A Withholding tax on digital transactions

A withholding tax on payments by residents (and local PEs) of a country for goods and services purchased online from non-resident providers has also been considered. This withholding tax could in theory be imposed as a standalone gross-basis final withholding tax on certain payments made to non-resident providers of goods and services ordered online or, alternatively, as a primary collection mechanism and enforcement tool to support the application of the nexus option described above, i.e. net-basis taxation. Both approaches raise similar technical issues with respect to the scope of transactions covered and the collection of the ensuing tax liability. In addition, the application of a standalone final withholding tax raises specific challenges regarding trade obligations and EU law.

1. Scope of transactions covered

The scope of transactions covered by the tax must be clearly defined, so that taxpayers and withholding agents will know when the tax applies, and to ensure that tax administrations will be able to ensure compliance. The scope should also be defined as simply as possible in order to avoid unnecessary complexity and classification disputes. The need for clarity and simplicity, however, must be balanced against a need to ensure that similar types of transactions will be taxed similarly, in order to avoid creating incentives for or against particular ways of structuring them.

For this purpose, although listing specific types of transactions covered would provide a degree of clarity, it would also likely result in disputes over the character of transactions, particularly as technology continues to advance. Such an approach also could lead to differences in treatment for tax purposes between economically equivalent transactions depending on their form. For this reason, a more general definition of covered transactions appears more appropriate. The tax could be applied, for example, to transactions for goods or services ordered online (i.e. digital sales transactions), or to all sales operations concluded remotely with non-residents. The latter would have the advantage of flexibility, and would ensure tax neutrality between similar ways of doing business, and may reduce disputes over characterisation. In addition, if withholding is used as a tool to support net-basis taxation, a broad scope covering all distance selling would be more consistent with the sales threshold discussed above in the context of a nexus based on significant economic presence.

2.   Collection of the tax

In practice, the liability to pay a withholding tax on outbound payments is often shifted from the non-resident enterprise to a local collecting agent, such as the customer or a third-party payment processing intermediary. For such a mechanism to function efficiently, the agent responsible for withholding must have access to information about the covered transactions sufficient to know when the tax will apply, and must be reasonably expected to comply with its obligation to withhold.

In the case of B2B transactions, businesses resident in the source country may reasonably be expected to comply with the withholding obligation. In the case of B2C transactions, however, requiring withholding from the payor would be more challenging as private consumers have little experience nor incentive to declare and pay the tax due. Moreover, enforcing the collection of small amounts of withholding from large numbers of private consumers would involve considerable costs and administrative challenges.

One possible solution would be to require intermediaries processing the payment to withhold on the payment in a B2C context. As a practical matter, however, this presents several technical issues. For example, an intermediary would generally not have access to transaction-identifying information enabling it to determine its character and hence the amount of tax due. In practice, it would only see a value without any description of the underlying transaction, in which case it would not be able to determine with sufficient certainty when it was required to withhold. The task of the intermediary could be facilitated if the collection regime is supplemented by a mandatory registration system for non-resident enterprises whereby all remote sellers of goods and services must designate a dedicated bank account for all payments received from local customers. In the latter situation, intermediaries may be required to withhold the tax only for payments made to these specific bank accounts. However, the application of this approach may pose challenges in imposing compliance obligations on intermediaries that are situated in third-countries with no connection to the jurisdiction of the customer, thereby creating opportunities for tax avoidance strategies.

3.  Negative impact of gross-basis taxation and relationship with trade and other obligations

The initial development and hosting of the technology required to provide products and services online typically requires substantial up-front investment of resources, including labour and capital. After initial creation of the technology, however, providing products and services online frequently requires only limited marginal costs for businesses. Where this is the case, it has been argued that payments made in consideration for digital goods or services share common features with royalties and fees for technical services, i.e. that gross revenue is a reliable proxy for net income. In many businesses, however, providing products and services online will require ongoing expenditures for continued product development (including maintenance of products and addition of new features), marketing, and ongoing customer support due to rapid product cycles as technology and competition evolve. Where this is the case, imposition of withholding tax on gross revenues will be an imperfect proxy for tax on net income. One potential way to reduce the negative impact of gross-basis taxation would be to fix the rate at a relatively low amount that would reflect typical profit margins. Such margins could be determined, for example, on the basis of a statistical analysis of actual profit margins of local domestic taxpayers operating in the same specific class of industry or type of business.

Assuming that domestic suppliers of similar products are subject to net-basis taxation, the imposition of a standalone gross-basis final withholding tax on foreign suppliers for remote sales of goods and services is likely to raise substantial conflicts with trade obligations and EU law. Trade obligations may differ substantially depending on whether a particular digital transaction is treated as involving a product, in which case the General Agreement on Tariffs and Trade (GATT) would apply, or a service, in which case the General Agreement on Trade in Services (GATS) would apply. Both agreements generally require foreign suppliers of goods (in the case of GATT) and services (in the case of GATS) to be taxed no less favourably than domestic suppliers. However, GATS provides broad exceptions for the application of provisions of tax treaties and for the imposition of direct tax provisions aimed at ensuring the equitable or effective imposition of direct taxes. In contrast, GATT contains no exceptions to national treatment obligations, and simply prohibits parties from subjecting imported products to taxes in excess of those that would apply to similar products produced domestically. Thus, at least to the extent GATT applies (i.e. to goods delivered physically, and to digital products considered “goods” for trade purposes), consideration would need to be given to ways to preserve national treatment.

In addition, for some countries EU law imposes comparable obligations – i.e. nondiscrimination between resident and non-resident businesses – that would not permit the application to non-resident suppliers of a gross-basis final withholding tax, even if the rate is fixed at a very low amount.

Given the above issues, a more viable approach could be to use this mechanism as a back-up mechanism to enforce net-basis taxation on the basis of a significant economic presence nexus, rather than as a standalone option. Whether the withholding tax is used as a gross basis payments tax or a collection mechanism for net basis income tax, remittance of the tax by local businesses would both ensure compliance and facilitate identification of the covered remote sales. One approach in this regard would be to establish a registration system for taxpayers that agree to file tax returns and pay tax on their net income, coupled with a credit system enabling taxpayers to pay any tax due on net income in addition to the tax withheld, or for taxpayers that are in a loss position on a net basis at the end of the fiscal year to claim a tax refund. However, such a system would need to take into account that taxpayers may have an incentive not to file a return where their net tax liability would be greater than the amount of withholding tax payable.