Taxation of E-commerce – Needs Multilateral Approach!

Introduction:

 The advent of e-commerce was resulted in significant changes in the way in which multinational companies operate in the business. Because of the rapid development of communication, multinational companies can make decisions as a real-time access to information and perform marketing, ordering, and delivering services through the Internet. Additionally, the increasing use of intranets facilitates faster and better flows of information within organizations. However, the removal of geographical boundaries due to e-commerce raises the question as to how to allocate the functions of gathering and disseminating information across different organizations and parts of organizations located in different jurisdictions.

 It is also possible to be heavily involved in the economic life of another country, e.g. by doing business with customers located in that country via the internet, without having a taxable presence therein (such as substantial physical presence or a dependent agent). In e-commerce non-resident taxpayers can derive substantial profits from transactions with customers located in another country, questions are being raised as to whether the current rules ensure a fair allocation of taxing rights on business profits, especially where the profits from such transactions go untaxed anywhere.

 Governments and international institutions are now considering how to tax the digital economy. They intend to formulate new tax rules which would expand tax jurisdiction, so that e-commerce firms that are not physically present in a India have to pay their 'fair share' of tax. Activities covered by the legislation could include: gaming; music; video; and e-books. It could include services that are paid by consumers and through advertising. The changes are likely to focus on business-to-consumer activities, but the principles would also apply to business-to-business activities. An attempt was made in Union Budget 2016 in the form of equalization levy for collection of taxes from e-commerce firms. At this scenario this article proposes solutions for taxation of e-commerce namely: the formulary apportionment approach, the base erosion approach, and the multi lateral approach. However this paper will not further elaborate on solutions, it rather identifies the issues at present, and as a result emphasizes the need to move on from the status quo.

 (i) The Case for Formulary Apportionment (F.A) :

 A formulary system divides some of the income of a business group among tax jurisdictions according to the relative volume of the group's observable income-producing activities within those jurisdictions. Under formulary apportionment the income of a group is measured on an aggregate international basis, and is then divided among the different group members according to measures of their relative levels of economic activity, such as perhaps their relative level of sales. The formulary approach would substitute for the current practice of attempting to measure each entity's income on a separate accounting, or arm's-length, basis, an exercise which requires attempts to estimate arm's-length prices for the many transactions that typically occur among the different members of contemporary multinational groups. The formulary principle may be implemented in many different ways. Versions of it are employed to allocate taxing rights over companies between the states of the United States and the provinces of Canada.

 The Canadian system generally divides companies' income among the provinces according to a two-factor formula. Equal weight is given to sales volumes and payroll expenses. The tax obligation of a company to any one provincial government is determined by the proportion of total company sales and payroll costs that is made in that province. The formulas historically employed by some US states involve sales, payroll expenses and the value of plant and equipment. Many US states now, though, use only a single factor - sales. Any variant of formulary apportionment involves a degree of arbitrariness in the allocation of corporate income between the company and the tax collectors, and between different taxing jurisdictions. The core reason for considering a formulary approach is prevention of tax avoidance. Currently the complexity of arm's-length pricing has permitted many multinational groups to shift substantial amounts of taxable income through what the OECD has labelled 'base erosion and profit shifting' (BEPS), to zero- and low-tax countries where the multinationals conduct few if any business activities. Under a formulary system this would not be possible, as income could be apportioned only according to real and observable economic activities. Apart from considerations of tax avoidance, a formulary system could remove a good deal of subjectivity from the workings of the international tax rules, thereby providing greater economic certainty to taxpayers and governments. Under the arm's-length transfer pricing rules now in use around the world, income is apportioned according to multinational groups' own estimates - which are subject to review upon examination by tax authorities - of the levels of income that would be earned by the different affiliates of commonly-controlled business groups if those affiliates were not commonly controlled, but instead operated in the manner of independent companies transacting with one another at arm's length. In practice under arm's-length transfer pricing rules groups estimate the proper division of income among their affiliates based on often-elaborate analyses by professional economists, according to the economists' perceptions of the different income-producing activities performed, assets owned, and business risks borne by the groups' affiliates in the countries in which the affiliates operate.

 Accounting barriers to formulary apportionment:

 Formulary apportionment will place large and novel accounting demands on corporate taxpayers, as well as on the agencies that must audit their tax returns. These demands arise largely from the fact that each country has unique rules for translating taxpayers' 'book' (i.e. financial statement) income into taxable income. To determine a taxpayer's local taxable income, a national tax authority will need a measure of the taxpayer's global income - the income earned by the taxpayer from all sources around the world - that has been translated into taxable income according to the locally-applicable tax accounting rules. For example, if a taxpayer conducts business in ten different countries, and all of those countries have adopted formulary apportionment, the taxpayer might need to make ten separate translations of its global book income into taxable income under the different tax accounting rules of all ten countries. This task is complicated by the fact that translating book into taxable income typically requires a detailed transaction-by-transaction look at the taxpayer's activities, since tax accounting rules are often activity-specific (e.g. requiring acceleration of income for long-term construction contracts, or mark-to-market accounting for some holdings of investment instruments). The need for multiple book-to-tax translations might not be as prohibitive a barrier to formulary apportionment as it might initially appear to be. Multinational groups almost certainly already collect all the information necessary to accomplish the translations in their accounting databases; gearing up to conduct the translations therefore might amount primarily to an exercise in computer programming, albeit an expensive one. Although categorising some transactions under the applicable rules will require human judgment, the translation process should remain primarily electronic and over time companies would likely learn to accomplish the task reasonably smoothly. After companies surmount the learning curve, the cost of the accounting needed for formulary apportionment might end up being less than is now required to implement, document and defend a group's transfer pricing under arm's-length rules. For the new accounting practices required for formulary apportionment to be developed, however, companies will need to commit willingly to the necessary work. A less-than-full commitment is likely to cause endless breakdowns in the accounting system and delays in successful implementation of the formulary system. Accordingly, the adoption of formulary apportionment on a widespread basis will probably need to wait until much greater support develops for it among business leaders. An alternative means of dealing with the complexities of book-to-tax translations under formulary apportionment would be for the countries of the world to adopt a largely uniform tax base. Taxpayers doing business in multiple countries then generally would need to convert their combined global book income into taxable income only once, just as is required today in each country under arm's-length transfer pricing rules. Countries might even, in connection with the adoption of formulary apportionment, take the step of adopting book-tax conformity - conforming their tax accounting rules to financial accounting rules - thereby achieving many simplifications to their tax systems in addition to smoothing the route to formulary Substantially greater uniformity among countries' tax accounting systems - even to the point of book-tax conformity - seems politically unlikely unless a great deal of support arises around the world for a formulary apportionment regime. The many differences among contemporary tax accounting regimes have tended to arise from local political considerations, and might be politically quite difficult to modify. Moreover trying to establish a global norm for tax accounting might be perceived by some countries' governments as infringing on their flexibility in lawmaking, and even on national sovereignty. In sum, of the major concerns typically raised against formulary apportionment, the need to simplify translations of book into tax income constitutes the largest practical impediment. The political will necessary to overcome this obstacle is not evident today, so the sensible course of action, as the OECD is to defer attempts to implement full-scale formulary apportionment and instead to draw on various potential remedies for BEPS, some of which are derived from principles of formulary apportionment, in order to assist countries in controlling base erosion within the overall framework of existing transfer pricing rules.

 (ii) The Base Erosion and Profit Shifting (BEPS) Approach:

 Base Erosion and Profit Shifting is a tax planning strategies that make use of the gaps and mismatches in the tax rules of a particular country to shift profit to countries having low- or non-tax policies through manipulation, resulting in little or no overall corporate tax being paid. It is a technique used by multinationals companies to avoid paying taxes in a country by under-stating the taxable profit, thus ending up paying less tax on the profit than it should have been. The BEPS Project is OCED sponsored endeavor to address the tax-avoidance practices of multinational corporations. In July 2013, a BEPS Action Plan was endorsed by the G20 which identified 15 key areas to be addressed by 2015. The OECD work related to BEPS is based on this action plan to equip governments with domestic and international instruments to address the challenge. Out of these fifteen Action Points, nine of them are on substantive issues, and six are aspects of coordination or procedures. The latter include, first a study on the Digital Economy, which will in effect be a check on whether the other action points can deal effectively with this issue, perhaps supplemented by indirect taxes. Another is the collection of better data on the extent of international tax avoidance. Two more concern transparency: the development of model provisions for disclosure of `aggressive tax planning' strategies and improving transfer pricing documentation requirements. To help deal with conflicts between states, it is proposed to strengthen the `mutual agreement procedure', probably by introducing compulsory arbitration, although this has been resisted until now especially by developing countries. Indeed, if there is little clarity or agreement on the rules to be applied, referring disputes to arbitrators to decide would be unhelpful, and perhaps dangerous. Further, the secrecy of these procedures undermines their legitimacy, and creates public distrust and suspicion of private deals by revenue authorities with big business. Finally, and most ambitiously, a group of international lawyers will develop a multilateral instrument, as a means of more rapid implementation of proposals which would otherwise require renegotiation of many bilateral treaties. While this is potentially far-reaching, this idea is legally problematic. It would also act as a brake on developing radical proposals, since such a treaty would have to be accepted by states, so its content would tend to the least common denominator. Of the nine substantive action points, the first group of four aim to establish coherence of international tax standards and concern issues on which the CFA has done little or no previous work. First is `hybrid mismatches': entities (e.g. corporations) or instruments (e.g. bonds) which have a different legal status in different countries, thus allowing entities to be dual resident, or instruments to be treated differently, e.g. as debt in one country and equity in another.

 BEPS frameworks which are relevant for e-commerce sector are:

•  Action Point No.1 - Address tax Challenges of Digital Economy
• Action Point No.2 - Neutralize Hybrid mismatches
• Action Point No.3 - Strengthen CFC Rules
• Action Point No. 5 - Countering Harmful Tax Practices More effectively, taking into Account Transparency and Substance
• Action Point No. 6 - Preventing the Granting of Treaty Benefits in Inappropriate Circumstances
• Action Point No. 14 - Compulsory Arbitration
• Action Point No. 15 - Multilateral Instrument
• The issues surrounding BEPS are universal in the generic sense as it applies to all countries around the world. Some issues, however, might be limited to regional regimes based on certain chief characteristics of transactional structuring or tax administrations. India's concerns to the issue of BEPS is primarily two fold, i.e., safeguarding its own revenue interests with respect to profit shifting by Indian multinationals and effectiveness of the tax administration to check (and recover) taxation revenues from cross-border and offshore transactions having an integral connection to India.

 (iii) Multilateral Implementation :

 From a governance perspective, extraterritorial tax enforcement as proposed in the present paper, and considering the aforementioned transfer pricing approach, could be achieved internationally in different ways. In general, a multilateral action seems beneficial as it would lower the risk of juridical double taxation significantly and would also likely reduce the overall compliance costs of the enterprises of the digital economy. Considering such a multilateral action, following section will throw some light on difference between potential multilateral hard or soft law instruments.

 (a) Hard Law:

 States could consent through a multilateral convention, i.e. a binding hard law instrument, to shift part of their enforcement sovereignty with regard to the taxation of the digital economy as proposed in this paper to other states. As a consequence, through such a hard law instrument certain states would also face the legal duty to collect taxes on behalf of other states.

 A multilateral binding instrument would need to contain provisions with regard to the concrete procedure of the proposed extraterritorial taxation. For instance, it should also contain specific rules stating if and in what manner the state collecting the taxes should be remunerated for its services. Furthermore, it should provide for safeguarding provisions to ensure, inter alia, that the exact amount of taxes is actually collected and in a timely manner distributed among the participating states. Importantly, it should also be regulated in which jurisdiction a taxpayer could appeal against an assessment.

 The efficiency of such an instrument depends on various factors. For instance, it relies on the possibility of exchange information in order for the participating states to control the appropriate application of the consented provisions. The introduction of such binding hard law instrument could potentially also be combined with an arbitration clause in case states cannot agree on either the exact income calculation or the applicable allocation key.

 If a hard law instrument is chosen, it needs to be considered that the development process (i.e. multilateral negotiations and domestic ratification processes) might take years and could trigger difficult interpretation issues if certain states implement other measures to tax the income of the digital economy in the meantime.

 (b) Soft law :

 Through a global forum (or the OECD/G20) and using soft law recommendations states could try to achieve an efficient implementation of the aforementioned transfer pricing recommendations would therefore relate to the actual procedure of the collection of taxes and also elaborate the distribution mechanism of the collected taxes among the participating states.

 However, compared to other areas of international tax coordination such as the fight against harmful tax practices, the aforementioned transfer pricing approach and the extraterritorial tax collection as proposed in the present paper require a highly technical international coordination. One would need to further elaborate whether soft law might indeed be the right instrument in this regard.

 Furthermore, the fiscal revenue amount at stake is large so states might prefer having a normative base that could also allow them to potentially appeal at the level of the International Court of Justice (ICJ) or at an arbitration court in case a state is blocking taxes collected on behalf of other states or miscalculating the taxes to be paid to another state. Also, the implementation of an extraterritorial taxation derived from a traditional understanding of tax sovereignty seems to require a hard law instrument.

 Conclusion:

 Various alternatives have been proposed to tax e-commerce transactions. It is essential for e-commerce companies to understand the definition of a permanent establishment under a state's domestic law because, unless a state has the right to tax a non-resident under its domestic law, it cannot tax the non-resident by virtue of any double tax treaty. Hence, before there can be any taxation of a non-resident's business profits, the non-resident must have a taxable business presence in the host state under the host state's domestic law. If governments can't find multilateral solutions, there's a risk that technology-importing countries will apply their own domestic solutions. These could violate their international obligations and potentially trigger major tax litigation cases.

Source : Thru CA Bhupendra Shah, [email protected], in GlobalindianCAs