A debate more active than ever with the digitalization of the economy : How are tax powers distributed among countries?

Pablo PorporattoPablo Porporatto    03 March 2020
A debate more active than ever with the digitalization of the economy : How are tax powers distributed among countries?

International taxation is the most dynamic area of fiscal policy and the distribution of tax powers among countries has gained great importance, with particular attention to the challenges posed by the digitalization of the economy. In this sense, we are interested in presenting some ideas in this field, reviewing proposals and opening the debate on the position of the Latin American countries (AL).

Business models based on information and communication technologies, the ubiquitous ICTs, grouped under the umbrella concept of “Digital Economy”, show that some traditional concepts of taxation have lost validity; they are and will be at the center of the debate on international taxation in the coming years, and it is very difficult to evaluate the future results of this controversy.

Historically, the debate regarding the distribution of the taxing powers between the countries has been opposing, essentially, the criterion of the source against the one of residence. These discussions have mirrored, in some way, the confrontation between the fiscal interests of developing countries (importers of capital) and the developed (capital-exporting) countries.

In these circumstances, it was stressed that the territorial criterion of source or origin of (real taxation), in addition to representing better the interests of developing countries (represented, substantially, by the models of double taxation treaties of the Andean Community of Nations, based exclusively on source, and that of the UN, whose wording attributes, in more cases, the tax power to the countries of source, as opposed to the OECD Model), in some way led to greater neutrality in the import of capital.

By contrast, the criterion of residence or of income better respects the character of a global, personal and progressive income tax (taxpayers that are resident in the same country with different sources of income, from the country and from abroad, will be treated equally).

Also, this last criterion is a safeguard to the principle of neutrality in the export, that is to say, the residents are taxed as much if the investments are carried out in the country as well as abroad. In addition, it allows for better co-responsibility of the resident of a country with the public goods and services it uses.

Regarding this debate, we should remind that some LA countries maintain the principle of source or territoriality, although in some cases these principles are extended to tax certain foreign income, for example financial revenues.

In fact, depending on how we define “source” and “residence”, the above principles will be more opposed or some intermediate situations will appear, for instance if a very broad concept of place of performance of services is applied.

In that context, and, before the BEPS project (2013), international fora discussed in respect of the implications on taxing the then-limited notion of “electronic commerce” and its impact on the rules of distribution of the taxing powers, raising discussions as to the qualification of income, for example, with the purpose of defining which countries had the power to tax.

The location of a web site server and other issues were also investigated for the purpose of reviewing the existence of a stable establishment that would give a source country the power to tax the income earned by that “fixed” establishment.

The ambitious BEPS project once again put on the table the discussion about tax powers and their distribution, perhaps in a way not foreseen by its editors and promoters.

This project promotes the idea of taxation in the jurisdiction where the value is generated, a matter with particular relevance in terms of transfer prices and, in particular, in respect of intangible assets.

In these moments, the impressive advances of the digital economy, which includes e-commerce, imposes, on the other hand, new fiscal challenges, because traditional concepts of taxation based on physical presence no longer have relevance (the most obvious example is that of “permanent” establishment) and other notions prevail, such as those of the territories of consumption or market, as well as the data and their exploitation by users.

In October 2015, the final reports of the BEPS project were published with some initiatives in this field, among which Action 1 described the “challenges of the digital economy”. On that occasion, the need to not treat the digital economy as an isolated concept from the rest of the economy was already explained, given that, in a short time, the global economy itself would be digital, but there was no consensus on fiscal solutions to this new economy.

After many debates and clashes of political and economic interests, the latest G20 meeting in Japan adopted a new OECD report on the tax challenges of digitalization and supported the ambitious work programme put forward by this institution, consisting of a radically new approach to international taxation, a “unified approach” around the so-called two pillars formulated by that organization in January 2019.

The first pillar focuses on the allocation of taxation powers between States and the review of the allocation of the profits and the regulation of the nexus (permanent establishment). On the other hand, the second Pillar is a development of the principle of protection of the tax base and includes other aspects arising from BEPS and also exceeding their limitations. It provides for the right of any state to exercise its power of taxation when it is not enforced by the primary jurisdiction or when the payment of the tax is null and/or the actual taxation is at a low level.

Since the beginning of this decade, the distribution of profits of multinational groups among different jurisdictions has been at the center of the debate, at which point the OECD is trying to install a new paradigm of principles that should be understood and shared by the different countries, so that they can be applied by consensus in the near future[1].

The so-called Pillar I aims to generate agreements to tax profits from the digital economy or from business models focused on final consumers, that is, those companies that interact remotely with their consumers of another jurisdiction through different “software” or technological elements, in relation to multinational groups with annual revenues greater than EUR 750 million.

The proposal addresses the concept of territorial income linkage, leaving aside the physical presence of the business establishment and paying attention to sales or revenues in each market. At present, the tax power of the states in respect of corporate profits obtained by a non-resident subject may be exercised by the state of source, insofar as the state of source structures its business through a fixed place of business, for the purpose of staying in that jurisdiction.

New business models, based on the digital economy, on the contrary, do not necessarily require a physical presence to grow in a country, there are companies that interact with their customers, users or consumers at a distance, without having a physical presence or significant economic exploitation in that country, or intermediaries.

In this way, this proposal tries to assign the income to the place of its consumption, allowing to capture the income in those countries where there is no physical presence of the taxpayer, but a market that consumes their services or digital products.

In a very synthetic way, the proposal provides that any multinational business should remunerate the functions, assets and risks in the jurisdiction in which they occur and, once that remuneration is determined, part of the remaining profit, which exceeds a “routine” amount, should be reallocated to the different jurisdictions where the markets are located. In principle, it would be based on sales.

The OECD hopes that this new scheme will increase global revenue, as a result of this reallocation of tax powers, venturing that developed states would capture residual profits that were previously lost to them, due to the existence of jurisdictions that are now used as intellectual property reservoirs with low or zero taxation[2].

In short, there would be a derivation of today’s untaxed profits to the markets where the digital services are consumed. Countries in Latin America[3] and other emerging nations, as consumer markets,[4]could also benefit from this shift, considering that they do not currently tax these incomes.

Finally, it should be noted that the last meeting of the G7, held in France (July 2019) fully supported the goal of reaching a solution based on those two pillars for international taxation, to be adopted by 2020.

In the latest public debate documents regarding the two pillars, a global agreement is sought in 2020, aiming to achieve new rules to address new business models, allowing companies to do business in a territory without physical presence, with new tax powers that could be determined by reference to criteria that reflect the level of active participation of the business in the jurisdiction of a client or user, such as the existence of valuable intangibles or the use of a highly digitalized model.


[1] The members try to avoid unilateral fiscal initiatives, hence the position of the OECD and the US, from where are the main digital multinationals known as “GAFA” (Google, Amazon, Facebook and Apple).  However, several countries have made progress with taxes on Digital Services, approving them or doing so shortly, such as the United Kingdom, France, Italy and Spain and AL itself, known as “Netflix taxes”.

[2] The IMF (2019) says that “many of the (best-known digital companies) are highly profitable and yet in many cases pay relatively few taxes anywhere.” In this sense, the European Commission (2017) reports that, on average, companies with digital models of business are subject to effective taxation (including all taxes) of 8.5%, and that this rate is half of that applied to those companies with traditional business models.

[3] It is worth noting, in some countries, the implementation of VAT to digital services: Argentina, Colombia and Uruguay and others in short: Costa Rica, Chile and Paraguay. In income tax the initiatives are more scarce, existing in Peru and Uruguay, but the development of “Netflix taxes” is also expanding (Colombia, Chile, etc.)

[4] According to O’sullivan (2019), online market sales in Latin America reached $87.3 million in 2018 and the annual growth rate of online sales from abroad to Latin America is expected to reach 44% between 2014 and 2020.

 

This article is authored by Domingo Carbajo Vasco and Pablo Porporatto

 

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