by Laurence Todd & Connor Vance
Introduction
Advances in technology have led to radical changes in existing business models and
the creation of radically new ones. With the advent of the internet, many
corporations no longer need physical establishments or proximity to customers
to do business. This new digital age has encouraged the emergence of an
enormous variety of new products and services, easily accessed online.
However, there has been a growing sentiment within some
governments that the reach and accessibility of new digital channels poses a challenge
to the long-standing principles of taxation. In response to these concerns, the
OECD has established a Task Force on the Digital Economy to seek to develop a
global consensus and is due to report in 2020. But some countries want to move
faster, and several jurisdictions are now considering new unilateral taxes
targeting digital activity.
The emergence of digitalisation is of course not unique to
any one country, and there are many different perspectives on how
digitalisation changes the way we think about taxes – or even whether it should
at all. In Malaysia, the previous government was actively looking into ways to
raise revenue from digital activity; Second Finance Minister Datuk Seri Johari
Abdul Ghani stated in January 2018 that the government had sought out “feedback
from the OECD” on potential methods for imposing a new digital tax in Malaysia
(The Malaysian Reserve, 2018). As the new Pakatan Harapan government develops
its first budget, they too may consider targeting the revenue of digital companies.
With this in mind, this Brief Ideas considers the main issues, domestically and
globally, in the debate over digital tax.
The case for digital tax
Those countries arguing for new tax measures targeting
digital activity often advocate two arguments in favour of this course of
action:
- First, that digital companies pay less tax than non-digital companies;
- Second, that digitalisation has fundamentally altered the way value is generated.
Before we consider these two arguments, we should note the
challenge in specifying a company as “digital” for the purpose of taxing it.
Many, if not most businesses, will seek to use digital channels to some extent,
including for sales and advertising. This includes many traditional “brick and
mortar” companies that have adapted to the innovations provided by the internet
and digital technology, but these cannot be classified as “digital companies”.
Of course, many new predominantly digital business models have also emerged
over the past few years, such as social media platforms, but even among these,
there remains an enormous variety in size and function. In recognition of this,
the OECD concluded 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.” This difficulty
in defining exactly what it is that is going to be taxed makes policy
development significantly more challenging and risks new taxes being unfairly
targeted, which can in turn create market distortions. Any new digital tax
would almost certainly have an inadvertent impact on traditional companies.
Are digital companies paying enough tax?
Much of the debate has centred on the claim that digital
companies are paying insufficient tax. In the EU, where the European Commission
has progressed significantly with new tax proposals, the Commission argues that
“[o] n average, domestic digitalised business models are subject to an
effective tax rate of only 8.5%, less than half compared to traditional
business models”(European Commission, 2017). In fact, this claim has been
disputed by the authors of the paper the European Commission relies on for this
figure, who issued a statement clarifying that it is incorrect to represent
their figure as being an average tax rate for digital multinationals.
The idea that digital companies are paying less tax has also
been brought into question by research from ECIPE, who used industry data to
conclude that effective tax rates (ETRs) for a range of different categories of
digital business models were in fact higher than the European Commission
suggested, higher than the amount paid by traditional companies, and higher
than the average Asian tax rate (ECIPE, 2018). The results are displayed below,
alongside the standard corporate tax rate in Malaysia, to provide the Malaysian
perspective.
 |
Chart 1: Tax rates across traditional and digital companies (ECIPE, 2018)
|
Where is the value generated?
The long-standing, internationally agreed principle of
taxing business income is that tax should be paid in the jurisdiction where
value is generated. Some have argued that digitalisation has challenged the way
we think about value creation, as intangibles – such as assets, data and
knowledge, have become significantly more important but also much more
dispersed. Taking the example of a social media company, the European
Commission argues that value is generated by the data collected from users,
which is in turn used to allocate advertising space, but that the profits
generated from advertising revenue are not taxed in the same jurisdiction in
which the users are located.
However, the use of customer feedback to inform product
development has been common for decades in traditional industries. While some argue
the scale of this is greater in digital technology, others hold that the value
created by raw user data is grossly overestimated. Indeed, the OECD Task Force
on the Digital Economy notes that some countries “explicitly reject the
suggestion that data and user participation should be considered value creation
by the business in the user’s jurisdiction. According to this view, user data
and user contributions should be viewed in the same way as other business
inputs sourced from an independent third party in the business’ supply chain”
(OECD, 2018).
In his recent blog for Kluwer International, Werner
Haslehner argues that in order to create value, a “firm needs to add something
to existing inputs it acquired in the market; this can be conceivably assigned
to the place where the firm exercises its value-creating functions, uses assets
and, arguably, assumes risks” (Werner Haslehner, 2018). Applying this approach
to the case of the social media company, advocates of this approach would argue
that the data on its own does not hold value, but rather the tools used to
analyse the data and develop an advertising product generates value. And the
human capital and intellectual property required to create and operate these
tools can be captured for tax purposes in the jurisdiction in which they
operate.
As we noted above, there are also a variety of different
digital business models aside from social media platforms, and the importance
of user participation varies significantly across these business models. In the
examples below, the role of user generated content is arguably minimal:
- Cloud computing services, such as Amazon Web Services, connect users with a software and remotely accessible hardware;
- Online retail platforms, such as Lazada or eBay, connect buyers and sellers across borders;
- Subscription based services, such as iflix or Spotify, provide consumers with digital content, such as movies or songs.
Future policy
Disagreements on these issues have resulted in a lack of consensus internationally on whether global tax rules need to be updated to reflect digitalisation. The OECD Task Force on the Digital Economy is considering proposals to address this and will produce its final report in 2020 (OECD, 2018). However, a number of countries have taken or are considering unilateral measures to raise more tax revenue from digital companies before the Task Force concludes:- Countries including Israel and India have sought to broaden the definition of a permanent establishment, the traditional basis for taxation of business profits, to include a digital “significant economic presence” (SEP) based on a company’s local revenue or user count. The SEP threshold would allow source countries to demand a proportionate share of digital companies’ profits, regardless of whether said companies keep physical operations within those countries. However, it would require other countries to amend their double tax treaties with India so as to divert money from their own tax base to India instead.
- A number of countries have introduced taxes on turnover in their jurisdictions, as opposed to final profits. These are based on the value of certain transactions (typically payments made for digital services like online advertising), not on the profit reported. Examples include Italy’s levy on digital transactions, and France’s tax on distribution of audio-visual content.
- The United Kingdom and Australia have a Diverted Profits Tax (DPT), aimed at digital corporations and multinational enterprises more broadly. The goal of the DPT is to recoup lost tax revenue from corporate profits deemed to be artificially shifted out of the source country’s jurisdiction. Typically set at a punitively high rate, the DPT is meant as a deterrent against attempts to relocate profits to low-tax jurisdictions.
- Some countries have considered the withholding tax (used on transactions with a domestic payer and a foreign payee) as a tool. Governments can use the withholding tax either through expanding the legal definition of royalties or by applying the tax to payments for technical services. In so doing, they can “withhold” a portion of a payment to a foreign company, even if it has no permanent establishment whatsoever in the source country, so long as the corporation paying for the services is based there.
The Malaysian Perspective
This debate over digital tax has also gathered momentum in
Malaysia, with calls for higher taxes on digital companies (The Star, 2018). In
response, the previous Malaysian government confirmed it was considering
measures to tax digital activity. Setting aside the broader global debate over
the case for these measures, what are the risks from the Malaysian perspective?
Legal perspective
The first issue that arises is whether these measures might
result in cases of double-taxation, where two or more countries are taxing the
same income. Multiple treaties and international agreements have been agreed,
precisely to avoid double taxation emerging. In recognition of this, the
unilateral measures to redefine significant economic presence in both India and
Israel have stated explicitly that should conflict with international
commitments arise, then those agreements must take precedence over the new law.
This raises the question of whether such a measure would be effective, because
it is hard to imagine other countries agreeing to voluntarily hand over
portions of their tax base.
In the case of Malaysia, the government holds Double Tax
agreements with 74 countries (Inland Revenue Board, 2018), which could severely
constrain the options for taxing foreign-based digital business income. In
theory, the Multilateral Convention to Implement Tax Treaty Related Measures to
Prevent BEPS might provide a vehicle for managing this.
Economic perspective
Direct impact
The costs of digital
goods and services will likely increase. Firms supplying digital goods and
services to Malaysia will treat any new tax as an additional cost, either by
reducing operating costs and investment, reducing returns to shareholders or
increasing prices. Given that many digital goods and services are supplied in
multiple different countries, it is unlikely that firms would look to reduce
operating costs in response to increased tax in any one country. Therefore,
firms are likely to increase prices and reduce investment in response to
additional taxes, at least to cover some portion of the additional cost.
The price of digital
goods and services will likely increase for consumers. As a consequence,
the price of digital goods and services of the end-user will likely increase.
Consumers’ use of the internet is high in Malaysia. A survey by the Malaysian
Communications and Multimedia Commission (MCMC)found that of the 32 million
people in Malaysia, 24.5 million (76.9%) have access to the internet (MCMC,
2017). Of these, 70% use the internet to stream or download digital video and
49% use the internet for online shopping. Any increase in prices for these
goods and services would therefore be felt by a large number of consumers.
Firms could also respond to increased costs by reducing investment in goods and
services tailored to the Malaysian market, lowering the overall quality of the
products available to Malaysian consumers.
The costs of using
digital platforms will increase for Malaysian businesses – impacting
productivity and trade. As with consumers, the costs for Malaysian
businesses accessing digital platforms could increase. This is important, as
access to digital platforms has been shown to increase the productivity of
firms. A study by the World Bank found that the more intensively a company uses
the Internet, the greater the productivity gains. Increased internet usage is
also associated with increased value and diversity of products being sold (The
World Bank, 2016). A report by the US Congressional Research Service noted that
“the Internet, and cloud services specifically, has been called the great
equalizer, since it allows small companies access to the same information and
the same computing power as large firms using a flexible, scalable, and
on-demand model” (Digital Trade and U.S. Trade Policy, Congressional Research
Service, 2018). Access to these services can help Malaysian companies to grow
and compete in the global marketplace.
Social media platforms have been found to be beneficial in
this respect too. In their paper on the factors influencing the use of social
media by SMEs and its performance outcomes, Ainin, Parveen, Moghavvemi, Jaafar
and Shuib find that: “Facebook usage has a strong positive impact on financial
performance of SMEs; similarly it was also found that Facebook usage positively
impacts the nonfinancial performance of SMEs in terms of cost reduction on
marketing and customer service, improved customer relations and improved information
accessibility (Ainin et al, 2015).”
Access to digital platforms is also important to Malaysian
businesses – and particularly SMEs – looking to export their goods and
services. For many of these companies, access to international e-commerce
platforms is essential. A study of U.S. SMEs on the e-commerce platform eBay
found that 97% export (Manyika et al, December 2015). Facebook’s Future of
Business Survey Report found that online tools play a role in SMEs’ ability to
trade internationally and grow. “SMEs attribute growth — in revenue, resources,
and employees — to their use of online tools to trade internationally. More
than half of exporting SMEs (54%) report that more than 75% of their
international sales depend on online tools. 65% of exporters agree that using
online tools for selling internationally has increased their revenue” (The
Edge, 2017).
The Digital Free Trade Zone was specifically set up to
improve Malaysian SME exports by onboarding SMEs to global e-commerce
marketplaces and it is working: Malaysia was among the fastest-growing
exporters to China on the cross-border platform of Alibaba, Tmall Global, in
2017 (NST, 2018).
A unilateral tax measure risks increasing the costs for
Malaysian business accessing these digital platforms, and therefore the
potential to increase productivity and trade.
This has fiscal implications too given the productivity
benefits of digital technology, a reduction in investment will likely have a
negative impact on the growth of the overall economy - meaning the tax base
would be reduced from where it would otherwise have grown to. It is therefore
possible that a digital tax would have a net negative impact on the overall tax
take.
Indirect impact
If Malaysia adopts a unilateral digital tax, that is likely
to encourage others to do the same. This could have the following consequences:
The costs for
Malaysian businesses exporting overseas will increase. If other countries
adopt unilateral tax measures, then the costs for Malaysian businesses
exporting digital goods and services to those markets will increase. As we
noted above, these additional costs will likely result in higher prices, making
those Malaysian businesses less competitive in overseas markets.
Malaysia is an open, trading nation which stands to benefit
from unrestricted access to overseas markets. Malaysia runs a surplus in
overall trade and its trade in services has been steadily growing, reaching a
record RM341.1 billion in 2017. In the same year exports of services increased
to RM159.2 billion, an increase of 7.9% compared to the preceding year and up
42.8% since 2010. The digital economy is making a growing contribution: numbers
from the Department of Statistics Malaysia indicate that the digital economy
accounted for 18.2% of the country’s GDP in 2016. In light of this, a
proliferation of measures which increase the costs for Malaysian digital
exporters would be harmful, in particular when many of those exporting are
SMEs: nine out of 10 business establishments in Malaysia are SMEs. Of these, 28%
have an online presence and 15% already use that presence for export purposes
(Digital News Asia).
This will be
particularly harmful in the case of taxes based on revenue. As noted above,
some of the unilateral measures being considered by some countries include
taxes on gross revenue rather than profit. If these are adopted in Malaysia’s
export markets, this will be particularly harmful for Malaysian SMEs which are
often loss-making in the early years of development. Twitter recorded its first
profits for 12 years in February of this year; if it had been subject to
additional turnover taxes it might not have survived (www.record.net, 2018). A
survey by RAM Holdings Bhd estimated that 28% of Malaysian SMEs are operating
in the red, compared to 13% for larger corporates (The Malaysian Reserve,
2018).
In other words, these taxes could act as a significant
barrier to entry for new firms, supporting incumbents and reducing competition,
with ultimately worse outcomes for consumers.
Taxing consumption?
So far, we have focussed on direct taxation – whether to
apply additional taxes on the income of digital businesses providing goods and
services in Malaysia. The question of indirect tax has also been raised, in
particular whether foreign supplied digital goods and services should be
subject to consumption taxes. This is a less contentious issue globally:
whereas there is disagreement over where the value of digital services is
generated, it is clear where the consumption takes place. Introducing indirect
taxes on foreign supplied digital goods and services would also level the
playing field between foreign firms and domestic firms, who are already subject
to consumption taxes. In recognition of that, the OECD has issued guidelines on
applying GST/VAT to foreign supplied digital goods and services, which a number
of countries are now adopting (OECD, 2017).
In Malaysia, the Customs Department under the previous
government announced its intention to amend GST so that it captured digital
imports, (The Star, 2017). At the time Deloitte estimated the move would
increase GST revenue by 5%-10%.
Following GE14, the new government has abolished GST and is
replacing it with the previous Sales and Services Tax (SST). The government
could consider amending the scope of the SST to cover foreign supplied digital
goods and services. Of course, this would also entail many of the same costs as
a direct tax measure – it would increase the cost of the digital goods and
services for consumers and businesses, with the knock-on impacts on
productivity and trade outlined above. It has been reported that in Australia,
where a tax for foreign supplied digital services has been introduced, the cost
of home entertainment, apps, video games, e-books, and software is estimated to
rise by 150AUSD million in its first year (news.com.au, 2017). Furthermore, the
rapid implementation of the new SST already involves some risk, so the
government should approach any expansion in the scope of SST carefully and in
close consultation with industry.
Conclusions
It is difficult to define “digital businesses” for the
purposes of taxation and there is no definitive evidence that more digital
companies pay less tax than more traditional companies. There is disagreement
over whether digitalisation poses a challenge to the long-standing principles
of taxation and value generation, leading some countries to adopt unilateral
measures on tax.
Although it could increase revenue in the short term, a
unilateral direct digital tax in Malaysia would increase the costs of digital
goods and services, in turn increasing prices and the cost of trade. Reduced
investment in the digital economy would lead to lower productivity growth,
which in turn could mean that less is gained from a digital tax than is lost to
a reduced tax base from the overall economy.
As an open, trading, and pro-innovation nation, Malaysia
would suffer from a proliferation of unilateral taxes on digital trade. If
unilateral sector-specific taxes become the norm, countries could target other
sectors in which Malaysia runs a trade surplus. Taxes targeted at turnover
could be particularly dangerous for new start-ups looking to export. More
broadly, Malaysia, with its relatively small domestic market, should be
cautious of a global push to rebalance corporate income tax in favour of where
consumers – rather than businesses – are based.
The case for consumption taxes covering foreign supplied
digital goods and services is less contentious but would still negatively
impact prices in Malaysia, and implementation would need to be managed
carefully in close consultation with industry.
References
Ainin et al. 2015. “Factors Influencing the Use of Social
Media By SMEs and Its Perfomance Outcomes” https://www.researchgate.net/profile/Sedigheh_Moghavvemi/publication/274169330_Factors_Influencing_the_Use_of_Social_Media_By_SMEs_and_Its_Performance_Outcomes/links/55d1cbbb08ae2496ee658277.pdf
Digital Trade and U.S. Trade Policy, Congressional Research
Service, 2018. https://fas.org/sgp/crs/misc/R44565.pdf
Digital News Asia https://www.digitalnewsasia.com/digital-economy/malaysia-track-achieve-21-e-commercegrowth-2020
ECIPE, 2018. “Digital Companies and Their Fair Share of
Taxes: Myths and Misconceptions”.
ECIPE, 2017. “The Geopolitics of Online Taxation in Asia
Pacific” http://ecipe.org/publications/the-geopolitics-of-online-taxation-in-asia-pacific/
European Commission, 2017. https://ec.europa.eu/taxation_customs/sites/taxation/files/communication_taxation_digital_single_market_en.pdf
Inland Revenue Board, 2018.
http://www.hasil.gov.my/bt_goindex.php?bt_kump=5&bt_skum=5&bt_posi=4&bt_
unit=1&bt_sequ=1&bt_lgv=2
James Manyika, Sree Ramaswamy, and Somesh Khanna, et al.,
“Digital America: A Tale of the Haves and HaveMores,” McKinsey Global
Institute, December 2015,http://www.mckinsey.com/industries/high-tech/our-insights/digital-america-a-tale-of-the-haves-and-have-mores
Kluwer International Blog, Werner Haslehner, 2018.
News.com.au, 2017. https://www.news.com.au/entertainment/tv/australias-netflix-tax-which-digital-services-are-raising-their-prices/news-story/55f4c3c072b5a361fdd38f319be7ba0e
OECD, 2017. “Mechanisms for the effective collection of
VAT/GST” https://www.oecd.org/tax/tax-policy/mechanisms-for-the-effective-collection-of-VAT-GST.pdf
OECD, 2018. “Tax Challenges Arising from Digitalisation –
Interim Report 2018”.
Record.net, 2018. https://www.recode.net/2018/2/8/16989834/twitter-q4-2018-earnings-revenue-jack-dorsey
The Edge, 2017.
http://www.theedgemarkets.com/article/malaysian-smes-attribute-growth-international-trade-online-tools-says-facebook
The Malaysian Reserve, 2018. https://themalaysianreserve.com/2018/01/12/govt-talks-oecd-regulate-digital-platforms-malaysia/
The Malaysian Reserve, 2018. https://themalaysianreserve.com/2018/01/12/smes-need-expand-abroad-via-ecommerce-platforms/
The Star, 2017. https://www.thestar.com.my/business/business-news/2017/09/19/taxing-the-digital-economy/
The Star, 2018. https://www.thestar.com.my/business/business-news/2018/03/15/calls-for-tax-on-google-facebook-gaining-speed/
The World Bank Group, 2016. “World Development Report 2016:
Digital Dividends, 2016” http://www.worldbank.org/en/publication/wdr2016
Laurence Todd is the Director of Research and Development at
IDEAS. Laurence is a public policy professional with a wide range of experience
in economic policy, business regulation and international trade. Prior to
joining IDEAS, Laurence served in a number of different roles in the UK
Government, including in Her Majesty’s Treasury and the Ministry of Defence.
IDEAS is inspired by the vision of Tunku Abdul Rahman Putra
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