra n. 68, p. 114.
234
OECD, supra n. 2, p. 94.
235
Brauner, supra n. 6, p. 15.
236
Cockfield et al., supra n. 5, p. 490-491. A group of French economists underline the notion that tax policy
should consider the manifold aspects of digitalization. As research is far from complete, no governmental action
is initiated in France. See France Stratégie, supra n. 170.
40
6. Conclusions
[Preliminary]
 The digitalization of the economy creates to challenges for the taxation of companies.
These challenges have been recognized by the international community.
 The OECD has addressed the challenges by publishing its work on Action 1 that also
refers to the impact of the other Action Points on these challenges. The features of the
digital economy are seen as facilitators of aggressive tax planning. The overarching
goal is to align taxation with value creation.
 Different approaches to address the challenges are currently discussed in the literature.
While the OECD has so far focused on mitigating BEPS opportunities, several
scholars have proposed changes to individual concepts of the tax system. Selected
unilateral action has been initiated while the effects of reforms on tax revenues and
corporate decisions are unclear. Assuming harmful tax practices are mitigated by anti-
BEPS initiatives, broader challenges remain. So far, no common solution is in sight
that reflects the transformative nature of digitalized businesses from a tax perspective.
 Neither the work by the OECD nor related literature provides a definition of
“economic activity” or “value creation” as the new mantra of international tax policy.
This is particularly critical when considering digital business models. The digital
economy is not an exclusive group of multinational IT companies that engage in tax
planning. Digitalization rather entails new types of transactions and business models
across all sectors. A technical analysis of digital business models with an updated
understanding of the term value creation shows that, in particular, sales and software
development activities performed and IT assets employed by companies in foreign
markets lead to the generation of substantial revenues. However, current tax law
attributes the resulting profits primarily to the jurisdiction where parent companies or
regional hubs are located and important intangible assets are legally owned.
 Scientific evidence on the tax challenges is scarce. Further exploration of the tax
sensitivity, fiscal competition and tax revenues regarding digital businesses are needed
to progress in responding the tax challenges and evaluate potential policy action.
 The case studies as well as insights from scientific and practical literature in this paper
show that the nature of the tax challenges lies in the appropriate allocation of profits, i.
e. transfer pricing, if policy makers do not pursue fundamental reforms of the
international tax system. However, up-to-date guidance is underdeveloped. The BEPS
report on Actions 8-10 only provides an updated guidance on intangibles in general
without particular reference to the digital economy.
 As a pragmatic and concise policy option to meet the tax challenges of the digital
economy, specific guidance on transfer pricing of digital business models could be
developed. An internationally coordinated revision of the common analysis of assets,
functions and risks for digital economy should produce concrete output in form of a
separate chapter in the current guidelines. This work should also produce a commonly
accepted definition and instruments to measure value creation (in the digital
economy). An interdisciplinary approach might be needed to establish purposeful
guidance. One conclusion might be that locally performed activities constitute rather
entrepreneurial elements of the digital value chain. Accordingly, the TPSM with the
IT infrastructure used, people functions including software development, customer
support and sales might be more suitable to compensate activities in the market
41
 locations than the currently applied cost plus method. Such an approach would avoid
complex ways of measuring data and user base thresholds as well as network effects
directly. The presented ideas are intended to contribute to the ongoing academic
discussion and might serve for future policy considerations.
 Elaborating on concise input for revising transfer pricing mechanisms for the digital
age would be in line with the evolutionary approach and the idea to align taxation with
value creation. At the same time, it would contribute to limiting the danger of
increased legal uncertainty, discriminatory tax treatments and additional compliance
that are inherent in other proposals such as alternative nexus rules or flat rate profit
attributions.
 Policy makers, with OECD as frontrunner, have recognized that the digitalization of
the economy poses serious challenges to the existing international tax framework. To
fully understand and accept the challenges, more research from different fields is
needed. If the OECD and the EU adhere to their conservative evolutionary
approach,237 expert knowledge on digital business models from several disciplines
should be consolidated to derive an updated notion of the arm’s length standard for the
digital economy as well as appropriate tools for international profit allocation.238 The
aim should be to arrive at an administrable taxation of corporate profits that does not
distort corporate decisions and paves the way for digital innovations. Such an
approach could make the difference between addressing and meeting the tax
challenges of the digital economy.

237
Apart from discussing the fundamental reform option of a cash-flow tax, the European Commission also argues
in favor of adopting existing principles rather than introducing changes to the international tax system. Westberg,
supra n. 111, p. 543, European Commission, supra n. 106, p. 41.
238
Singh, supra n. 118, p. 325, Already during the work of BEPS Action 1, the lack to recognize the need of
fundamental reforms and the commitment to discuss such options has been detected, see, e.g. Brauner, supra n. 6,
p. 17.
42