Taxing the Digital Economy
In the 21st Century, technology and internet connectivity have undoubtedly become critical infrastructure for personal and business activities worldwide. Inevitably, digitalization has over the years played, and continues to play, a huge role in how business is transacted in various sectors including software development, management and engineering consultancy, gaming and betting, tourism, entertainment, education, transport and logistics among others. Internet connectivity has enabled and facilitated the e-commerce industry allowing many businesses to develop enhanced digital platforms to market and sell their products. Electronic commerce (‘E-commerce’) is a sector that has therefore grown exponentially over the years into a multibillion dollar industry as more entrepreneurs are rapidly shifting from the traditional methods of carrying on business to the online platform which offers a wider market for their goods and services.
The development of e-commerce as a mode of doing business has obviously caught the attention of tax authorities worldwide because tax rules have traditionally been based on the principle of permanent establishment whereby taxation is linked to the place where all or part of business activities are physically carried out. The lack of a physical establishment for most online businesses has created a headache for tax authorities as far as taxation of the proceeds of digital economy is concerned. This is an issue that has sparked a global debate on how governments can align their current tax laws and regulations to cater for the taxation of the income derived by individual and corporate entrepreneurs, specifically Multinational Entities (MNEs), from e-commerce. The existing tax laws in most, if not all, jurisdictions the world over are insufficient in setting out a strict tax framework for the e-commerce industry, with the obvious result being the loss of potential revenue in the millions. One can rightly argue that MNEs that majorly operate through e-commerce platforms have been taking advantage of the lack of sufficient and/or clear legal frameworks on e-commerce worldwide to effect tax planning measures that lead to corporate tax avoidance. This is one of the reasons why experts have attributed the shift towards e-commerce as an ingredient for tax base erosion.
The big question then remains as to whether the current international tax laws are fit for purpose. Currently, the international debate on taxation of the digital economy has largely taken place within the framework of the OECD/G20 BEPS (Base Erosion and Profit Shifting). The tax challenges arising from the digitalization of the economy were identified as one of the main areas of focus of the BEPS Action Plan, leading to the 2015 BEPS Action 1 Report on Addressing the Tax Challenges of the Digital Economy (the Action 1 Report). This Report: –
- recognized that digitalization, and some of the business models that it facilitates, present important challenges for taxation;
- acknowledged that it would be difficult, if not impossible, to ‘ring-fence’ the digital economy from the rest of the economy for tax purposes because of the increasingly pervasive nature of digitalization;
- highlighted the ways in which digitalization had exacerbated BEPS issues; and
- noted that digitalization had raised a series of broader direct tax challenges such as data, nexus and characterization which chiefly relate to the question of how taxing rights on income generated from cross-border activities in the digital age, especially by multinationals, should be allocated among countries.
Some countries have proceeded to effect individual measures as far as taxation of the digital economy is concerned. A case in point is the Indian Equalization Levy introduced in India in 2016 with the intention of taxing digital transactions, that is, the income accruing to foreign e-commerce companies from India, which covers online advertisement and any provision for digital advertising space, facilities or service for the purpose of online advertisement. Hungary also introduced an advertisement tax in July 2017 on companies with a sizeable turnover from broadcasting or publishing advertisements, sectors in which digital businesses play a pivotal role.
Foreseeing the possibility of more countries taking up independent measures to tax the digital economy such as India and Hungary have, the European Commission, proposed new rules to ensure that digital business activities are taxed in a fair and growth-friendly way on 21st March 2018. The first proposal from the Commission, which is a long-term solution, will enable EU Member States to tax profits that are generated in their territory, even if a company does not have a physical presence in any of the Member States. Accordingly, under this directive, Member States will be looking at establishing a significant economic/digital presence in the case of corporate entities that do not have physical permanent establishments for purposes of establishing a taxable nexus.
The criteria for determining significant digital presence includes either:
- the proportion of total revenues obtained during a tax period and resulting from the supply of digital services to users located in that Member State in that tax period exceeds EUR 7,000,000;
- the number of users of one or more of those digital services who are located in that Member State in that tax period exceeds 100,000; or
- the number of business contracts for the supply of any such digital service that are concluded in that tax period by users located in that Member State exceeds 3,000.
A short term solution by the Commission was to introduce a three per cent (3%) digital services tax (DST) on the gross revenue from digital services but no consensus was reached by the Member States. France, however, is one of the countries that has taken the initiative of adopting the short term proposal by the Commission and in July 2019 introduced the proposed DST on the gross income from digital services of companies with global revenues of EUR 750m per year or more and revenues above EUR 25m per year within the country. This tax was to apply retrospectively from 1st January 2019.
Digital services of targeted advertising and e-commerce intermediaries also fall within the scope of the tax, while some other products and services are exempt. Italy has also recently adopted the proposed DST which will come into force by January 2021. This tax will be levied on revenues generated from certain business-to-business and business-to-consumer digital services that are provided to Italian customers by companies or groups of companies that satisfy certain criteria. Entities subject to the DST include those with a total worldwide revenue of not less than EUR 750 million and revenue of not less than EUR 5 million obtained in Italy from the digital services.
Closer home, Uganda introduced a social media (Over The Top) tax in July 2018 which targeted users of social media platforms such as Facebook, Twitter and WhatsApp, as well as mobile money banking services,. at a daily rate of 200 Ugandan shillings. However, the consequences of introduction of the levy in Uganda have been drastic as a huge number of internet users have since ceased using the affected platforms, which has had an impact on total revenue collected asthe Ugandan levy affects only the users while the multinational corporates offering the services remain with their profits untouched.
In Kenya, the Finance Act 2019 has brought the digital economy into the tax net by introducing a provision prescribing that income accruing through a digital market place would be considered as income for tax purposes. Section 3 of the Income Tax Act has been amended by the introduction of a new paragraph providing that income accruing through a digital market place is chargeable to tax. The Act defines a digital market place as a platform that enables the direct interaction between buyers and sellers of goods and services through electronic means. The Cabinet Secretary for National Treasury is expected to issue regulations to provide the mechanisms for implementing the provision in regard to taxation of the digital economy. The Kenya Revenue Authority (KRA) seems to be ready to take up the challenge and recently, the institution called for bids for a technology service provider to install a monitoring and payments system that will track and audit transactions between both local and international merchants and their customers. However, the move by KRA has been criticized by some stakeholders as one aimed at undermining the right to data protection as envisioned under the Data Protection Act, 2019. Moreover, multinationals have warned that the introduction and coming into effect of the digital tax could raise the cost of products and services in the country and would also raise the risk of double taxation.
Noting the foregoing, it is clear that the digital economy will only keep evolving due to constant advances in technology. Business models have changed and will keep changing and it is therefore imperative, for countries the world over to be realistic and focus on key principles for effective and efficient taxation of the digital economy. It will also be important for governments to involve the players in the digital economy to ensure that the laws, policies and guidelines put in place to regulate digital taxation do not in the first place violate the rights guaranteed under the Data Protection Act and that such regulations do not also suffocate start–ups and Small and Medium Enterprises (SMEs) which would lead to the tax authorities losing out on revenue despite expanding the tax base.