Digital taxes: If multilateral fails, look for bilateral solutions

OECD has not been able to get a consensus as its one-size-fits-all approach is fundamentally at odds with the inherent attributes of the digital industry

Whereas it means a source of tax revenues for nations, which is crucial in these times, it also means uncertainty and risk of dual taxation, given that such efforts are not coordinated between nations.

How should foreign service providers who earn revenue in other countries be taxed on digital services provided by them? A solution still eludes this issue, officially recognised as requiring a concrete solution at the OECD/G20-led BEPS talks in 2015. Since then, christened by the OECD as ‘Pillar One’ under the inclusive framework for taxing the digital economy, the deliberations for a solution have witnessed unprecedented participation of both state and non-state entities. Citing the forthcoming presidential election in November, the US withdrew from the discussions in June this year. Unruffled, European nations and the OECD insisted on continuing the search for a mutually-acceptable solution under a consensus approach, notwithstanding the concerns arising from the fact that most technology-giants are headquartered in the US. It appears that the doubts were not unfounded, given that, last week, the OECD deferred unveiling of the framework on Pillar One at least till mid-2021 and shifted the focus on to Pillar Two, an alternative, which focuses on global anti-avoidance. The deferral has implications, particularly for India, which has been in the news for its path-defining efforts to address the challenges to taxation of digital services.

At this stage, it is prudent to recount changes effected as part of India’s domestic tax policy. As early as 2016, the ‘equalisation levy’ was introduced as a new tax on digital advertisement services received by Indian businesses from foreign service providers (‘FSP’). The levy of 6% on consideration for the services was to be borne by the Indian service recipients. Despite non-availability of credit (which is a standard practice under bilateral tax treaties, popularly known as ‘DTAA’), the FSPs were largely agnostic to this levy as, owing to their superior bargaining power, they could contractually shift the burden to Indian recipients. With the advent of GST in 2017, special provisions were made for online digital services (also called ‘OIDAR services’), which adopted a mechanism similar to the 2016 equalisation levy. The OIDAR scheme, however, obliged the FSPs to seek registration in India and discharge GST liability on services provided to non-business Indian consumers. Given that GST on OIDAR could be passed on to Indian consumers, FSPs did not bear costs except those relating to tax-compliances. The tide shifted in 2020 for FSPs, when the scope of the equalisation levy was substantially expanded from April 1; this obliges an FSP operating a digital platform to pay 2% of the consideration received for making any electronic supply to Indian residents. These FSPs are further obliged to similarly discharge tax even where the supplies are made to non-residents where the supply relates to, (i) advertisements targeted to Indian customers, or (ii) sale of data collected from Indian residents. Notwithstanding initiation of formal ‘301 proceedings’ by the US threatening trade sanctions, India has maintained its ground and continued with the imposition of the expanded equalisation levy. There were indications that India would revisit the equalisation levy framework upon the formulation of the OECD-led global consensus on digital taxes. On an immediate basis, the deferral announced by OECD vindicates India’s position that the revenue-pressures, particularly in the incumbent Covid-affected economic realities, and the inequities owing to non-taxation of FSPs require immediate legislative measures justifying the imposition of the equalisation levy.

The aforesaid should not be construed to view India as a disjointed island, disengaged from global efforts. On the contrary, India is a prominent participant at the global stage, seeking to shape an acceptable solution on taxing digital services. In fact, deferring the implementation of the ‘Significant Economic Presence’ test, which forms part of the statute to tax FSPs, officially links it to the Pillar One outcome. Covid and geopolitical developments shall, however, stall any outcome before the start of the next financial year. India is also simultaneously pressing the issue with like-minded developing countries, advocating higher taxing entitlements for the source states at the United Nations’ Committee of Tax Experts. To this end, India’s representative at the Committee has presented a treaty-based solution, advocating for the adoption of a draft article (to be opted by countries in their bilateral tax treaties) for allocation of taxing rights to source states as ‘income from automated digital services’. The draft proposals, formulated by a 13-member team including India, if adopted, would provide for a rule-based order in the international tax system to tax FSPs, obviate disputes and misgivings arising out of unilateral measures. The UN proposals, which will come up for debate soon, offers simplicity and imminent solutions. There could be challenges to progress, but if adopted, it will speak for India’s influence in shaping global tax policy with a penchant for a rule-based international order.

This takes us to the technical nuances of the issue. The reason for OECD’s inability to garner consensus is pedestaled on its underlying objective to achieve a consensus under the ‘unified approach’, which is perhaps predicated on a one-size-fits-all approach and is, therefore, fundamentally at odds with the inherent attributes of the digital industry, besides being seen as going against the interest of emerging consumer markets. This necessitates an evaluation of the interest of diverse stakeholders forming parts of the digital ecosystem. At one end of the spectrum are those who simply seek to sell goods online, ranging from grocery to jewellery to automobiles, either on their own or supported by intermediatory platforms. Similarly placed are digital service providers who do not require a physical interface with their customers; this will be the universe of traditional businesses who have moved to the digitised platform. Positioned at a different level are e-commerce platforms, also called ‘marketplaces’, that earn revenues from a host of functions, ranging from electronic teller-ing, web-hosting, online storage, cloud computing, etc. The fold of the digital economy also accommodates players who earn from tapping consumers’ data (also labelled as oil of the digital platform) from social media and other platforms. The supplies within this universe are an intertwined mix of B2B and B2C. This is further expanded by infrastructure- support services, such as telecom, ISPs, etc. A single method to tax different variant of supplies is clearly difficult if not impossible. Designing an optimal solution also requires an appreciation of the different extent of value creation in the host country. For illustration, value creation in country A from data originating from its users through a platform in country B cannot be equated with value in country A from the purchase of software developed in country B.

Besides the challenges on income determination, another reason for the elusive consensus that OECD is dwelling upon is where Amount A (presenting the new taxing right for source countries to obtain a share of residual profit of FSPs) and Amount B (which requires the calculation of a fixed return for certain marketing, distribution-related activities in countries where an FSPs have a physical presence) form the ‘building blocks’ of Pillar One. This does not factor Amount C (entitlement to tax beyond Amount B) which has been dropped recently from the consideration matrix. These amounts represent a complex formula, which, in turn, requires gathering large data, besides being riddled by subjective determinations. No wonder, thus, that tax-administrations are non-committal, a part of their decision being influenced by the perpetual fears over lack of global data of the FSPs, which undermines their efforts to achieve a fair and equitable taxation outcome.

To conclude, in the short term, deferral of consensus will ignite pangs for unilateral measures. Whereas it means a source of tax revenues for nations, which is crucial in these times, it also means uncertainty and risk of dual taxation, given that such efforts are not coordinated between nations. In the context of India, further expansion on the scope of equalisation levy can’t be ruled out. We must also critically examine the rationale for the hiatus. Is it not better to have no solution instead of a dysfunctional one? What purpose can be achieved with consensus on Pillar One if it is likely to fail on the pragmatic paradigm, particularly given the acute lack of resources available with the tax-administration in developing countries, which have the biggest stake in these discussions. India’s stress on a bilateral treaty-based solution, as opposed to OECD’s multilateral design, appears to confer greater width to the countries in designing their tax policies and systems beside presenting a solution which is flexible to accommodate their diverse interests. The bilateral tax-treaty based system has been successfully assuaging the concerns of nations and taxpayers alike for over a century. There is no reason why it should not be given a chance to prove its effectiveness, even in the context of digital taxes. Only time will prove what the system shall prevail.

The authors are Partners, BMR Legal. Views are personal