A Slice of the Digital Pie
Discussions about what governments want from digital corporations and what they can do about it.
A century ago corporations operated close to target markets to gain easier access to their customers. That is changing today, thanks to the internet. Through the infrastructure of the web, a business need not set up shop in the markets they service. The platform business model enables this structure.
Platform businesses facilitate interactions between multiple participants. Andrei Hagiu, (an Associate Professor of Information Systems at Boston University) refers to them as multisided platforms. He defines them as technologies, products, or processes that create value primarily by enabling direct interactions between two or more customer or participant groups. Imagine for instance the number of participants product platforms like Alibaba, Amazon, and eBay bring together, or asset sharing platforms like Uber and Airbnb.
With Amazon, for instance, the traditional business model would involve manufacturers listing their products in physical locations of store owners. However, with Amazon, buyers and sellers meet under one platform (over the web) that facilitates the exchange. The reward for facilitating this exchange is a commission from sales.
There are other revenue models used by platforms besides commission on sales. However, that is not the focus of this article.
Aleksandra Bal, a Senior Product Manager at Vertes Inc., has classified platform businesses into product platforms, service platforms, asset-sharing platforms, communication platforms, social media platforms, development platforms, and search platforms.
In these platforms, there are usually two or more players. We have the host of the platform, the customers and the users. The platform business operates in such a way that more value is derived by having more users and customers (termed "the network effects"). For instance, Facebook’s impressive number of active monthly users grew from 608 million in December 2010 to 2.23 billion in June 2018. Within that timeframe, Facebook’s advertising revenue grew from USD 655 Million to USD 13.038 billion. The reason advertisers are drawn to Facebook's platform is because of the large number of users to market their products.
Governments are increasingly interested in the platform business model especially because participants of the platforms come from their countries where the platform owners possibly have no physical structure. The current international tax rules operate in a way that without a physical structure in a country, a corporation is not subject to tax there. For instance, in the second diagram above, income Operating Co. receives from State B is not taxed there. State A taxes it. Although we can see a Local Sub in state B, its only business purpose is maintaining a warehouse for temporarily storing goods for onward delivery to customers. Under international tax rules, this function on its own is insufficient to make Operating Co. considered as doing business in State B.
State A has a preferential system of taxing entities like Sub 1. When Sub 1. Sublicenses the IP to Operating Co., Operating Co. gets a deduction of license fees from revenue made from State B online purchases. However the income at Sub 1. Level gets taxed at a low rate. Assuming Sub 1. licensed the same IP from Parent Co., the income received from Operating Co. is subject to a further deduction. If Parent Co. operates in a high taxed jurisdiction, there is more incentive to assign the IP to Sub 1 because Sub 1 will not have to pay license fees that will be subject to high taxes. Looking at the overall picture, the multinational enterprise's global revenue will have a lower effective tax rate by shifting income away from high taxed jurisdictions and putting the income in low or no taxed jurisdictions.
Going back to the above diagram the question governments around the world want to resolve is who gets to tax the resulting revenue from operating a platform business. Is it Parent Co.’s country where the company is registered? State A where Sub 1 is registered and owns the IP used in operating the platform? Or State B where the customers and users are resident?
In 2015, the OECD released a report on taxation of the digital economy. The report was part of 15 Action items designed to curb what is termed "Base Erosion and Profit Shifting" (BEPS). BEPS means actions taken by multinationals to leverage on the weaknesses of international tax rules by shifting profits from high taxed jurisdictions to low or no tax jurisdictions where they have little or no business activities. Countries expected that the OECD would address the physical presence requirement which is lacking for digital corporations. However, that was not the case. The OECD's focus was on tax avoidance strategies like for instance ensuring that maintaining a warehouse constitutes doing business where it is a core function in a corporation's business model.
Note that the question of taxation based on physical presence has to do with what country has the right to tax. Using the diagram above, if we say there is no physical presence in State B, it means business income isn’t taxable there. However, if countries decide to take the maintenance of the warehouse as constituting physical presence, it means that the business income resulting from sales to Country B residents is taxable in country B. Governments around the world want more than physical presence as a basis of taxation because digital platform corporations can easily circumvent it. For instance, the platform can operate in such a way that the products are not physical goods that need storage. In that case, Operating Co. can sell directly to country B residents.
The OECD has noted that countries could implement safeguards to avoid erosion of their tax base by digital corporations as long as they observe their international obligations under treaties. For instance, implementing a significant digital presence can make an entity taxable in a state regardless of whether it has a physical location there. Other safeguards include withholding tax on certain digital transactions or an equalization levy which is currently implemented by India. In India, resident persons are required to withhold 6% of gross payments ("an equalization levy") made to non-resident entities.
Country responses to platform businesses
Countries are implementing the safeguards discussed above in their local laws in two ways. The first is by expanding the meaning of doing business by introducing concepts like "significant digital presence" or "significant economic presence." The second i