Taxation Is Catching Up With The Digital Economy
First BEPS. Now PoW. Key highlights of the new OECD report on effective ways of taxing the digital economy.
With the advent of online businesses and innovative revenue models, taxation of the digital economy has been a hot topic of discussion across the globe. Initial steps on taxing the digital economy were initiated by the Organization for Economic Co-operation and Development and Group of 20 countries at the time of the introduction of Base Erosion and Profit Shifting Action Plans in 2015.
BEPS Action Plan 1 specifically dealt with addressing tax challenges of the digital economy. It discussed various approaches, however, since there was no consensus between member countries, no concrete measures were recommended.
The plan suggested certain interim measures which countries were free to implement in their domestic tax laws, keeping in mind international treaty obligations. Many countries introduced different measures to tax the digital economy like...
India introduced the ‘equalisation levy’ and ‘significant economic presence’.
Israel introduced ‘significant economic presence’.
The U.K. introduced ‘diverted profits tax’, imposing tax on profits that have been shifted to low- or no-tax jurisdictions resulting in reducing the taxable base of the country.
France introduced the tax on online and physical distribution of audio visual content, referred to as the ‘YouTube Tax’ in media.
Italy introduced a ‘levy on digital transactions’.
These were intended to be interim measures, to be examined in an interim report by the OECD in 2018. It was also committed to issue a final report in 2020.
Then in March this year, OECD issued a consultation report which has now culminated into the “Programme of Work” issued on May 31, 2019 - to develop a consensus solution to the tax challenges arising from digital economy after considering comments from across the globe.
Pillar I – Revised Nexus And Profit Allocation Rules (New Taxing Rights)
The focus of the new taxing rights is to allocate taxing rights to market jurisdiction (i.e. jurisdiction of customer/users) in cases where business activity is carried out in other jurisdiction through remote participation.
New taxing rights contemplate the existence of nexus in the absence of physical presence.
OECD appreciates that certain additional work would be required to reach political consensus, but in the meanwhile it has proposed certain methods for quantifying profits and their allocation.
The methods provided broadly are as follows:
- Modified residual profit split method: provides for allocating non-routine profit of the multinational enterprise.
- Fractional Apportionment Method: involves the determination of profits without making a distinction between routine and non-routine profit. This method looks at allocating overall profitability of the relevant group or business line basis appropriate allocation key to market jurisdiction.
It is pertinent to note that the Indian government’s proposed profit attribution discussion paper, recently released, also highlights the fractional apportionment approach as a profit attribution mechanism.
- Distribution-based approach: involves determination of a profit threshold (based on the multinational enterprise’s overall profitability) in the source jurisdiction for marketing, distribution and user-related activities. This would take care of not only allocating higher profits to source jurisdiction but also reduce ongoing controversies with respect to suitable pricing of marketing and distribution activities undertaken in source jurisdictions.
- Method based on business line and regional segmentation: considers allocation of profits based on multiple business lines of a multinational enterprise by using relevant data from the financial statements and other regulatory reports filed for allocating appropriate profits.
OECD has also discussed certain scope limitations (negative lists, threshold limits, etc.) and special rules for treatment of losses.
The second part of Pillar I discusses the revised Nexus Rules. Such rules would prescribe scenarios where a remote taxable presence could be triggered and not be constrained by physical presence requirements.
These rules suggest making relevant changes in the tax treaty, introduction of standalone provisions for taxing such presence, etc.
Pillar II – Global Anti-Base Erosion Proposal
The focus of this proposal is on the introduction of a minimum level of tax on multinational enterprises in the digital economy and beyond. The global anti-base erosion proposal focuses on not only highly digitalised businesses but also those businesses which operate on a global scale (i.e. multinational enterprises), which allows them to shift profits from high-tax to low/no-tax jurisdictions. To achieve this objective, it is proposed that all internationally operating businesses should pay a minimum level of tax in the source jurisdiction.
This proposal attempts to address the remaining BEPS risks of profit shifting to entities subject to no- or very low-tax through:
- Income Inclusion Rule
The income inclusion rule would act as a supplement to CFC rules and would be implemented as a minimum tax by requiring a shareholder in a corporation to account for a proportionate share of income of that corporation if it was subject to tax below the minimum rate of tax. These rules would ensure that income of the multinational enterprise is subject to a minimum tax so that the practice of shifting profits to low or no-tax jurisdictions is not undertaken by them.
This rule prescribes two methods for setting a minimum rate of tax which are briefly discussed below:
- Top up to minimum rate – Establishes a floor on tax rates ensuring that the multinational enterprise would be subject to tax on its global income at the minimum rate irrespective of the jurisdiction where it was incorporated.
- Using a fixed percentage rate – Uses a fixed percentage tax rate instead of a percentage based on jurisdiction’s corporate tax rate.
- Base Erosion tax – this rule imposes tax on base-eroding payments.
It is a two-step process wherein:
- Related party payments which are taxed at a rate lower than the minimum tax rate would not be allowed as a deduction or alternatively, withholding tax would be imposed on such payments in the source jurisdictions.
- Tax treaty benefits would be allowed to such payments provided these payments were subject to tax at a minimum rate.
Note: OECD’s base erosion tax is similar to the United Kingdom’s Diverted Profits tax wherein tax is imposed on the profits which have been shifted to low- or no-tax jurisdictions resulting in reducing the taxable base of the United Kingdom.
However, it is commendable that the OECD has intensified its efforts for finding global consensus-based solutions to address tax challenges arising from the digital economy and there is hope that sooner or later, a more comprehensive or encompassing digital tax would be a reality.
Although, the PoW covers most of the aspects which are relevant for digital economy, however, there are still some grey areas that need to be addressed.
For instance, the revised profit allocation rules require FAR (functions, assets, risk) analysis to determine the quantum of profits to be attributed to market jurisdictions. However, India and many other developing countries have rejected FAR analysis for attribution of profits since it does not take into account the demand factors (i.e. sales).
Recently, India’s newly appointed Finance Minister Nirmala Sitharaman attended the G20 Finance Minister and Central Bank Governors meeting in Japan where she highlighted that the concept of Significant Economic Presence could be a potential solution to taxing digital economy transactions. She also reiterated India's push to revisit the nexus concept to adapt tax rules for the digital age and mentioned that unless we determine nexus, countries can't effectively and justly share tax revenues.
On an overall basis, it appears that the steps taken by India to address problems of taxation of digital economy are not in variance to the global approaches.
Once these changes are implemented, there could be significant tax implications for various online businesses like social media companies, e-commerce companies, online search engines, etc. It would be interesting to see how these companies would prepare themselves for the additional taxes.
We are headed for interesting times where tax rules may change drastically, and it would take the combined effort of countries to ensure the changes are done in the right way.
However, until consensus is reached, unilateral implementation by various governments, including India, would lead to chaos.
While it’s clear this is still work in progress, the path has been laid down. Taxation is very quickly catching up to the digital economy.
Maulik Doshi is Partner and Nishit Parikh is Principal at SKP Group.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its Editorial team.