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No. 332,  28 August 2020

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UN Tax Committee provides draft guidance on taxing the digitalized economy

A drafting group of developing country members within the United Nations Tax Committee (UNTC) have prepared a proposal on how to tax the digitalized economy. The proposal seeks to amend the UN Model Convention by introducing a new Article 12B which would tax income from Automated Digital Services (ADS) on either a gross basis or net income basis. The scope of the tax is wide, it is relatively easy to implement for developing countries, and contains certain carefully drafted anti-abuse provisions.

In a historic development, the United Nations (UN) Committee of Experts on International Cooperation in Tax Matters (UN Tax Committee/UNTC) has come out with a draft proposal on how the income of digitalized companies – which include tech giants such as Facebook, Amazon, Apple, Netflix and Google – can be taxed. As is well known, these companies have seen an increase in sales and subscribers during the COVID-19 pandemic, and their billionaire shareholders have reported record increases in wealth.
The draft proposal is of major significance as this is the UNTC’s first contribution to the ongoing global discussion on this topic. The modern economy has meant that firms can sell their digital goods and services in jurisdictions without needing to have any physical presence. This does not fit in with existing international tax rules, which require physical presence as the essential criteria for nexus or taxable presence. Hence, the 2015 Organisation for Economic Co-operation and Development (OECD)/Group of Twenty (G20) Base Erosion and Profit Shifting (BEPS) Project sought to reform and update international tax rules to close such loopholes and counter tax avoidance. Part of the agenda was taxing the digitalized economy examined under Action 1.
However, the negotiations on Action 1 over time expanded into a larger discussion on the re-allocation of taxing rights between source countries (which are largely capital importing and developing) and residence countries (which are largely capital exporting and developed). It also meant a re-examination of fundamental aspects of international taxation such as nexus and profit allocation. The OECD/G20 Inclusive Framework has been the key global forum where this negotiation is taking place, and thus far the UNTC’s role was limited to observing the proceedings and raising concerns.
This changed at the 20th Session of the UNTC. In the run up to the meeting, the Committee Member from India made an independent proposal on the taxation of the digitalized economy.[1] This laid out certain pertinent critiques of the “Two Pillar Approach” solution being discussed in the OECD/G20 Inclusive Framework. It contained an alternative approach, which essentially sought to narrow the scope to automated digital services (such as online advertising) and attribute profits through fractional apportionment taking revenue derived from the jurisdiction as the tax base.
Subsequently, during the 20th Session deliberations, a drafting group of developing countries was formed and mandated to propose an additional provision in the UN Model Tax Convention to deal with certain aspects of taxation in an increasingly digitalized economy. In record time of a month, the drafting group, which importantly included all 13 developing country members of the UNTC, came out with their proposal.
The drafting group’s cover note can be accessed here. The proposal, which can be accessed here, seeks to add a new Article 12B to the UN Model Convention. The aim of the new Article is to tax income from Automated Digital Services (ADS). The key features of this article are given below:
Broad definition of Automated Digital Services (ADS)
Para 4 defines “income from ADS” as “any payment in consideration for any service provided on the internet or an electronic network requiring minimal human involvement from the service provider.” The commentary goes on to give examples such as: Online advertising services; Online intermediation platform services; Social media services; Digital content services; Cloud computing services; Sale or other alienation of user data; Standardised online teaching services.
The commentary lays out important considerations for determining whether a service can be called ADS. These tests look only to the supplier of the service, without regard to any human involvement on the side of the user. These include:
  • user can obtain the service automatically, as opposed to requiring a bespoke interaction with the supplier to provide the service,
  • focus on provision of service and does not include human interventions in creating or supporting or maintaining the system needed for provision of service,
  • ADS would still apply where the provision of service to new users involves very limited human response to individual user requests and
  • whether there is ability to scale up and provide same type of service to new users with minimal human involvement.
Para 35 of the Commentary gives detailed explanation of the types of ADS. Para 36 goes on to give examples of those services that do not come under this category, as they are considered crossing the essential threshold of ‘minimal human involvement’. These include customized services provided by professionals and online sale of goods and services other than ADS.
The commentary recognizes there may be practical challenges in distinguishing between payments for royalties and services and refers to guidance from paragraph 12 of the Commentary on Article 12 of the UN Model Convention.
Covers B2B and also B2C
The scope of the tax extends to B2C transactions. The commentary states, “it cannot be disregarded that many multinational enterprises that rely on digital business models derive a very significant portion of income from the provision of automated digital services generally to individual consumers.”
However, it adds that using withholding tax mechanisms may be difficult to enforce and other collection mechanisms may be required. It says some jurisdictions “require non-resident providers to present a tax return where the tax obligation has been self-assessed and subject to examination by the tax administration. Other jurisdictions, instead, have the obligation to determine and pay the tax due by the non-resident provider, to the financial intermediary that individual consumers access to make the payments for the automated digital services involved.”
No threshold required
Importantly, Article 12B does not require any threshold, such as a permanent establishment, fixed base, or minimum period of presence in a Contracting State as a condition for the taxation of income from ADS.
ADS income deemed to arise where the payer is
Para 6 lays down the source rule that “in a Contracting State if the payer is a resident of that State or if the person paying the income, whether that person is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the obligation to make the payment was incurred, and such payments are borne by the permanent establishment or fixed base.” Hence, the income is deemed to arise where the payment has been made. The commentary adds that it is not necessary for the services to be provided in the Contracting State in which the payer is resident or has a permanent establishment or fixed base.
ADS income is taxable by the source state/Contracting state where the income has arisen. This can be done on a gross basis and also on a net income basis.
Taxation on gross basis
Para 2 of Article 12B establishes the primary right of the country in which income from automated digital services arises to tax those payments in accordance with its domestic law. It allows for charging a tax on a percent of the gross amount of the income. The precise percent is to be established through bilateral negotiations and enforced through a withholding tax. Accordingly, the country in which the recipient of the income is resident is obligated to prevent double taxation of those payments using the relief mechanisms provided under Article 23 (credit or exemption method).
Taxation on net income basis
Para 3 gives the beneficial owner of the income from ADS the option to be taxed on its “qualified profits” for a net basis annual taxation. Qualified profits is defined as 30% of the amount arrived at by applying overall profitability of the beneficial owner or the profitability of its ADS segment, if the same is available, to the gross annual revenue derived from the Contracting State where such income arises. If the beneficial owner belongs to a multinational group, the profitability ratio to be applied shall be that of such group, or of its ADS segment, if available.
The profitability ratio of the beneficial owner or the multinational group to which the beneficial  owner belongs, is understood to be the total annual profits divided by the total annual revenue, as revealed by the consolidated financial statements of the beneficial owner or of the group it belongs, or of the ADS business segment, as the case may be.
To prevent abusive tax planning, the beneficial owner’s qualified profits can be considered as the higher among: (i) the group’s overall profitability ratio (ii) the beneficial owner’s overall profitability ratio, and (iii) the beneficial owner’s profitability ratio of the ADS business segment.
The net income shall be taxable at the tax rate provided in domestic law of the Contracting State. Taxes withheld at source, if any as per gross basis taxation, would be taken into account against the tax liability determined on net basis.
Focus on beneficial owner to address tax avoidance
Article 12B emphasizes the “beneficial owner” of the income from ADS rather than simply the entity receiving the payment. This is to bypass conduit companies and tax havens used for tax avoidance purposes. An important aspect of being a beneficial owner is their ability to “use and enjoy” the income. Conduit companies are typically constrained by a contractual or legal obligation to pass on the income received to another person and hence will be eliminated through this requirement.
The commentary on para 2 emphasizes that the concept of beneficial owner is not a solution to all forms of tax avoidance and hence does not restrict in any way the application of other approaches to addressing such cases.
Author: Abdul Muheet Chowdhary is Senior Programme Officer with the South Centre Tax Initiative (SCTI), part of the Sustainable Development, Climate Change and Gender (SDCCG) Programme of the South Centre.
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