The digital economy is growing. Its total value in most countries today may be less than 10 percent, but it’s expected to grow rapidly. The global management consulting firm A.T. Kearney estimates that digital economy– related revenue in the Association of Southeast Asian Nations (ASEAN) region alone is around $150 billion annually. In Southeast Asia, e-commerce is growing apace, but it still accounts for less than 1 percent of total retail sales, compared with rates of six to eight percent in Europe, China, and the United States.
This rapid growth has created challenges to taxpayers and tax administrators alike. First, it has resulted in uncertainty for companies over how they’ll be taxed. Second, it threatens to erode the tax base that governments rely on to finance infrastructure and human-capital investments needed to boost growth and further expand the digital economy.
"One thing is clear from our work: Existing tax policies—designed primarily with physical goods and locally delivered services in mind—are being aggressively challenged"
Credible data on this are hard to come by, and often the subject of debate. But the European Commission estimates that digital businesses in Europe face an effective tax rate of only 9.5 percent, compared with 23.2 percent for traditional business models.
The World Bank is helping more than 100 governments improve their tax systems by strengthening the capacity of revenue administrations, supporting better tax codes, simplifying rules, reducing the burden on companies, and promoting greater predictability. An increasing part of our work here is helping governments in developing countries and emerging markets institute sensible tax policies and modernizing their tax administration so that they can respond more effectively to the digital economy.
One thing is clear from our work: Existing tax policies— designed primarily with physical goods and locally delivered services in mind—are being aggressively challenged. The structure of the digital economy is fundamentally different from the traditional brick-and-mortar model. For instance: (1) services are virtual and can be delivered through the Internet (e.g., music streaming, web design, and recruitment); (2) goods can be easily identified through search engines and purchased on electronic platforms hosted in foreign countries; (3) only the final consumer, and the digital intermediary, is apparent and traceable; (4) variable costs of new business models tend to be low, whereas sunk costs are high; (5) many online firms have significant cross-jurisdictional scale but no physical presence in the markets where consumption takes place; (6) some business models rely on users and companies to co-create valuable content (e.g., on YouTube, Snapchat, and Facebook); and (7) sharing-economy business models involve private individuals, who aren’t typically the subject of hotel taxes, taxi fees, and the like.
Businesses exhibiting these characteristics face uncertainty over how digital services and e-commerce will be taxed. Existing tax codes are usually silent on these issues— which, in turn, can open the door for a range of tax-evasion and avoidance schemes. It can also make taxpayers’ and administrators’ efforts to ensure compliance more difficult.
Regulators are considering how to address these tax challenges. To date there’s been little consensus on the taxation of income and profits. In fact, a global debate about how to tax the digital economy is raging, with divergent—and often directly opposing—viewpoints on how to tax e-services. Broadly speaking, countries that host digital-service providers prefer revenues and profits to be taxed in their physical location, while countries that don’t would rather tax where companies a significant digital presence—in other words, where the users are.
Digital taxation is now at the heart of the tax agenda for the G20, the United Nations (UN), the Organization for Economic Cooperation and Development (OECD), the European Union (EU) and other regional groupings, and numerous countries. While international consensus exists on how to address indirect taxation of the digital economy, there is significant disagreement on direct taxation. Here are the hot-button issues that policy-makers and politicians are currently grappling with:
1. Which jurisdiction gets to tax activities under the digital economy? A permanent establishment (PE) threshold test is set forth in many national tax laws, is a core provision of numerous treaties, and is addressed in the Base Erosion and Profit Shifting (BEPS) Action 7. Among other things, the PE threshold determines whether a company has a sufficient local, physical presence to be taxed. The fact that many digital service providers have thousands of paying customers in a country but no physical presence— which lets the providers avoid paying taxes—has prompted significant action. For example, the government of India introduced last year, a six percent equalization levy on online advertising revenue by non-resident e-commerce companies earned in India.
2. Where in the production chain is the value created? Value drivers such as algorithms are highly mobile and can easily be located to tax havens. The established, arms-length principle for pricing intra-company transactions is also harder to apply to knowledge-intensive services that are more likely to be produced by workers and business units spanning multiple jurisdictions. This is further complicated by the fact that such enterprises operating in the digital economy often pursue aggressive growth strategies that forgo short-term profits for longer-term revenue growth, further complicating efforts to value—and thus tax—each link in the production chain.
3. How should the value of services co-created with users be taxed? The value of social-media companies such as Facebook, Instagram, LinkedIn, Twitter, and YouTube is directly related to the number of customers and the contents they produce—it drives advertising revenue, future user fees, and other income streams. But revenue authorities don’t have the instruments—let alone the rights—to tax foreign companies, which benefit commercially from the involvement of their users.
4. What should jurisdictions do to promote compliance in e-commerce? Foreign e-tailers’ increasing popularity is creating compliance issues. This occurs when e-tailers fail to register for value-added tax (VAT) purposes in the various markets they serve (typically required when national sales exceed a certain threshold) and when customs duties are not paid (e.g., because items are declared as gifts or deliberately undervalued). The response by governments such as the UK has been to enter into agreements with platforms for them to institute compliance measures, e.g., obligating the platforms to share information about their online sales and to enforce VAT-registration requirements with their merchants.
5. How should the sharing economy be taxed? Platforms for individuals to share their assets—such as cars (e.g., Lyft and Uber) and houses (e.g., Airbnb)—are challenging conventional business models, modes of regulation, and existing tax structures. The key issues here are determining whether these companies should pay VAT and payroll taxes, and how to verify that private individuals pay income tax on the revenue earned through these platforms.
In time, we expect these various tax challenges to be addressed at the global, regional, and national levels—though at different speeds. Countries are taking the first steps to institute new tax rules at the national level. Agreement at the regional and global level of what the tax arrangements need to look like is taking longer, efforts by the European Commission and in the context of the BEPS project notwithstanding.
CFOs are well-advised to keep up with legislative proposals in their key markets, engage in consultations led by regulatory agencies, and ensure compliance with local tax codes. Going forward, these will be the best ways to avoid incurring unforeseen tax liabilities, potential penalties and charges—and damage to their reputation.