The future of indirect taxation in a digital world

Thus far, there is relatively little evidence (even anecdotal) of audit activity regarding the VAT rules governing the digital economy. This is perhaps not surprising because many countries only recently implemented these rules and need time to educate taxpayers to maintain voluntary compliance and build their own tax authority processes. Moreover, the COVID-19 pandemic reduced audit activity more generally.

Soon, there are likely to be two categories of taxpayers impacted by audit activity in this area. The first is for new or emerging digital economy participants, who may not have registered and accounted for VAT in a given country, or in any country, for that matter. The second is for established digital economy participants, for which the audit activity will focus on their compliance with the detailed rules in a given jurisdiction. Let’s examine each.

The group of taxpayers represented by many new or emerging digital economy players potentially has some of the most challenging issues in the event of an audit. It is a familiar story — a digital economy business grows very quickly, its tax compliance systems and processes lag behind its growth, and then it discovers that it should have registered for VAT at an earlier stage.

The problem in most cases is that the business did not charge VAT to its customers, though it could potentially have done so. They learn that they are liable for the VAT from the outset, and this represents a massive unbudgeted cost. This problem may be present in one jurisdiction, or many.

Moral and ethical difficulties often arise when the failure to account for VAT is initially identified internally within the business, or by its external advisers. The business may want to comply on a go-forward basis but is concerned about revealing past liabilities. The temptation to continue to “fly under the radar” is high.

From a tax authority perspective, this form of non-compliance gives rise to equally difficult issues. They may have some empathy for the situation, though they will typically not be able to waive non-compliance of the VAT liability for past periods. They will be concerned that the business has gained a commercial advantage over domestic businesses or other businesses that have complied and have charged and collected VAT. In many cases, there is more room to remit interest and penalty charges. However, the empathy has its limits as recently shown by the Audit General of Quebec who in a report was very critical of the way Revenue Quebec and the Canada Border Services Agency collect the Quebec sales tax under the e-commerce rules.¹¹⁸ Germany is also notorious for forwarding non-compliant digital providers to the prosecutor for criminal proceedings.

Countries such as Australia, India, Singapore, and even Ghana have been quite active in approaching non-compliant businesses. These jurisdictions leverage different tools to identify non-compliant businesses, including exchange of information between tax authorities, information gathered from domestic anti-money laundering bodies, or setting up dedicated investigation units.

Several countries, with Chile, Indonesia, Japan, Russia and Mexico as prominent examples, publish the list of suppliers of digital services registered for VAT purposes. These lists are no doubt cannon fodder for tax authorities elsewhere in seeking to ensure that these companies are registered for VAT purposes in their jurisdictions too.

The root cause issue here is that we need to recognize the sheer enormity of the challenge digital economy businesses have in complying with their global obligations, whether they are new or established businesses. Without regard to some of the more complex issues, the inconsistency in registration thresholds around the world, and the almost daily occurrence of new countries implementing these measures, already prove an enormous barrier for new businesses.

Even for those established digital economy players who have managed their registration and compliance obligations around the world (if not perfectly, at least with a reasonable risk mitigation strategy in place), compliance with the rules is an impossible task. Let’s take a quick inventory of the common areas of divergence which frequently arise.

The first example is where the jurisdictions adopt inconsistent customer location information to determine where VAT must be accounted for. While the EU approach of sourcing requires no less than two non-contradictory pieces of evidence is helpful (e.g., IP address, billing address, bank details), even among mature VAT systems this is not uniform. For example, South Africa will look not only if the recipient is in South Africa, but also if the payment for the service originates from a bank in South Africa.¹¹⁹ Certain less developed countries, such as Cambodia, have not provided any guidance at all.

In reality, digital economy businesses are often not capable of maintaining multiple rule sets within their systems and processes. Indeed, some digital businesses maintain only a single criteria for determining customer location due to challenges in reconciling and resolving inconsistencies.

To be clear, though, while full compliance with these requirements may be a pipedream, it does not necessarily follow that there would be substantial liabilities arising in practice for non-compliance. The authors believe there should be considerable caution taken by tax authorities before assessing liabilities in this area. Specifically, if:

• All the in-scope transactions have been allocated to jurisdictions using a consistent methodology which is objectively viewed as reasonable; and
• VAT is being dealt with for those transactions.
  

It is difficult then to see why we should be retrospectively reallocating the VAT for transactions carried out with a customer in one country to that of another country, especially in circumstances when a credit or refund from the first country will not be forthcoming. In other words, if the digital service provider has a robust global compliance program, we should be careful before “cherry picking” perceived non-compliance in one jurisdiction that leads to a mere reallocation. In an overall sense, it is a nil-sum game for the affected businesses (though this does not lead to reallocation between revenue authorities)..

However, tax authorities with contradictory geolocation rules may be tempted to not simply reallocate the sourcing of the taxable revenues but to consider that VAT is also due in their jurisdiction. For instance, if a South African resident is temporarily in Europe and purchases a digital service with their South African credit card, both the EU tax authority and the South African Revenue Service could assert that their VAT is due. Unfortunately, as shown with the roaming example discussed under Proposition 2, tax authorities do not have to take into consideration the tax treatment applied in a foreign jurisdiction (except for other EU Member States) and thus there is an increasing risk of double taxation. If countries start taking this approach, businesses will likely have to take increasing steps to ringfence their sales to specific jurisdictions, for instance by blocking any person that has any contradictory geolocation (e.g., if an individual lives in Luxembourg, uses his French credit card, and visits his parents in Germany).

Differentiating B2B and B2C sales is a growing problem as we find an increasing number of tax authorities, especially in less developed countries, seeking to impose VAT registration and compliance obligations on non-residents engaging in B2B transactions. In our view, such an approach should be rejected as being fundamentally inconsistent with good policy design. Plainly, requiring non-residents to register and account for VAT in preference to domestic businesses (who are already within the ambit of the jurisdiction and can self-assess the VAT on “imported” services) imposes unnecessary compliance costs.

We have observed the following:

• Countries seeking to require non-residents to register and account for the VAT on B2B transactions. Specifically, the Bahamas, Barbados, Indonesia, Malaysia, and South Africa are clear examples of this. Not only does it create an overlap with reverse charge rules, but it raises questions around the entitlement of the domestic business recipient to credits and whether tax invoices are required; and
• Countries, such as Cambodia and Vietnam, where we see a hybrid approach emerging. Under this hybrid approach, the non-resident supplier may be required to register and report B2B transactions, but not collect the VAT. To complicate matters further, in Cambodia, the applicability of VAT to the non-resident supplier’s services to the resident business recipient is also dependent on whether the counterparty pays directly from a bank account registered in their name.

Quite apart from these examples, there is a general lack of consistency globally in terms of differentiating B2B versus B2C transactions. In particular, tax authorities differ in whether the recipient in a B2B transaction is a business that is VAT registered (leaving B2C to capture everyone else) or whether the consumer recipient in a B2C transaction must be an individual. In practice, difficulties abound when considering the position of public bodies, non-profit organizations, sole traders, as well as small taxpayers who are below registration thresholds, and even branches.¹²⁰

To improve and simplify compliance for everyone, tax authorities need to recognize the importance of developing public databases in which the VAT status of the service recipient can easily be checked, and make application program interfaces (APIs) freely available to ease the ability to automate the verification process. Anything less than that will subvert their own compliance goals.

While VAT registration thresholds around the world vary considerably, the issue is not only that they differ. Specifically, we are witnessing a growing number of countries applying “nil” thresholds, or thresholds that are so low that they are not achieving the objective of properly balancing compliance costs with the tax being collected. We are also seeing countries increasingly applying different thresholds for domestic businesses as compared with non-resident businesses, which creates an uneven playing field (see Proposition 3). For instance, the latest Kenyan Finance Act repealed the VAT registration threshold for non-resident digital businesses entirely.¹²¹

We have already discussed above several issues surrounding the complexity of determining the correct VAT treatment applicable to digital services under various propositions. However, with respect to new rules surrounding low value consignment goods, the use of differing transaction thresholds can create compliance challenges. There is debate recently in both the EU and Australia about expanding or providing optionality around the import thresholds for low value goods as the current consignment value thresholds can, in practice, be illogical. For example, in Australia, imported goods under AU$1,000 (USD$700) are accounted for by the non-resident platform (or supplier) as a taxable supply, whereas tax on imported goods exceeding that amount is collected at the border even if the non-resident platform (or supplier) is already registered for GST purposes. Optionality would allow the non-resident platform to choose to account for GST on all transactions as a taxable supply, thereby avoiding the need to differentiate the GST collection method based on the value of each shipment or whether B2B or B2C. There is, of course, a third category which commonly applies when a digital platform may maintain a warehouse within the jurisdiction, and therefore it also carries out domestic transactions. In this case, the non-resident digital platform is not liable for GST and the liability reverts back to the underlying supplier, even if the digital platform is already registered for GST purposes.

The more that can be done to create alignment or at least optionality for alignment, the better. The recent conclusion by the Board of Taxation in Australia following its review of these measures is disappointing as the Board does not recommend providing suppliers an option for paying GST on high-value goods.¹²²

While most countries apply their digital economy measures only to B2C transactions, there are still many jurisdictions that require the customer to be provided with a tax invoice even though consumers cannot recover VAT and thus do not need a VAT invoice that includes all the complex invoicing requirements. For example, Albania, the Bahamas, Cambodia, India, and Malaysia require the issuance of VAT compliant invoices. This can be challenging to implement for companies that make sales in 190 plus countries.

In addition, the rise of mandatory e-invoicing and digital reporting rules raises a new layer of challenge for digital economy participants. At this juncture, there is only a handful of jurisdictions that require non-established businesses to use e-invoicing and/or digital reporting (e.g., Taiwan), but this is an area of growing importance to monitor.

While the theory of requiring digital economy participants to prepare only a “simplified compliance return” is sound, filing obligations are beginning to grow.

Even under a simplified EU-wide regime, digital platforms may be liable to file three returns — IOSS (import one-stop shop), OSS (one-stop shop) for services (non-EU scheme) and OSS for goods (EU scheme). Some countries also require the filing of supplemental reports (e.g., Turkey requires a B2B report even if VAT is collected only on B2C sales as does Cambodia).

In principle, the registration process should be fast and streamlined through an internet portal; Chile provides a good example. From a practical perspective, however, we continue to see that complying with remote seller rules can be complicated. For example:

• Requiring appointment of a fiscal representative (e.g., Japan, Mexico, South Africa);
• Requiring an in-person meeting with the tax authorities (e.g., Mexico, Cambodia) in the period before its online portal goes live;
• Requiring documents to be provided or certified by a notary and translated (e.g., Mexico);
• Varying rules around exchange rates. In Colombia, for example, there is a timing issue between filing the return via the tax authority’s portal and making a payment from a foreign account which can lead to an exchange rate loss and potential under payment of tax; and
• Differing, strict rules relating to price displays to customers. For example, Australia and Malaysia generally require VAT-inclusive pricing displays, thus creating a technical and commercial challenge for a single site that reaches multiple countries.

The recent sanctions applicable in Russia and Belarus, and the state of emergency in Ukraine, have also created significant compliance challenges.

Finally, we are seeing a growing conflict between a company’s internal data privacy standards and its obligations to tax authorities under certain of the new measures. Some countries have proposed customer lists be provided as part of the VAT compliance process. For example, Chile and Turkey require non-resident digital providers to provide a listing of their B2B customers, even though the VAT rules apply only to B2C transactions. For new business models such as crypto and NFTs, collecting this customer information data may be highly problematic given its pseudonymous nature.

It is important to recognize that for traditional businesses, they will have made a “choice” or conscious decision to enter a given jurisdiction and to comply with the tax rules in that jurisdiction. For digital businesses, no such conscious decision has necessarily been made, because they will often have decided merely to make their products or services available on the internet. They do not have the luxury of time to meet these obligations.

It is well accepted that imposing these types of compliance obligations on the largest digital economy businesses throughout the world may be considered a more acceptable balancing of tax revenues with compliance costs. However, as more and more traditional businesses switch on their digital presence, the challenges are immense.

As demonstrated above, the practical issues are a result of multiple countries taking unilateral compliance approaches to businesses, which in their essence do not abide by traditional borders. These compliance differences, without regard to size of the seller or the revenue at risk and without sufficient implementation time, become seriously onerous. In imposing these sorts of requirements, tax authorities have a practical obligation to consider size, timing, options for compliance, and avoiding differences among one another. This would improve the chances for compliance and will be to their benefit.