OECD BEPS: Consensus eludes on three approaches to tax the digital economy

India is taking a lead on this issue as it seeks to have in place a consensus-based solution by 2020

India will hold a string of bilateral talks with countries, including the United States, to garner support for its proposal to tax digital companies such as Google, Facebook and Netflix. The country is taking a lead on this issue as it seeks to have in place a consensus-based solution under OECD Base Erosion and Profit Shifting (BEPS) framework by 2020.

Addressing the taxation challenge due to digitalisation of economy, 129 countries that are part of the Inclusive Framework under BEPS, have huddled together to rework the traditional international tax system, and make digital firms pay taxes regardless of their physical presence or measured profits in a country.

Base erosion and profit shifting (BEPS) refers to the exploitation by multinational companies, of gaps and mismatches in tax rules, in order to shift their profits to low-tax regimes. Internet companies operate out of low-tax jurisdictions, but do business in several others without having a physical presence and end up avoiding taxes.

India is fighting it out with the US and UK to push through its ‘significant economic presence’ proposal, arguing that permanent establishment should not only require a fixed place of business and the definition of ‘nexus’ needs to be changed, to give more taxing rights to market-driven economies, or developing countries.

The United States, on the other hand, has been pressing for taxing digital economy through the ‘marketing intangibles’ principle and the UK through a ‘user-base’ principle.

The OECD had estimated revenue losses due to base erosion and profit shifting equivalent to 10 per cent of global corporate tax revenues, and created the Inclusive Forum to collaborate on the implementation of BEPS framework.

India will hold bilateral talks with several countries, including the US, UK, South Africa, Germany and France, among others, to push through its approach on widening the scope of profit attribution and nexus rules under BEPS.

India had, in fact, introduced the SEP (Significant Economic Presence) concept in the Finance Bill 2018-19, which had widened the scope of ‘business connection’ to include provision of download of data or software, if aggregate payments from such transactions exceed a prescribed amount, or if a multinational's interaction is with a prescribed number of users. However, since the provision would not override India’s double taxation avoidance agreements, each treaty needs to be revised separately. India has taken on what seems to be a herculian task, as its presses for a multilateral instrument under OECD BEPS, which will automatically amend all treaties.

According to the US’ ‘marketing intangibles’ principle proposal, the market jurisdiction (where users are located) would be entitled to tax some or all of the ‘non-routine’ income associated with such intangibles, while ‘routine’ income would continue to be allocated, based on existing transfer pricing principles. Marketing intangibles include brand, trade name, customer data, customer relationships, and customer lists.

However, India feels that the US’ proposal may not be feasible, as it will be very difficult to compute income, considering the volume of data required for the purpose. Indian officials argue that most developing countries don’t have that capacity to distinguish routine and non-routine profit or identify and put a value to intangibles of an enterprise.

Archit Gupta, founder and CEO, Cleartax, pointed out that the concern with using this approach is the ability to arrive at a value of the intangible which will be acceptable to the tax authorities. “Valuation methods may differ widely due to the nature of an intangible and the type of intangibles could vastly differ in different businesses. Besides, such an approach may have more relevance to a consumer centric business and may be argued against by B2B businesses,” he said.

On the other hand the UK’s user-based principle takes into account only highly digitalised businesses where only the user is to be taken into account. This approach is too restrictive, India feels.

Inclusive Framework narrows options

With consensus eluding the discussions around the three approaches by India, US and the UK, the Inclusive Framework in its last meeting in May narrowed it down to methodologies to be adopted, which included that proposed by India.

New Delhi’s proposal is based on proportional assignment of global profits of internet giants among market jurisdictions, where users are located.

Meanwhile, the US is flexing muscle around its proposal of allocating only non-routine profits of firms to different jurisdictions, seen as too complicated to be of use for developing economies.

“India’s approach is much simpler compared to that of the US. A lot of countries would want to adopt that. Hopefully a consensus will arrive soon,” said a government official.

India has pitched for a ‘Fractional Apportionment’ method for profit allocation, wherein the entire profit of the group will be apportioned to different countries in which the group operates through a formula, taking into account factors like employees, assets, sales, and users.

The Central Board of Direct Taxes’ report on ‘Profit Attribution to PE' provides different weightage for digital companies categorising them as "high" and "low or medium" user base with significant economic presence in India. In case of 'high user intensity', the weight of users should be 20 per cent, share of assets and employees, 25 per cent each, and sales at 30 per cent, while for 'low and medium user intensity', users should be assigned a weight of 10 per cent, while three factors would have a weight of 30 per cent each.

However, that is not seen as the best of approaches by tax experts.

“Allocating significant value to user base is bound to create distortion in profit allocation and remote to business realities. Sustained engagement with user doesn’t lead to revenue generation and its monetization,” said Amit Singhania, partner, Shardul Amarchand Mangaldas.

Amit Maheshwari, Managing Partner, Ashok Maheshwary & Co pointed out that user base does not necessarily result in profits, as several digital giants have a significant user base in India, but derive very low revenues from the country.

Meanwhile, the Modified Residual Profit Split Approach of the US calculates the non-routine profits of a business and allocates some or all of those profits to different jurisdictions by either using modified transfer-pricing rules or a formula method.

The third proposal -- Distribution-based approach-- talks about using a simple formula to specify a baseline profit in a market jurisdiction for marketing, distribution and user-related activities to move more taxable profit towards market jurisdictions.

Unilateral taxation initiatives by countries

There is an increasing worry that in case the inclusive Framework does not deliver a comprehensive consensus-based solution within the agreed 2020 time frame, there is a risk that more jurisdictions will adopt uncoordinated unilateral tax measures.

India had imposed a six per cent equalisation levy in June 2016 on non-resident digital firms on amounts paid to internet firms by advertisers in India. The government has mopped up over Rs 1,000 crore from the levy in 2018-19. It is seen as an easier method to tax digital companies, as it can be adopted under domestic laws without requiring amendment of a large number of tax treaties as it is not a tax on income. “The issue with SEP lies in its overlap with equalisation levy, since advertising services may fall under both the concepts. Besides, some taxpayers may be eligible for treaty benefits leading to ultimate non-taxation and yet compliance may be required,” said Gupta of Cleartax.

Italy has a web tax of three per cent on digital services. France has also proposed a three per cent tax on advertisement revenue of digital companies.

Spain and UK are working on similar proposals to tax advertisement services revenues of digital companies.