Context
Over the past four years, 137 countries have engaged intensively with the OECD to find a solution to the tax challenges arising from digitalisation. Like any international agreement, finding a middle ground has been difficult and a series of compromises have been made.
What makes it difficult to tax the digital economy?
- Operation across the border: The unique feature of the digital economy is that firms can operate seamlessly across borders and users and their data contribute to their profits.
- However, this made it harder to tax such an economy.
- It was not clear how profits were to be pinned down to any jurisdiction.
- Political issues: Taxing digital economy became a political issue because the largest technology firms are tax residents of developed countries and redefining digital presence as the basis of taxation would potentially allow large markets like India more right to tax.
- Developing vs. developed countries: Developing countries wanted that profits from digital operations should be fractionally apportioned to markets while developed countries believe that a fraction of residual profit, mainly arising from marketing functions, should be taxed in markets.
Equalisation levy and DST issue
- The divergence in developed and developing countries as explained above compelled countries to implement unilateral measures.
- India was the first country to implement a gross equalisation levy on turnover.
- This is not covered by tax treaties.
- So, while the income tax act does not apply to the levy, credit is available for the tax paid by the company in its home country.
- Similarly, several other countries have announced or implemented a digital services tax (DST).
- In 2021, India expanded the scope of the equalisation levy.
- The US initiated the US Trade Representative investigations which found DST to be discriminatory, and then announced retaliatory tariffs.
Two-pillar approach and issues with its adoption
- The DSTs encouraged the US to actively participate in finding a consensus-based solution.
- As talks progressed, the OECD announced that the issue of allocation of taxing rights would be actively considered and adopted a two-pillar approach.
- Pillar One approach: The first pillar was to define the rules for taxing digital companies.
- Sovereignty issue: Pillar One was to go beyond digital companies and apply to large companies with annual revenue over € 20 billion. To ensure certainty to taxpayers, the solution will require excessive global coordination.
- Whether this will undermine sovereignty, remains to be seen.
- Therefore, it is important to consider if the consensus approach is worth pursuing.
- EL may still apply to companies not covered by OECD proposal: In fact, the EL may apply to companies that are not covered by the OECD proposal, leaving one to wonder whether it will truly address the tax challenges from digitalisation.
- Complications: Corporations that argue in favour of simplicity must also consider the potential benefits from an EL like tax that sets aside the complications of attributing profits to complex functions.
- The OECD approach creates a fiction of reallocation, where the profits reallocated through Pillar One could in fact be compensated for by taxing back global profits taxed below 15 per cent.
Conclusion
As per Pillar One proposal, DSTs will be removed once the OECD approach is ratified in 2023. It is imperative therefore that countries assess the price of compromise.
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