The question of how the increasingly digital economy will be taxed is under discussion by revenue authorities, multinational entities and advisory bodies alike around the world. There is no consensus on how this will be done — not even at the level of the Organisation for Economic Co-operation and Development (OECD), which is trying to lead global discussion on this subject.
What is critically important for South Africa is that business and regulators grapple with now with the tax evolution to position the country as best as possible for a new tax era.
Traditionally, discussions about who pays tax and where have been based on two models: residence taxation and source taxation. The former holds that people and companies should contribute to the public services provided for them by the country where they reside and that this tax applies to all their income, no matter where it comes from. The latter holds that the country providing the opportunity to generate income or profits should have the right to levy tax.
Both of these models are well understood when they relate to physical goods and services. But in the realm of digital services, it is more complex. Digital services often result in consumers in one country receiving a product or service without the supplier of that product or service being physically present in the country.
For example, anti-virus software. Where previously you would have gone to a computer store to buy a CD to install the software to your computer, now you can download the program online, directly from the software company. Whereas before you were paying value-added tax (VAT) on the item purchased in-store, now you are not paying any tax in South Africa.
Many regulators, including those in South Africa, are implementing rules to prevent losing out on tax revenue. With effect from April 1, the minister of finance has, through promulgating a regulation prescribing VAT on electronic services, caused the scope of what is considered an electronic service to be significantly broadened.
Electronic services are now defined as “any services supplied by means of an electronic agent, electronic communication or the internet for any consideration”. Foreign suppliers of electronic services to South African recipients will be required to register as VAT vendors if they meet certain requirements. This will increase the administrative burden on foreign companies and could also have the effect of increasing the final price that consumers will pay for these services.
Effect on transfer pricing
Given that about 60% of global trade takes place within multinationals, transfer pricing is another area that will be affected by evolving tax rules relating to digital services.
Transfer pricing involves the prices charged, or profits earned, by members of large multinationals for goods and services exchanged between the entities that make up the company. For example, an automotive company based in Europe might manufacture components in various countries, and distribute its vehicles through local subsidiaries globally. These companies might drive sales through their own marketing initiatives or by developing sales channels. Transfer pricing principles govern how all transactions between these companies in the group are accounted for, and how profit is distributed, depending on the value created by each entity.
Transfer pricing generally operates on the basis that profits should be taxed in the countries where value has been created. The question that arises is: To what extent is value created in the country where the electronic product or service is consumed? For example, if travellers are booking hotel rooms using an online service such as Booking.com or Airbnb, where is the value created? Is it in the country where the online service is based, the country where it runs the bulk of its operations, or the countries where the hotel rooms are physically based?
In March 2017, the G20 finance ministers mandated the OECD to prepare an interim report on the digital economy. This report was delivered in March last year and it identified three specific characteristics of the digital economy, namely that it produces “scale without mass”, has “a heavy reliance on intangible assets” and there is an important role of “data and user participation” in creating value.
In February, the OECD released a report, Addressing the Tax Challenges of the Digitalisation of the Economy. In March it held a public consultation in Paris on possible solutions to the tax problems facing the digital economy.
The public consultation was attended by revenue authorities, corporates, nongovernmental organisations and other stakeholders. Whereas there was consensus that changes needed to be made to the way that digital transactions were taxed, views regarding how this should happen and the timing of the changes differed considerably.
The OECD will develop a plan for further work on the digital economy. This will be presented to the G20 finance ministers in June. The final consensus set of outcomes is expected to be finalised by the end of 2020. South Africa, as a member of the G20 and an observer of the OECD, is likely to consider the final proposals made.
The outcomes of the OECD plan will potentially affect all multinationals operating in the digital economy. It is, therefore, imperative that relevant stakeholders contribute to the discussion. This includes taxpayers and tax authorities.
For example, the value of digital services provided into African countries is generally greater than the value of digital services provided out of African countries. Accordingly, there may be a tendency for countries in Africa to seek to use this G20/OECD project to implement protectionist measures.
But countries in Africa that are seeking to increase their services economies and encourage local companies to provide services to recipients in other countries should consider how potential proposals may affect these companies.
Revenue and other authorities need to take a proactive approach in discussions on this issue, and to ask the key questions: How do we identify digital transactions; how do we determine value; how do we tax these transactions and how do we encourage the growth of the digital economy in South Africa?
Businesses should identify how their digital strategy will be affected by different countries’ regulations (regarding VAT, income tax and transfer pricing) and track and plan for the developments in the territories in which they operate. There are opportunities to be had, too — digitalisation can help South African businesses to enter new markets and achieve higher levels of growth and profitability than previously available.
Beyond that, business needs to find ways to take advantage of digitalisation — to do things better and smarter. Old methodologies may no longer work. Businesses need to consider themselves as technology businesses. The internet of things is changing entire value chains and companies need to get a handle on this or risk losing relevance.
Michael Hewson is a director at Graphene Economics, an African transfer pricing advisory firm