On June 5, 2020, the Office of the U.S. Trade Representative (USTR) published the notice of initiation of an investigation into digital service taxes (DST), which have been adopted or are under consideration in Austria, Brazil, the Czech Republic, the European Union, India, Indonesia, Italy, Spain, Turkey, and the U.K.
The USTR has initiated this investigation under Section 301 of the 1974 Trade Act. Section 301 empowers the USTR to determine if the policies under investigation are unreasonable or discriminatory and burden or restrict U.S. commerce. If the USTR finds the policies under investigation to be actionable under Section 301, the U.S. under the direction of the President may unilaterally impose duties, tariffs, and other trade sanctions on items of trade from the foreign country subject to the investigation. Section 301 thus enables the U.S. to impose unilateral measures on trade outside the World Trade Organisation (WTO) System.
Prior to the DST investigation under Section 301 initiated on June 5, 2020, a few investigations have already been concluded, most notably in the cases of China and France. The 2017 investigation by the USTR on the technology transfer regime in China found that China’s regime of technology regulations was discriminatory, restrictive, and harmful to U.S. commerce. The USTR held that China was using foreign ownership restrictions, such as joint venture requirements and foreign equity limitations in addition to various local administrative review and licensing processes, to require or pressure technology transfer from U.S. companies.
The investigation found China’s regime of technology regulations to be forcing U.S. companies seeking to license technologies to Chinese entities to do so on non-market based terms that favor Chinese recipients. The Section 301 investigation also found China to be unfairly facilitating the systematic investment in and acquisition by Chinese companies of U.S. companies and assets to further aid the transfer of technology to Chinese companies. Finally, the USTR concluded that China conducts and supports cyber-intrusion and theft from the digital networks of U.S. companies to access sensitive commercial information and trade secrets. Following the conclusion of the investigation in 2018, the U.S. under the Trump administration increased tariffs by 25% via four successive tariff actions with the latest amounting to $300 billion in Chinese imports which had the effect of escalating trade tensions between two of the world’s largest economies.
In 2019, the USTR initiated a Section 301 investigation into the 3% DST adopted by France on revenue generated from providing certain digital services to, or targeted at, persons in France. The USTR in its 2019 determination held that the DST is unreasonable, unfair and discriminatory towards U.S. commerce. The French DST was held to be inconsistent with accepted principles of international tax policy due to its application to revenue rather than income, retroactive and extraterritorial application, and its purpose of discriminating against U.S. companies. The Section 301 investigation found that the DST was especially discriminatory against digital companies based in the U.S., such as Google, Facebook, Amazon and Apple. The USTR proposed 100% ad valorem duties on certain products of France including French cheese and wine. The imposition of the duty is currently on hold as the two countries have arrived at a temporary truce until the end of 2020 in view of the Organization of Economic Cooperation and Development (OECD) efforts to arrive at a global consensus on the taxation of the digital economy.
The 2020 investigation
The 2020 Section 301 investigation into DST covers 10 different tax jurisdictions. Each jurisdiction has adopted or is considering its own variety of DST. For instance, the 2% DST on U.K. digital services revenues is distinct from the 2% Indian equalization levy on e-commerce supply or services. However, the basis of determination by the USTR is the same. A policy or practice may be found to be unreasonable even if it is not in violation of or inconsistent with the international legal rights of the U.S. as long as it is otherwise unfair and inequitable. The following DST measures are the subject of this investigation:
- Austria: A 5% DST on revenues from online advertising services has been in force since Jan. 1, 2020. The tax applies only to companies with at least 750 million euros ($844 million) in annual global revenues for all services and 25 million euros ($28.1 million) in in-country revenues for covered digital services.
- Brazil: A legislative proposal is under consideration entitled the “Contribution for Intervention in the Economic Domain” or CIDE. On adoption, CIDE would apply to the gross revenue derived from digital services provided by large technology companies.
- Czech Republic: A draft law is being considered that would apply a 7% DST to revenues from targeted advertising and digital interface services. The tax would apply only to companies generating 750 million euros ($844 million) in annual global revenues for all services and 50 million Czech krounas ($2.11 million) in in-country revenues for covered digital services.
- European Union: An EU DST is being considered as part of the financing package for its proposed Covid-19 recovery plan. The EU DST is based on a 2018 DST proposal that was not adopted. The 2018 EU proposal included a 3% DST on revenues from targeted advertising and digital interface services, and would have applied only to companies generating at least 750 million euros ($844 million) in global revenues from covered digital services and at least EUR 50 million in EU-wide revenues for covered digital services.
- India: With effect from April 1, 2020, a 2% DST or equalization levy was adopted which only applies non-resident companies, and covers online sales of goods and services to, or aimed at, persons in India. The tax applies only to companies with annual revenues in excess of approximately 20 million Indian rupees ($265,000).
- Indonesia: An electronic transaction tax has been adopted that targets cross-border, digital transactions. Further implementing measures are required for the new tax to go into effect.
- Italy: A 3% DST has been adopted for revenues from targeted advertising and digital interface services. This tax applies only to companies generating at least 750 million euros ($844 million) in global revenues for all services and 5.5 million euros ($6.19 million) in in-country revenues for covered digital services. The tax applies as of Jan. 1, 2020.
- Spain: A 3% DST is being considered for revenues from targeted advertising and digital interface services. This tax would apply only to companies generating at least 750 million euros ($844 million) in global revenues for all services and 3 million euros ($3.37 million) in in-country revenues for covered digital services.
- Turkey: A 7.5% DST has been adopted for revenues from targeted advertising, social media and digital interface services. The tax applies only to companies generating 750 million euros ($844 million) in global revenues from covered digital services and 20 million Turkish lira in in-country revenues from covered digital services. The Turkish President has authority to increase the tax rate up to 15%. The law is in force since March 1, 2020.
- United Kingdom: A DST proposal is being considered as part of its Finance Bill 2020. The measure would apply a 2% tax on revenues above 25 million British pounds ($30.9 million) to internet search engines, social media, and online marketplaces. The tax applies only to companies generating at least 500 million British pounds ($619 million) in global revenues from covered digital services and 25 million British pounds ($30.9 million) in in-country revenues from covered digital services. The bill is in the final stages of adoption by Parliament, and if passed, payments would be due from affected companies in 2021.
Procedure Under Section 301
The process under Section 301 is a consultative one. As per the Notice of initiation published in the Federal Register on June 2, 2020, consultations have been requested with the governments of the tax jurisdictions under investigation pursuant to Section 303(a) of the Trade Act. Written comments may be submitted to the USTR until July 15, 2020. The investigation is initially intended to focus on the following issues:
- Discrimination against U.S. companies;
- Retroactivity and possibly unreasonable tax policy;
- Whether the DSTs diverge from norms reflected in the U.S. tax system and the international tax system in—extraterritoriality, taxing revenue not income, and a purpose of penalizing particular technology companies for their commercial success; and
- Other aspects that may warrant a finding that one or more of the covered DSTs are actionable under Section 301.
Under Section 301, any action with respect to the import treatment of any product or the treatment of any service can be taken, an opportunity must be provided for the presentation of views concerning the taking of action with respect to such product or service. Appropriate public hearings are required to be provided upon request by any interested person with respect to the taking of action with respect to such product or service, and review. Investigations under Section 301 so far have comprised of the following steps:
Investigation into the Indian “DST”—are there any merits?
The USTR notice states that India adopted a 2% DST which applies to non-resident companies. The DST being referred to is the Indian “equalization levy” on e-commerce supply and services. The 2016 Memorandum to the Finance Bill which introduced the first 6% equalization levy on online advertisements provided the following reason for the levy: “The typical direct tax issues relating to e-commerce are the difficulties of characterizing the nature of payment and establishing a nexus or link between a taxable transaction, activity and a taxing jurisdiction, the difficulty of locating the transaction, activity and identifying the taxpayer for income tax purposes.” Thus, the equalization levy as envisaged in the BEPS Action Plan I was introduced in India to prevent the escape of e-commerce revenues from taxation in India. Section 10(50) of the Income Tax Act 1961 (the Act) provides that the revenues on which equalization levy applies would not be subject to income tax under the Act.
In order for a foreign trade practice to be deemed unreasonable and discriminatory by a Section 301 investigation, the foreign country must be proven to be any of the following:
- Maintaining unjustifiable or unreasonable tariff or other import restrictions which impair the value of trade commitments made to the U.S. or which burden, restrict, or discriminate against U.S. commerce.
- Engaging in discriminatory or other acts or policies, which are unjustifiable or unreasonable, and which burden or restrict U.S. commerce.
- Providing subsidies (or other incentives having the effect of subsidies) on its exports of one or more products to the U.S. or to other foreign markets which have the effect of substantially reducing sales of the competitive U.S. product or products in the U.S. market or those other foreign markets.
- Imposing unjustifiable or unreasonable restrictions on access to supplies of food, raw materials, or manufactured or semi-manufactured products, which burden or restrict U.S. commerce.
The grounds of investigation in both the 2019 French DST investigation and the 2020 DST investigation are materially similar and can be divided into a few major issues—discrimination against U.S. companies, retroactivity and divergence from U.S. and international tax principles on issues such as extraterritoriality, taxing revenue not income; and a purpose of penalizing particular technology companies for their commercial success. The findings of the USTR in the French DST investigation are examined in contrast with the Indian equalization levy below:
Discrimination against U.S. companies
The Section 301 investigation into the DST adopted by France found the French DST to be discriminatory against U.S. companies. In the French case, the USTR concluded that there was a deliberate targeting of U.S. digital giants with the tax itself being named the “GAFA” (Google, Apple, Facebook and Amazon) tax. The DST was stated to have been targeted to affect only the largest digital companies above certain thresholds with the added incentive of encouraging local start-ups.
Unlike the French DST, the equalization levy as adopted in India is very broad in scope and expansive in its application. The 2% equalization levy applies equally on the amount of consideration received by all non-resident e-commerce operators regardless of the country where the e-commerce operator is resident. The basis of the levy is the consideration being received by the non-resident e-commerce operators from users resident in India or using an IP address located in India. The threshold for the equalization levy in India is relatively low at 2 billion Indian rupees (approximately $26.5 million) as compared to other jurisdictions such as Italy setting the threshold at 5.5 million euros ($6.19 million). The Indian equalization levy can in no way be concluded to be discriminating against the U.S. “digital giants”.
The French DST was found by the USTR to be unreasonable and burdensome due to its retroactive application. It was a substantively new tax requiring new reporting and accounting systems for its implementation and was made effective immediately upon the law’s publication and also for seven months preceding its announcement. Unlike the French DST, the Indian equalization levy does not have any retrospective application and came into effect on April 1, 2020. Due to the global pandemic, compliance under equalization levy provisions have also been deferred to June 30, 2020.
Divergence from norms reflected in the U.S. tax system and the international tax system in—taxing revenue not income
The USTR in its report on the French DST relied on fundamental principles of taxation as affirmed by the OECD as well as several model and in-use international tax treaties to hold that taxing revenue and not income was against principles established by international taxation and the U.S.-France tax treaty itself. Due to the DST’s application on revenue and not income, U.S. companies were found to be taxed twice, once on their income and once on their revenue. The USTR also held this practice to be unreasonably burdensome on U.S. companies which were unprofitable or less profitable. On profitable U.S. companies also, the inability to deduct costs from the gross revenue was held to be unreasonable and equivalent to an effectively higher income tax.
In the Indian scenario, the separation of the equalization levy from the income tax regime through Section 10(50) of the Act may shield the levy from any implications of double taxation. However, the Indian levy is definitely a tax on revenue as it specifically applies to the consideration received by the non-resident without any qualification as to what may be included or excluded from the gross consideration amount. On this point, the levy may be concluded to be against principles of international taxation.
Divergence from norms reflected in the U.S. tax system and the international tax system in—extraterritoriality
The Section 301 investigation into the French DST also concluded that it was extraterritorial in nature. Under French law, DST payments are deductible expenses against French corporate income tax. Because French companies are more likely than U.S.-based companies to pay significant income taxes in France, the DST’s relationship to the French income tax was much more likely to benefit any French companies covered by the tax than the many U.S.-based companies expected to be covered. The USTR further held that the French DST was essentially an extra layer of taxation on the existing French corporate tax regime. International tax principles require a significant territorial nexus fall within a country’s corporate tax regime. According to the USTR, the French DST was being used to extraterritorially apply the French corporate tax regime on companies not even having a permanent establishment in France.
In contrast to the above, the Indian equalization levy has been enacted to be completely removed from the direct tax regime. Section 10(50) of the Act specifically exempts revenues on which equalization levy is applicable from being taxed under income tax provisions. However, the issue is a contentious one as the equalization levy seeks to tax the consideration received by a non-resident which can be categorized as taxing revenue and not income of an entity which may not have been covered by the Indian tax regime in the first place.
Although it may be argued that the Indian levy does not discriminate against U.S. companies, it may still be determined to be an extraterritorial measure. The Supreme Court of India in several pronouncements over the years has determined how the legislative power enshrined in Article 245 of the Indian Constitution may be limited by the doctrine of territorial nexus. The Supreme Court has held that the state may not only levy a tax on a person, object, transaction, or property located within its territorial limits but also when there is a sufficient territorial nexus.
Here, the nexus is deemed to be the Indian resident. However, in view of the innumerable ways an e-commerce transaction may be affected, the e-commerce levy may find itself applicable to even an Indian tourist purchasing items online in a foreign country. Given the broad manner in which the levy is sought to be applied, the extraterritorial implications are unavoidable.
A purpose of penalizing particular technology companies for their commercial success
The French DST was applicable only to companies of a certain scale having global revenue of 750 million euros ($844 million) per year. The USTR held the revenue thresholds to be arbitrary and particularly discriminatory against U.S. companies as the high thresholds resulted in very few French companies being eligible and several U.S. companies were definitively affected. In contrast, the Indian equalization levy is applicable based on a significantly lower threshold (approximately 231,000 euros or $260,000). The equalization levy would thus be applicable on several non-resident e-commerce operators of varying nationality.
However, the arbitrary nature of the Indian equalization levy may be found to be penalizing on other grounds. As per the 2016 Report of the Committee on Taxation of e-Commerce, the equalization levy is intended to bring local and non-resident e-commerce operators to a tax-neutral level playing field as well as provide clarity to non-resident e-commerce operators.
Indian e-commerce operators are subject to a comprehensive income tax regime which covers all steps from the charging of tax, payment of tax, dispute settlement and appeal provisions. There is an absence of any dispute settlement mechanism or appeal process almost has the effect of penalizing non-resident e-commerce operators who cannot contest the levy under any circumstances.
The levy, like the French DST also demands a complete overhaul of existing accounting systems to calculate emergent tax liabilities and file necessary returns and statements. This issue is contentious and may be decided against the levy provided no clarifications are issued by the Indian tax authorities.
Investigation into the Indian “DST”—what next?
The investigation under Section 301 is a comprehensive and consultative process. The DST investigation at hand covers 10 different tax jurisdictions and is likely to involve multiple rounds of hearings and negotiations between representatives. In light of the ongoing global pandemic and the upcoming U.S. elections, it can be assumed that the investigation will require a considerable period of time to proceed.
The Indian equalization levy as discussed above is starkly different in its scope and application from the French DST which was found to be discriminatory under Section 301. It is unlikely that the equalization levy can be equated to a tax discriminating against U.S. commerce. However, in view of the contentious issues discussed above, the levy may be concluded to be unreasonably burdensome. Even if the equalization levy is found by the USTR to be unreasonable or discriminatory due to any reason, India will be able to present its case before the USTR and negotiate accordingly.
In the background of the investigation, negotiations are still ongoing between the U.S. and French governments over the French DST. Towards the end of this year, the OECD is scheduled to make progress on negotiations with member states on the issue of taxing the digital economy. As several jurisdictions have adopted or are in the process of adopting taxes targeted at digital companies not having a physical presence in those jurisdictions, consensus between jurisdictions on this issue is key to ensuring global tax certainty.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Asim Choudhury is a principal associate, and Aesa Dey is an associate at Khaitan & Co. LLP in Kolkata.
The views of the authors in this article are personal and do not constitute legal/professional advice of Khaitan & Co. For any further queries or follow up please contact us at firstname.lastname@example.org.