Section 4 - Issues related to Tax Neutrality between Domestic & Multi- National Enterprises and their Implications
4.1 Principles of Tax Policy & Tax Neutrality
36. As part of its work, the Task Force on Digital Economy revisited and reviewed the fundamental principle on tax policy. It recalled that these principles were the basis of discussion in the 1998 Ottawa Ministerial Conference, and have been deemed appropriate for an evaluation of the taxation issues related to e-commerce. The Task Force listed these principles as neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility in its 2014 Report15, paragraphs 27 to 30 of which are reproduced below for ease of reference:
“1. Overarching Principles of Tax Policy 27. In a context where many governments have to cope with less revenue, increasing expenditures and resulting fiscal constraints, raising revenue remains the most important function of taxes, which serve as the primary means for financing public goods such as maintenance of law and order and public infrastructure. Assuming a certain level of revenue that needs to be raised, which depends on the broader economic and fiscal policies of the country concerned, there are a number of broad tax policy considerations that have traditionally guided the development of taxation systems. These include neutrality, efficiency, certainty and simplicity, effectiveness and fairness, as well as flexibility. In the context of work leading up to the Report on the Taxation of Electronic Commerce (see Annex 1 for further detail), these overarching principles were the basis for the 1998 Ottawa Ministerial Conference, and are since then referred to as the Ottawa Taxation Framework Conditions. At the time, these principles were deemed appropriate for an evaluation of the taxation issues related to e-commerce. Although most of the new business models identified in Section IV did not exist yet at the time, these principles, with modification, continue to be relevant in the digital economy, as discussed in Section VIII. In addition to these well-recognised principles, equity is an important consideration for the design of tax policy.
· Neutrality- taxation should seek to be neutral and equitable between forms of
business activities. A neutral tax will contribute to efficiency by ensuring that optimal
allocation of the means of production is achieved. A distortion, and the
corresponding deadweight loss, will occur when changes in price trigger different
changes in supply and demand than would occur in the absence of tax. In this sense,
neutrality also entails that the tax system raises revenue while minimizing discrimination in favour of, or against, any particular economic choice. This implies
that the same principles of taxation should apply to all forms of business, while
addressing specific features that may otherwise undermine an equal and neutral
application of those principles.
· Efficiency- compliance costs to business and administration costs for governments
should be minimised as far as possible.
· Certainty and simplicity- tax rules should be clear and simple to understand, so that
taxpayers know where they stand. A simple tax system makes it easier for individuals
and businesses to understand their obligations and entitlements. As a result,
businesses are more likely to make optimal decisions and respond to intended policy
choices. Complexity also favours aggressive tax planning, which may trigger
deadweight losses for the economy.
· Effectiveness and fairness- taxation should produce the right amount of tax at the
right time, while avoiding both double taxation and unintentional non-taxation. In
addition, the potential for evasion and avoidance should be minimised. Prior
discussions in the Technical Advisory Groups considered that if there is a class of
taxpayers that are technically subject to a tax, but are never required to pay the tax
due to inability to enforce it, then the taxpaying public may view the tax as unfair and
ineffective. As a result, the practical enforceability of tax rules is an important
consideration for policy makers. In addition, because it influences the collectability
and the administrability of taxes, enforceability is crucial to ensure efficiency of the
tax system.
· Flexibility- taxation systems should be flexible and dynamic enough to ensure they
keep pace with technological and commercial developments. It is important that a tax
system is dynamic and flexible enough to meet the current revenue needs of
governments while adapting to changing needs on an ongoing basis. This means that
the structural features of the system should be durable in a changing policy context,
yet flexible and dynamic enough to allow governments to respond as required to keep
pace with technological and commercial developments, taking into account that
future developments will often be difficult to predict.
28. Equity is also an important consideration within a tax policy framework. Equity has two main elements; horizontal equity and vertical equity. Horizontal equity suggests that taxpayers in similar circumstances should bear a similar tax burden. Vertical equity is a normative concept, whose definition can differ from one user to another. According to some, it suggests that taxpayers in better circumstances should bear a larger part of the tax burden as a proportion of their income. In practice, the interpretation of vertical equity depends on the extent to which countries want to diminish income variation and whether it should be applied to income earned in a specific period or to lifetime income. Equity is traditionally delivered through the design of the personal tax and transfer systems.
29. Equity may also refer to inter-nation equity. As a theory, inter-nation equity is concerned with the allocation of national gain and loss in the international context and aims to ensure that each country receives an equitable share of tax revenues from cross border transactions (OECD, 2001: 228). The tax policy principle of inter-nation equity has been an important consideration in the debate on the division of taxing rights between source and residence countries. At the time of the Ottawa work on the taxation of electronic commerce, this important concern was recognised by stating that “any adaptation of the existing international taxation principles should be structured to maintain fiscal sovereignty of countries, [and] to achieve a fair sharing of the tax base from electronic commerce between countries…”.(OECD, 2001: 228)
30. Tax policy choices often reflect decisions by policy makers on the relative importance of each of these principles and will also reflect wider economic and social policy considerations outside the field of tax.”
4.2 Tax Neutrality: An Important Concern
37. Among these, the issue of tax neutrality, which was listed as the first of these principles in the report, was considered in detail during the work by the Task Force.16 The principle of tax neutrality provides that tax should seek to be neutral and equitable between various forms of business activities. When tax neutrality is violated, the unfair tax advantage enjoyed by some market enterprises can distort the market economy and the dead weight loss arising from it can adversely impact market efficiency. The Task Force noted that a neutral tax contributes to market efficiency by ensuring optimal allocation of resources in the market.
38. In the context of digital economy, tax neutrality has emerged as a major concern. While a purely domestic enterprise is taxed at the marginal tax rate under the domestic laws, a multinational enterprise may not be taxable at all in the country of source due to the ability of digital enterprises to conduct their business through digital and telecommunication networks without requiring any physical presence in the country of source. As the existing international taxation rules in the treaties require the presence of permanent establishment based on physical presence, the multinational enterprises conducting digital businesses in the same way as their domestic competitors would not be taxed on the income derived by them from the source country. The multinational digital enterprises are characterized by high mobility, can easily locate in low tax jurisdictions and thereby minimize their global tax liability, resulting in significant tax advantages over their domestic competitors.
4.3 Committee’s Observations
39. Taking the aforesaid issues related to tax neutrality into account, the Committee is of the view that the asymmetry in tax burden faced by purely domestic and multi-national enterprises can have distortionary impact on the market competition and can adversely affect the development of purely domestic enterprises. The clear tax advantage faced by foreign enterprises over their Indian counterparts also creates strong incentives for Indian enterprises to either locate themselves in a low tax jurisdiction outside India or sell their businesses to such an enterprise. Thus, distortionary taxation arising from the limitations of existing international taxation rules and the lack of tax neutrality are likely to pose significant constraints in development of Indian digital industry, and thereby pose significant long term challenges for this extremely important sector of economy.
40. Another important manifestation of lack of tax neutrality and its implications is the difference between the tax burden faced by the traditional brick and mortar businesses and digital enterprises competing with them. The traditional brick and mortar businesses are likely to be taxable fully on their business income arising in source jurisdictions, such as India, either as a tax resident, or as the permanent establishment of a foreign company, and thus face a much higher tax burden on their profits than their multinational counterparts conducting their businesses by digital means. This lack of tax neutrality between digital enterprise and traditional enterprises can distort the market in favor of the former and thereby disrupt the existing market equilibriums.
40. Another important manifestation of lack of tax neutrality and its implications is the difference between the tax burden faced by the traditional brick and mortar businesses and digital enterprises competing with them. The traditional brick and mortar businesses are likely to be taxable fully on their business income arising in source jurisdictions, such as India, either as a tax resident, or as the permanent establishment of a foreign company, and thus face a much higher tax burden on their profits than their multinational counterparts conducting their businesses by digital means. This lack of tax neutrality between digital enterprise and traditional enterprises can distort the market in favor of the former and thereby disrupt the existing market equilibriums.
41. These violations of tax neutrality can result in significant impacts on the economy. The tax advantage faced by multinational digital enterprises can adversely impact the growth of digital industry in India and profitability and expansion of traditional brick and mortar businesses in India. The long term impact of these distortions can be adverse to Indian businesses in general and Indian brick and mortar enterprises in particular, and in addition to the adverse impact on the economy, can also lead to fiscal constraints for Government of India. These fiscal shortfalls may need to be compensated by additional tax burden on local tax residents, which may further erode their competitiveness, thereby creating a vicious downward cycle.
15. The work under Action 1 was initially scheduled to be completed by September, 2014. Accordingly, the Task
Force prepared its Report in September, 2014. In this report, it was decided to carry on follow-up work, which was
undertaken after September, 2014 and led to the 2015 Report.
16. These observations were retained in a summarised form in the 2015 Report in paragraph 6 and Box 1.1 of that
Report.
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