“The hardest thing to understand in the world is the income tax”- Albert Einstein.
The emergence of diverse business models in a digital economy and the responses (and proposed responses) of various governments to tax companies in this space are certainly vindicating Einstein!
Some of such models include (spotted as of today and still evolving) online advertising, eCommerce, on-demand streaming services, platform/marketplace and digital payments. These business models possess certain characteristics, that are shaping the business value chain which is somewhat different than that of the traditional brick and mortar business models. These characteristics are:
- Scale without mass: The ability to have a significant economic presence in a country without a major physical presence
- Reliance on intellectual property: Particularly heavy reliance on intangible assets such as technology
- User participation and the value of data: Includes elements of data, user participation,
user-generated content and network effects
Though most of the countries agree to the above and want to find a solution, the approach and consensus remains a topic of debate globally.
To understand the developments around reaching a consensus, one should start from the beginning of the process and actions undertaken globally in recent times.
The Task Force on the Digital Economy (TFDE), a subsidiary of Committee on Fiscal Affairs, Organisation for Economic Co-operation and Development (OECD), constituting of non-OECD G20 countries as well was established in 2013. It analyzed the nuances of digital economy (DE) and detailed the options to address the same. OECD’s 2015 final report on Action 1 (AP 1) expressed such conclusions. It considered the direct and indirect tax challenges created by increased digitalization and provided an evaluation of three options: (a) Significant economic presence, (b) Withholding tax and
(c) Equalisation levy (EQL). However, none of the above were ultimately recommended. It further indicated that there would be follow-up work carried out in this area and a supplementary report would be released by 2020.
Indian tax administration constituted a committee in 2016 on taxation of ecommerce. The committee examined the tax issues relating to new business models in the DE in terms of valuation of contributions made by users and data, as well as took cognizance of detailed discussion by the OECD report of AP 1. Basis the same, India introduced EQL at the rate of 6% with effect from 1 June 2016 on payment for online advertising and related services. India took one more step towards taxation of DE by introducing the concept of Significant Economic Presence (SEP) in 2018. This time it was based on revenue and users based conditions. The thresholds are yet to be prescribed.
On 16 March 2018, the OECD released “Interim Report 2018 – Tax Challenges Arising from Digitalisation”(the Report). The Report provided an analysis of the features commonly found in certain highly-digitalized business models and value creation in the digitalized age, but did not make any specific recommendations. The members agreed to work on a consensus based solution for nexus and profit allocation rules. The Report mentioned that there are divergent views on how the issue should be approached:
- User participation creates value for the business models in DE that is not captured by the existing international tax framework
- Existing international tax framework is not effective enough to tackle the challenges posed by the ongoing digital transformation of the economy and this is not exclusive or specific to highly digitalized business models. Some countries within this group also explicitly reject the suggestion that data and user participation should be considered as value creators by the business in the user’s jurisdiction
- BEPS actions have largely addressed the concerns of double non-taxation and hence there is no need for any significant reform of the international tax rules
The Report recognized that there is no consensus as of now. It noted that further work will need to be carried out and update will be provided in 2019.
The European Commission also published its own proposals on 21 March 2018 recognizing that current tax rules fail to recognize the new ways in which profits are created in the digital world, in particular the role that users play in generating value for digital companies. It highlighted that value is often created from a combination of algorithms, user data, sales functions and knowledge. Accordingly, a two-phased approach was proposed with an interim solution being Digital Services Tax (DST), followed by a longer-term Council Directive of Significant Digital Presence (SDP). DST of 3% of gross revenues was proposed on online advertising space, digital intermediary activities (platforms) and sale of data.
Last several months have seen hectic activity to build a consensus within the EU on the three-pronged DST as discussed above. However, DST failed to secure political consensus in the December 2018 meeting of Economic and Financial Affairs Council (ECOFIN), which constitutes of finance and economic ministers of the EU Member States. This is proposed to be discussed in the February meeting of ECOFIN. Meanwhile, various EU countries have proposed / are contemplating unilateral measures in their local regulations.
On the other hand, the US has proposed an idea to tax profits on marketing “intangibles”. These intangibles could include the insights from algorithms about users (as used by technology companies) as well as the profits generated by more traditional marketing investment. US believes that it is unfair to use an approach that “ringfences” the digital economy.
OECD’s Business and Industry Advisory Committee (BIAC) on 21 January 2019 released 11 principles to guide tax reform for the digital economy. Recommendations of the BIAC are that any changes to the existing tax principles be “coherent, pro-growth, and do not inhibit the innovation and digitalization that is transforming our world.” BIAC recommendations include that the reforms should be based on “well-founded underlying principles of international taxation including taxation of net income, nexus, permanent establishment, and transfer pricing based on the arm’s length standard.” The Committee also highlighted the importance of including businesses and other stakeholders in the conversation considering they are at the forefront of driving digitalization.
In the 23-24 January 2019 meeting of Inclusive Framework on BEPS (BEPS IF), attended by 264 delegates from 95-member jurisdictions and 12 observer organizations, a new two-pillar approach as a base for future discussions has been identified. The Policy Note as approved by the BEPS IF says that the two-pillar approach will focus on the following:
First pillar: Allocation of taxing rights including nexus issues:
The Policy Note mentions that various proposals have been received that would allocate more taxing rights to market or user jurisdictions in certain conditions. The BEPS IF recognizes that some proposals may lead to solutions that go beyond the arm’s length principle or the limitations on taxing rights determined by reference to a physical presence.
Second pillar: Addresses remaining BEPS issues related to profit shifting to no/ low tax jurisdictions
Under this pillar, the BEPS IF will explore taxing rights that would strengthen the ability of jurisdictions to tax profits where the other jurisdiction with taxing rights applies a low effective rate of tax to subject profits.
Overall, even BEPS IF recognized that what is proposed may affect not only a small group of highly digitalized businesses but could affect a much wider group of enterprises with cross border business operations. The Policy Note shared as an example here of groups with marketing intangible profits but limited risk distribution structures in market jurisdictions.
Basis the above developments, the affected multinational companies may analyses the impact on their effective tax rates going forward. They should note that the above may lead to an altogether fresh international tax framework with several changes.
OECD will carry out further work in 2019 on the analysis of the value contribution of certain characteristics of highly digitalized business models as well as digitalization more broadly. It has stated that technical solutions would also be explored to test the feasibility of different options with respect to the profit allocation and nexus rules. It would be interesting to witness an innovative model assigning value to marketing intangibles or user participation.
As various stakeholders have their own considerations, one could look up to the OECD to provide some common meeting ground for taxation of companies with digitalized business models, in the short and medium term. Note that we do not write long term solution since the pace of changes in technology will probably require another review of international taxation system much earlier than 100 years!
Watch this space!
The author of this blog is Vishal Rai, Tax Partner, EY india
The blog is co-authored by Himanshu Gupta, Tax Manager, EY India