Summary: The digital economy has become deeply integrated into mainstream commerce, making it difficult to isolate digital businesses from traditional ones. This integration has led to significant tax challenges, including tracking remote sellers, assessing sales, and enforcing tax liabilities. BEPS Action-1 highlights the diverse models of digital businesses and their reliance on intangible assets and network effects, which complicates tax administration and raises risks of base erosion. The core tax debate centers on the allocation of taxing rights between market and residence countries. Developing nations argue for a redistribution of taxing rights to reflect economic contributions by users, while developed nations maintain that value creation occurs within their borders. OECD’s Pillar-1 aims to address these issues by reallocating a portion of multinational profits to market jurisdictions and standardizing tax rules, but it faces criticism for its complexity and potential unfairness. The Pillar-1 approach also requires countries to withdraw unilateral measures like India’s equalization levy, which complicates its adoption. Despite its shortcomings, Pillar-1 represents a significant step towards reforming digital taxation, though its success will depend on international cooperation and further refinement.
Today the digital-economy has integrated into mainstream economy, which has blurred boundaries between traditional and digital-businesses, with nearly every business digitized to varying degrees. Hence, there is no way to ring-fence the digital-economy anymore.
BEPS(Action-1) acknowledges varied digital business-models, from e-commerce platforms like Amazon to digital-nomad services and social-media advertising. These businesses operate remotely, crossing borders with minimal initial-investment while scaling without mass, and relying on mobile intangible-assets, exacerbating BEPS-risks.[1]Many digital-businesses employ automated data-collection for behavior-based customer targeting, essentially making users the focal point of business. They also increasingly rely on loyalty-driven network-effects, wherein users or customers actively contribute value to the business and serve as its central focus.[2]
Digitization poses tax-administration challenges of tracking remote sellers, assessing sales, and enforcing tax-liabilities, specifically in peer-to-peer online markets. Also, transfer-pricing is challenging due to limited-guidance available on digital-model modifications to functions, assets, and risks. These challenges contribute to significant revenue-loss. Tax-neutrality concerns emerge as online enterprises often evade tax obligations, shifting the burden onto traditional-businesses that are less digitized, thereby disrupting the marketplace.
Taxing-Right Allocation: The core issue lies in the distribution of taxing authority between market-based source-countries and residence-countries, a longstanding debate in international-tax law. Historically, capital-exporting developed-nations retained the majority of taxing-rights, leaving developing-countries with limited-options such as withholding-taxes or reliance on PE. Today, as developing-nations find themselves marginalized from benefits of the digital-economy, they are advocating for a redistribution of rights through forums like G-20/UN. They are arguing for taxation based on economic-allegiance, considering the value contributed by customers in marketing-jurisdictions(supply-demand approach).[3]Conversely, developed-nations contend that value-creation and capital-deployment predominantly occur within their borders, justifying their sole-right to tax(supply-based approach).Moreover, they apply benefits-theory to argue that digital-businesses leverage the infrastructure of developed-nations, hence they should have taxing rights.[4]This discourse led OECD(developed-nations) to shift stance from denying taxing-rights to market-jurisdictions to Pillar-1.
Insights from BEPS(Action-1):Action 1 is not included in the minimum standard of BEPS. Nonetheless, it remains relevant as it underscores the primary challenges of the digital-economy, as outlined below:
Nexus: Tax-allocation hinges on nexus. Digital-businesses operate globally without physical-presence, led by centralized-management and online-procurement, and customer network-effects.Action-1,Report proposes nexus-solutions based on economic-substance and value-creation. However, value-creation was clearer in traditional-models, and digitisation requires one to consider new criterias like network-effects, user added value, supply-chains etc.[5]
Data: It is difficult to value data but it’s nonetheless valuable. For instance, data on customer browsing behavior is valuable. Also, user-generated reviews on a website or other digital-content on a website can enhance product-value. Taxing such transactions is hindered by the lack of data value-capture mechanisms. Also, data as a commodity is usually excluded from business balance-sheets and profit calculations. Additionally, current-laws treat data as an individual’s property rather than corporate assets posing further challenges.
Characterisation: Taxing emerging digital-products/services poses challenges in characterizing them as business profits, royalties, or technical services. For instance, difficulties arise in characterizing income from downloading of digital-content(as seen in the Engineering Analysis Centre of Excellence), in transfer of know-how, from software/digital-licenses, for technical-fees, for updates/add-ons/limited-duration software, from website-hosting and advertising(discussed in Pinstorm Technologies, Yahoo and Google by Indian-ITAT[6])each potentially falling under different tax-categories.[7]
Difficulty in characterisation was also discussed in Hootsuite and Amazon where characterisation of income from cloud-computing services and income from a social-media platform using cloud-computing and dedicated high-speed(non-internet)network was considered. As emerging technologies continue to evolve, new challenges emerge daily. For instance, the availability of advanced 3-D printing in the market enables remote manufacturing of goods, presenting challenges in their tax characterization—whether as royalties, fees for technical-services(FTS), or business-profits.
PE: Digital-businesses fail the physical-presence test for PE.[8]E-commerce predominantly occurs through intangible platforms like phone-apps/websites, neither constituting a fixed-place-of business. While servers hosting these websites may qualify as PE, they can be relocated or mirrored to other jurisdictions, potentially facilitating tax-avoidance.[9]
In digital-economy, preparatory/auxiliary activities, such as goods delivery, warehousing for online-sellers or advertising, may be integral to businesses, necessitating revisions to PE-exceptions. Also, online contract conclusions render Agency-PE definition ineffective, with commissionaire-arrangements often used to circumvent regulations. Furthermore, businesses-fragment their activities to sidestep PE-thresholds.
Evaluation of BEPS(Action-1): Action-1 is not a minimum BEPS-standard but it suggests separate measures for market-jurisdiction and ultimate-parent jurisdiction to be undertaken to rise to the challenge of digital-economy. It stresses on implementation of BEPS(Action-2,3,4,5,6-10). Action-6(treaty-abuse),a minimum-standard, has been implemented and has reduced treaty-shopping/conduit-companies, common in digital-businesses.Action-7, not a minimum-standard, is optional[10].However, states which have opted for OECD-Model-Treaty(2017) have incorporated changes to preparatory/auxiliary exceptions and agency-PE definition while adding an anti-fragmentation rule, positively affecting taxation of digital-economy.
BEPS also discusses additional safeguards like introduction of a tax on bandwidth-use, nexus(as ‘significant economic-presence’) based on revenue, digitization(use of local domain-name/local-payment)or users, withholding-tax[11] on certain types of digital-transactions, and equalization-levy. Several countries have adopted recommendations akin to these. For example, Israel has instituted a nexus-rule grounded in digital-factors, while India has enforced an equalization-levy.
Pillar-1: It expands the taxing-rights of ‘market-jurisdictions’, by re-allocating 25% of a qualifying group’s residual-profits(in excess of 10% of revenue) from ‘largest and most profitable’ multinationals to marketing-jurisdictions(Amount-A).[12]
Moreover, a fixed return from certain marketing/distribution activity in the market-jurisdiction will be allocated by the ‘arm’s-length principle’(Amount-B).A Multilateral-Convention to Implement Amount-A(MCI) has been released in 2023(to be signed by June,2024), which inter-alia abolishes existing digital-services taxes.
Evaluation of Pillar-1: Pillar-1 brings several advantages. Firstly, it re-allocates tax-revenues to market-jurisdictions, ensuring that large-businesses pay their fair-share while minimizing compliance-costs for these jurisdictions. Secondly, it provides tax-certainty by eliminating dependence on ambiguous factors like value-creation or economic-substance. Thirdly, by promoting tax-neutrality with traditional businesses, it helps reduce unfair-competition and avoids instances of double-taxation.
However, there are certain concerns surrounding Pillar-1.Firstly, its complexity and cumbersome nature pose challenges, particularly in replicating it for smaller businesses due to high compliance-costs. It may also lack alignment with diverse domestic-laws and countries policy-goals, necessitating numerous adjustments.
Secondly, employing predetermined-formulas like in Pillar-1 makes things less fair because it’s less flexible and may not accurately reflect real-situation. In-fact Pillar-1’s allocation not being directly based on value-creation, may lead to unfairness. For example, platforms like YouTube ,relying heavily on user-generated content, shall be required to pay the same taxes to market-jurisdictions as entities like Netflix who rely very little.[13]
Thirdly,Pillar-1 requires countries to withdraw unilateral-measures like India’s equalization-levy and[14]Israel’s foreign digital service-tax[15] limiting state-sovereignty. This may hinder many countries from adopting it. However, effectiveness of withholding-taxes is debatable, given the challenge tax-authorities face in monitoring online-activities. Hence, Pillar-1 may be a viable alternative.
Fourthly, the fiscal impact of Pillar-1 may be more for high and middle-income nations. Moreover, the over-all Pillar-1’s scope has shrunk due to revisions in calculation/allocation methods and now it has limited reach, only to 100 largest corporations.
Fifthly, developing-countries advocate for a larger-share of profits from what is allocated by Pillar-1. They have proposed a UN-initiative, suggesting 30% profit-share for market-countries without revenue-thresholds. However, challenges in implementation and establishing nexus/source for digital-businesses are anticipated.[16]
Sixthly, some countries wish to adopt Virtual-PE, suggesting inclusion of non-physical determinants like a user-base or revenue threshold for PE-definition.[17]This would imply that a website can also be held to be Virtual-PE. Saudi Arabia and some Indian court decisions have supported ‘virtual service-PE’, which may impact remote-services like consulting or call-centers. A draft EU-Directive for establishing new-PE thresholds and attribution rules, also proposes virtual-PE. Nonetheless, assigning profits to Virtual PE remains challenging, with countries currently employing a transactional profit-split method, which presents difficulties such as identifying external comparables.
Conclusion: Addressing complexities of the digital-economy poses a formidable challenge, with any proposed-solutions requiring substantial restructuring of the current international-tax framework. Integration of the digital-economy with traditional economic-structures precludes the feasibility of separate regulatory-regimes. The absence of consensus on the OECD’s Pillar-1 approach further complicates matters, with nations persisting on employing diverse-methods. To forge a more equitable-future, Pillar-1 is a good beginning but its success will depend on collaboration between nations.
[1]Action-1,Report,Pg.12,78
[2]OECD, Tax-Challenges-Arising-from-Digitalisation – Interim-Report,2018
[3] OECD,Are-current-treaty-rules-for-taxing-business-profits-appropriate-for-E-Commerce?-Final-Report,2004
[4]HM-Treasury,Corporate-Tax-and-Digital-Economy:Position-Paper,paras.2.4-2.6
[5]Stefan-Greil (Journal-Article)
[6]S.Tandon (Journal-Article)
[7]Technical-Advisory-Group’s-Report-on-Tax-Treaty-characterisation-issues-arising-from-e-commerce,2001
[8]OECD-WP1-Project(2010-2012)
[9]OECD-Model-Commentary(42.1 -42.10),2010;OECD-Commentary(Article-5),Paragraph-122
[10]Part-IV,MLI
[11]TFDE-2014
[12]MCI,Report-on-pillar-1-blueprint
[13]Jinyan-Li (Journal-Article)
[14]Finance-Act,2016
[15]ITA-circular
[16]Graeme-Cooper(Journal-Article),UN-Model-Treaty-on-digital-services,2021(Article-12B)
[17]Hongler-and-Pistone
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