By Ross Tieman
The rise of the digital economy poses a quandary for governments.
Policymakers need big, stable revenues to deliver effective administration and high-quality public services.
The digital economy, however, has upended traditional business models and multiplied opportunities for companies to reduce their tax bills.
The impact is potentially enormous.
“We are going through a sea change in how national governments are taxing corporations, and the level of transparency that governments — and the citizens they protect — are demanding.“
Jeff Saviano, Americas Tax Innovation Leader, EY
Raul Katz, Director of Business Strategy Research at the Columbia Institute for Tele-Information and President of Telecom Advisory Services, estimates that up to 12% of all retail trade already occurs online in developed countries.
So do many services, from taxi bookings to translation, rendering obsolete many established ways of collecting sales or income taxes.
Governments and global organizations are also increasingly concerned that some large digital companies are exploiting the mobility and intangible nature of digital platforms and goods to sidestep tax.
A global drive to close the tax gap posed by the digital economy looks set to transform tax collection worldwide.
“Policymakers need to make sure that the taxation revenues derived from digital trade are being captured,” Katz says.
But if they make it more difficult or costly to acquire digital technologies, “it reduces the impact that digitalization can have on economic growth.”
The online economy raises new kinds of taxation issues.
Historically, taxation systems were typically designed to tax sales of goods or services at the point of sale, and corporate and personal income in the location where it is earned.
Most taxation was typically framed by the answers to three questions, according to Jeff Saviano, Americas Tax Innovation Leader:
- What are you taxing?
- Where is it?
- What’s its value?
But digital businesses have created new types of assets, new delivery mechanisms and new business models.
In the digital economy, those questions are hard to answer — for both companies and tax authorities.
“In many cases, you have a square peg of innovation in a round hole of taxation,” Saviano says.
A Brazilian consumer, for example, can place an online order for low-value goods to be shipped from elsewhere in the world.
Such global, online transactions raise many questions:
- Is the appropriate level of value-added tax (VAT) being charged and collected by the foreign online retailer, or is no VAT being paid?
- How can domestic tax authorities keep track of the VAT that is due?
- Does the foreign online retailer pay income or other taxes in Brazil even though it may not have a physical presence in the country?
The digital economy: a closer look
The digital economy is transforming business models and disrupting traditional tax streams. This is forcing governments to write new tax rules, and enact methods of facilitating tax compliance.
Manufacturing: The arrival of 3D printing dramatically alters the mix of income stem-ming from local manufacturing, warehousing and transpor-tation vs. intel-lectual property (ownership of the blue-print and authorization of its use). Local jurisdictions will need to address how to levy taxes on sales and raw materials on 3D printed goods.
Tourism: More individuals are renting their personal apartments and homes to travelers through room sharing apps. Municipalities are starting to combat diminishing hotel and tourism taxes through agreements with these apps to collect the tax revenue.
Health: Wireless devices are enabling people to monitor their own health, including their sleep, fitness and calorie consumption. These new health apps raise questions about whether they are a consumer product or a medical service and how they should be taxed.
Financial Services: Digital applications help innovative services proliferate, including peer-to-peer lending, crowdfunding and crypto currencies. Disruption across financial services could create gaps in tax collection.
Retail: Online retailers sell to consumers worldwide. But it’s not always clear whether the many low-value goods they send across borders are being charged the correct amount of value-added tax (VAT) or any at all.
Transport: Ride-sharing services are growing in popularity and governments are answering by levying new taxes — in part to subsidize the traditional taxi industry. More disruption is ahead with the advent of driverless vehicles, which could significantly reduce the size of the workforce in the transport industry and impact payroll taxes.
Sources: EY, OECD, Australian Taxation Office, Ontario Chamber of Commerce
The digital tax gap is hurting competitors with traditional business and taxation models.
Brick-and-mortar retailers, for example, complain that online rivals have an unfair advantage as they can “jurisdiction shop” for the lowest tax rates and sidestep in-country property and other taxes.
The number of independent bookshops on the main streets of UK towns, for example, has declined to 907 from 1,894 in 1995, hurt by online retailers as well as big chains, according to a manifesto released in 2016 by the Booksellers Association in the UK.
The association argues that tax on business properties is no longer appropriate for small bookshops.
Sales of music and films on physical formats have slumped in the face of digital competition.
In 2015, global sales of digital music leapfrogged physical formats for the first time, accounting for 45% of music revenue worldwide, according to the IPFI recording industry organization.
The sharing economy is also adding vast numbers of new transactions without a clear taxation model.
Historically, many city authorities have taxed hotel users.
Now some, such as Paris, are trying to tax those who rent their spare rooms to short-stay visitors.
Identifying liabilities and collecting taxes are proving difficult.
Traditional definitions of employee status — which shape liabilities for income tax and social contributions — are being challenged by the “gig” economy, in which internet platforms are used to connect freelance workers with providers of services.
In some places, taxable status has become a courtroom issue.
The issues touch companies and tax authorities at many levels.
A typical US company pays myriad taxes to many different jurisdictions.
A nationwide retailer, for example, would pay federal and state corporate taxes, sales taxes at the state level, and property taxes to municipalities.
It might have liabilities in tens of thousands of jurisdictions.
“We are going through a sea change in how national governments are taxing corporations, and the level of transparency that governments — and the citizens they protect — are demanding,” says Saviano.
The digital revolution and the ensuing tax system overhaul will affect all aspects of the corporate tax life cycle.
“It’s changing the very nature of how companies manage the overall tax burden and tax compliance in particular,” as well as how they handle and resolve disputes with tax authorities over liabilities, Saviano says.
The digital future
The G-20 called upon the Paris-based Organisation for Economic Co-operation and Development (OECD) in 2012 to study reforms to the global taxation system to address base erosion and profit shifting (BEPS).
The OECD’s BEPS report in October 2015 formally suggested governments take critical actions with regards to taxation and the digital economy.
“The spread of the digital economy poses challenges for international taxation,” the OECD wrote in its report on Action 1, which addresses the tax challenges posed by the digital economy.
There are 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 characterization of income for tax purposes.”
The OECD recognizes that policy responses must be all-embracing, as the “the digital economy is increasingly becoming the economy itself.”
In its report, the OECD recommends different options for tackling taxation issues in the digital economy, including some that are addressed in other BEPS actions:
- Changing the controlled foreign company (CFC) rules
- Updating transfer pricing guidelines
- Adopting a stricter definition of what constitutes a permanent establishment (a taxable presence)
- Addressing indirect taxes for certain digital transactions
Since every transaction in the digital economy is recorded by computers, tracking liabilities should be easy.
Nothing could be further from the truth.
New York-based Ryan Tweedie, EY Americas Systems Leader, People Advisory Services, says the quality of much corporate data declined four to five years ago when companies turned their software systems into easy-to-operate applications that mimic consumer platforms.
Because the software became easy to use, employees began enthusiastically entering a mass of “unrationalized” data.
Now human resources and finance directors are discovering the database and its architecture are not up to the challenge of organizing the data.
Companies face a massive and urgent challenge: “We have to rationalize the overall enterprise data dictionary across all kinds of human resources, finance, procurement, tax and audit systems,” says Tweedie.
Only then will companies be able to build reliable rules, workflow and parameters that enable them to correctly assess and settle their liabilities.
Artificial intelligence — computer systems that learn from experience — could potentially be used to tackle the tax issues generated by the digital economy and the overhaul of tax systems that is emerging in response to it.
EY’s Saviano is optimistic on this score.
More and more clever start-ups are inventing digital tools designed to help countries and companies overcome the increasing complexity of tax compliance issues, he says.
Whether you are a tax administrator or a taxpayer, these new tools will allow people to access historical information in new ways and to solve tax problems by accessing a tremendous database of knowledge that no human could ever possess,” says Saviano.
Key action points
- Organizations should review whether their foreign activities will constitute a PE under new BEPS rules.
- International companies should align overseas operations to revised definitions of what constitutes a CFC.
- Organizations trading online across different tax jurisdictions should review how new tax rules are likely to impact their business model, and make any necessary adjustments.
- Companies should start rationalizing their enterprise data dictionary across human resources, finance, procurement and taxation to obtain the information needed to accurately assess tax obligations.
This article is included in Tax Insights issue 17 – Transformation and innovation (pdf)