Reaction paper on The Transformation of International Tax Regime: Digital Economy

Archit Gupta
12BALLB15

With the advent of the digital era, the international tax community saw the concept of PE face
its first major challenge in the sense the evolution of innovative business processes and
models, which require less physical presence and more digital presence has challenged the
adequacy and fundamental validity of basic principles of international taxation for assessing
the tax liability. Therefore, new practices and regimes are being developed to broaden the
scope of permanent establishment and include such companies providing goods and services
from third-party countries through the use of digital transactions.

Issue:

The article mainly investigates the regional and national policies with respect to direct and
indirect tax to prevent the erosion of the tax base in light of the digital economy and tracks
the transformation of international tax law.
The author has rightly detailed the issues faced in the application of the existing or traditional
OECD model to digital transactions and web-based companies and has summarised a few
approaches, both by the OECD and by individual nations, which could probably solve the
ambiguities in the existing approach of PE vis-a-vis digital transactions.

The Existing Tax Rules and its deficiencies:

According to the OECD Model Tax Convention, a company is only subject to tax on its
profits if it has a permanent establishment in the country in which it is a non-resident. It
defines a permanent establishment in Article 5 as a fixed place of business through which the
business of an enterprise is wholly or partly carried on. From the definition, it is clear that
there has been an attempt to distinguish substantive economic activity, which creates a
taxable presence, from a mere preparatory or ancillary activity wherein the latter does not
create a taxable permanent establishment.
Such a specific differentiation permits non-resident companies which interact with customers
in another country to deal in buy goods and services remotely via digital instruments to
legally escape any tax liabilities which their national counter-parts may be subject to. Such a
goal is achieved by conducting its business through online platforms which do not require
establishing a physical presence in the country.
The existing taxation structure, when applied to the modern forms of business, faces the
following problems:
1. The traditional approach to direct and indirect taxes is inapplicable due to the
difficulties in pin-pointing the competent authority which will enforce the rules.
2. The foreign actors in the digital economy generate a net loss in taxable revenues by
engaging in transfer pricing to decrease the tax bills and thereby availing exemptions
from taxation.
3. Technological improvements permit such enterprises to penetrate the markets without
having to build a taxable presence through a permanent establishment.
4. Multinational companies now have the flexibility to centralize their functions in
specific jurisdictions which provide mechanisms for BEPS.

The Modes of Base Erosion and Profit Sharing:

Some of the major methods to challenges the concept of PE and to minimise tax liabilities are
as follows:
 Taxable presence – The enterprises minimise their tax liabilities in the market country
by avoiding such presence. If avoiding it is not possible, they seek to shift the gross
profit or reduce net profits by claiming as many deductions as possible.
 Withholding tax – the taxable presence is established in a jurisdiction where such tax
is either non-existent or minimal.
 Payment by the recipient – The recipient of the transactions is located in jurisdictions
with little or no taxation. This is paired with building of substantial nonroutine profits
via intra-group arrangements.
 Parent company - No current taxation of the low-tax profits.

In adopting such a mechanism, the enterprises avoid tax in the market country, by virtue of a
double taxation avoidance treaty, in the other country to the treaty, by avoiding a taxable
presence, and in the country where the company is incorporated, by establishing the same in a
tax haven.

The way forward

As was correctly pointed out in the BEPS Action 1 Report, due to the global nature of such
companies and the problems faced, a ringfenced solution merely involving changes to
national laws sine a global consensus and action, the challenges posed by the internet
communication technologies are bound to continue. The report mentions certain
recommendations, which once fine-tuned, may provide certain reliefs. It prescribes the
formulation of a new tax nexus of “significant economic presence” as opposed to the
requirement of a “permanent establishment”, the use of a withholding tax on certain types of
digital transactions, and a “digital equalization levy”.
In order to better account for digital transactions, the new tax nexus of ‘significant economic
presence’ was altered to ‘significant digital presence’. According to the proposed model, a
virtual PE is created by the website operated by the enterprise. In addition to the virtual PE, it
was recommended that foreign businesses which provide on-site services must also maintain
an onsite business presence PE. However, due to the difficulties in the implementation of
such a model, virtual PE was modified as ‘deemed PE’.
As an alternative to the collection of the PE based withholding tax, the OECD has also
recommended an ‘equalization levy’, in the form of VAT, be collected with respect to digital
transactions of foreign businesses with the domestic customers on the bases of the gross value
of the transactions. Such a model is based on and gives effect to the destination principle of
taxation. However, the replacement of withholding tax with VAT provides certain benefits to
the businesses as it would lead to the replacement of a direct tax with an indirect tax, the
burden of which is transferred to the customers. However, a modified version of such
approach has been adopted by India through the introduction of an ‘equalization levy’ in the
form of a withholding tax/surtax on foreign companies for specific digital services vide the
Indian Finance Act, 2016.
While the author has discussed the OECD initiatives for direct taxation in detail, while
analysing on the indirect taxation regime, the focus has shifted from a review of the OECD
initiatives to an exemplary summary of the measures undertaken by various nations. Italy, on
similar lines as the OECD recommendations for direct taxation prescribed certain rules for
‘virtual permanent establishments’ and withholding tax for the provisions of digital services.
Chile, on the other hand, adopted an alternative mechanism wherein the taxpayers have been
required to report information regarding electronic gambling activities, digital commerce,
online applications, and digital services. Finally, Japan reformulated its VAT regulations and
has removed certain exemptions which were granted for the distribution of digital books,
music, image, and software.
While such individual reforms may not be adequate to effectively adjust to the modern forms
of business, basis such reforms a three-pronged approach may be adopted. First, akin to
Japan, exemptions from taxation granted for conducting business online may either be
withdrawn or relaxed in a phased manner. Secondly, as adopted by Italy, rules for recognising
a ‘virtual permanent establishment’ or a ‘deemed PE’ as under the OECD recommendations
may be implemented. Finally, a reporting mechanism for such transactions must be enforced.
However, the final prong of the approach may be subject to criticism due to the governments
shirking its responsibility by requiring the citizenry to inform them of the business being
conducted in its jurisdiction.

Recommendation:

Due to the global model adopted by digital companies, it is the need of the hour that the
nations come together to formulate an international framework for taxation. The nations may
consider the establishment of a voluntary international organisation, like the UN, dealing
specifically with taxation of such transactions. The treaty empowering the body must provide
for a mechanism for the distribution of the proceeds collected by it and a truly representative
model to ensure fairness in functioning.
While it is recognised that a proposal for the creation of such a body may be perceived by the
nations as a possible infringement of their sovereignty, however, owing to the continuing
rapid changes in the Information and Communication Technology, it is possible that the
nations may face a situation where a majority of all business conducted in their jurisdiction is
conducted by adopting such mechanisms. In such a situation, the nations would be under-
prepared to tackle the problem and might face a situation of concentration of world on a
global level.