By Andrea Laura Riccardi Sacchi
This blog is part II of a series which reflect the author’s participation at the International Centre for Tax and Development (ICTD) conference: Global Tax Governance at a Crossroads, 5 to 7 June 2023, Nairobi, Kenya. The opinions expressed hereby are of the author’s and do not necessarily reflect the position of the institutions to which she is affiliated.
In the first part of this blog post the author started sharing how Latin America has been reacting in general to the taxation of (digital) services, highlighting key aspects of Latin American countries’ tax systems that underpin said response and describing the few, but eventually inspiring unilateral measures introduced at the national level in Peru, Uruguay, Paraguay and Colombia[1] to specifically capture profits from digital businesses.
The measures that were adopted may not be perfect but have proven to be feasible solutions. Notwithstanding, as it is argued, the big disadvantage of these measures may consist of the risk of double or multiple taxation as probably a unilateral or treaty-agreed tax credit or exemption applied by the jurisdiction of residence of the foreign provider may not apply.
However, double or multiple taxation should not be a problem per se, but the total tax burden is what seems to really matter.[2] In this sense, source countries may perfectly apply, without creating an issue of excessive taxation, either a reduced tax rate on gross income that results from taking into account a presumptive taxable net amount of domestic source profits, or the general tax rate but on a deemed amount of domestic source taxable profit (ideally based on the average profit margin of the specific business and the consideration of factors existing at source). Such rules, which allocate income to a jurisdiction even if the recipient is not resident or has a PE in the country, have been normal practice in Latin America for decades. As seen in the first part of this blog post, while in the Paraguayan case the effective tax burden on digital services of 4.5% may seem reasonable, in the Peruvian case the effective source tax rate of 30% on gross income may lead to excessive taxation.
Additionally, the measures adopted have arguably increased tax certainty. In contrast, countries that have decided to neither modify existing regulations nor introduce new income tax legislation targeting digital services, may have been interpreting extensively those existing provisions which were clearly designed for a “brick and mortar” economy, bringing sometimes great and undesired uncertainty.
Implications of the UN and OECD initiatives and next steps
Considering what has been previously presented, the UN initiative on Article 12B on automated digital services seem to be more in line with Latin American tax systems. Indeed, the UN initiative consists of introducing a provision to bilateral tax treaties that allows the exercise of taxing rights at source in the absence of a PE by incorporating a specific distributive rule for income derived from automated digital services. For this purpose, it adopts a sourcing rule based on the criterion of the jurisdiction of residence of the payor.
The key question to be posed in relation to Article 12B may be whether the developed world would agree on introducing such a measure into bilateral treaties. Probably the US (home country of many digital businesses) would not, but other countries which have already introduced DSTs or similar measures or are planning to do so, may be willing to substitute those for an equivalent tax burden imposed via an income tax measure, and therefore, accept the introduction of a provision based on Article 12B into tax treaties.[3] Eventually, the US may join if competition disadvantages and risks of corporate inversions start to arise.
Having said this, it is interesting to know (and useful for the current assessment) that there already exists a “kind of” Article 12B provision in two of the seven tax treaties in force in Peru (a country that has been taxing certain digital services since 2004), in the context of Article 12 on royalties. Both, the tax treaty with Brazil, signed in 2006[4], and the tax treaty with Switzerland signed in 2012[5], establish that the definition of royalties includes payments received from the rendering of digital services (with a limitation at source of 15% and 10%, respectively).
Additionally, in response to some critics to Article 12B in relation to the difficulties derived from the collection of the tax in the case of B2C transactions, it is important to highlight that, for instance, in Uruguay foreign providers are already remitting directly their income tax via a simplified registration and compliance process. Furthermore, synergies with VAT may be seized. Indeed, OECD International VAT/GST guidelines recommend that “the most effective and efficient approach to ensure the appropriate collection of VAT on cross-border business-to-consumer supplies is to require the non-resident supplier to register and account for the VAT in the jurisdiction of taxation”.
Eventually, the introduction of a SEP test for taxing digital services would also be a feasible alternative for the taxation of digital services, though, in the author’s view, a more complex one and not as broad as Article 12B, since it implies the introduction of a threshold.
When it comes to complexity and reduced scope in respect to digital services providers, the Amount A mechanism designed under the so-called Pillar One of the IF two-pillar solution -whose scope, after the US Biden administration proposal, goes beyond covering digital businesses, but covers only the biggest and most profitable multinational groups- would represent in the author’s view a magnificent challenge for developing countries, including the Latin American region.
Indeed, being a halfway solution, said extreme complexity derives from the coexistence of the new multilateral rules of Amount A with existing national tax systems and bilateral rules that do not necessarily reflect OECD standards. And complexity usually leads to uncertainty.
For this coexistence three elements of the design of Amount A are of particular relevance.
The first element is the commitment to withdraw and not to implement DSTs and similar unilateral measures in the future on all companies. As per the last pubic consultation document issued by the Secretariat in January this year, the measures introduced by Latin American countries would not qualify as measures that must be withdrawn or not adopted in the future, since they are part of their income tax systems and, therefore, respect the tax treaty commitments assumed. In effect, said document foresees that “the term ‘digital services tax or relevant similar measure’ shall mean any tax imposed, however described, if it meets all of the following criteria…
- the application of such tax, or the amount of tax imposed, is determined primarily by reference to the location of customers or users, or other similar market-based criteria;
- such tax either: i. is applicable by its terms solely to persons that: 1. are not residents… or 2. are primarily owned, directly or indirectly, by non-residents (“foreign-owned businesses”); or ii. is applicable in practice exclusively or almost exclusively to non-residents or foreign-owned…; and
- such tax is not treated as an income tax under the domestic law…, or is otherwise treated… as outside the scope of any agreements… that are in force between the… [jurisdiction] and one or more other jurisdictions for the avoidance of double taxation with respect to taxes on income”.
Since Latin American national measures were introduced as part of the countries’ income tax systems, and the criteria are cumulative, criteria c seems to be conclusive. Then it will depend on each country what to do, this is, to remove the adopted measures or to maintain them. As per the limited scope of Amount A (the largest and more profitable digital business will be amongst those approx. 100 total businesses in scope), the second alternative seem to be preferable. Indeed, while for in- scope digital businesses the multilateral convention implementing Amount A may rule out the coexistence of the new mechanism with national measures, for those out of scope, national measures may bring the desired tax certainty on the treatment of digitalised businesses.
The two other relevant elements for the abovementioned coexistence are (i) the mechanism for the elimination of double taxation due to Amount A, since Amount A has been presented as a redistribution of taxing rights in respect to existing international tax standards, and (ii) the so-called – and in the author’s view confusing – “marketing and distribution safe harbour” which may limit the portion of Amount A being reallocated to market jurisdictions.
Though the consideration of how the exercise of taxing rights at source beyond OECD standards (measures which also do not distinguish between routine and residual profits) impacts the design of the Amount A mechanism is of upmost importance[6], the discussion on this matter was ignored when the IF agreed on the October 2021 statement.
Indeed, the alleged “Amount A allocation of taxing rights to the developing world”, may only be reached in a scenario where a tax treaty based on the OECD tax standards exists, already limiting source taxation. However, this may not be the case where a tax treaty does not apply and developing countries are already unilaterally exercising taxing rights at source beyond the existence of a local entity or a permanent establishment of a non-resident.
Until Amount A design is not 100% finished, countries may find it difficult to conclude on the real implications of the implementation of the novel multilateral mechanism. It is no news that the OECD time schedule is very tight, however, in the author’s opinion, rushing should not be an option for jurisdictions, including Latin America, which should take informed decisions and consciously analyse – without feeling pressured – the alternatives for next steps.
[1] Subnational measures will not be addressed in this blog post.
[2] “In the international setting, taxation of a given activity by various governments is similarly unobjectionable provided that such taxes are coordinated to give an appropriate total burden”; Musgrave, R.A. & Musgrave, P.B., “Inter-nation equity”, in Bird, R.M. y Head, J.G. (Eds.): Modern Fiscal Issue, Essays in honour of Carl S. Shoup, University of Toronto Press, Toronto, 1972.
[3] Of course, some limitation may arise, for example, resigning to tax digital advertising services where the “eyeballs” are.
[4] In force since 2010, its Protocol establishes that the definition of royalties not only applies to every payment for technical services and technical assistance but to “digital and business services, including consultancies”.
[5] In force since 2015, it establishes that the term royalties include payments received from the rendering of technical assistance services and digital services.
[6] The author has been making claims in this respect since May 2021. For a comprehensive analysis the reader can access the following series of blog posts: El “eslabón perdido” en el diseño del Pilar 1 del Marco Inclusivo sobre BEPS de la OCDE/G20 – TAXLATAM, El “acuerdo global” en materia de imposición a la renta empresarial transfronteriza – TAXLATAM, La búsqueda de una solución global en materia del impuesto a la renta societaria: El verdadero problema – TAXLATAM, El futuro del reparto internacional de los derechos de imposición sobre la renta empresarial – TAXLATAM).