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The Transformation of International Tax Regime: Digital


Economy

Submitted by: Priya Tyagi Submitted to: Ms. Preeti Lakhera


Roll no: 56LLB15 and Dr. Jasper Vikas

2020

NATIONAL LAW UNIVERSITY, DELHI


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. At the same time, the digital economy is associated with major challenges for the
international tax system. With regards to digital business models, the main tax challenges in
the digital economy stem from the 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, 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.
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. There is a general
consensus that the digital economy cannot be “ringfenced” for tax purposes. 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. The objective of the research is to critically analyze the
OECD policies with regard to digital taxation.

Issue
The author recognizes that due to development of digital economy there has been growth in
tax evasions by the companies. Many companies in the digital economy engage in tax base
erosion by exploiting the loopholes in international tax laws. The growing of the digital
economy has challenged domestic and international tax laws. The author looks into national
and local policies with regard to direct and indirect tax for preventing eroding the tax base
and transformation of international tax law.
Implications of Digitalization for Taxation
Several specific issues related to taxation arise as the digital economy grows in size and
complexity. The article talks about the following points:
1. Tax Revenue Loss
Digitization of business operations can facilitate BEPS, and can result in double nontaxation
and reallocation of taxable income. Multinational companies in the PRC can avoid tax
liabilities in several ways, including (i) avoiding local permanent establishment,(ii)
minimizing the scope of operations and assets to reduce taxable income, and (iii) exploiting
the PRC’s tax treaty network with developing countries that impose generally lower tax rates.

2. Missing Taxable matters


Current international tax rules allow the source country to tax the non resident’s business
profits only if its local presence constitutes a permanent establishment, whether it is a
substantial physical presence or a dependent agent. However, in a digitalizing world, business
can be conducted through a website in the market jurisdiction without any physical presence;
even the website servers need not be set locally. Typical examples are online advertising and
social network platforms. Furthermore, the digital transformation of business models also
challenges the exception clause of permanent establishment rules. Activities traditionally
considered as preparatory or auxiliary may become the core business model in the market
country. In addition, with advancing digital technology, in-person services can be delivered
online, allowing a business to avoid creating a permanent establishment in the market
country. In summary, the current nexus rules capture only physical presence, with the “digital
presence” out of reach, even when it is significant.

3. Unclear income characterization


The tax laws in general rely heavily on the categorization of income to determine the rate and
means of taxation. With digitalization, it is difficult to clearly distinguish some types of
income, especially among royalties, service fees, and business profits. A typical example is 3-
D printing, where it is unclear whether the payment is for royalties, service fees, or business
profits if the buyer is licensed to use the design and print the product locally. If the producer
is a non resident, the implication is more significant because international tax law does not
allow the source country to tax business profits without a local permanent establishment.
Other examples include payments for cloud computing services, rental of cloud space, and
other technical services. The issue of income characterization is not limited to direct taxation;
it also has implications for VAT. In the VAT system, the categorization of transactions and
incomes determines the tax rate. Digitalization also challenges traditional tax practices with
new business models. Typical examples are the sales of software, e-books, and 3D printing.

4. Ineffective value added tax collection


Digitalization raises issues of VAT collection, particularly in business to-consumer(B2C) and
consumer-to-consumer(C2C)transactions. First, the cost of collecting VAT on low-value
transactions of goods may be higher than the tax revenue collected. Second, the complexity
of VAT collection on service and intangible transactions makes taxation of cross-border,
online transactions difficult. C2C transactions, which account for an important part of e-
commerce, are different from business-to-business (B2B) and B2C markets, where a tax
registration and administration system is already in place. Suppliers in C2C are generally
individuals and households. When the existing VAT system does not include a specific
registration and collection regime for individual suppliers, C2C suppliers are not subject to
VAT.

Proposed measures for the digital economy to counter Tax Base Erosion
and Profit Sharing

- OECD BEPS Action 1


The BEPS plan includes five main categories and fifteen action items. The general categories
can be divided into 1) define the tax challenges of the digital economy; 2) creating
international coherence of taxation, 3) reinstate the effects and advantages of international
standards, 4) improving transparency, and 5) implementing the actions in a timely manner

Because of the changing of the international tax landscape so dramatically in recent years,
with political support of G20 Leaders, the international community has taken joint action to
improve transparency and exchange of information in tax issues, and to address weaknesses
of the international tax system Digital economy ś tax base is jeopardized by the fact that the
MNEs are progressively supplying goods and services in countries without a physical or legal
presence; bypassing of withholding tax via transfer pricing applications such converting
royalties into services; by situations where customers pay for specific digital services by
supplying costumers individual data free of charge, so creating more visibility and to get
more customers in the market country; and by artificial agreements created for profits.

- Proposed Council Directives by the European Commission

In the Europe, the former VAT regulations imposed a levy on imported goods from non-EU
countries to be collected at the customs but each Member States have thresholds. The VAT
was imposed at each stage of production of goods that originated within the EU. But this
created certain obstacles and EU companies were disadvantaged. The current VAT system
applied to cross-border e-commerce is an intricate and high- cost system for the Member
States and other similar businesses. Driven by heir Digital Single Market strategy, the
Commission issued a legislative proposal on 1 December 2016 to modernize and disentangle
VAT for cross-border e-commerce. The “Action Plan on VAT” proposal published by the
European Commission has shown that a move towards a more ‘destination-based’ VAT
accounting creates a fair playground for whole suppliers in the same national market. The
proposals are to provide convenience for consumers and companies, especially for start- ups
and SMEs, in buying and selling goods and services online. According to the plan, online
traders will have to register for VAT possibly in all the Member States to which they sell
their products.

Some Initiatives after BEPS

Action Plan 1 addresses the challenges that arise in collecting VAT/GST on services and
intangibles supplied by foreign suppliers and allows tax authorities to collect the tax within
the jurisdiction that affects the consumer by referring to the destination principle. The
measures are incorporated into the OECD’s International VAT/GST Guidelines, which have
been endorsed by over 100 countries, jurisdictions, and international organizations. By
encouraging more consistent and effective application of the agreed methods, the solution
will elevate the compliance levels while also placing limitations on the compliance costs for
digital suppliers. By following the OECD Guidelines, rules have been laid down by the bulk
of the OECD and G20 countries for the collection of VAT from B2C supplies on services and
intangibles by foreign suppliers. Australia, India, New Zealand and South Africa have
recently implemented the offered solutions. The total VAT revenue declared via the
simplified compliance regime (Mini One Stop Shop or MOSS) of the EU in the operation
year of 2015, which adds up to more than €3 billion, constitutes the early data obtained from
the EU

The elimination of the VAT exemption thresholds for the importation of low-value goods
from online sales and the implementation of the approaches for a more efficient collection of
import VAT have been carried out or considered by several countries.

- Steps taken for direct taxes

The OECD/G20 BEPS Discussion Draft of 24 March 2014 introduced a new standard for
nexus named ‘significant digital presence’ for the presence of a virtual permanent
establishment, virtual agency PE, virtual fixed place of business PE, and on-site business
presence PE. After the meetings in the OECD, virtual PE was modified as ‘deemed PE’. The
Discussion Draft of May 2015 under BEPS Action is close to the final recommendation of
the OECD that concerns the proposed changes to Article 5(5) of the OECD's Model Tax
Convention on Income and on Capital. As such, taxpayers with entity structures are allowed
to create deemed PEs by following the new standards. The OECD has recognized the
opportunities and issues of a withholding tax that is collected from digital businesses in
market countries on digital transactions. This proposal by the OECD is referred to as an
“equalization levy” in the present literature. This tax can be gathered from entirely remote or
only digital transactions of foreign businesses with domestic customers that are based on the
gross value of the transactions, as a VAT. This implementation, indeed, can be applied for all
B2B transactions . Many countries try to apply new methods targeted at taxing income from
digital commerce. Among others, Australia, France, Hungary, India, Israel, Italy, Luxemburg,
the Netherlands, and the United Kingdom have presented measures for taxation of digital
companies. Italy has recently approved a new transfer pricing rule that entails employing
valuation techniques that are different from the cost-based indicators for determining the
arm’s length prices of digital transactions.

- Steps taken for indirect taxes

There have been major initiatives of VAT regulations in the digital economy. Their

implementations depend largely on EU and OECD guidelines. Australia, France, India, and

Canada opted to apply the principles of the International VAT/GST Guidelines for the
collection of VAT on cross-border B2C supplies of services and intangibles. In July 2017,

GST was extended to B2C supplies of digital products, services, and other intangibles. At the

same time, it also proposed the abolition of low-value threshold on the importation of goods.

In the Netherlands, the tax authorities introduced Internet Service Center for the EU MOSS

regime for digital services on 29 March 2016. In New Zealand, a person who makes ‘taxable
supplies’ in excess of the registration threshold have to register, while as an alternative to
this implementation, a non-resident who registered to a consumption tax in the country they
reside in should meet certain other requirement.

Critical Assessment
On 31 May 2019, the OECD reported that there is an agreement for a "road map" with regard
to resolving the tax challenges arising from the digitalization of the economy and a
commitment for continued work toward a consensus-based long-term solution by the end of
2020. The latest document is full of statements about moving towards a "consensus solution"
whereas in previous OECD documents there were explicit statements that a consensus had
not yet been reached and documents were being published "without prejudice". There is still
no consensus but there is a clear intent to move towards one.
The basic proposals in the latest OECD roadmap are unchanged since the February
consultation document:
Pillar 1 focuses on the allocation of taxing rights, and seeks to undertake a coherent and
concurrent review of the profit allocation and nexus rules.
Pillar 2 looks to develop a global anti-base erosion (GloBE) rule which focuses on the
remaining BEPS issues and seeks to develop rules that would provide jurisdictions with a
right to "tax back" where other jurisdictions have not exercised their primary taxing rights or
where the payment is otherwise subject to low levels of effective taxation.
While it is true that work undertheG20/OECD agenda is progressing, taxing digital
businesses remains a contentious issue worldwide, mainly because it implies a change: a
genuine reallocation means that there will be winners and losers. Nonetheless, the
G20/OECD work has delivered outcomes, and the shift to taxing all multinationals – without
a special focus on digital businesses – has been welcomed by a large number of stakeholders,
since it grants many
countries new taxation rights at the expense of big multinational companies and restricts
the number of low tax jurisdictions. Moreover, taxation experts consider the less contentious
GloBE proposal favourably.
However, in December 2019, the US position on the G20/OECD work shifted, as it preferred
voluntary, rather than mandatory, digital taxes. This shift has increased doubts as to the
possibility of finding an effective global solution. During the 2020 World Economic Forum
in Davos, US representatives maintained that any international digital taxes must follow 'safe
harbour' rules; however, these rules would be reformulated to avoid declaring the taxes
'optional'. Many observers see this as a unilateral approach, without genuine support for
finding a global solution.
In January 2020, the OECD/G20 Inclusive Framework on BEPS issued a statement
underlining that many of its members are concerned about implementing pillar one on a 'safe
harbour' basis, as this may lead to new difficulties, heighten uncertainty, and risk failing to
meet overall policy objectives. Resolving this issue remains crucial to reaching consensus.
During its next meeting, scheduled for July 2020, the Inclusive Framework will seek to reach
agreement on all the controversial pillar one issues, while the deadline for a complete
consensus based solution remains the end of 2020. While tensions have been reduced, it
remains to be seen whether efforts to reach a global consensus will succeed, as the situation
continues to be rather fragile. In the case of a failure to reach a global solution, the most
likely outcome is the implementation of a plethora of national solutions, which could
aggravate the current situation.
Conclusion and Recommendations

As it is well known digital economy raises serious problems for the current international tax
system which was not designed to deal with such a fast-moving economy. Unexpected results
that have occurred in recent years, in the taxation of digital economy have forced tax
authorities, countries, and international organizations to work together in order to develop
more coherent and common policies. The OECD has been working on topics related to BEPS
and has produced BEPS Action Plans to take control of issues regarding international
taxation. The BEPS Action Plan ensures a comprehensive analysis of the current issues faced
by governments, with measures designed to ameliorate the resultant problems. The OECD
deems ring-fencing digital businesses highly unlikely in view of its integration with all
sectors of the economy and instead of proposing specific measures, it opts for supporting and
encouraging further work and monitoring to be responsive to specific tax challenges to which
digital activity may give rise in the future

This is of great significance since the world will undoubtedly be more digitalized in the
future. Nevertheless, digital tax issues are not fully addressed in the BEPS 2015 report, but
this process will continue to 2020. Both direct and indirect taxation for digital business will
be modified as expected in the coming years. Furthermore, this has prompted certain
countries to try to find their own solutions for taxation of digital economy by implementing
such measures as withholding tax, deemed PE, bit tax and etc.

In a nutshell, international tax regime, especially in relation to digital economy, cannot be as


consistent as it is required. Tax authorities should make greater efforts to take into account of
understanding developments of the digital economy in their mission to improve tax
compliance. The existing tax system does not adequately capture the value creation and profit
making of enterprises in the digital economy. It needs to be transformed to make it both fair
and efficient in a digitalizing world.

Bibliography

- OECD Digital Economy Outlook 2019

- Andrew Wyckoff, Setting the foundations for the digital transformation, OECD 2018

- Nadim Ahmad, Towards a framework for measuring the digital economy, OECD
2018

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