Challenges in taxing digital economy

DailyTimes  |  May 09, 2021

The digital economy is a new reality and it has triggered a heated debate and posed new challenges to tax policymakers. This not only encompasses the application of tax rules designed for brick-and-mortar activities to new disruptive business models but also with regard to the effective enforcement of such tax rules against companies that do not have a physical presence within the country. These threats to national tax systems emanate from the absence of physical presence, the strong dependence on intangible assets, the complex nature of the transactions carried out in the digital economy, and the difficulty of qualifying assets, activities and types of income. In general, countries that have adopted new tax measures to tax the digital economy seek a larger allocation of taxing rights to the source state in which the consumer market is located. They argue that the allocation of taxing rights should reflect the present stage of economic development in which multinational companies develop their business without a physical presence. In addition, the adoption of measures to tax the digital economy would serve to reduce the competitive advantages of companies operating in the digital economy. These large technology companies allegedly face a lower tax burden than their competitors in the traditional economy which has led to a scenario that distorts competition and increases the economic power of digital giants. The taxation of the digital economy would also prevent an increase in the tax burden levied on less volatile elements, such as labor income. Finally, countries claim that the exponential increase of the digital economy and the digitalization of the traditional economy require the adoption of new tax rules, given the growing gap between the economic reality and tax systems, which did not follow the development of new business models.

In this context, the digital debate focuses on direct taxation and the creation of new taxing rights arising from the tax claims of market jurisdictions on income obtained by foreign digital suppliers conducting business therein without any physical presence

In this context, the digital debate focuses on direct taxation and the creation of new taxing rights arising from the tax claims of market jurisdictions on income obtained by foreign digital suppliers conducting business therein without any physical presence. Therefore, the digital economy has now become a global phenomenon that requires a global solution: the creation of global taxing mechanisms and global institutions that provide technical assistance and support for successful global implementation. Such an understanding is essential to obtaining global support, achieving tax compliance, and fostering multilateral tax cooperation. Thus, there is a widespread – but not yet universal – view that the international tax system needs reform in order to address the digitalization of the global economy. Both the OECD and the EU have conducted loads of empirical research on this subject and the OECD has, subsequently, released its proposals on allocating profit to different countries in which an international company makes sales or derives value. This is the OECD’s two-pillar ‘Unified Approach’, and is supported by the OECD/G20 Inclusive Framework on BEPS (IF). The latest blueprints represent a huge volume of technical work and discussion, but many key aspects remain subject to political agreement, and questions remain as to when, and indeed if, the OECD’s proposals will be implemented. The 137 members of the Inclusive Framework have not yet reached agreement on a specific, implementable plan.

However, the extension of the OECD timeline for reaching agreement on the proposals to mid-2021 at the earliest is indicative of the challenges faced by the OECD in reaching political agreement on matters which would see a reallocation of global taxing rights between territories under Pillar One, and a potential impact on jurisdictional tax sovereignty under Pillar Two. On the other hand, the Unified Approach seeks to give countries the right to tax profits of international businesses (regardless of whether they have a base in the country or not) based on calculating a new pot of profit in combination with enhanced dispute prevention and resolution mechanisms. This moves away from the long established principle of “profit where the business has physical presence” which has been the cornerstone of the international framework, and represents arguably the most significant change in the international tax architecture in 100 years. This proposal represents a reattribution of value to market jurisdictions where users of a digital service or customers of a consumer facing business are based, coupled with an intended simplification of certain aspects of transfer pricing rules. The Pillar Two proposals are designed to counter profit-shifting by multinationals who are subject to low or zero taxation. This proposal is seen as seeking to prevent a ‘race to the bottom’ on corporation tax rates by imposing an effective minimum rate of tax on corporate activities.

But this is far easier said than done and there some daunting snags impeding the desired outcomes. One of the most demanding challenges is to reach a political consensus. The US Treasury has already taken a tough position. It has stated that it feels that countries should be dealing with the current pandemic and have called for the OECD to suspend its work temporarily. More recently, the US has also pulled out of talks with their EU counterparts and have threatened to apply retaliatory sanctions on those countries that have implemented unilateral measures to tax the profits of US headquartered digital companies. The European Commission is focused on reform to the taxation of the digital economy. It is understood, from public statements made by EC leadership, that the EC will move ahead with a digital tax proposal in the first half of 2021 if work at the OECD level on an international corporate tax framework fails or stalls. The question of taxation of the digital economy, therefore, remains politically sensitive. However, the OECD is under tremendous pressure to come to a consensus. Where the timelines are not met, there is concern that there is likely to be a proliferation of domestic taxes on digital activities and trade wars. That is why it is imperative to monitor and update on the progress made by OECD, regularly.

Furthermore, in addition to political divides preventing the adoption of a consensus driven policy on digital taxation, there are legal complexities involved in this quagmire. There exists a substantial constraint on the introduction of unilateral tax measures lies in the obligation to comply with international commitments, such as tax treaties and trade agreements. However, in practice, several unilateral tax measures have been adopted at the margins of international commitments because of the lengthy and bureaucratic procedure required for the renegotiation of international agreements. One important aspect to be considered upon the introduction of new tax measures is to avoid segregation between digital and non-digital activities. In the 2015 BEPS Action-1 Report, the OECD highlighted that the digital economy is not at the margins of some real or physical economy, because the whole economy is becoming digital to a certain extent. Several companies are increasingly engaged both in the digital and physical world, so that ring-fencing the digital economy would lead to debates related to unequal treatment and enormous practical difficulties. The temporary nature of new unilateral tax measures is another aspect frequently highlighted from an international standpoint because such rules should only be effective until countries reach a comprehensive and multilateral solution. For this reason, such new tax measures should not give rise to high compliance or administrative costs, since it would make no sense to oblige companies to invest significant amounts in systems and controls to fulfill ancillary obligations related to the new tax if it will be levied on a temporary basis.

In the final analysis we can conclude that the digital economy brings with it not only a wide array of opportunities but also some new challenges. Positioning of any country on the global stage largely depends on its ability to adapt to the new realities. While the digitally advanced countries from the developed world continue to reap immense financial gains, the developing countries are found on the left side of this digital divide and are struggling to adequately respond to the growing demands of the digital economy owing to inadequate access to the latest technology, lack of sophisticated telecommunications infrastructure, low computer literacy as well as numerous cultural and socio-economic roadblocks. Therefore, time has already come for adopting a universally agreed framework under OECD to tax digital economy and thus let the gains flow from the “digital haves” towards the “digital have-nots”.

The writer is a civil servant by profession, a writer by choice and a motivational speaker by passion!

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