De-Escalating The Digital Tax Debate
Like most domestic laws and bilateral treaty networks that were established prior to the digital revolution, the international tax regime was built for a brick and mortar economy. Its inability to be adept to new business models and commercial practices in the digital economy has sparked an ongoing debate over reforms in international taxation principles.
A standout feature of this reform is that in order to be brought into effect in an equitable manner, without subjecting businesses to double taxation, global consensus is required. However, stakeholders represent vastly different economies, with varying policy priorities. Their tax policies and dispute resolution mechanisms also stand at varying degrees of maturity.
Take India for instance: It is generally perceived that India falls in the bracket of countries that lose out on tax revenue as technology giants remotely cater to our vast population but pay few taxes here. The U.S., on the other hand, is the residence jurisdiction for many of these technology giants. Thus, in the event of a reallocation of taxing rights, the U.S. will have to give up some of its tax revenue in favor of market jurisdictions like India. Therefore, building consensus among such different countries in the exercise of a sovereign function such as the levy of tax is a difficult feat to achieve, and has now gradually ballooned into tax wars.
The OECD Tried, But...
The Organisation for Economic Co-operation and Development has made an earnest attempt to address and take up the task of building consensus. The issue first came into focus at a global level in 2015 when it was identified as one of the points in the Base Erosion and Profit Shifting Action Plan, leading to the 2015 BEPS Action 1 Report. The report acknowledged the need for global consensus, but failed to provide any conclusive recommendations on the matter. However, at the time, several countries were of the view that any measures in this area would only ringfence the digital economy and stifle growth.
In the absence of global agreement to address the issue, many countries began to impose unilateral measures. The primary idea behind such levies was to impose a tax that would equalise the tax burden on foreign and domestic suppliers. The OECD, rightly so, did not impinge upon the tax sovereignty of nations by preventing nations from imposing such unilateral measures.
This signalled a license to nations to pursue individual tax policy objectives within the framework of BEPS measures, and in our view was the first step of dissonance which has merely escalated in the past few years.
The proliferation of such unilateral levies, along with international negotiations managed to develop a broad consensus towards devising a globally acceptable mechanism to tax the digital economy in 2018. By this time, international agreement on the market jurisdiction’s contribution to value creation, and the consequent need to reassess existing international tax principles to reallocate taxing rights began to develop. This consensus was last reiterated as recently as January 2020, when 137 countries reaffirmed their commitment to bridge the remaining differences and reach an agreement on a consensus-based solution to tax the digital economy by the end of 2020.
Covid-19 And Digital Tax Consensus Attempts
In the last couple of months, there has been a dramatic escalation in the matter, which has had geopolitical ramifications, and destabilised the consensus approach. The New York Times recently dubbed the digital tax fight as a global economic threat. To appreciate this tag, it is necessary to first understand the impact of the ongoing Covid-19 crisis on negotiations to devise a mechanism to tax the digital economy.
The digital economy has seen a meteoric rise in the last decade. Businesses operating in that ecosystem have witnessed skyrocketing valuations and are earning unusual profits by remotely catering to large markets, leaving tax administrations in market jurisdictions anxious. The Covid-19 crisis has merely accentuated the reliance on digital operations. Restrictions on physical activities have forced customers to shift to online businesses, and in order to survive the pandemic, traditional brick and mortar businesses are also embracing digitalisation. Parallelly, tax revenue collection of nations across the globe has seen a steep fall due to abnormal decrease in economic activity and compliance relaxations. This has exerted fiscal pressures on the sovereign treasury’s function and left governments scrambling to find new sources of revenue to finance public services in the time of this pandemic.
Many countries in the last few months have either specifically discussed the imposition of a tax on digital giants, or actually done so. In India for instance, Finance Act 2020 exponentially widened the scope of equalisation levy. In addition to online advertising services, the same is now also imposed on revenues of e-commerce operators from e-commerce supply of goods or services in a wide variety of circumstances.
Notably, the imposition of such taxes affects many companies that operate digitally, subjecting them to payment of tax both in their country of residence, as well as the jurisdiction where they provide services digitally. Many of these companies are U.S. residents and unsurprisingly, the U.S. has also taken action. The U.S. Trade Representative has initiated an investigation in relation to such levies imposed by several countries including India. More recently, the U.S. has also reportedly backed out of international negotiations, with a communication to 10 nations, including India, though, U.S. administrations actions are not solely targeting India.
At a bilateral level, India’s official stance suggests that the recent U.S. action labelling India’s expansion of equalisation levy as being discriminatory is defendable on many grounds. That said, it appears that the Indian administration realises the wider threat that this investigation poses and that it may potentially adversely affect tariffs, market access and immigration. For India, while the timing is bad, it is widely perceived that a standoff at this crucial juncture is to no one’s advantage and that wider areas of partnership between the two nations should guide the agenda.
In any case, even if OECD negotiations were to take place as per the planned timelines, it was likely that their course would have been fundamentally altered. The economic impact of coronavirus would have negatively impacted most countries’ appetite for a compromise thus, deeming early 2021 deadline for arriving at a consensus-based solution an unlikely target.
In the past, the OECD has managed to broker a truce between the U.S. and France. In an unprecedented move in December 2019, the U.S. reacted to the French digital services tax with a threat to impose an import tariff of up to 100%.
Notably, there are two primary differences between then and now.
- First, the U.S. is outnumbered by a plethora of countries that have either already imposed a digital tax or are seriously considering it.
- Second, this time the global economy is witnessing an unprecedented slowdown and there is a pressing need for nations to focus on revenue collection.
Time To Pause?
Given these circumstances, it is imperative that efforts are made to continue negotiations, at multilateral and bilateral levels.
That said, there may be some merit in the continuation of unilateral measures to propel global negotiations, but with understanding and smart diplomacy.
However, it is imperative that unilateral measures, such as India’s equalisation levy, in their current form are revisited such that their legal infirmities are addressed. Specifically, it should be ensured that such a levy is not discriminatory, it is implemented after adequate stakeholder consultation, imposed at a net operating profit level, and the rate, as well as the revenue thresholds, are determined after conducting an extensive cost-benefit analysis.
At the global level, instead of targeting complete consensus, the multilateral approach of OECD may refocus their efforts towards devising an equitable framework that does not necessarily deal with “all business models” solutions, but imposes a moral obligation on nations against unilateral measures, while still granting countries a certain degree of flexibility to address the tax challenges of digitalisation.
Mukesh Butani is Managing Partner at BMR Legal and Vidushi Gupta leads the tax law vertical at the Vidhi Centre for Legal Policy.
The report ‘Removing Roadblocks in Taxing Business Income in the Digital Era’ by the Vidhi Centre for Legal Policy and BMR Legal analyses the issue at length and provides actionable recommendations to tax the digital economy in a fair and equitable manner.