As digital transformation makes it increasingly common for companies to enter markets in jurisdictions where they may have relatively little or no physical presence, international tax rules struggle to evolve.
Digitalization is changing the way companies operate and is rapidly changing the tax environment. New tax requirements (both indirect and direct) aim to ensure that taxes are collected at the point of consumption, but it is often difficult for businesses to keep track of rules where customers are located.
The purpose of the VAT rules aimed at the digital economy are to create equal conditions of competition between services purchased in the country and services offered remotely, so that a consumer does not receive a price reduction just by purchasing certain services from abroad or a company does not receive an unjustified benefit, simply for settling abroad, however, policymakers often focus more on whether digital companies pay their fair share of taxes on their country than in having equal conditions of competition.
Policymakers around the world have started the journey of taxing the digital economy through indirect tax systems such as Value Added Tax (VAT) or Goods and Services Tax (GST). Five basic principles have been established in the International VAT/GST guidelines of the OECD:
- digital companies must be taxed through indirect taxes on the same basis as traditional companies to ensure a level playing field;
- indirect taxes should be applicable and levied in the jurisdiction where the relevant goods or services are consumed;
- if the digital service provider is not located in the jurisdiction where the consumption takes place, it should be required to register and satisfy VAT in that jurisdiction;
- the widespread use and ease of online shopping mean that the exemption thresholds at the VAT collection threshold, which result from consumers buying low-value goods online from abroad, should be lowered, readjusted, or even abolished; and
- in many jurisdictions, the obligation to collect and provide VAT could be imposed as an administrative measure on the digital platform instead of sellers whose goods or services are sold on the platform and brought under the jurisdiction of the consumer.
These principles were intended to be consistent with and give practical effect to the laudable objective of taxation of final consumption expenditure at the consumer’s location. However, policymakers urged on taxing everything and everyone, when simply sometimes the traditional economy and the digital economy’s approach to taxation are not compatible.
Certain trends and activities have led to the taxation of what is sold in the digital space, although there is a special treatment for similar products and services in the traditional economy. This may be because policymakers do not consider the two types of delivery equivalent or it may be because policymakers are trying to adjust their rules to create equal business models for the digital economy, that compete with the traditional economy. Aligned with this, we have observed that the concept of digital services has evolved and gradually the VAT scope was expanded.
The change in business models also brings more events and activities under the VAT digital service scope. Initially, Tax Authorities introduced measures for the taxation of digital services. The understanding of what was (or was not) within the scope of digital services varied from jurisdiction to jurisdiction. However, in 2006, when the European Union (EU) introduced the concept of electronically provided services, the EU’s requirements influenced policymakers around the world. The main features of those key measures were:
- digital services were those that were provided with little or no human intervention and that was not possible without the use of information technology;
- digital services included downloadable digital content and software, subscription-based streaming and other media content, web hosting, cloud storage, pre-packaged distance learning, and virtual classrooms (where human intervention was minimal);
- the exceptions concerned only digital transmission or the supply of traditional services;
- there were exceptions to distinguish the online booking service from the underlying good or service provided, such as restaurant service, event ticket, car rental, accommodation reservation, etc.; and
- there were exceptions namely concerning telecommunications and advertising services, as these services were subject to a specific place of supply rule.
Since then, there have been three main developments that have led to a significant change in the boundaries of digital services subject to VAT. First, the distinction between digital and non-digital services has become significantly more difficult due to technological and product developments. Second, some countries have tried to redraw the boundaries between digital and non-digital services or, even worse, have created extremely broad definitions without considering all possible functions. Third, countries like Australia, New Zealand and Singapore decided that the whole concept of digital services should not be the cornerstone of non-resident taxation and instead began to tax remote services (basically the term remote services ensures that the supply of resident consumers from abroad to the jurisdiction falls within the VAT scope).
Under this new design, all remote services rendered cross-border (B2C) are potentially taxable and the only real protections are the minimis registration thresholds, exemptions and zero-rating. Consequently and here is the riddle, on one hand, the taxation of all remote services leads to the final consumption of households in accordance with the general VAT principle, but how can this interact with the tax policy of neutrality, efficiency, consistency, simplicity, efficiency, and fairness of VAT treatment?
An increasingly important issue is the need to determine whether a remote service is relevant to the consumer, in other words, when buying a package of rights, it is getting more difficult to understand, in practice, whether the consumer is paying for a remote service or a traditional service delivered remotely.
For example, think about the FinTech industry that uses technology to challenge and offer alternatives to the traditional financial services industry, which in most jurisdictions are exempt financial services from VAT, for economic reasons (additional costs or already taxed by other national taxes) and because the calculation of VAT on exempt financial services can be difficult.
As FinTech companies have financial services and digital components, policymakers are challenged to decide whether FinTech services should be treated as VAT-exempt financial services or taxable digital services.
For instance, in many mature VAT jurisdictions, most payment processing services would not be VAT-exempt financial services because they are unlikely to fit within the strict definition of exemption. Even in the EU, which has broader VAT exemptions for financial services, the VAT Committee reached the same conclusion. However, payment processors are now a crucial part of the digital business ecosystem and the average consumer views them as performing the same functions as traditional financial service providers. As a result, policymakers will likely need to examine the scope of the VAT exemption for financial services.
This review becomes even more critical as technological tools become necessary for the delivery of many financial services, such as stock trading, investment decisions and lending decisions. In this sense, traditional definitions of financial services may no longer apply. The European Court of Justice (ECJ) seems to have recognized the issue, as it opened the door for certain software services to be eligible for VAT exemption regarding the management of special investment funds, but until policymakers address the evolving technology and the different VAT treatment, FinTech services will continue to be subject to more indirect taxation than competing services in the traditional economy.
In short, the VAT initiatives regarding the taxation of the digital economy are growing from a marginal part of the country’s indirect tax system to an important, material and, with time, perhaps even a dominant part.
Nuno Jacinto
April 2023