Taxation Of The Digital Economy
The rise of the digital economy over the past few decades has transformed the way we carry out business; from the way transactions are carried out all through to the type of commodity being sold. By way of example, a multinational company based in Seattle, Washington (a state in the United States of America) can now merchant goods to people in Kenya. This is the case of Amazon.com, Inc and the company has been described as “one of the most influential economic and cultural forces in the world, as well as the world’s most valuable brand”.
Amazon is the largest internet company by revenue in the world (with a revenue of approximately $ 280.5 B in 2019) and is the largest online marketplace, AI assistant provider, live-streaming platform and cloud computing platform. Yet the company has come under fire over the fact that it has employed various tax credits and deductions to reduce its tax obligations. It has also been reputed for seeking huge tax incentives worth billions of dollars as part of its search for a second headquarters in 2018. Such practices by multinational enterprises (MNEs) like Amazon can also be applied to avoid taxes in other jurisdictions/countries. This is one of the rationales for the G20/OECD BEPS project which is currently leading global efforts to respond to the problems of base erosion and profit shifting similar to the case of Amazon.
The major observable feature of the evolving digital economy is the rise of a few, very large global digital platforms that have demonstrated innovative manipulation of digital technology, and have data-centric business models. Both their high market valuations, and the speed at which global digital companies have attained high capitalizations attest to the new value associated with being able to transform digital data into digital intelligence. Subsequently, investors are betting on the disruption and reorganization of whole economic sectors, such as retail, transport and accommodation, or health, education and agriculture, which, they believe, will enable the generation of high profits in the future.
As a result, the market dynamics of the digital economy are characteristic of monopolistic trends; reinforcing market positions through acquisition of, and copying competitors; expansion of digital MNEs into new sectors such as retail, transport, accommodation, education, and health, among others; as well as asymmetric information as a result of controlling massive amounts of user information. Further, given their need for market dominance, such MNEs are known to partake lobbying activities to influence policymaking as well.
This poses a threat to the developing world, especially Africa, where cutting-edge digital technologies are not as prevalent as in the developed world, and there is still a need for many developing countries to develop their technological capabilities.
Such market dynamics create opportunity to exacerbate inequality between the developed and developing worlds. This is because, with the continuous rise of digitalisation, the use of digital technologies in various sectors of the economy will no longer offer businesses an edge to the competition, as is the case now, but all business and sectors will be required to digitalise. In such a scenario, the principal elements of the digital economy that seek to ensure the dominance of certain tech giants may suffocate the growth/rise of upcoming digital platforms from the developing world. Moreover, the practice of MNEs exploiting gaps and mismatches in tax laws and countries’ tax systems to avoid paying taxes, as in the case of Amazon above, may affect developing countries, who have higher reliance on corporate income tax, and as a result end up losing out on potential tax revenues.
One of the biggest problems identified by the BEPS project in regard to taxation of the digital economy is the ‘traditional’ approach to taxation that establishes a tax obligation in different jurisdictions based on a permanent establishment or a nexus. This standard cannot be maintained with regard to the digital platforms because of the inherent nature of the digital economy.
Given that digital platforms rely heavily on intangible assets, which are difficult to value and measure, they can easily move them around from higher tax jurisdictions to lower tax jurisdictions to avoid paying their fair share of taxes. Another problem is the lack of clarity on where value is produced; whereas Amazon is a US-based company and the intellectual property associated with it is from the US, it is worth noting that Amazon is reported to have over 150 million paid prime members globally and over 300 million active customer accounts worldwide who create value for the company through network effects and user data. This shows that there is a disconnect between where value is created and where taxes are paid.
As a result, there is an emerging consensus that the existing approach to international corporate tax based on creating a nexus is lagging behind the digital economy, and therefore the first Action Point of the BEPS project is to address the tax challenges arising from digitalisation. The Action Point seeks to establish appropriate ways to tax digital platforms in light of digitalisation, which has enabled many economic activities to take place online without the need of a physical presence.
While this may be a concern for all countries at any level of development, it may be even more relevant for developing countries such as Kenya due to their greater need for domestic resource mobilization (DRM) for development, as well as the lower capacity of their tax administrations to collect taxes. They also have less bargaining power against powerful digital platforms who now partake in lobbying and policy influencing. Moreover, most developing countries do not physically host digital platforms, though they often contribute significantly to user-generated value as markets for digital platforms.
Development and Domestic Resource Mobilisation (DRM)
The Sustainable Development Goals (SDGs) were adopted in the 2015 to pick up from where the Millennium Development Goals (MDGs) left off, while also setting ambitious goals that target economic growth and social development for poverty eradication, with consideration of environmental protection. However, the financing needed to achieve the post-2015 development agenda is extremely large with the Intergovernmental Committee of Experts on Sustainable Development Financing in 2014 estimating that providing a social safety net to eradicate extreme poverty globally would cost roughly US$66 billion a year, whereas improving infrastructure to protect the environment could cost as much as US$7 trillion a year.
The SDG Agenda has shifted the focus of sustainable development from relying solely on Official Development Assistance (ODA) and necessitated the development of a new financing framework. Through the Addis Ababa Action Agenda (AAAA) for Financing and Development, all participating countries in the 2015-post development agenda acknowledge and seek to address all sources of finance for sustainable development (public and private, domestic and international). As a result, Domestic Resource Mobilization (DRM) has been identified as a key source of funding development, especially for the developing world; development that is not only specific to the SDGs but all-encompassing to other development agenda such as the Agenda 2063 in Africa.
Even while DRM has been made a core priority for sustainable development, domestic revenues in the developing world, where needs are most pronounced, still fall short of what is needed to support a more robust development agenda.
A look into the case of Kenya shows that the revenue performance for FY 2018/19 reflected a revenue shortfall of KSh 123.5 B. Similarly, in the succeeding FY 2019/20, there was a revenue shortfall of KSh 131.2 B due to the impact of the COVID-19 pandemic on tax revenues in the country. Moreover, the Budget Review and Outlook Paper, 2020 noted that the pandemic will not only worsen the revenue performance for the FY 2019/20 but will also affect revenue performance in the FY 2020/21.
And while COVID-19 has affected Kenya’s revenue collection efforts, it also continues to reaffirm the need for countries like Kenya to strengthen DRM for their development agendas given that most donor countries have now started to reprioritize their aid efforts. One of the opportunities countries like Kenya have to explore in order to improve DRM, especially in light of the pandemic, is tap into the wealth created by the digital disruption.
While there is an agreement on the need to reform the current tax regime to make the system fairer, there is less consensus over how best to tax global digital platforms. Even though the OECD, through the efforts of the inclusive framework, represents significant progress made in reaching a global consensus to taxing the digital economy, there are concerns that it has not managed to fully address the problem given that digital MNEs still continue to shift profits to low-tax jurisdictions using transfer pricing mechanisms.
Further, despite the inclusive framework being comprised of over 135 countries, developing countries may have little influence on how the tax reforms are developed. This is because such digital tech giants (who are against the tax reforms geared to tax the digital economy) have apportioned their resources to cover lobbying and policy influencing within their governments, who already have high bargaining powers within such foras (unlike countries from the developing world). Therefore, this means that if Kenya would like to advocate for the taxation of digital tech companies, the USA which is home to the Big Five tech companies, and one of the G20 members could easily influence the multinational decision to benefit itself and its residents.
This has been the actual case with trying to reach a multilateral consensus on taxing the digital economy, whereby since January 2019, the inclusive framework has been seeking to reach a long-term consensus but close to 2 years later, member states are still to reach an agreement on the digital service tax. As a result, numerous countries have decided to implement unilateral measures to tax the digital economy including Austria, France, Italy, Spain, the UK, Malaysia, Singapore and India. African countries that have opted to impose some form of digital tax include Kenya, Uganda, Tanzania, Zambia, Nigeria and Ghana.
For the Case of Kenya, the government amended the Income Tax Act (ITA) through the 2019 Finance Act to levy income tax on income accruing through a “digital marketplace” which took effect from November 2019. The 2020 Finance Act further expanded Kenya’s taxation of the digital economy by introducing the Kenyan digital services tax (Kenyan DST) which will take effect from 1 January 2021 at a rate of 1.5% of the gross transaction value payable by a person who derives income from services offered on the digital market place. In addition to the DST, Kenya will also collect a VAT on the supplies of digital services to consumers in Kenya.
However, unilateral DSTs have been criticized as not being an optimal solution as they can lead to increased complexity and uncertainty. For instance, the key observable limitations to the Kenyan DST include: how the tax will be collected in practice given that it is on the basis of voluntary compliance; whether users will be sufficiently and reliably identified; and whether the threat of restriction of access to the digital marketplace upon non-compliance will have an impact. It is also unclear how these new rules will affect business in Kenya as there is no revenue threshold, and all suppliers will be forced to account for this tax on gross transaction value. This further feeds into concerns about the costs of the DST being passed on from suppliers to customers.
While the Kenyan DST and the associated VAT rules have potential to enhance revenue performance in the country, we urge the government and various policy makers to be keen on improving the design of the DST so as to ensure that the tax does not reduce economic activity by cutting the number of active internet users, and thus become counterproductive.
Furthermore, it is important to keep in mind one the principles of public finance management as outlined under Article 201 of the Constitution of Kenya; that public money shall be used in a prudent and a responsible way. So that even as the Kenyan Government pursues enhanced revenue streams, they should ensure that financial management shall be responsible and that there shall be openness and accountability in financial matters; also described within Article 201.
Naomi Majale is a Project Officer at National Taxpayers Association.