VAT and the digital economy

Introduction

In September 2014 the OECD launched some of it’s deliverables on the 15 actions from it’s BEPS Action plan. Amongst these deliverables is the deliverable on action 1: Address the Tax Challenges of the Digital Economy.

Political leaders, media outlets, and civil society around the world have expressed growing concern about tax planning by multinational enterprises that makes use of gaps in the interaction of different tax systems to artificially reduce taxable income or shift profits to low-tax jurisdictions in which little or no economic activity is performed. The real issue and background of these BEPS issues is however to be found in a more fundamental change that is taking place around the globe.

“The spread of the digital economy poses the most important challenge for international taxation. The digital economy is characterized by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises 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.”

Therefore, it should be realized that one of the prominent factors in the BEPS discussion is the enormous scale and pace in which business models are changing and in some cases radically flip as a result of the digital possibilities. With each radical and fundamental change in business models comes the challenge to keep pace and transform the way in which we deal with the legal, people, regulatory and tax issues. A number of different views exist on how to tackle the issue of taxation in the new digital economy. There are clear indicators of a move and transformation into indirect taxes. Not only a move towards the existing sales tax systems and VAT but going even further along the route of a “digital transaction tax”. Therefore, the outcomes of the OECD’s action 1: “Addressing the Tax Challenges of the Digital Economy” is of interest not only for the future of direct taxation but also for indirect taxation or a completely new form of tax altogether.

The report links to the 15 actions identified by the OECD to tackle BEPS. These actions are to be considered as the biggest expected change in the tax system since the 1920s and are meant to restore the fairness and integrity of the different tax systems and more generally the global financial system with the goal to have the fair amount of tax paid at the right place.

VAT and action 1

The OECD’s deliverable on action 1 addresses in the paragraphs 5.3, 6.3, 7.6 and 8.2.2 the BEPS issues with respect to VAT created by cross-border trading of goods/services that are magnified by the digital economy. The most challenging issues identified are:

- Remote digital supplies to exempt businesses and the remote digital supplies to Multi-location entities (MLEs). We believe these are mostly issues resulting from various current tax audits in the financial sector more than hard-core issues from digital businesses itself. Having the CJEU’s recent judgment in the Skandia America Corporation case in mind, it seems that within the framework of the EU VAT Directive the CJEU is able to deal with situations where there is a threat of non-taxation in case of MLE’s;
- Imports of low value parcels from online sales on which VAT is not always levied, and;
- The growth of cross-border digital supplies made to end customers, where it is difficult for countries to collect VAT on supplies made by non-residents. The borderless nature of the digital economy produces specific administrative issues around the identification of business, determining the extent of activities and tracking the supplies of digital services by non-resident vendors.

Collection of VAT

In our view, the most important issue for BEPS with respect to VAT lies in the latter bullet point here above with the location of a non-resident Vendor (or supplier) in a Business to Consumer (hereafter B2C) transaction. Especially where the vendor is located outside the EU and the consumer is within the EU. It seems that very few of the non-EU suppliers have effectively registered and declared their VAT (less than 1000 companies in the world have spontaneously registered on the EU portal) and it remains to be seen whether they will actually do so in the future. Some countries have suggested that it is currently impossible to track the supplies of digital services by non-resident vendors to private consumers altogether.

The main issue here is that an effective international framework to ensure VAT collection in the market jurisdiction is absent. The absence of an international standard for charging, collecting and remitting VAT to a large number of tax authorities creates large revenue risks and high compliance costs.

The OECD likewise stresses that cooperation between tax authorities on collection of taxes is key to cope with this challenge of the digital economy. In our view this is “THE” major concern of BEPS in a VAT environment. Failure to register by the non-resident suppliers and difficulties to track and get hold of the actual supplies taking place invalidates the VAT collection mechanism and creates possibilities for harmful and unintended VAT competition. In this respect the OECD also considers obtaining information from third parties such as the customers of these non-resident suppliers and payment intermediaries.

Solutions

Several options are considered for addressing the challenges raised by the digital economy. The options include lowering the threshold for low value imports and requiring vendors to register and account for VAT in the jurisdiction of importation or consumption. The draft also refers to requiring non-resident suppliers of remote digital B2C supplies to register and account for VAT in the customer’s jurisdiction as will be implemented in the European Union 2015 place of supply changes for B2C transactions.

It is remarkable that also creation of alternative (indirect) taxes such as a withholding tax on digital transactions in which financial institutions could play a role in collection thereof may be considered. The OECD also brings up the option of a bandwidth or bit tax, based on the number of bytes used by a website. A step further would be to align altogether with the financial streams and the way in which the digital economy operates for example by an automated withholding and remittance of a “digital tax” via the electronic payment means (e.g. integration of a withholding in a bitcoin or similar closed system).

Intermediaries

The growing C2C-economy where transactions between consumers take place are also a result of the digital economy. Enterprises take a role here as well, mostly as intermediaries, e.g. putting up a website consumers use to sell or rent assets such as residential property or cars. Unfortunately the OECD does not address the C2C economy as regards VAT. We believe that this is a missed opportunity. Particularly in the area of VAT the qualification of the services of an intermediary are difficult and the rules seem not to cope with the non-traditional types of intermediaries, such as the ones operating in the digital economy.

VAT impact for new definition of permanent establishment

Apart from the above specific VAT options, the draft mainly deals with the digital economy’s related direct tax challenges and solutions. Interesting points brought forward are modifications to the exceptions from permanent establishment status (e.g. for storage of goods being currently considered as a preparatory or auxiliary nature of activities), the introduction of the notion of virtual permanent establishment, the creation of nexus via a significant digital presence etc.

The introduction of new or changed concepts for direct tax and altogether new nexus rules based on mere “digital presence” could possibly bring up new interpretations of these concepts for VAT purposes (e.g. broader concept of VAT PE) but will inevitably impact the business mode of multinationals and as a result change the way in which they manage VAT and other indirect taxes as a result of this interaction. These changes will need to be properly reflected in the way they address supply chain issues and have set up their compliance, systems, invoicing and intercompany agreements. The OECD also aims for a greater consistency between direct and indirect taxes, potentially resulting in additional inquiries from authorities.

An important message we would like to share with you is although the discussion on BEPS seems to evolve around direct taxation, we believe there is a broader and more fundamental change taking place in the international tax system globally which should be seen in interaction with other taxes such as indirect taxes which could even result in introduction of a completely new type of tax. Reason enough for internationally operating companies and other stakeholders to follow this development closely.

VAT and the digital economy - Deloitte