The world has gone digital, that’s a popular phrase. Going digital has two dimensions; one digitization which is changing from analogue process to a digital one, the second aspect is digitalization which means adoption of modern technology to change a business model. Thus digitization is an overhaul of an old process while digitalization is augmenting an old process with modern technology. Having this definitions in mind should help us understand that talking of the digital economy is more or less talking about the entire economy because every aspect of our life has been digitized or digitalized.
Digital economy is the fastest growing sector, with technology based companies commanding fifty six percent of world’s market capitalization in 2018 from a meagre sixteen percent share in 2009 according to UCTADs digital economy report 2019. The report further indicated that the sector was estimated to be sixteen percent of the world’s GDP growing 1.7 times faster than the general economy. This is evidenced by the number of dollar billionaires in the Forbes list, the Top 10 is dominated by the Tech Gurus.
The challenge in taxing the digital economy
Digital transactions at a small scale are not quite visible to the tax gatherers, some might not seem to be in a profitable venture at a glance. The participants in the digital economy at informal level might not be conscious that they are doing business let alone finding it necessary to file tax returns. If the informal economy under brick and mortal model has been a nightmare to tax authorities then taxing digital activities in the informal world is a real monster.
Taxing multinationals in the technology world is even more complicated. It calls for well thought out strategies to place the tax authorities ahead of technology and tax laws that are precisely address the scenario presented by the digital market place. Tech giants hide behind the complex nature of their operations citing intangible assets that they have to invest in, their global presence making it hard to define where they are operating from. The archaic tax laws that have been in forces were designed for brick and mortar business.
The brick and mortal based tax laws only needed distinction between doing business in a country and doing business with a country. To illustrate this, consider a Japanese firm with a branch in Kenya selling to Kenyans through that Branch is doing business in Kenya so the income is derived in Kenya therefore taxable in Kenya. That would be different if the goods are bought by Kenyans from Japan, a case of doing business with Kenya which has no income tax implications. Considering this example, think of a digital service like advertising made available in Kenya by a foreign company that has its presence in the clouds. Where is that business carried on? Kenyans did not go to another country to buy it, it was brought to Kenya through technology.
Evolution of the concept of permanent establishment
An OECD convention dating back to post World War I period in the 1920s created the concept of permanent establishment. This concept has since been the yardstick for taxing MNCs across many jurisdictions Kenya included. The principle states “an enterprise in one state shall not be subject to a direct tax on its business profits based on net income in the other state unless it carries on business in that other state through a permanent establishment (“PE”) located in the other state.
The above criterion is no longer viable in an age where technology allows buyers and sellers to conduct cross-border business without ever establishing a physical presence in a non-resident state. The argument is now favors considering the economic rather than physical nexus.
OECDS BEPS action 1 report 2015 proposed that the taxable presence in a jurisdiction would arise when a non- resident enterprise has a significant economic presence on the basis of factors that evidence a purposeful and sustained interaction with the jurisdiction via digital technology and other automated means. Though this concept was not included in the final BEPS Project recommendations, several countries have bought in to the idea incorporation significant economic presence in their tax laws. The European Commission in 2017 contemplated a legislative proposal which would introduce new nexus rules on the basis of significant economic presence’ or a ‘virtual permanent establishment’ within the member states. India’s Finance Act 2018 expanded the scope under domestic law of the term – ‘Business Connection’ to enable taxation of non-residents having a Significant Economic Presence (SEP). In April 2016, Israel issued a Virtual Economic presence circular, a similar move was made by Nigeria in May 2020 by issuing the Significant Economic presence order.
Tax compliance by the Digital Giants
The digital giants have been infamous corporate citizens as far as taxation is concerned. The big four Google, Amazon, Facebook and Apple branded the GAFA’s in tax circles have literally given many governments a run for their money. The GAFA’s together with Microsoft and Netflix form the widely revered “Silicon six”, celebrated for reasons except for tax compliance. The Silicon six command a market capitalization of $4.6 Trillion, more that the value of the 1000 firms listed in the London stock exchange. This is not reflected in their payments to the exchequer. A damning report by Fair Tax Mark in 2019 indicated that the silicon six had $100 Billion global tax gap between the year 2011 and 2020. According to the institute of tax and policy report 2017, Apple earned $305 Billion profits before taxes between 2008 and 2015 and paid a foreign tax of around six percent of this amount. At the same time Apple avoided paying $78.5 billion of US taxes by using offshore business structures. Google virtually paid no taxes in the UK in 2018 with over $6.5 Billion worth of transactions. Facebook in the same year 2018 paid £15.8m in tax in the UK despite collecting a record £1.3bn in British sales. This is a sales profit ratio of 6% quite outrageous for a technology company.
This is how the digital giants dodge taxes, they cite high costs of intangible assets in the name of intellectual property and work through tax havens. The common practice is by use of double Irish Dutch sandwich strategy. A US multinational company develops an intellectual property and licenses it to its Irish subsidiary. The subsidiary registered in Ireland but its management being run from another country in this case a tax haven probably Bermuda. A second subsidiary will be set up in the Netherlands and the license will be transferred from the first Irish company to the Dutch company. A third subsidiary will yet be established in Ireland still which will be the company generating the actual sales. The Dutch subsidiary now having the License will sublet it to the license to the third subsidiary. Some facts we need to establish here, US companies are not taxed unless they repatriate dividends from their foreign subsidiaries. Second fact is the Irish tax law, a company can be tax resident by place of management but not country of incorporation if it is controlled by another entity residing in a country that has a double tax treaty with Ireland.
The third subsidiary based in Ireland will now be making sales in all countries except the US, generating revenue and hence they will need to pay royalties for using an intellectual property belonging to the Dutch subsidiary. The profits now generated by this third subsidiary will be taxable in Ireland, now transfer pricing kicks in. The royalties from the Dutch subsidiary will be hiked in price, such that the third subsidiary makes minuscule profits which will be taxed at Ireland’s corporation rate of tax 12.5% which is the lowest in Europe. That justifies the choice of Ireland.
The payment of royalties should ordinarily attracting withholding taxes, but wait a minute, under a European Community directive of 2003 provided for exemption of Withholding tax on interest and royalties between member states. That means payment of royalties by the third subsidiary in Ireland will to the Dutch subsidiary will not suffer withholding taxes in Ireland. Finally the Dutch company has to pay for the royalties for the license from the first company, which is in Ireland but for tax purposes is in Bermuda. Now, Netherlands does not levy withholding tax on royalties. On the final destination Bermuda, there will be no taxes because this is a tax haven.
The double Irish Dutch Sandwich Illustrated
PROPOSAL ON TAXING THE DIGITAL ECONOMY
(I) OECD Approach to taxing the digital Economy.
The challenges posed by the digital players on taxation falls under the wider scope of Base Erosion Profit Shifting (BEPS). Base Erosion Profit Shifting refers to a corporate tax avoidance strategy of shifting profits from high tax jurisdictions to low tax jurisdictions thus eroding the tax base of the high tax jurisdiction countries. This challenge has prompted the Organization for Economic Corporation and Development (OECD) to embark on a BEPS project with fifteen action plans. Action one and arguably the most critical is “Tax Challenges Arising from Digitalization”.
OECD proposal under Action 1 comes up with a two pillar approach that suggests a way of ensuring that multinational enterprises pay a fair share of taxes wherever they operate. As of 5 July 2021, the two pillar approach had the buy in by 131 countries.
Pillar One- Reallocation of taxing rights
Pillar one seeks to enforce fairness in taxation by distributing profits and taxing rights among countries where the MNEs operate and generate those profits whether they have physical presence or not. To appreciate the concern under pillar one, carry in mind that a multinational enterprise in the digital world is capable of generating revenue from a country where it has no physical presence. For instance, Facebook over eight million users in Kenya, yet it has no physical presence in the country save for its content review centre in Nairobi. With these millions of users in Kenya, the entity must be generating revenue from adverts.
Under Pillar One, taxing rights on more than USD 100 billion of profit are expected to be reallocated to market jurisdictions each year. The profit reallocation framework provides for a three-tier mechanism.
Amount A– A share of deemed residual profits of a company shared by jurisdictions irrespective of Physical presence. This applies to both digital and consumer facing business. A nexus rule is applied to determine whether a jurisdiction qualifies for amount A allocation. The proposed threshold for a jurisdiction to qualify allocation is that MNE in question should be generating at least 1 Million Euros in revenue from that jurisdiction. A lower threshold of 250,000 Euros is set for smaller economies with a GDP of less than 40 Billion Euros. The proposal then sets a quantum of 20% to 30% of the residual profits to be allocated, residual profits being defined as amounts in excess of 10% of the revenue. The 10% threshold is still subject to debate, if accepted the OECD estimates that 780 MNEs and approximately $500 billion of income would be subject to Amount A.
Amount B– Allocation of a fixed remuneration for baseline distribution and marketing functions that take place in a certain jurisdiction. The definition of baseline marketing and distribution activities covers distributors that
- Buy from related parties and resell to unrelated parties; and
- Have a routine distributor functionality profile.
Pillar Two-
Pillar Two consists of:
- Two interlocking domestic rules (together the Global anti-Base Erosion Rules (GloBE) rules):
- an Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of a constituent entity; and
- an Undertaxed Payment Rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR; and
- a treaty-based rule (the Subject to Tax Rule (STTR)) that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate.
The minimum tax rate used for purposes of the IIR and UTPR will be at least 15%.
The second pillar has inspired the much touted global minimum tax set at 15% which I thought to be a lasting solution to the menace of low tax jurisdictions. Put this way, if a firm controlled from US but registered in low tax jurisdiction where it pays taxes at the rate of 5%, it will be required to make-up for the 10% difference. This will give no advantage to countries seeking to entice investors with low tax rates but most of all, there will be no sense of setting up fictitious companies in low tax jurisdictions.
Joe Biden, the US president has taken a lead in supporting the Global minimum tax, and idea that had buy in from the G7 countries, then by the G-20 countries and later on 1 July 2021 130 countries were in support of global minimum tax. Seemingly, this is an idea whose time has come.
Unilateral attempts on taxing the digital Economy
Because of the tax delinquencies by the Digital players, nearly every government and global economic organizations’ have been on a chase for their fair share of their digital dollars. France enacted a 3% digital service tax effective 1 January 2019.The French model tax was introduced targeting online intermediation or advertising companies with a gross global turnover of Seven hundred and fifty million Euros. This can be read to mean that the target the big four digital giants. Italy and Spain followed suit, introducing digital serves tax effective January 2020. In April 2020 UK introduced digital service tax at 2% on revenues of search engines, social media platforms and online marketplaces to the extent that their revenues are linked to the participation of UK users. This applies regardless of where the corporate owner of those revenues is located and irrespective of the physical presence that the corporate has in the UK.
India introduced a form of digital service tax in the name of Equalization levy in 2016. The levy was charged at 6% on advertisements and online services provided by non-resident persons with no permanent establishment (PE) in the country. In April 2020, India expanded the scope of their Equalization levy to cover E-commerce transactions but at a lower rate of 2%. Closer home, Uganda in 2019 introduced tax on social media usage but that was a ridiculous tax meant to discourage idle talk and gossip.
Kenya’s tax attempts on the Digital Economy
The 2019/2020 finance act inserted the words digital market place in Sec 3(2) d of the income tax act. This paragraph is intended to bring to tax e-commerce transactions and mobile apps. The insertion of the phrase digital market place in 2019 did not give much detail. The finance act 2020 created a provision that Resident and non-resident entities who offer digital services are liable to digital services tax payable at a rate of 1.5% of the gross transaction value, effective from 1 January 2021. The scope of digital service tax extends to online content providers, digital marketplace flat forms that link buyers and sellers, webhosting service, cloud services as well as ELearning services. Finance act 2021 removed resident entities from the scope of digital services tax, a move that seems to point towards the digital multinationals.
In yet another smart move targeting the digital trade, the 2020 tax laws amendment act introduced a 20% withholding tax on payments to non-residents for sales promotion, marketing, advertising services. Most the digital multinationals like Facebook and Google’s YouTube generate a lot of revenue through local adverts placed by Kenyan Businesses. See, the concept of withholding tax works on the premise “it takes two to tango” so get hold of one party fast and gather some tax and information.
Besides Digital Service Tax, transactions carried over the digital market place are subject to VAT. This has been the case since 2013, however the VAT law was not quite precise until September 2020 VAT regulations were issued. The new regulations spell out transactions subject to VAT when supplied from outside Kenya. This applies only for business to customer (B2C) transactions. Foreigners making suppliers locally are therefore required to register under a simplified online system alternatively they will be required to appoint a local tax representative. VAT on online business to business (B2B) transactions involving a foreign supplier fall under imported services requirements.
Conclusion
The digital future that was ever spoken about is here with us. The notion of brick and mortar economy versus digital economy is soon going to get behind us. Every dimension of business is going to a have a digital aspect. If taxes must be collected, then they must be collected from the digital economy.