Section 3 - Tax Challenges from Digital Economy & Action 1 in BEPS
3.1 Evolution of new Business Models in Digital Economy
23. The advancements in the Information & Communication technology in the last few decades have literally revolutionized the human society in ways that may not have been envisaged a hundred years back. The extraordinary reduction in communication costs and the widespread connectivity at a small fraction of what it used to cost in the middle of the last century has changed most aspects of our life, including the way modern businesses are conducted.
24. Till a few decades back, it was essential for businesses aiming to supply goods and services to a large number of consumers to be in proximity to the market where they wish to have a significant presence, as otherwise the prohibitive costs of communication and transport, apart from other potential constraints, would make it impossible for them to access such markets. This need for proximity made it essential for such businesses to have a physical presence in proximity to the markets, even more so for the suppliers of services, in an era when services were provided primary in the form of human intervention. However, with advancements of ICT, it is now possible for the businesses to have significant participation in the economic life of a jurisdiction without any physical presence, as the digital or telecommunication networks become a substitute for physical proximity. This has enabled the evolution of new business models that enable them to have significant participation in a jurisdiction without necessitating physical presence. In particular, business models have emerged that can be conducted primarily by exchange or transmission of data. These digital enterprises have already acquired significant space in global economy, and as per current and anticipated trends, their proportion in the total economy will continue to rise. Due to their ability to cater to international markets at low transactions costs, many of these enterprises are already among the most valued enterprises globally.
3.2 Impact of Taxation
25. The international taxation rules on the basis of which taxing rights are allocated under Double Taxation Avoidance Agreements for avoiding double taxation are largely derived from the recommendations made by a group of four economists13 appointed by the League of Nations in the 1920s, long before such new technological advancements were even conceptualized. They recommended division of rights of taxation between the Country of Residence and the Country of Source while recognizing the rights of both to levy tax on such income. The existing rules that were developed as a consequence of their analysis, provide for a threshold for taxation of business income in the form of “permanent establishment” largely conceived as a physical presence of business entity, which differentiate businesses having significant economic presence in a tax jurisdiction from those having an economic participation of occasional nature. The permanent establishment based threshold thus derives its justification from the rationale that attempts at taxing a business that has a less than significant economic presence in a jurisdiction can lead to costs of compliance and administration that are unlikely to be commensurate with the revenues obtained by such taxation.
26. While the physical presence threshold has served an important purpose in optimizing compliance burdens for businesses that existed and were prevalent at the point of its conceptualization, its relevance stands undermined now with the emergence of digital enterprises, creating a need to modify the international tax rules so as to adopt them for the new business models of digital economy. This challenge related to the nexus thresholds in the existing rules is further complemented by challenges relating to characterization of certain incomes that arise from digital economy, challenges in developing rules for fairly attributing such income, as well as the challenges in valuation of contributions made by users and data belonging to them in the profitability of a digital enterprise in multidimensional business models. Thus, the emergence and evolution of new business models in the digital economy have given rise to substantial tax challenges that need to be addressed.
3.3 Action 1 of BEPS Project: Address Tax Challenges of Digital Economy
27. There have been growing concerns around the globe, raised by political leaders, media outlets and civil society, about the exploits of the multinational enterprises avoiding taxes in the economies from where their profits are derived. These concerns led to the adoption of Base Erosion & Profit Shifting (BEPS) Project by G-20 and OECD to analyze the loopholes in the existing international taxation rules that enable the multinational enterprises to avoid taxes. A BEPS Action Plan detailing the activities of the BEPS project was published in July 2013. The need for undertaking work for analyzing the tax challenges arising from digital economy were noted in the action plan of BEPS as under:
“the spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.”
28. The Action 1 of the Base Erosion and Profit Shifting (BEPS) Project of G-20 and OECD included addressing the tax challenges of the digital economy as the first of the fifteen actions that were planned as part of this project. The following action was planned to be undertaken under this action:
Action 1 – Address the tax challenges of the digital economy
Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation. Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.
29. The BEPS Action Plan, including Action 1, prepared by the OECD was adopted and endorsed by the G-20 countries, including India, in the G-20 declaration issued by its Leaders after their meeting in St. Petersburg on 5-6th September, 2013.
30. For implementing Action 1, the “Task Force on the Digital Economy” (TFDE) was established in September, 2013, with representatives of OECD, G-20 and other countries associated in the BEPS project. The mandate of the Task Force was to undertake work on Action 1 and submit a report on the same. As part of its work, the Task Force also held public consultations with the stakeholders including industry (both digital as well as brick & mortar industry), academicians and non governmental representatives. The report of the Task Force was finalized by September, 2014, wherein it analyzed in detail, the new business models which have come into existence as a result of advances in information and communication technology and the expansion of digital and telecommunication networks around the world. This report concluded that important issues related to nexus, characterization and data have arisen in the wake of development of digital economy that need to be examined further.
31. Further work on these issues was subsequently carried out by the task force and its focus groups, in consultations with renowned academicians and experts who have been working on this subject, while also seeking feedback from industry and other stakeholders from time to time. As a part of this work, the Task Force further detailed the broader tax challenges that have come into existence, including contributions made by the users and the value of data belonging to them, which contribute to profits of digital enterprises in multidimensional business models. In view of these challenges and the need to find solutions to address them, the Task Force identified and analyzed in great detail, the potential options that can be adopted to address these challenges.
32. The Final Report on Action 1 was finalized by the Task Force in September, 2015 and has since been endorsed by the G-20 as well as the OECD. The Report provides an internationally accepted recognition of the broader tax challenges arising from digital enterprises, their unprecedented business models including multi-dimensional businesses, mobility of these enterprises, their ability to relatively easily avoid taxes in jurisdictions that significantly contribute to their profitability, and the challenges and difficulties that arise in the application of currently practiced international taxation rules in their case.
33. The Executive Summary of the Report describes the contents of the report in the following manner:
“This final report first provides an overview of the fundamental principles of taxation, focusing on the difference between direct and indirect taxes and the concepts that underlie them as well as double tax treaties (Chapter 2). It then examines the evolution over time of information and communication technology (ICT), including emerging and possible future developments (Chapter 3) and discusses the spread and impact of ICT across the economy, providing examples of new business models and identifying the key features of the digital economy (Chapter 4). It then provides a detailed description of the core elements of BEPS strategies in the digital economy (Chapter 5) and discusses how they will be addressed by the measures developed through the work on the BEPS Action Plan and the OECD work on indirect taxation (Chapter 6). It identifies also the broader tax challenges raised by the digital economy and summarises the potential options to address them that have been discussed and analysed by the TFDE, both in the areas of corporate income tax (Chapter 7) and of indirect tax (Chapter 8). Finally, it provides an evaluation of the broader direct and indirect tax challenges raised by the digital economy and of the options to address them (Chapter 9), taking into consideration not only the impact on BEPS issues of the measures developed in the course of the BEPS Project, but also the economic incidence of the different options to tackle these broader tax challenges. The conclusions of the TFDE, together with determination of the next steps, are included at the end of the report (Chapter 10)."
34. This Report, the first of its kind, and a result of a two year effort undertaken by representatives from around the world, with contributions of experts and governmental representatives, has been finalized after several rounds of public consultation with stakeholders14 and taking their views and suggestions into account. This report, which has since been adopted and endorsed by the G-20 and OECD provides a detailed overview of the tax challenges arising from digital economy. It is a first of its kind recognition of the limitations of the existing international taxation rules, as embodied in the Model Tax Conventions recommended by OECD and UN Committee of Experts, in respect of the digital enterprises that conduct their businesses in a manner that was not conceivable at the time the existing taxation rules were being written in the last century. The Report also provides a broad international consensus on what can be done, by recognizing the possible measures that can be considered or undertaken for addressing the tax challenges arising from digital economy. The Conclusions of the Report do not recommend any measures for universal adoption at this stage, but recognize the right of countries that may prefer to address these challenges by adopting any of the options in their domestic laws, or in their bilateral tax treaties.
3.4 Committee’s Observations
35. In view of its acceptance by G-20 and the OECD, the Committee has placed extensive reliance on the BEPS Report on Action 1 (2015) in its work. However, the Committee also took into account the Indian perspective, the work done in this field by other experts as well as its independent analysis in preparing this report.
“Considering the importance of stakeholders’ input, the OECD issued a public request for input on 22 November 2013. Input received was discussed at the second meeting of the TFDE on 2- 3 February 2014. The TFDE discussed the evolution and pervasiveness of the digital economy as well as the key features of the digital economy and tax challenges raised by them. The TFDE heard presentations from delegates outlining possible options to address the BEPS and tax challenges of the digital economy and agreed on the importance of publishing a discussion draft for public comments and input. The input received was discussed by the TFDE and contributed to the finalisation of an interim report, which was published in September 2014. In accordance with the interim report, the TFDE continued its work until September 2015 in order to (i) ensure that work carried out in other areas of the BEPS Project tackles BEPS issues in the digital economy, and that it can assess the outcomes of that work; and (ii) continue the work on the broader tax challenges related to nexus, data, and characterisation, so as to refine the technical details of the potential options and enable their evaluation in light of the outcomes of the BEPS project.”
13. Professor Gijsbert Bruins, Professor Luigi Einaudi, Professor Edwin Seligman and Professor Sir Josiah Stamp
14 The stakeholders included representatives from industry, tax consultants, tax experts, academicians and nongovernmental
organizations. The details of public consultations held by the Task Force are provided in paragraph 8,
which is reproduced below for ease of reference:
“Considering the importance of stakeholders’ input, the OECD issued a public request for input
on 22 November 2013. Input received was discussed at the second meeting of the TFDE on 2-
3 February 2014. The TFDE discussed the evolution and pervasiveness of the digital economy as
well as the key features of the digital economy and tax challenges raised by them. The TFDE
heard presentations from delegates outlining possible options to address the BEPS and tax
challenges of the digital economy and agreed on the importance of publishing a discussion draft
for public comments and input. The input received was discussed by the TFDE and contributed to
the finalisation of an interim report, which was published in September 2014. In accordance with
the interim report, the TFDE continued its work until September 2015 in order to (i) ensure that
work carried out in other areas of the BEPS Project tackles BEPS issues in the digital economy,
and that it can assess the outcomes of that work; and (ii) continue the work on the broader tax
challenges related to nexus, data, and characterisation, so as to refine the technical details of the
potential options and enable their evaluation in light of the outcomes of the BEPS project.”
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