Indirect taxes and the digital economy — What to tax?

— While there are direct tax debates about which countries have taxing rights over a given transaction, there is near unanimous agreement that indirect taxes should be applied to B2C transactions based on the destination principle.

— The question in indirect taxes is not ‘what’ to tax but ‘who’ will collect the tax.

— Key issues include ensuring indirect tax is applied to all cross border transaction and also to what extent it should be applied to C2C transactions.

There is near unanimity in the view that indirect taxes should be applied to B2C transactions based on the destination principle.

On a superficial level, the question of what to tax by way of indirect taxes such as a Value Added Tax (VAT) or a Goods and Services Tax (GST)¹¹ in the digital economy is a comparatively easier problem to solve relative to many other forms of taxation. The answer is relatively uncontroversial —indirect taxes such as a VAT seek to tax final private consumption expenditure¹² in the place or location in which the relevant good or service is consumed.¹³  

As Professor Rebecca Millar recently noted,¹⁴ there is a real contrast in the challenge for policy makers in taxing cross-border transactions under corporate taxes as compared with indirect taxes: Yet the conclusion that “something needs to be done” simply does not have the same significance for VAT as it does for income tax. This is not because VAT on global digital transactions is easy to collect: it is not.Nor is it because VAT raises different collection problems than income tax:for the most part, it does not. What is different about VAT is the almost universal agreement on the substantive jurisdictional principle that should be used to determine the tax base. Some countries might pay lip service to the destination principle, particularly countries with limited tax collection capacity and a high reliance on VAT to meet their revenue needs. Other countries — or their tax administrations and/or courts — might disagree about what the destination principle requires in particular circumstances. Nonetheless, there is little or no significant disagreement on the fundamental principle. Nor is there any significant disagreement about the most important aspect of the neutrality principle, which entails the notion that there should generally be no tax burden on business-to-business(B2B) transactions under a VAT. Thus,whatever it is that needs to be done,it is unlikely to involve a fundamental re-think of the jurisdictional basis upon which decisions are made about which country has the right to tax consumption.

While many corporate tax commentators embark on a quest to identify the elusive concept of where value is created, and they vigorously debate whether to apply source or residence based taxation, Rebecca Millar’s quote highlights the fact that there is near unanimity in the view that indirect taxes should be applied to B2C transactions based on the destination principle.Indeed, the major work being carried out by the OECD’s Working Party No.9 on Consumption Taxes has been in establishing clear guidelines upon which the destination principle can operate in respect to the digital economy. Their recent major focus has been on plugging three potential gaps in indirect tax revenue which have grown more prevalent through digital economy business models.

The issue in indirect taxes is not ‘what’to tax — the issue is ‘who’ will collect the tax

Perhaps the major source of controversy in indirect taxes globally right now is in resolving the problem of ’who’ will collect the tax. In particular, in seeking to collect VAT on B2C importations of low value goods and B2C cross-border supplies of services, governments are faced with a number of choices. They could seek to:

1. Collect the VAT from the nonresident supplier, but they may lack the practical ability to enforce the collection of the tax (for example,where the non-resident supplier has no assets or other physical presence in the jurisdiction).
2. Collect the VAT from the end consumer (but history shows compliance with these types of measures is extremely low).
3. Collect the VAT from an online marketplace (in lieu of the seller).
4. Collect the VAT from the debit or credit card issuer used in the transaction (though there is some doubt about whether most of these issuers would have sufficient transaction level data upon which to calculate and account for the tax);
5. Collect the VAT through a so-called‘split payment method’, in which the purchaser pays the VAT into a separate bank account which is diverted for the tax authority’s benefit.
6. Collect the VAT by deeming a permanent establishment to exist in the country if goods or services are supplied to customers in that country either through a local domain name address, or through local payment processing.

As things stand right now, there is a patchwork of solutions being adopted around the world. In 2017, the OECD released a document entitled “Mechanisms for the Effective Collection of VAT/GST when the Supplier is not located in the Jurisdiction”¹⁵, but disappointingly this document seemed to fuel more of an ‘anything goes’ style approach.In an effort to provide countries with flexibility of approach, the OECD lost sight of two core objectives.The first being that the more globally consistent the approach, the more effective the enforceability, and the more tax revenue will ultimately flow to every country. The second error was in ignoring the fact that online sellers and online marketplaces often sell to a global marketplace and therefore the greater the consistency of approach, the more their one-time investment in systems and processes could be replicated. In short, consistency in approach produces a win-win for both governments and online marketplaces.

Interestingly, Australia in 2017 (for B2C services) and in 2018 (for low value goods) legislated to collect the VAT from online marketplaces in priority to the actual offshore sellers. This approach, while controversial, shows some signs of gaining momentum with a number of other jurisdictions signaling an intention to follow suit.¹⁶ The question remains whether the collection of VAT on cross-border supplies from online marketplaces may ultimately be extended to domestic sales too, as a means of combating increased VAT fraud. Only time will tell.

Whether to tax C2C supplies

Virtually all VAT systems around the world have, as a precondition for registration and VAT payment obligations, that the supplier is carrying on either a business, or they are an entrepreneur, or they carry out some other commercial activity.

Many countries are fast discovering that advances in digital marketplaces mean that businesses or entrepreneurs need not have a physical shop front, need not hire employees, and in fact, need not really have inventory either. As a result,the traditional tax base of applying VAT in situations akin to when a business has a permanent establishment must surely be under threat. The question this raises is whether a profit making pursuit, coupled with a de minimis exclusion (where compliance costs would exceed the tax collected) is all that is really needed as a precondition for imposing VAT liabilities?

Many digital marketplaces now facilitate trade between private individuals. Consider the growth of peer-to-peer (P2P) lending, the rise of online accommodation platforms, and even ride sharing companies in their role as an intermediary between a passenger and a transportation provider. Developments in other areas of commerce, with labels such as the ‘sharing economy’, ‘crowdfunding’ or ‘crowd sourcing’ further illustrate the point.

The central question is why should the profit or gains derived from these activities fall outside the VAT net? Already there is some tax authority activity in this area, especially in relation to crowd funding and ride sharing.¹⁷ But to what extent are these merely symptoms of a bigger issue — which is that VAT systems need to be adapted to tax the value added, irrespective of whether it is by a traditional business or a consumer sitting online. The value added by employees is already taxed in the hands of the business or company they are servicing, but what about the value added by these other forms of independent contracting?

Again, while this issue is not limited to the digital economy, the growth and expansion of the digital economy makes it increasingly easier to generate profit without the traditional indicia of a business. The challenge for governments around the world is to ask whether their VAT systems are fit for the modern way in which value may be created in the digital economy, and therefore whether all forms of private final consumption expenditure are truly subject to tax.

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