While most nations remain divided on how to tax the digital economy, the United Nations has introduced a proposal, in the form of Article 12B (Income from Automated Digital Services), possibly in a bid to unite the disgruntled nations (particularly, the developing countries) which have chosen the unilateral path of adopting different forms of taxes to deal with digital businesses. Most have intentionally kept such digital taxes outside the ambit of their local tax laws so as to avoid tax treaty obligations. Whether such taxes can still be eligible for tax treaty benefits under the definition of substantially similar taxes or by invoking a non-discrimination clause in tax treaties is a different argument altogether and is not a part of this discussion.
In short, the United Nations has come forward to unite the divided nations on the taxation of digital economy by proposing a source-based taxation rule similar to the existing passive income articles in the model tax conventions.
Interestingly, this proposal significantly diverges from the Organization for Economic Co-operation and Development’s (OECD) Pillar 1 and Pillar 2 proposals. The United Nations’ proposal seems to be much simpler and more realistic in terms of its coverage and formula when compared with the OECD’s work on this subject. Of course, this proposal has its own set of issues which are discussed in the following section.
In total, eight paragraphs have been proposed under Article 12B along with the commentary comprising of 61 paragraphs. Out of the 61 paragraphs, the first 10 paragraphs are general in nature followed by paragraph-specific commentary.
Broadly speaking, the proposed Article 12B is substantially similar to the existing Article 12A (Fees for Technical Services) of the UN Model Double Tax Convention 2017 barring a few differences which will be discussed in the following section.
Salient Features of the Proposal
Paragraphs 1 and 2 of Article 12B
The Article grants a non-exclusive right to tax to the resident country, while the source country is given a limited right to tax on gross basis. Such limitation to tax shall only apply if the recipient also happens to be the beneficial owner of such income.
The rate of tax to be levied in the source country is left to the mutual discretion of the contracting countries to decide. It does, inter alia, recognize the importance of balancing the need to impose a reasonable tax rate without creating effects of potentially passing on the additional tax cost to the payer of the source country or deterring the investment by capital exporting countries into capital importing countries.
In case the recipient is not a beneficial owner, the source country is free to impose tax as per its own domestic tax laws. The term ‘’beneficial owner’’ is again vaguely defined under the respective commentaries of Articles 10, 11, 12 and 12A.
Paragraph 3 of Article 12B
This new Article also, at the option of the beneficial owner, allows taxation on “net basis” in the source country. This is something new as normally the source country simply applies a flat tax rate on a ‘’gross basis’’ based on the withholding tax mechanism.
Article 12B coins a new term “qualified profits” to arrive at the “net basis taxation.’’ In case one opts for ‘’net basis taxation,’’ the applicable tax rate shall be as per the domestic tax law of the source country. The same has been discussed in the following section.
Paragraph 4 of Article 12B
This Article provides an exhaustive definition of the term ‘’Income from Automated Digital Services” as discussed in the following section.
Paragraph 5 of Article 12B
Similar to the passive income Articles in the OECD Model Tax Convention 2017 and UN Model Double Tax Convention 2017, i.e. articles on dividend, interest, royalty and fees for technical services, this Article will not get attracted if such income is effectively connected with a permanent establishment or fixed base in the source country.
Paragraphs 6 and 7 of Article 12B
It also provides for cases where the income shall be ‘’deemed to arise’’ in the source country and also cases where the income shall “not be deemed to arise” in the source country.
Paragraph 8 of Article 12B
Lastly, it restricts its applicability in case of special relationship between the contracting parties as is also applicable in case of Articles pertaining to interest, royalty and fees for technical services.
Net Basis Taxation
Paragraph 3 provides an option to the beneficial owner to pay tax in the source country on “net basis” against the “gross basis” as required under paragraph 2. It is at the sole discretion of the beneficial owner to opt for “net basis” over the default “gross basis.”
It deems 30% to be qualified profits. Such qualified profits are to be determined using profitability ratio either of the beneficial owner as a whole or relevant automated digital services segment of the beneficial owner. However, if the beneficial owner belongs to a multinational group then the overall profit ratio of that group as a whole or for the automated digital services segment of the group as a whole shall be considered.
Paragraphs 26–29 discuss the application of paragraph 3 of Article 12B. Paragraph 27 defines the term ‘’qualified profits.’’ See the formula below:
Qualified profits = 30% of the derived amount;
Derived amount = Overall profitability ration x Gross annual revenue in the source country;
Overall Profitability Ratio — Could be the beneficial owner as a whole or only for the relevant segment of automated digital services. However, if the beneficial owner is part of a multinational group then, in such a case, the ratio of group as a whole or only for the relevant segment of automated digital services of the group shall be considered. The commentary refers to the consolidated financial statements of the group to arrive at the desired figures.
Paragraph 29 also acknowledges the situation of setting off of losses of other business segments against the profits of automated digital segment as that will reduce the overall profitability ratio. The suggestive mechanism requires higher of the three to be considered:
- group’s overall profitability ratio; or
- beneficial owner’s overall profitability ratio; or
- beneficial owner’s profitability ratio of the relevant segment.
Scope of Automated Digital Services
Paragraph 31 elaborates on the concepts of “automated” and “minimal human involvement.” The commentary clearly spells out that a service is regarded as automated when there is no bespoke activity. In other words, when the services are standardized services and there is no customization tailored to specifications of the service recipient, such services shall fulfill the criteria of being “automated.”
Interestingly, the commentary also focuses on the human involvement and per unit costs to cater to new customers. It specifically provides that in case the same business set-up can be used to scale up the operations and cater to new customers, it will fall under the automated category. Likewise, if there is an increase in per unit costs of catering to new customers, it may not fall under the automated category.
It further clarifies that the definition focuses on provision of service and, therefore, does not include human interventions in creating or supporting or maintaining the system needed for provision of service.
Furthermore, on the human intervention condition, the commentary clarifies that this aspect is only to be seen from the perspective of the service provider and not the service recipient.
Paragraph 33 clarifies that the definition of “automated digital services” is exhaustive. Paragraphs 34 and 35 list the services which are included in the automated digital services along with their brief explanation.
Paragraph 36 lists the exclusions from automated digital services followed by paragraphs 37–40 which briefly describe such exclusions.
The following services are considered to be covered under “automated digital services”:
- online advertising services;
- online intermediation platform services;
- social media services;
- digital content services;
- cloud computing services;
- sale or other alienation of user data;
- standardized online teaching services.
The following services are considered not to be covered under “automated digital services”:
- customized services provided by professionals;
- customized online teaching services;
- services providing access to the Internet or to an electronic network;
- online sale of goods and services other than automated digital services;
- broadcast services including simultaneous internet transmission;
- composite digital services embedded within a physical good irrespective of network connectivity (“internet of things”).
Deemed and Not Deemed to Arise in Source Country
Paragraph 6 of the Article deems income from automated digital services to arise in the source country in either of the cases:
- the payer is a resident of such source country; or
- the payer, irrespective of it being a resident of the source country or not, has a permanent establishment or a fixed base in such source country and such payment is borne by the permanent establishment or the fixed base.
Paragraph 7 of the Article deems such income to arise outside the source country if the payer is a resident of that country but carries on business in other contracting country through a permanent establishment or a fixed base in that other country and such expenses are borne by that permanent establishment or fixed base.
Paragraph 50 clarifies that the place of rendering services is irrelevant. This is similar to paragraph 108 of the commentary to Article 12A of the UN MTC 2017.
Furthermore, paragraphs 54 and 56 are similar to paragraphs 112 and 114 of the commentary to Article 12A of the UN MTC 2017 which clarify that the term ‘’borne by’’ must be interpreted in the light of underlying purpose of the aforesaid paragraphs i.e. the fact that the payer has actually claimed a deduction or not is irrelevant as long as he was eligible to claim such deduction but either chose not to claim such deduction or the underlying income was exempt.
Existing Article 12A vis-à-vis Proposed Article 12B
Paragraph 41 of the commentary differentiates between Article 12A which does not apply to payments made by individual for services for personal use. Such exclusion does not apply for Article 12B as the commentary acknowledges that a significant chunk of digital services is consumed by individuals for their personal use. Having said that, it does acknowledge the practical challenges if individuals are required to comply with withholding tax obligations.
Article 12A does not offer the option of ‘’net basis’’ taxation and only has a ‘’gross basis’’ mechanism whereas the proposed Article 12B offers both options.
- Simplified approach when compared with OECD proposals.
- No complex calculation mechanism.
- Exhaustive definition of ‘’automated digital services’’ already provided.
However, one should not forget that these conventions are only suggestive and not binding and, therefore, countries may tinker with the definition based on their respective self-interest.
- Only broad level digital services covered under the ambit. Fails to appreciate the rapid pace of technological advancement and underlying change in business models.
- No minimum threshold prescribed for revenue, profitability, etc.
- Substantiating that the recipient of income itself is the beneficial owner in order to claim the benefit under paragraph 3 (Net Basis Taxation) remains a concern as the concept of beneficial ownership is already a matter of debate all around the tax world.
- Incorporating it only in the model tax convention will not serve the desired purpose unless it also provides a mechanism to amend the plethora of existing tax treaties. It could be done through a multilateral instrument similar to BEPS Action Plan 15.
- Ensuring fair collection under the ‘’net basis’’ mechanism could be a challenge.
- Considering consolidated financial statements in computing qualified profits would be a challenge due to different accounting years followed by different countries.
While the UN’s latest proposal to deal with digital businesses is certainly a bold move, whether it will actually settle the dust or instead spread more dust, will be interesting to see.
The question that arises with the UN significantly departing from the OECD’s view is whether the so-called consensus-based approach is really something which one should look forward to, especially when international organizations like the UN and the OECD themselves are miles apart in their approach. Where is the so-called consensus?
Is the (dis)united nations’ pursuit through OECD/G-20 to reach a consensus (i.e. taxing digital businesses) with different ideologies a dream far from reality? We will wait and see.
Karnik Gulati is a Tax and Regulatory Consultant at Coinmen Consultants LLP in India. He is also a member of the International Taxation Committee of the Bombay Chartered Accountants’ Society. The author may be contacted at: email@example.com or firstname.lastname@example.org
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