Can global and local tax regulations catch up with the digital economy to ensure it pays its fair share of tax, without stifling growth?
By Abdul Razak Rahman
Where taxation of digital businesses are concerned, there is no single universally accepted method despite the relentless efforts of agencies like the Organisation for Economic Cooperation and Development (OECD) and governments including Malaysia that wish to get their fair share of tax revenue.
Here in Malaysia, Section 3 of the territorial Income Tax Act (ITA) states that income tax is charged on income ‘accruing in or derived from Malaysia or received in Malaysia from outside Malaysia’. Section 12(1) of the ITA further states that gross income from a business that is not attributable to the operations of the business carried on outside Malaysia shall be deemed to be derived from Malaysia. How then should these principles be applied to e-commerce transactions, when the business is everywhere and nowhere at the same time?
The Inland Revenue Board Malaysia (IRBM) in the Guidelines of Taxation of Electronic Commerce has defined e-commerce as ‘any commercial transactions conducted through electronic networks including the provision of information, promotion, marketing, supply, order or delivery of goods or services though payment and delivery relating to such transactions may be conducted off-line’. Interestingly, the IRBM also makes it clear that location of server or website is not a determinant whether the individual is taxed or not. Instead, income from e-commerce is regarded as derived from Malaysia if the business operations test shows that the business is carried on in Malaysia.
“In determining the taxability of e-commerce businesses, the concept of Permanent Establishment (PE) and the business income attributable to the PE is of great importance,” remarked Vijey M. Krishnan, Partner, Tax Practice Group of Raja, Darryl & Loh. “The traditional definition of PE is very much physical-based and generally refers to the nexus, an office or a branch where the business is conducted or as a place of management.”
“Storage facilities or a place that merely display products do not constitute a PE and therefore any business income arising from e-commerce transactions derived out of such premises will not be subject to tax,” Vijey explained. “The challenge then is dissecting complex e-commerce transactions since the tax implications should follow the terms and conditions, and the substance of the e-commerce transaction. Important information such as beneficiary of payment, purpose of payment and role of the recipient, either as agent or facilitator, need to be established in order to have the correct tax treatment.”
Global Developments in E-Commerce Taxation
The BEPS (Base Erosion Profit Shifting) Action 1 report acknowledged that because the digital economy is increasingly becoming the economy itself, it would be difficult, if not impossible, to ‘ring-fence’ the digital economy from the rest of the economy for tax purposes.
In the area of direct taxation, the main policy challenges fall into three broad categories. First and foremost, the continual increase in the potential of digital technologies and the reduced need for an extensive physical presence in order to carry on business raises questions as to whether the current rules to determine nexus with a jurisdiction for tax purposes are appropriate. Second, the sophistication of information technologies has permitted companies to gather and use information across borders, which has led to difficulties in attributing value created from the generation of data through digital products and services. Lastly, the development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation of payments made in the context of new business models.
International tax disputes related to e-commerce such as Flipkart’s disputes with the Indian Inland Revenue also warrant attention in formulating digital tax regulation. Flipkart, India’s equivalent of Amazon, was selling products at a loss but the Indian Inland Revenue argued that the discounts and marketing expenses were not tax expenses but incurred to create intangibles and market share, which is crucial for the e-commerce sector. The expenses were reclassified as capital expenditure resulting in profits for Flipkart.
New legislations were also introduced in other countries such as UK’s Diverted Profits Tax, India’s Equalisation Levy and Australia’s Multinational Anti-Avoidance Law to enable tax authorities to extend their territorial scope because of the fluid nature of e-commerce businesses.
Ensuring E-Commerce Pays Its Fair Share of Tax
Despite the strong growth in the digital economy, its tax contributions are still low compared to the traditional economy. In the European Union countries for example, the corporate tax rate in 2017 for the digital economy averaged between 8.5% to 10.1%, compared to the traditional businesses that paid between 20.9% to 23.2% tax. Malaysia is experiencing the same issue; therefore, there is an urgent need to review the tax mechanisms to enhance tax revenue contribution from the digital economy sector. “Malaysia has seen a gradual increase in the contribution of e-commerce revenue to GDP from 5.9% in 2015 to 6.1% in 2016 and this is expected to grow. The revenue from the e-commerce sector amounted to USD1,078 million in 2017 and is expected to grow at a CAGR (compound annual growth rate) of 18.6% by 2022,” projected Abdul Aziz Kechik, Director, E-commerce Division, IRB Malaysia.
The fact that the digital economy transcends both the residence and source taxation rules makes it difficult for tax authorities to enforce tax compliance. Daniel Woo, Head of Tax Advisory and International Tax, Grant Thornton Malaysia said: “There is a great challenge in applying the PE concept in tax treaties since it has allowed enterprises to sell their products directly to consumers without establishing their presence in the said countries. Scientific innovations and emerging technologies such as internet of things, digital currencies, advanced robotics and 3-D printings will continue to push the digital frontier.”
Daniel added that under the source taxation rules, which are applicable to Malaysia, a source country may only tax a foreign person if he or she participates to a significant extent in its economy in accordance with the PE rules. Applying international tax rules, source taxation may not be warranted in the digital economy as a business’s principal participation in the source country in supplying of goods and services to local customers is not sufficient to constitute source taxation jurisdiction.
BEPS Action 1 – Possible Solutions
One of the recommendations put forth by the BEPS Action 1 committee to resolve digital taxation issues is to apply withholding tax mechanisms when the physical presence rules in establishing PE are broken. The withholding tax mechanisms can be used to broaden the scope of what is ‘derived in Malaysia’ via deemed derivation. If the withholding tax approach is adopted, the right classification of the income is important, either as royalty, technical fees, or gains or profits under Section 4(f). “In introducing the withholding tax mechanism, the rate should not be too high as it will affect the cross-border businesses or create an incentive for tax evasion. Neither can the rate be too low as it will become an elective toll charge,” commented Daniel.
However, BEPS Action 1 does not define the digital economy and therefore it would be a challenge for tax authorities to impose withholding tax on payments relating to digital transactions. Unclear definitions may impose a heavy burden on the withholding tax agents to comply, resulting in an overly prudent approach in withholding taxes that could eventually hinder the digital economy’s growth.