The future of indirect taxation in a digital world

The VAT rules aimed at the digital economy are designed to create a level playing field between domestically purchased services and those provided remotely so that a savvy consumer would not receive a price reduction from simply buying certain services from abroad or a business would not receive an undue economic advantage simply from being established abroad. However, policymakers and the citizenry are often more focused on whether digital economy companies pay their fair share of income taxes in their jurisdictions. While adapting consumption tax rules to the digital economy has been a relative success so far, adapting the income tax rules has been far more challenging. These challenges were first identified as a focus of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, leading to the 2015 BEPS Action 1 Report, titled “Addressing the Tax Challenges of the Digital Economy”. ⁸²

Since the release of the Action 1 report, progress has been slow, leading some countries to adopt unilateral measures, such as digital services taxes (DSTs).⁸³ Most DSTs that have been implemented or proposed have similar characteristics and are designed as temporary measures (though India did not state that the expanded Equalization Levy would be only a temporary measure) until a global consensus is reached on profit allocations of large multinational companies. Existing DSTs are a mix of gross receipts taxes and transaction taxes that apply at rates ranging from 1.5 percent to 7.5 percent on receipts from the sale of advertising space, the provision of digital intermediary services such as the operation of digital platforms, and the sale of data collected from users.⁸⁴ For the most part, DSTs are aimed at a small number of large digital companies. To be subject to a DST, a company, on a group level, must generally satisfy a double threshold: a worldwide revenue threshold, e.g., EUR€750 million or (USD$783 million) in DSTs imposed by France, Italy, Austria, and Turkey, and a domestic taxable sales threshold e.g., EUR€25 million (USD$26 million) in France or EUR€5.5 million (USD$5.7 million) in Italy.⁸⁵ The sourcing of DST revenue is generally based on whether the taxed service is viewed or enjoyed by a user that has a device located in the jurisdiction imposing the DST. A device is generally deemed located in a DST jurisdiction based on its internet protocol (IP) address or any geolocation method.

These unilateral measures have especially caught the eye of developing countries that have reported difficulties in taxing highly digitalized businesses operating in their countries. For instance, on 30 September 2020, the African Tax Administration Forum (ATAF) released its Suggested Approach to Drafting Digital Services Tax Legislation that proposes a rate between 1 and 3 percent on gross annual digital services revenue earned by a company or multinational enterprise (MNE) in a country.⁸⁶

These unilateral DST measures have accelerated discussions at the OECD level with the aim of reaching a consensus position. This resulted in the release of a package comprising a two-pillar solution, which received consensus by 135 countries in October 2021.⁸⁷ The two-pillar approach includes changes to profit allocation and jurisdiction to tax rules applicable to business profits under Pillar One. These seem uncertain to be implemented as the OECD Secretary-General updated the implementation timeline of Pillar One, aiming to have the multilateral convention developed and signed during the first half of 2023, to be implemented in 2024.⁸⁸ In addition, the US has and may well continue challenges in adopting such measures.⁸⁹

In the absence of global adoption of Pillar One, it is very likely that what will remain will be a patchwork of unilateral measures layered on top of the consumption tax rules. More countries will likely implement DSTs. The Pillar One agreement of October 2021 already foresees this by stating that no newly enacted Digital Services Taxes or other relevant similar measures will be imposed on any company from 8 October 2021 until the earlier of 31 December 2023 or the coming into force of the new rules. However, countries with existing DSTs can continue to apply these taxes.⁹⁰ The Canadian Finance Minister already announced in December 2021 that the federal government would introduce a DST effective 2024 if the OECD/G20 Inclusive Framework’s multilateral approach has not come into force by that time.⁹¹ Other countries that have hit pause on the implementation of a DST will likely follow (e.g., Czechia and Poland) and new jurisdictions may follow as well.

Moreover, once DSTs have been tried and tested for large companies, it is not unthinkable that the scope of services falling under DSTs may be broadened to more digital services and that the compliance thresholds may be drastically reduced, as India and Kenya already have in progress. India and Kenya demonstrate how VAT and DST rules may well interact in future. In India, digital services in scope of the Equalization Levy are broader than those under the GST Online Information Database Access and Retrieval (OIDAR) services rules, meaning that companies may be excluded from GST compliance but still be required to comply with the Equalization Levy. However, in Kenya, the government appears to be trying to harmonize the two taxes to the degree possible.⁹²

Other jurisdictions may rather follow a full tax obligation approach (i.e., corporate income taxes and VAT), like Nigeria’s significant economic presence standard⁹³ or Vietnam’s recent new tax rules aimed at the digital economy.⁹⁴ In both cases, taxpayers are not only required to collect and remit VAT but are also subject to local income tax rules as if they were established as resident companies. A similar approach is for countries to adopt virtual PEs, as we have seen in Pakistan. The implications of these approaches are significant. They generally run counter to established double tax treaties and from a VAT perspective would render the application of special digital economy rules (such as simplified compliance approaches), useless.

Even in countries that will not adopt a broad approach to taxing digital economy companies, may choose to tax certain specific revenue streams, as is already the case in a few jurisdictions. These can, for instance, include gross receipts taxes applied to revenues from streaming companies to support local television productions (e.g., proposed in Denmark and Switzerland)⁹⁵ or gross receipts taxes on digital platforms for distribution and delivery of goods and food (e.g., Mexico City and France).⁹⁶ Even the UK has recently entered the fray, with consultation measures underway to consider an “Online Sales Tax”.⁹⁷

For businesses involved in the digital economy, the proliferation of such taxes in a non-harmonized way will increase their tax risk and compliance costs. This is especially true for companies that are already compliant with digital economy VAT rules, who will see their tax exposure increase as tax authorities will already have gathered key information on some of their local sales via the VAT returns. India’s tax authorities may foreshadow this approach as the direct tax authorities in charge of the Equalization Levy regularly exchange information with the indirect tax authorities responsible for GST OIDAR rules, even though the scope and compliance rules for the regimes differ.

In a worst-case scenario in which the Pillar One discussions crumble and governments start imposing unilateral measures, the rising tax obligations will likely result in an increase in prices. In addition, some countries will be tempted to impose trade or other countermeasures as the United States Trade Representative was suggesting with respect to existing DSTs before the October 2021 OECD/G20 agreement on a two-pillar solution.

There is a risk that only a few businesses will be prepared for the onslaught of these new measures. DSTs and similar taxes are currently managed by diverse groups in many companies (e.g., international tax, indirect tax or accounting/finance), and few professionals have a full grasp of the complexity of these global rules. Therefore, businesses in the digital economy will be required to adopt the same approach as traditional businesses and seriously consider the direct tax and indirect tax implications before they enter new markets. The long-term effects of these changes are unknown, but they will likely erect virtual borders which will produce winners and losers for businesses, consumers, and tax authorities.